Keep INVESTING Simple and Safe (KISS)
****Investment Philosophy, Strategy and various Valuation Methods****
The same forces that bring risk into investing in the stock market also make possible the large gains many investors enjoy. It’s true that the fluctuations in the market make for losses as well as gains but if you have a proven strategy and stick with it over the long term you will be a winner!****Warren Buffett: Rule No. 1 - Never lose money. Rule No. 2 - Never forget Rule No. 1.
Carol Loomis of Fortune has a new article out saying that Warren Buffett's valuation metric says it's time to buy stocks. I decided to compare Warren Buffett's stock valuation metric with Robert Shiller's. They both compare nicely. Warren Buffett's stock valuation metric: Total stock market value as a percent of GNP. Yale economist Robert Shiller's stock valuation metric, based on Benjamin Graham's advice in Security Analysis: S&P 500 10-year price/earnings ratios.
Robert Shiller doesn't compare the S&P 500 only to its current year earnings. Instead, he compares it to the average of the past ten years, adjusted for inflation. This way, he avoids getting fooled when single-year corporate earnings rise and fall with the business cycle. Although Warren Buffett's and Robert Shiller's valuation methods are entirely different, they both seem to track each other fairly nicely. Knowing what happened in 1929, however, it looks like Robert Shiller's valuation method is slightly better than Warren Buffett's.
Comparator analysis (sometimes called comparison company analysis) is a relative valuation approach. For $IBM we looked at four peer companies – Accenture ($ACN), HP ($HPQ), Microsoft ($MSFT) and Oracle ($ORCL). We calculated enterprise values – market capitalisation plus net debt (long-term borrowings less cash). Then we measured a range of metrics against the enterprise value for $IBM and the peer set.
We have used the last financial year (LFY) as the base set of metrics. $IBM has not yet released the 2008 LFY profitability (EBIT and EBITDA) and free cash flow results. For this analysis we have used the 2008 revenue numbers with the 2007 profitability and free cash flow margins. The highlighted column links our DCF valuation to the current market valuation.
$IBM is currently trading in the middle to the upper-end of the valuation metrics of the peer group. Our DCF valuation places a value on $IBM well above where the market is currently valuing the company and the peer group. Reviewing our assumptions we remain comfortable with our valuation. Using the DCF valuation approach we believe that $IBM is trading at a discount to intrinsic value. The market is definitely voting negative – but in the long-run we believe $IBM represents value at current prices.
Precision Auto Care is a network of franchised and company-owned auto repair and tuning shops. The company has over 380 service facilities in 8 different countries including China and the Middle East. Recently, Precision Auto Care recently “went dark” and stopped filing with the SEC in order to reduce the costs in complying with Sarbanes-Oxley. With the majority of stock held by company management, the lack of free floating stock and virtually no analyst coverage, Precision Auto Care has almost entirely disappeared off the investment radar.
Financial information for Precision Auto Care.
Historical share price of Precision Auto Care.
As you can clearly see, the market has rewarded the improving balance sheet, revenue and earnings of Precision Auto Care by cutting the company’s share price by over 80%. The price now suggests that the company not only is there no chance of growth, but also that there probably isn’t a future for Precision. Given the recession, large cash position, reasonable business prospects and solid revenue; it does seem that there is a degree of overreaction in the share price movement.
Is the firm in a cyclical industry (such as commodities or automobiles) or a stable industry (such as breakfast cereal or beer)? Because the cash flows of cyclical firms are much tougher to forecast than stable firms, their level of risk increases.
Without knowing what a stock is worth- in other words its Intrinsic Value- how can you know how much you should pay for it? Stocks should be purchased because they are trading at some discount to their intrinsic value, not simply because they are priced at a higher or lower point than similar companies.
The big drawback of the ratios discussed in the Stock Valuation Basics section is that they are all based on price - they compare what investors are currently paying for one stock to what they are paying for another stock. Ratios do not, however, tell you anything about value, which is what a stock is actually worth. Comparing ratios across companies and across time can help us understand whether our valuation estimate is close to or far from the mark, but estimating the intrinsic value of a company gives us a better target.
Pat Dorsey, Director of Stock Analysis, Morningstar Inc. in his very useful book - The 5 Rules for Successful Stock Investing - tells us how we can go about calculating what a stock is really worth- in other words, its Intrinsic Value. His writings are the primary source for this article.
Having an intrinsic value estimate keeps you focused on the value of the business, rather than a piece of the stock - and that's what you want because, as an investor, you are buying a small piece of a business. Intrinsic valuation also forces you to think about the cash flows that a business is generating today and the cash it could generate in the future, as well as the returns on the capital that the firm creates. It makes you ask yourself, "If I could buy the whole company, what would I pay?
Second, having an intrinsic value gives you a stronger basis for making investment decisions. Without looking at the true determinants of value, such as cash flow and return on capital, we have no way of assessing whether a P/E of, for example 15 or 20 is too low, too high, or right on target. After all, the company with the P/E of 20 might have much lower capital needs and a less risky business than the company with the P/E of 15, in which case it might actually be the better investment.
Cash Flow, Present Value, and Discount Rates
What is a stock worth? Economists Irving Fisher and John Burr Williams answered this question for us more than 60 years ago. The value of a stock is equal to the present value of its future cash flows. No more and no less.
Companies create economic value by investing capital and generating a return. Some of that return pays operating expenses, some get re-invested in the business, and the rest is free cash flow. Remember we care about the free cash flow because that's the amount of money that could be taken out of the business each year without harming its operations. A firm could use free cash flow to benefit shareholders in a number of ways. It can pay a dividend, which essentially converts a portion of each investor's interest in the firm to cash. It can buy back stock, which reduces the number of shares outstanding and thus increases the percentage ownership of each shareholder. Or, the firm can retain the free cash flow and re-invest it in the business.
These free cash flows are what give the firm its investment value. A present value calculation simply adjusts those future cash flows to reflect the fact that money we plan to receive in the future is worth less than money we receive today.
Why are future cash flows worth less than the current ones? First, money that we receive today can be invested to generate some kind of return, whereas we cant invest future cash flows until we receive them. This is the time value of money. Second, there is a chance that we may never receive those future cash flows, and we need to be compensated for that risk, called the risk premium.
The time value of money is essentially the opportunity cost of receiving money in the future versus receiving it today, and is often represented by the interest rates being paid on government bonds. Its pretty certain that the government will be around to pay us our interest in a few years.
Of course, not many cash flows are as certain as those from the government, so we need to take an additional premium to compensate us for the risk that we may never receive the money we have been promised. Add the government bond rate to the risk premium, and we have what's known as a discount rate.
Now you can start to see why stocks with stable, predictable earnings often have such high valuations - investors discount their future cash flows at a lower rate, because they believe that there's a lower risk attached to the likelihood that those future cash flows will actually show up. Conversely a business with an extremely uncertain future should logically have a lower valuation because there is a substantial risk that the potential future cash flows will never materialise.
You can see why a rational investor should be willing to pay more for a company that's profitable now relative to one that promises profitability only at some point in the future. Not only does the latter carry a higher risk (and thus a higher discount rate), but the promised cash flows won't arrive until some years in the future, diminishing their value still further.
Changing discount rates and the timing of cash flows can have a telling effect on present value. In all three examples, below -StableCorp, CycliCorp, and RiskCorp -the sum of the undiscounted cash flows is about $32000.
However, the value of the discounted cash flows is quite different from company to company. In present value terms, CycliCorp is worth about $2700 less than StableCorp. That's because StableCorp is more predictable, which means that investors' discount rate isn't high. CycliCorp's cash flow increases by 20 percent some years and shrinks in some years, so investors perceive it as a riskier investment and use a higher discount rate when they are valuing its shares. As a result the present value of the discounted cash flows is lower.
The difference in the present value of the cash flows is even more acute when you look at RiskCorp, which is worth almost $8300 less than StableCorp. Not only are the bulk of RiskCorp's cash flows far off in the future, bu also, we are less certain that they will come to pass, so we assign an even higher discount rate.
This is the basic principle behind a discounted cash flow model. Value is determined by the amount, timing, and riskiness of a firm's future cash flows, and these are the three items you should always be thinking about when deciding how much to pay for a stock. That's all it really boils down to.
Calculating Present Value
To find the present value of a $100 future cash flow, divide that future cash flow by 1.0 plus the discount rate. Using a 10% discount rate, for example, a cash flow of $100 one year in teh future is worth $100/1.10. or $90.91. A $100 cash flow two years in the future is worth $100/(1.10x1.10), or $82.64. In other words, $82.64 invested at 10% becomes $90.91 in a year and $100 in 2 years. Discount rates are really just interest rates that go backwards through time instead of forwards.
Generalising the previous formula, if we represent the discount rate as R, the present value of a future cash flow (CF) in year N equals
Fun with discount rates
Now that we have the formula down, we need to figure out what factors determine discount rates for use in Intrinsic Value calculations. How do we know whether to use 7 percent or 10 percent?
Unfortunately, there is no precise way to calculate the exact discount rate that you should use in discounted cash flow (DCF) model, and academicians have filled entire journals with nothing but discussions on the right way to estimate discount rates for Intrinsic value calculations.
Here's what you want to know for practical purposes. As interest rates rise, so will discount rates. As a firm's risk level increases, so will its discount rate. Let's put these two together. For interest rates you can use the long-term average of treasury rates as a reasonable proxy. (Remember we use interest rate on treasuries to represent opportunity costs because we are pretty certain that the government will pay us our promised interest).
Now for risk, which is an even less exact factor to measure. Here are some factors that should be taken into account when estimating discount rates.
Smaller firms are generally riskier than larger firms because they're more vulnerable to adverse events. They also usually have less diversified product lines and customer bases.
Firms with more debt are generally riskier than firms with less debt because they have a higher proportion of fixed expenses (debt payments) relative to other expenses. Earnings will be better in good times, but worse in bad times, with an increased risk of financial distress. Look at a firm's debt-to-equity ration, interest coverage, and a few other factors to determine the degree of a company's risk from financial leverage.
Is the firm in a cyclical industry (such as commodities or automobiles) or a stable industry (such as breakfast cereal or beer)? Because the cash flows of cyclical firms are much tougher to forecast than stable firms, their level of risk increases.
This factor boils down to a simple question: How much do you trust the folks running the shop? Although its rarely black or white, firms with promotional managers (who leave no opportunity to drum up stock prices through their media appearances), managers who draw egregious salaries, or who exhibit any of the other red flags are definitely riskier than companies with managers who do not display these traits.
Does the firm have a wide moat, a narrow moat, or no economic moat? The stronger a firm's competitive advantage -that is, the wider its moat- the more likely it will be able to keep competitors at bay and generate a reliable stream of cash flows.
The essence of risk is uncertainty. And its tough to value what you can't see. Firms with extremely complex businesses or financial structures are riskier than simple, easy-to-understand firms because there's a greater chance that something unpleasant is hiding in a footnote that you missed. Even if you think management is as honest as the day is long and that the firm does a great job running its operations, its wise to incorporate a complexity discount into your mental assessment of risk.
How should you incorporate all of these risk factors into a discount rate? There is no right answer.
Morningstar uses 10.5 percent as the discount rate for an average company based on the above factors and creates a distribution of discount rates based on whether firms are riskier or less risky than the average. A so mid-2003, firms such as Johnson and Johnson, Colgate and Wal-Mart fall at the bottom of the range at around 9 percent, whereas riskier firms such as Micron technology, JetBlue Airways, and E*Trade -top out at 13 percent to 15 percent.
The key is to pick a discount rate you are comfortable with. Don't worry about being exact -just think about whether the company you are evaluating is riskier or less risky than the average firm, along with how much riskier or less risky it is, and you will be fine.
Discount rates for the Indian market context
In the Indian market context we may use 15% as the discount rate for an average company (8 percent risk-free rate + 7 percent risk-premium). High-Quality companies may be discounted at a low rate of 12%, above-average companies at 13%, and poor quality companies may be discounted at a high of 18%.
Calculating Perpetuity Values
We have cash flow estimates, and we have a discount rate. We need one more element called a perpetuity value. We need a perpetuity because it's not feasible to project a company's future cash flows out to infinity, year-by-year, and because companies have theoritically finite lives.
The most common way to calculate a perpetuity is to take the last cash flow (CF) that you estimate, increase it by the rate at which you expect it to grow over the very long term (g), and divide the result by the discount rate (R) minus the expected long-term growth rate.
The result of this calculation than must be discounted back to present, using the method discussed for calculating present value. For example, suppose we are using a 10-year DCF model for a company with an 11 percent discount rate. We estimate that the company’s cash flow in year 10 will be $1 billion and its cash flow will grow at a steady 3 percent annual rate after that. (Three percent is generally a good number to use as your long-run growth rate because it’s roughly the U.S. gross domestic product [GDP] growth. If you are valuing a firm in a declining industry, you might use 2 percent).
Perpetuity Value = $ 1 billion x (1+ 0.03) / (0.11-0.03)
= $ 1.03 billion/ 0.08
= $ 12.88 billion
To get the present value of these cash flows, we need to discount them using the formula
where n is the number of years in the future, CFn is the cash flow in year n, and R is the discount rate. Plugging these numbers, N = 10, CFn = $12.88 billion, R= 0.11
Now all that we need to do is add this discounted perpetuity value to the discounted value of our estimated cash flows in years 1 through 10, and divide by the number of shares outstanding. That was a brief outline of the process. You can follow along by matching the following steps:
1. Estimate free cash flows for the next 4 quarters. This amount will depend on all of the factors discussed earlier -how fast the company is growing, the strength of its competitors, its capital needs, and so on. Using Clorox as an example, our first step is to see how fast free cash flow has grown over the past decade, which turns out to be 9% when we do the math. We could just increase the $600 million in free cash flow that Clorox generated in 2003 by 9 percent, but that would assume the future would be as rosy as in the past. Mega retailers like Wal-Mart -which now accounts for almost a quarter of Clorox sales -has hurt the bargaining power of consumer-product firms. So, let's be conservative and assume free cash flow increases by only 5 percent over the last year, which would work out to $630 million.
2. Estimate how fast you think free cash flow will grow over the next 5 to 10 years. Remember, only firms with very strong competitive advantages and low capital needs are able to sustain above-average growth rates for very long. If the firm is cyclical don't forget to throw in some bad years. We won't do this for Clorox because selling bleach and Glad bags is a very stable business. We will however be conservative on our growth rate because of the "Wal-Mart factor", and will assume free cash flow increases at 5 percent annually over the next decade.
3. Estimate a discount rate. Financially Clorox is rock-solid, with little debt, tons of free cash flow, and a non-cyclical business. So we will use 9% for our discount rate, which is meaningfully lower than the 10.5 percent average we discussed earlier. Clorox, is a predictable company, after all.
4. Estimate a long-run growth rate. Because people will still need bleach and trash bags in the future, and its a good bet that Clorox will continue to get a piece of that market, we can use the long-run GDP average of 3 percent.
5. That's it! We discount the first 10 years of cash flows, add that value to the present value of the perpetuity, and divide by the shares outstanding.
This is a very simple DCF model. The one used at Morningstar has about a dozen excel tabs, adjusts for complicated items such as pensions and operating leases, and explicitly models competitive advantage periods, among many other things. But a model doesn't need to be super complex to get you most of the way there and help you clarify your thinking.
The important thing is that we forced ourselves to think through these kinds of issues as discussed earlier, which we wouldn't have if we had just looked at Clorox's stock chart or if we had just said, "Sixteen times earnings seem reasonable". By thinking about the business, we arrived at a better valuation in which we have more confidence.
Valuing Clorox using a Discounted Cash Flow model
Margin of Safety
We have analysed a company, we have valued it - now we need to know when to buy it. If you really want to succeed as an investor, you should seek to buy companies at a discount to your estimate of their intrinsic value. Any valuation and any analysis is subject to error, and we can minimise the effect of these errors by buying stocks only at a significant discount to our estimated intrinsic value. This discount is called the Margin of Safety, a term first popularised by investing great Benjamin Graham.
Here is how it works. Let's say we think Clorox's intrinsic value is $54, and the stock is trading at $45. If we buy the stock and we're exactly right about our analysis, the return we receive should be the difference between $45 and $54 (20 percent) plus the discount rate of about 9 percent. That would be 29 percent, which is a pretty darn good return, all things considered.
But what if we are wrong? What if Clorox grows even more slowly than we had anticipated -may be a competitor takes market share - or the firm's pricing power erodes faster than we had thought? If that's the case, then Clorox's intrinsic value might actually be $40, which means we would have overpaid for the stock by buying it at $45.
Having a margin of safety is like an insurance policy that helps prevent us from overpaying - it mitigates the damage caused by overoptimistic estimates. If, for example, we had required a margin of safety of 20 percent before buying Clorox, we wouldn't have purchased the stock until it fell to $43. In that case, even if our initial analysis had been wrong and the fair value had really been $40, the damage to our portfolio wouldn't have been as severe.
Because all stocks aren't created equal, not all margins of safety should be the same. It's much easier to forecast the cash flows of, for example, Anheuser-Busch over the next 5 years than the cash flows of Boeing. One company has tons of pricing power, dominant market share, and relatively stable demand, whereas the other has relatively little pricing power, equal market share, and highly cyclical demand. Because I am less confident about my forecasts for Boeing, I'll want a larger margin of safety before I buy the shares. There's simply a greater chance that something might go wrong, and that my forecasts will be too optimistic.
Paying more for better businesses makes sense, within reason. The price you pay for a stock should be closely tied to the quality of the company, and great businesses are worth buying at smaller discounts to intrinsic value. Why? Because high-quality businesses - those that have wide economic moats - are more likely to increase in value over time, and it's better to pay fair price for a great business than a great price for a fair business.
How large should your margin of safety be? It ranges all the way from just 20 percent for very stable firms with wide economic moats to 60 percent for high-risk stocks with no competitive advantages. For above-average firms we would require a 25 percent margin of safety, while on average, we require a 30 percent to 40 percent margin of safety for most firms.
Having a margin of safety is critical to being a disciplined investor because it acknowledges that as humans, we are flawed. Simply investing in the stock market requires some degree of optimism about the future, which is one of the biggest reasons that buyers of stocks are too optimistic far more often than they're too pessimistic. Once we know this, we can correct for it by requiring a margin of safety for all of our share purchases.
Every approach to equity investing has its own warts. Being disciplined about valuation may mean that you will miss out on some great opportunities because some companies wind up performing better for longer periods of time than almost anyone could have anticipated. Companies such as Microsoft looked very pricey back in their heyday, and its unlikely that many investors who were very strict about valuation would have bought it early in their corporate lives.
Being disciplined about valuation would have meant missing those opportunities, but it also would have kept you out of many investments that were priced like Microsoft, but which wound up disappointing investors in a big way. Although we acknowledge that some high-potential companies are worth a leap of faith and a high valuation, on balance, we think its better to miss a solid investment because you are too cautious in your initial valuation than it is to buy stocks at prices that turn out to be too high.
After all, the real cost of losing money is much worse than the opportunity cost of missing out on gains. that's why the price you pay is just as important as the company you buy.
In this article you will find information about what is margin of safety, decide which methods to use and various methods to derive safety margin for each stock.
You will also find information about how safety margin relates to intrinsic value and why 52-weeks historical data is important.
What is Margin of Safety
It was first introduced by Benjamin Graham and David Dodd in 1934. It is basically the difference between the intrinsic value and the stock price. The objective is to determine whether the stock price worth its valuation.
It able to protect stock investors from inaccurate decision making or unexpected downturn in the market. As it is impossible to determine the true value of the company, this safety margin allow investment decision to be made with limited downside.
There are so many methods in determining company’s fair value from margin of safety principle. Here I list the simple ones that are easy and convenient, but as workable as those methods that are complicated. In any case, nobody knows exactly what the company worth for.
How to Determine Margin of Safety
First Method: Discounting the intrinsic value
This is simply discounting the calculated intrinsic value. You can use any discount rate, but 20 to 30 per cent works fine with me.
For example, you find that the intrinsic value for stock GE is $50 and are currently traded at $38. After applying 20 per cent discount, the fair value is $40 (20 per cent discount from $50).
So, current price at $38 is still lower than the discounted intrinsic value. In this case, it is safe for me to buy the stock today.
While Warren Buffet likes to invest in companys that is 50 per cent discounted intrinsic value, Mason Hawkins at Longleaf Partners says his group looks for businesses trading at 60% or less of intrinsic value.
So it is up to you how much you are comfortable with.
Second Method: Comparing with 52-weeks historical prices
To do this, you need to first calculate the difference between 52-week high and low prices, then multiply it with 40 per cent. Then add back to the 52-week low price.
For example, for the last 52-weeks, GE was traded between $32 and $39.5. The difference between 52-week high and low prices is $7.5 ($39.5-$32) and 40 per cent of the difference is $3. Its fair value will be $35 ($32+$3). In this case, as the stock price is still higher than the fair value, it is still not safe to buy it today.
Decide Which Methods to Use
How can the first method makes the current price safe to buy but not with the second method?This is not weird. If this happens, it is either:
you are too optimist with the its EPSGR (result to high future value and high intrinsic value),
you are expecting very low ROI (result to very high intrinsic value), or
the stock price is too high from it latest profits announcement etc (more gap between its fair value to current stock price.
The best is, use both and choose whichever is lower. Other than these two methods, I used the third method as well.
It known as sensitivity study. It is not as easy calculation as before, but sort of complementing those two methods.
The revolution began when Daniel Kahneman noticed how explanations of changes in task performance were based on a mental model that had little to do with actual behaviour.
Airforce flight instructors believed that praising students after a good flight and criticising them after a bad one led to worse performance in the first case and better in the second. But Kahneman theorised that this was simply mean regression in action – that regardless of what the instructors said or did, a poor performance was likely to be followed by a better one and a good performance by a worse one.
This observation kicked off a whole range of discoveries, with ramifications that investors cannot afford to ignore.
In particular, that mean regression might be the underlying principle behind stock movements is an idea that’s been around for over a century – but it hasn’t prevented billions of pounds being made by analysts, gurus, tipsheets, advisersand the whole panoply of apparently omniscient soothsayers that inhabit the securities industry and charge for saying otherwise.
Tversky and Kahneman’s big idea means that this is all an utterly pointless waste of money. Most short-term market movements are simple mean regression in action. It’s only human mental confusion that attributes these random movements to some kind of underlying purpose.
You don’t think like you think you think
As they dug through a series of remarkable experiments, Tversky and Kahneman began to uncover a previously unresearched series of behavioural biases – strange twists in human nature that cause us to act irrationally and against our own interests.
In essence what they showed was that people don’t act rationally, as defined by correctly calculating the probabilities of events, especially rare ones.
Now you may not think that surprising. After all, we don’t spend our days carefully calculating risks and rewards.
Yet this was exactly the dominant approach of economics at the time – the so-called Efficient Markets Hypothesis, which argues that all information about a stock at any given time is embedded in a single value, the price.
Instead, Kahnemann and Tversky showed that there are regular patterns of irrationality that lie behind people’s behaviour:
We judge people based on stereotypes.
We assess the likelihood of events happening based on our ability to retrieve from memory similar events.
We tend to make decisions based on some arbitrary starting point.
Labeled in turn the representative heuristic, the availability bias andanchoring, these three behaviours do a pretty good job of derailing our attempts to rationalise about investments.
Next came Prospect Theory (1979) – the first attempt at an explanation for the strange asymmetric risk taking behaviour they’d observed.
As other researchers followed up on this research, a whole raft of added behavioural twitches came to light. We are, quite simply, a mass of contradictory and illogical behaviours, to the point where it’s a wonder we can get out of bed in the morning, let alone be trusted with a kettle and a gas hob.
But there’s another twist in the history of behavioural finance, which is that the uncovering of this unsuspected mental world of confusion has begun to bother some researchers.
They agree that we’re essentially highly-evolved apes with an instinct for survival honed in a very different environment. But they wonder how it’s possible to reconcile the contradictions discovered by psychologists in a way that means we can function at all.
The answer, it seems, is that behavioural finance may also be wrong, although in some very peculiar ways.
Their evidence comes from taking experiments out of the laboratory and into the real world, and also by trying to explain human behaviour using an integrated theory of mental processing that doesn’t look anything like the statistical analyses so beloved of financial researchers.
The economist John List, for example, has been described as the most hated man in economics, largely on account of how his real-world experiments have unpicked a range of the most cherished theories in finance.
List has shown that outside the laboratory people aren’t altruistic in the way they are inside it, and that loss aversion – the idea that people are symmetrically inclined to avoid taking a loss but happy to take a profit based on some arbitrary purchasing anchor point – is not a general psychological principle.
List’s main point that if you put people in a lab experiment they’ll behave the way you expect them to, not the way they’d do naturally (whatever that may be).
You don’t think like they thought you think, either
A second front on behavioural finance has opened up around the way that we actually process information.
Although behavioural finance is superficially very different from the old Efficient Markets approach, underlying it is a similar model of the way that we make decisions, suggesting we perform abstract statistical calculations. Behavioural finance says it’s just that in the behavioural models we get the answers wrong.
But some researchers are now arguing this is a mistaken view of the human brain, and that we do something much simpler, which yields similar results, using an idea known as satisficing.
Satisficing is simply an approach that means we take the best answer we can come up with, given the range of information we have available to us.
Bizarrely the satisficing theories suggests that while a certain amount of information about a certain topic will lead us to improved solutions, beyond this point our decision making accuracy goes down!
If true, it again means there’s a limit to the effectiveness of stock analysis – although that’s still no excuse for simply sticking pins into the price pages of theFinancial Times.
Get your head examined
Scientific advance happens one funeral at a time, and resistance to the suggestion that behavioural finance is flawed is fierce. Progress happens only when someone finds a big enough pair of boots to kick down the old barriers.
That’s what Kahneman and Tversky started back in the 1970s, and the former’s Nobel Prize is unlikely to be the last time a psychologist wins the Economics prize.
Investors, meanwhile, should avoid wasting their money on hopeless explanations of future market movements. And if they can’t, perhaps they should go see a shrink instead?
I recently wrote a post on the importance of adding passive income to your income stream. Passive income can make your life a whole lot easier by increasing the amount of money that you earn and decreasing your dependency on your work income. A passive income stream can even shave years off your active working years until retirement. Today, I would like to take a look at a couple of strategies for generating passive income. Remember, passive income is money you make even when you’re sleeping and not doing anything. Some people like to think of freelance work as “passive income.” That’s not true, it would be considered an alternative stream of income, not passive income. These ideas are ones that will be making you money even when you’re not doing anything:
1. Dividend Investing
One of the easiest ways to generate passive income is by investing in high yielding dividend paying stocks. You can buy high yielding stocks like Verizon or AT&T which are currently paying almost 7% in dividends. Real estate investment trusts (REIT) are also great income producing investments. REIT’s are required by law to pay out 90% of their earnings back to shareholders. REIT’s like Hatteras Financial are yielding nearly 15%.
2. Rental Properties
It was quite popular to buy a property and rent one out during the early 2000s. Many property speculators left the market after the real estate market tanked in 2007. Now is a great time to invest in a rental property. With federal regulators tightening up lending regulations, it will be difficult for potential homebuyers to obtain financing for a home. The real estate market will be overrun with individuals looking to rent a house in the future. The rental payments will be a nice income stream for the shrewd investor.
You can earn royalties for life off of any creative work that you develop. If you are a skilled writer, write a book or a play. Submit your finished work to a publisher or sell it independently. If you are a great singer then you can record a CD. You can market it to a major label or sell it yourself online. Once you have finished your masterpiece, you can collect your royalties. Royalty payments are typically based on sales volume. Remember to obtain a copyright or patent on your work. This entitles you to receive residual income for years into the future.
Using the internet as a means for making money has grown dramatically since the 90s. Starting an ecommerce business is not the only way to make online anymore. You can create a website and get paid by ad companies. Advertisers are always looking for new sites to market their products and are willing to pay large sums to do it. You can register with Google Adsense, Yahoo Publisher, Commission Junction, and WidgetBucks. You can either go the route of selling a product on a website or creating an information-based website. This could be considered not passive if you’re actively running the website, maintaining it, and writing content. But, if you hire someone else to manage it, then it could be something that you benefit from in a passive way.
5. Limited Partnerships
A limited partnership is a partnership in which one or more of the partners is a limited partner. Limited partners have limited liability and no input in the day to day operations of the partnership. All income is deemed as passive since limited partners are not actively involved in the management of the partnership. Limited partnerships often require an initial investment in order to participate in the partnership’s profit sharing structure. One of the most popular limited partnerships is a master limited partnership (MLP). MLP’s are publicly traded limited partnerships that pay out quarterly distributions to investors.
Which of these five forms of passive income do you think is the right one for you? Do you have any other good ideas when it comes to ways to generate passive income streams?
Investing IN Retirement Is Different Than Investing FOR Retirement
Written by Jim Yih
I just got back from speaking to a group of industry professionals (Registered Deposit Brokers Association –RDBA) about how investing IN retirement is different than investing FOR retirement.
I think investing FOR retirement is a well-covered topic. This makes sense because the majority of Canadians are still not retired and still planning for retirement. Most of the articles and books and magazines are geared to investing FOR retirement but there is not as much on the topic of investing IN retirement.
I think things are about to change! Investing IN retirement is going to become a bigger and bigger deal – a huge deal! It will represent the future because of a group of people known as the Baby Boomers. The baby boomers have changed social and economic patterns ever since the day they were born. The first wave of baby boomers turned 60 in 2006. For the next 15 years, all the boomers are getting ready to retire and they will begin to bring massive changes to the field of retirement and investment planning. It’s already started.
Investing IN retirement is different
Retirement is a time when we begin to shift our thinking from saving to spending. That’s not always easy to do, especially for good savers. I’ve always said that it’s difficult for savers to become spenders overnight just like it’s tough for spenders to become savers overnight. Habits are tough to break – both the good habits and the bad habits. Retirees who do not spend their money in retirement can also lead to unintentional outcomes such as a dying with too much money. Many retirees don’t realize that higher returns can sometimes mean more tax in the future. Their focus should be shifted to estate planning.
That means we would shift our investment mindset from growth to income. Instead of growing capital we would be looking to preserve or even spend capital. Although higher returns on investments is the goal of every investor, regardless of what stage of life they are in, I would argue that through the course of retirement, returns become less important than other issues like simplicity of managing money, control over income, personal health, and quality of life become more important. Investors, who place too much emphasis on return and little or no emphasis on risk of loss, can get hurt when the market changes.
In retirement, portfolios should move from pre-authorized chequing plans (PACs) (where funds are transferred from personal accounts to investments accounts) to Systematic Withdrawal Plans (SWPs) (where the opposite happens cash flow comes to your operating account from your investments on a planned basis). To achieve this, there should also be a shift in thinking about the need for higher returns in order to manage risk. This is a critical change to be aware of because the math that once worked for you with dollar cost averaging now works against you.
The bottom line is there is a difference between pre-retirement investing and post retirement investing. As a result, retirees need to re-evaluate their investment portfolios the closer they get to retirement. I suggest that people who are three to 5 years from retirement need to get serious about it and start making sure their portfolios are positioned so there are in control over their retirement plans. Sometimes this period has been labeled the retirement risk zone. If pre-retirees don’t take the time to review their portfolio prior to retirement, they may join the thousands of people who have delayed, cut back or gone back to work in their retirement.