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All right, folks, welcome to Investing for Beginners podcast. This is Episode 156 tonight, Andrew and I are going to take a few moments, answer some listener questions. We’ve got another great batch of them this weekend. So we wanted to take a little bit of time to answer those for you guys on the air. So I’m going to go ahead and read the first question, and then I’ll throw it over to Andrew, and then we’ll do a little give and take. So first I have, hi Andrew. I’ve been listening to your archived podcast for the last few weeks, and I like what I hear. Long story short. I’m coming late to the party. I’m 61, and some inherited stocks and mutual funds for my parents. I’ve just let them sit and ride for the past couple of decades. And they’ve done very well. This COVID market crash got me interested in investing in some value stocks that have hit bottoms through no fault of their own. I’ve already made some small missteps and what to avoid more. My question is, at my age, is it too late to realize much profit from drip? I’m in good health, but logically we’ll need to rely on savings and portfolio balances within ten years. Thanks, Diana. Andrew, what are your thoughts on her question?
Well, I think it’s a question that’s impossible to answer. We don’t know what percentage of the money is in stocks versus mutual funds versus, you know, how much is there in cash. I think maybe we can put ourselves in, in the footsteps of maybe let’s take two different scenarios. This is not professional advice or anything, but you know, how would I react now? So maybe firstly, how would I react if I had, let’s say, I don’t know. I don’t know what the numbers are. Let’s say a $500,000 and stocks and mutual funds. And let’s say that that’s supposed to fund my retirement and I’m going to retire in 10 years in a situation like that. I think generally anybody who knows about personal finance has learned about it, been educated. They’ll generally tell you the closer you get to retirement, the more you want money in bonds versus stocks.
And the reason for that’s very simple, the stock market has gone up for a very long time, and over the very long term, it’s gone up for a very long time. And the reason for that is because there are very few things in the world, like a public corporation and businesses and the ability for businesses and people inside of businesses to grow businesses, to create more cash flows and serve more customers. And there’s nothing like that. And so as condominiums have grown and as businesses have grown, then you’ve seen growth in the stock market as well. Now the problem with the stock market is that it fluctuates from year to year and it’s not a nice fluctuation. You can have times like we just saw in March where the market drops 20, 25%. You can see the market drop as much as 50% in the year, back in the great depression, that dropped 80%.
So, you know, these things, they’re not the exception, they are kind of part of the game. And so when we realized that yes, over a long enough period, the stock market, as it’s done historically since the early 19 hundreds, it’s returned about 10% a year, if you’ve reinvested your dividends also known as a drip. And so that’s been the case, but there have also been huge swings. And the key to earning those returns over the very longterm is you have a ride those periods when stocks go down and when stocks go up, now, the closer you have to retirement, the less time you have to ride out and you sort of let’s call it a hiccup because basically if you, I don’t want to get too deep into the economics, but as economies expand, stocks tend to go up and as colonies, contract stocks tend to go down.
But as long as you believe in businesses and you believe in the ability to recover, even something as bad as the great depression, the stock market has been able to recover from the United States have been able to recover from. And that has continued to cruise much, much higher and produce more dividends and more returns for investors over the long term through those tough periods. So obviously the COVID crash has been a very trying time for many investors, many companies, and that’s not to say it’s time to sell immediately. Still, when you get closer to retirement, it’s a good time to look and make sure that any sort of huge, you have to think what will happen to my portfolio if the market crash 50% tomorrow, because that’s if you look at the history of the stock market, things like that have happened before.
And so if you’re not conservatively allocated between stocks and bonds, that could become a problem. And you don’t want that to impede on enjoying retirement. One of the things that I guess I think about when I think about this, this topic is you know, I’m kind of right in there with you Diana, I’m 53. So I’m, I’m on the borderline with you as well. And I guess I have a little bit farther to go. One of the things I think about as I’ve been learning more about the stock market and investing and retirement and, and a lot of the things that go into all this, one of the facts that remains is that we’re all living longer than we used to. And we’re living longer than our parents did and they’re living; they lived longer than their parents did. So when you’re saying you’re going to retire in 10 years, that means you’ll be 71 when you retire.
If, if all that’s accurate and there’s a good chance, you’ll probably have another 15 to 20 years after you retire. And so I think some of the rules are going to change a little bit as we get older. And as we live longer, because if we were tired, when we’re 65 and we lived in 95, this is 30 years, you have to have for income or some sort of money to get you from point a to point B. And just because we are quote-unquote late to the party, I don’t think it means that you completely abandoned some of the ideas I agree with Andrew. And, I agree that moving up a portion of your portfolio as you get closer to bonds is a smart thing to do simply for the fact of the extreme volatility that you can see. Nothing would suck more, more than to get to the doorstep of retirement and then have something happen.
Like what happened in March and have 30 to 50% of your portfolio drop. And now you’re like, Oh, what do I do? You know, it’s recovered quite a bit since then, but who knows what’s going to happen over the next three months to a year? It could jump all over the place. I mean, my portfolio went from 16% up to 10% down in three days. So nobody knows what’s going to happen. But I think if I were you and the dripping is I think the right way to go always. And any income that you can earn it, regardless of how close or how far away you are from retirement, is going to be that much more revenue or income. You don’t need farther down the road. So even if it’s accruing and it doesn’t mean that you can’t take part of that portfolio as well, and keep dropping that even going into retirement and continuing that past when you’re retired because that can help grow your wealth, provides you more income as we get closer to the end of our time here and not to be more of it. Still, there’s a little bit of kind of what we’re talking about.
And so I think for me; personally, that’s going to be, my plan is as I get closer to retirement, I will convert some of my portfolios into a bigger mixture of bonds just to have that safety and to have that income that I’m going to get from the bonds, even though it won’t be as much as, you know, a particular stock or stocks would be, it’s still a safety net, and it’s still a safe safety return. You’re still earning income on the bonds, and you can turn that into things that you can use to pay for stuff. And then part of my portfolio, I’m still going to keep in stocks and still dripping them and trying to use those dividends and all the things that Andrew and I talk about as another way to help me generate more revenue and more income as I go farther into retirement. And that’s, that’s kind of my plan. So I hope that helps answer your question, but I guess that was kind of my thought.
I think there’s value to, and you know, if you have a portfolio and you’re looking at maybe reduce it a little bit, trying to figure out which stocks would be the best drippers and which maybe there are some that just got up high in price, and they’re very, very overvalued. Maybe their feature isn’t as bright as another stock. I’d probably keep either, probably hold on to the stock. That’s either giving me a good deal now or that I perceive to continue to be able to grow this dividend for years and to be able to compound that longer. So maybe you, you draw down and narrow down into the best drip stocks in your portfolio, whatever that looks like. I mean, we don’t know. And I think I don’t hear social security being talked a lot when people talk about retirement these days. And so that’s a factor too, you know, the factor that into a budget. And, you know, maybe that allows you to leave more money in the market because you know that at least you have some safety net.
Yeah. That’s a very good point. I neglected to mention social security. So that’s, that’s a good catch by Andrew that’s, that’s a very important thing that he’s right. A lot of people don’t talk about that. And I, I admit, I, I, I did not either. I didn’t think of that either, but yeah, that’s income that at least our generation will get, you know, who knows what will happen with that in the future, but for sure our generation will be able to get it. So that’s something you should plan on.
Yeah. We’ll let that one slide, Dave.
Yeah. All right. The next question. Hi, Andrew and Dave. My name is Brian. I’ve been a listener for about a year, and I’ve learned a lot from your content. So first of all, thanks. Well, thank you. I recently rolled over funds from an employee retirement accounts or Roth in my ally account; about 16,000 half was a 401k the other half in a Roth 401k. Okay. The market has seen a significant rally as of late, and there are still a lot of unknowns with the coronavirus and its future economic impacts. He says I’m trying to decide whether I should immediately invest that 16,000 or spread it out over eight to 10 months, similar to your thoughts on receiving an inheritance or other lump sum to dollar cost average and leave the remaining amount as cash in the account. He says I worry that this rally is a little bit of false hope, and things are going to retract a bit regardless of my players for the longterm. My ultimate goal is to buy good businesses with dividends that will do well for the next 20 to 30 years. I’m 32 years old, and I hope to retire by age 60. Anyhow, I appreciate your thoughts. Thanks so much.
I think I, well, here’s what I think. I think he’s on the right track. He was talking to think about dollar-cost averaging. And I, I think that that’s probably, I would, that’s what I would do is dollar-cost average into the companies that you think are going to grow your wealth over the long term, dividend buyers are companies that are going to be paying that dividend over the next 20 or 30 years. And as you buy by those companies, you’re going to; you’re going to see the ups and downs. You just are, but as you dollar cost average, you’re going to reduce that ratio of what you’re paying for it versus what it’s worth. And eventually, it’ll get to the point where it’ll grow beyond that. And then you’ll be sitting pretty with it when the market is so fluid. Like it is right now, trying to time it as kind of a fool’s errand. And if you find a company that you like, just try to buy into it regularly, the stats have shown over years, that if you dollar cost average with a company that the company over time will do well, just because you are reducing that cost basis of what you’re initially buying it for.
And I’ll give you a quick example. There was a company that I bought recently, right before the coronavirus hit, and I bought it for $34 a share fast forward about a month, month and a half later, it dropped a $14 a share. So my first thought was, Oh, but my second thought was, Oh my God, it’s still a great company. And Holy crap, that’s cheap. So I bought some more $14 a share, which dropped my cost basis of the company from 34 bucks to share to about $20 a share. And then about a month later, it was still trading below $20. So I bought some more let’s drop my dollar cost, average my cost basis down even more so now it’s back up to around 20, $22 a share. So it’s a little bit above where I, where it’s by cost basis is, but I’m still making money on it.
And as the economy recovers and things that maybe not go back to normal, who knows if that’ll ever what normal or be. But I think as the economy starts to get better, this company will improve over time because the closing of stores only impacted it. The product that they sell is still in demand. People are still going to want it, and they’re doing a good job of selling it online, albeit slower than if people are walking into the stores, but it’s still going to recover. And my point with all this is, is that because I was able to use dollar-cost averaging to lower my cost basis on the stock, as it recovers over the next five, ten years, I’m going to do very well with that company. And I’m confident that I’m going to do well with that company. And so those are the kinds of advantages that you could see when you do something like a dollar-cost average. The trick is to find companies that you think are going to be successful, and Andrew has a great system and a great e-letter that can help you with that. You can listen to all the things that we talk about to help you find good stocks. So there’s, there’s a lot of great resources out there to help you do those things. But I personally, that’s where I would go, but I guess I’d be curious to hear what Andrew’s thoughts are with that.
Yeah, I mean, I generally agree. I think that dollar-cost averaging example is perfect when I first learned about it and got excited about it, that was exact, the exact best the words are, are elusive here. Still, it was the best way to buy low and sell high just naturally from the way it’s designed. And so you, what you saw, there was a perfect example of being able to buy low and being able to buy more when it’s lower, that lowers the cost basis. It raises your return over the long term by lowering that cost basis. And so, you know, one thing when I mentioned having a lot of money to invest and spreading it out and looking at the very, very longterm, this is something that I did with, I think it was like 20 grand or something where I spread it out over ten months and not something I’ve talked about a lot in the archives of our show. Still, I don’t think I’ve ever hammered down on; not only is it help you with the market timing aspect.
The fact of the matter is, is you’re not going to find eight to 10 to 20 great stock ideas. You’re not going to find that in one month and, you know, I might have, let’s call it 10, 12-grade ideas. And some of them are still in my portfolio, right. But a lot of them are good ideas anymore because they’ve gone up. And so, you know, as different stocks become too expensive, then they’re not good ideas anymore. And so if you’re trying to find all the best cheap stocks all at once, and then just deploying all of that capital now, I think you’re going to have a basket of pretty bad businesses, or, you know, if it’s like, if you’re doing it exactly right now, where the coronavirus has hammered all of these businesses, then you’re betting a hundred percent full stop on a complete recovery. So not only does dollar-cost averaging a large sum help you spread out that market timing part of the equation, but it also helps you, it buys you some time to find some of the best stock ideas, and that buys you some time to let other businesses also drop in price so you can pick those up. And so you’re just making the best out of the next eight to 10 months, rather than taking the best out of what’s there right now in one month. And that could or could not a great investment for your money.
Now, that is a great answer. That’s an excellent point. And, I wholeheartedly agree with what Andrew is saying. Warren Buffet talks all the time about having a punch card. And every time you find a great idea or great stock, you punch the card and that you limit yourself to 20 punches for the rest of your life. And I kind of agree with that. I think the more you get into this, the more it is; it’s hard to find that one or two great ideas every month, let alone every year. And so I agree with what he was saying. I think if you can find one or two a month, that’s going to be great. And by a little bit, by a little bit, just kind of just keep grinding, grinding away. My grandma used to have the saying that I always thought was kind of appropriate. Even water, even water dripping on stolen events. So that makes oppression. So dollar-cost averaging is not sexy, but over time it will, it will benefit you.
Moving on. The next question we have is hi, Andrew. I am a longtime listener from Sydney, Australia, many thanks to Dave and yourself for the price of information. I have a question concerning the return on equity. I read that whatever stock return must be compared to the S&P example if stock ABC returns 5%, but the S and P return 8%, then your investment did not outperform the market. How exactly is the stock return calculated? Is it through return on equity? If not, how exactly does one interpret this? The term stock ABC returned X percent over ten years? Well, formerly is used to figure this out. I hope the question makes sense and would love to hear both of your takes on this. Thanks a lot, Dylan. All right, Andrew, what are your thoughts on his question?
Yeah. So let Me give an example. So if you have a hundred dollars, you have a hundred dollars stock, and it goes up to $110, and so 110 is so 10% of a hundred is 10. And if you’re adding it to a hundred, you get $110, which is how much your stock has gone up. So basically, if your stock started at a hundred and that grew by $10, that’s 10% of a hundred and outside 110. And so that’s how that calculation works. I’ll give you another example just to hopefully hammer it home. Say, say I have a $20 stock and it Rose 10%. So 10% of the 20 is $2. So that means it runs by $2. So the stock went from 20 to $22. And so that, that’s just the calculation. That’s a simple way to do it; you can take the price that the stock is at now, and then you divide it by the price that the stock used to be at. And then you minus one, and that’ll give you a decimal, which is the percent, and that’s your percent return. So, as an example, again, if we took the $22, you divide that by 20, and then you subtract that by one, you’re going to get a 0.1, which is 10%. And so it’s, it’s a completely different thing than the return on equity. And maybe Dave can briefly summarize the return on equity and what that is.
Sure, absolutely. I could do that. So for those of you unfamiliar with return on equity basically what it is is it’s you take that after-tax income or the earnings of a company and you, and that’s a comparison to the shareholder equity, which is found on the balance sheet and what return on equity tells us is how much money is the company earning from the equity that’s the company owns. So if you have a return on equity of 10%, that means that for every dollar that the company earns, they’re earning a penny from that dollar and, or I’m sorry, back that up. So for every dollar of equity, they’re earning 10 cents. So the return on equity, the higher that number is more money than the company’s earnings from the equity that the company owns. And it’s not necessarily; it’s not connected to the return of the stock. It’s more about the efficiency of the company being able to use their equity or their assets to create more money for the company. So does that make sense?
Yeah, I guess I understand the confusion now because you know, stocks are also called equities. And so that kind of makes sense, right? Return on equity. But when they’re talking about return on equity, it’s the return on shareholders’ equity, which is just like the net worth of a company. So if a company has like 200 million in cash and a hundred million in debt, they have, I got to pick better numbers for this. I, because if I’m using, if I have two numbers anyway if they have 250 million in cash and a hundred, 130 million in debt, then 120 million would be their shareholders’ equity, basically their net worth. And so you would, you would want to calculate return on equity based on that. Right. A lot of investors use return on equity, and it can be a great way to figure out how efficient a company is. And I don’t know. I mean, I don’t know if there’s much like hard data or research on like higher return on equity stocks historically. I have led to higher growth, but I think conceptually, it makes sense that it would be easier to grow if you don’t need as much capital essentially to grow. And I know there’s been an example of that. Coca Cola is a perfect example of a high return on equity business. One of Warren Buffett’s best stocks he’s ever bought, and there was the very high return on equity back in the late eighties and then in the nineties. Such stocks like that tend to do well if the return on equity is high and if they can sustain that.
Yeah, I would, I would agree with that. And when you think about some of those kinds of calculations return on equity return on assets, those are more internal measurements. So they’re more comparing how efficient the company is in creating income from, as Andrew was saying the assets or the equity that they already own themselves, it’s not necessarily compared to the stock price of the company. It’s more related to how efficient the businesses that are taking a set asset are set equity and making money from those things. And generally, the higher the number, the better industry-wide, they’re going to be different averages for the different industries. Tech-related things generally are going to have higher returns on equity. Things like banks are going to have a lower return on equities and say Applewood. Still, they’ll also have a much lower return on assets simply based on how the businesses are set up, but the calculations themselves are fairly easy to perform.
And you just basically take the net income for return and equity. You just take the net income from the income statement, divided by the average common stockholder equity. So you take one year and another year, you add those stockholder equities together divided by two. That gives you the average for two years, and you divide that by the net income, and that will give you the return on equity. So it’s an easy formula to calculate. And it also gives you kind of a quick, easy way to determine how efficient the company is with their income and their generation of money for them and us in the longterm.
And he wrote a blog post with that too. And you nicely laid out a bunch of average return on equities for various industries. So if that kind of floats your boat, I think going to the website and putting the search bar in there, putting in average Roe you’ll, you’ll see that our, the code from Dave is good. It’s a good breakdown and gives you a lot of context on those kinds of ratios.
All right, folks. Well, that is going to wrap up our conversation for this evening. I wanted to thank everybody for taking the time to write us those questions. Those were great. And you guys keep coming up with some fantastic questions cause Andrew, and I had a chance to stretch a little bit and hopefully help you guys out a little bit. So please keep sending them, and we’ll do our best to get back to you and answer them as best we can. So without any further ado, I’m going to go ahead and sign this out. You guys go out there and invest with a margin of safety emphasis on the safety, have a great week, and we’ll talk to you all next.
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