One of the scariest things about investing is buying a stock at the absolute wrong time. Guess what? Timing the market wrong doesn’t matter that much. What is much more important is the time in the market. You read about all the stock market millionaires. Or billionaires. Guess what they all in common? It’s time in the market, not when they purchased the stock. Or at what price. So timing the market wrong really doesn’t matter.
Welcome to the show notes for Investing for Beginners. In today’s session, we answered questions from Braden. A beginning investor from Canada. He had some really great questions for us today. And the focus of the show was on several subjects. First being dollar cost averaging. This is a great investment idea that can help smooth out your returns. And help get you started in the circumstance that you don’t have a lot of money to start with. Fun fact. If you invest in a 401k through work. You already do this!
Next focus item was valuation metrics. These are the numbers that are used to help determine the value of a company. Numbers can be scary for people. But Andrew does a great job of explaining how they work. His ebook helps lay this out. In a very easy to understand way.
- Fees associated with dollar cost averaging and how to minimize them with this strategy
- DIY brokerages moving to free ETF trades and will bigger brokerages offer this as a way to keep their customers
- Explain in more detail the metrics P/E, P/B, P/S, and D/E and what are good standards for these numbers?
- Talk about the importance of putting your money in the market
- Recommendations for options using stocks that pay a dividend but it isn’t enough to buy a full share.
- How to utilize DRIP compounding
I have to say that the quality of questions that we have been receiving is awesome. They have been insightful, thoughtful and probing. Certainly not what you would expect from beginners. They have made us think and delve deep into our answers to help make sure that we cover all aspects of their questions.
So let’s take a look at the Q/A.
Fees associated with dollar cost averaging. How to mitigate those fees with this strategy?
Andrew: First a few questions for you. What are the commission fees? The fees are lower because I use them through my local bank here in Canada and it is $7 a trade. Braden is looking at an annual rebalance on his retirement account. As well as maxing out his individual retirement account using the dollar cost averaging strategy.
The reason for these questions is so that I can get a sense of how much money we are talking about. The amount of money that we contribute will have a bearing on how much of percentage the strategy takes out of our investments.
I will start by talking about my eletter portfolio that I follow and I have my readers follow. It is something that I prescribe to and have a big chunk of my life savings in. This puts in $150 a month and I am trying to show that the average person can do it with a small amount and make it great.
I pay $4.95 a trade and with a $150 investment I am losing out on about 2 to 3 percent, which is not ideal because that is a year’s worth of dividend payments. But for something that is such a long-term outlook and a lot of the positions I have recently closed have been gains much higher than 10 to 20 percent so that 3 percent bump doesn’t hurt me that badly. And because I am much younger. I have a longer time horizon so I can see the length of the investment canceling out the fee of the investment.
Braden is able to max out his retirement account in Canada which has a limit of $5500 a year. And if he breaks that up into a twelve-month investment outlook. And trades in 6 or 7 positions a month he is looking at a substantial amount of money in trade fees.
Is there an advantage to dollar cost averaging that would outweigh the costs of the fees?
Andrew: In the sense that you are not trying to time the market because a downside to putting it all in at once. Let’s say you look at putting it in at the beginning of the year as opposed to spreading it out over the whole year. If you do that you are basically betting on the fact that maybe this month will be the cheapest it will be.
Let’s say that over the next six months the market continues to go down and invested it all right now. Then your portfolio would be in a much worse position as opposed to if you stepped it in.
Because as it goes lower you are able to buy more shares. The whole idea of it gives you naturally the whole buy-low and sell-high strategy. Because as the market goes up you are buying fewer shares. And if the market is going down you are buying more shares. It will be the same dollar amount, which is why they call it dollar cost averaging. But you are going to get more or fewer shares depending on how the market moves during those twelve months.
Dave: One of the advantages of this strategy is that it is a long-term strategy and it is not something that you are going to do in-and-out, in and out. It is meant to work to your advantage over a long period of time.
I look at it the same way that Andrew does but instead of every month I add to my positions or buy new ones every quarter. And I do this as a way to take away the pain of the fees. This seems to work for me.
Plus I have a smaller portfolio of ten or so companies and I will look at adding to those positions depending on the price at that time or how the companies are doing.
Andrew: I did some math, so if you divide $5500 by 12 months that will come out to $450 a month and if you add to 6 to 7 positions a month you are looking at a very significant transaction fee cost that I would most likely not do. I would look at putting in one position per month at that amount. You would be looking at roughly 10 percent a month in fees which is prohibitive.
With new DIY brokerage accounts moving to free ETF trading. Is it worth switching over to these brokerages and do you see larger firms moving to this free ETF trades to try to retain their business?
Andrew: It is an interesting question and in the world of podcasting and new media of investing blogs a lot of us are aware of ETFs and to use we look at them the same way you look at an individual stock or mutual fund. A lot of us know that ETFs have a lot of great benefits compared to mutual funds because of the low fees compared to active management fees of a mutual fund.
That said, I saw the other day some research that said of people’s assets invested in their retirement accounts only 5% is invested in ETFs. So I think the trend can only go up from here.
I think as the trend towards ETFs continues to pick up steam you will see more large brokerages move towards free trading of these ETFs.
As we discussed before if you are looking at a smaller portfolio then you should try to take advantage of free trades, especially if you are trading in ETFs. Why not take advantage of that free trading fee and run with it.
That could really compound for you as well as you save money on the trading fees. That alone would make the move worth it for you.
Dave: The bank that I work for is looking at trying out some sort of trial of free ETF trading on their platform. But the one catch is that they will be offering a limited menu of ETFs to choose from.
So you won’t be able to choose from the whole universe of ETFs to invest in. Another disadvantage to this would be with the limited choices you could choose from some of the poorer performing ETFs which in the long run could affect your returns as well.
I know listening to some podcasts that Andrew and I both listen to there is a movement among some of the big players to start moving in the direction of offering free ETF trading to their customers.
You have to remember that this is in the best interests of the bank to keep your money with them. That is one of the ways that they make money is by having your money invested in them, regardless of the size of your portfolio.
Andrew: A thing to remember is that it is a must for you to look at the prospectus of an ETF to make sure you are aware of what the management fees are for that fund.
As people educate themselves, they think they are being so smart by investing in an ETF because it is cheaper but if they don’t investigate they could hurt themselves unknowingly.
It is an important factor to be aware of.
Dave: Another thing to note is that ETFs are designed to match an index, not beat the market. To match the S&P or whatever it is designed to match. They are not trying to beat the market only mimic it.
As you become more comfortable with picking individual stocks and using all the great tools out there, like the ones that Andrew has created you will be able to beat the market, which is what we are all here for.
To make money.
Can you explain in more detail the ratios P/E, P/S, P/B and D/E, as well as good numbers to look for with these?
Andrew: When you first start investing these numbers can be confusing and I try to break them down and make them as simple as I can. Of course, I can get into the educational, academic side but I find the best way to learn is when someone just lays it out there real simple, real easy.
The first three ratios can be broken down as a comparison to price, how expensive is the stock. So the P/E is the price compared to the earnings of the company.
You mentioned that Ben Graham liked to see the P/E under 15 and I like to see it under 25. I would like to say that what is more important with these three metrics is not getting it exactly at for example at P/E of 23 is better than a P/E of 25.
The more important thing is to not buy a P/E of 100 or 200 or even 50. We are just trying to get inside a little range and then if we line up our ducks in a row and look at these ratios and have everything ok, and we have no ugly ducklings that are going to ruin the rest of the batch.
I have bought stocks with a P/E of 30 and certainly looked at others there as well.
With the P/B, Ben Graham likes to see them under 1.5. The book is just talking about the book value and to make that the most simple I can. The book is the net value of the company.
The price to book is how expensive it is compared to the net value of the company. If you get a low book value you’re getting more of the company’s net worth as you invest.
As I start to look at screens for stocks I will look for companies with anything under a 3. If you see anything at a 5 or higher then I would say no way.
The same way with Price to Sales, they are very similar ratios. The sales are talking about the revenue the company brings in. Which makes sense because a company needs to bring in revenue to make earnings.
Recently Enron was able to manipulate their sales so that they showed great earnings but using these financial shenanigans to get their earnings to look good. Using Price to Sales is a good way to mitigate these shenanigans.
With P/S you are looking for anything under 3, ideally under 2 but definitely not above 5.
The last ratio being the debt to equity. This is simply how much debt a company has and you want to keep that ratio under 1. That is a good sign and you can go a little over one but anything over two, I will stay away from.
You can look it as a company owes money and if the debt to equity is under one. It basically means that they have enough of a cushion in their assets that if they had to pay off their debts today, they would have enough in their cushion to be able to pay that debt. And it would still leave their regular assets there.
This means that with a D/E under one they can cover their liabilities at any point.
Dave: These numbers are all great and Andrew did a great job of explaining them. I would like to add that I use these numbers as a starting point to evaluate a company to see if it is something that I would want to invest in.
Never will I buy a company just on those four numbers. They are for me to use as a guideline to start.
Monish Pabrai is one of my favorite investors. He is great to listen too, a great teacher, and an amazing investor. His record over the last twenty years is ridiculous and he is a big champion of checklists.
I have a checklist as well and part of my checklist are these four numbers. And everyone is going to have their own checklist that they will create. And these are just guidelines to help me identify companies that I want to dig into more and to learn more about to see if it is something that I want to invest in.
I look at companies that I want to invest in as a long-term friendship and I want to know as much about them as I can and these numbers are a guideline to help me figure out if it is something that I want to invest in.
It is also a guideline that I can use as part of my portfolio maintenance that I do every quarter to make sure everything is still going well with my companies. They can also help you decide if things are not going well whether or not I want to get out of the company.
Why timing the market wrong doesn’t matter that much.
Andrew: First off, good luck getting friends and family to take an interest in the time value of money. I just recently had a friend “see the light” and now he wants to tell everyone about the magic of compounding and how great it is.
Recently there was a story on CNBC that talks about a portfolio manager of the name of Ben Carlson who knew an investor that invested at the absolute wrong times in recent history. 1973, 1987, Black Monday in 1987 and 2007. With each investment, he put in $50,000 and by the end of the time, he made over $1.6 million!
What that shows you is how important it is to just get in the market and hold for the long term.
What a lot of people will do is get in the market and get so “invested”, maybe find a shortcut or secret when it is really just being patient and putting the money in the market and let it work for you.
I see this all the time where they try to have this controlling aspect on their money. And it gets to the point where you are trying to do too much.
Really when you are putting your money in that business, all you are doing is claiming your small sliver of ownership of that business. After that, you just wash your hands clean and the business will do what the business is going to do.
That is what you do when you invest in the stock market. You give your money to that business and they take that money and put it to work. They hire employees, build plants, expand into other markets, and hire more marketing teams. And then those earnings grow over time.
So the work that can be done with that money is way more grand than something we could do with our time or money.
This example of this investor is the power of letting businesses put your money to work and letting it grow over time.
Ben Carlson stated that the investor in question made about 9% annually, which is very close to market average.
Think about this he took almost $200,000 and turned it into $1.6 million, and this was his live savings. And because he was able to make a little over the market average over the 35 plus he was able to make himself a millionaire. And while investing at the absolute worst times in history. This is the power of compounding. Another note, he never sold his original positions, which is another factor that helped his money grow.
The proof is in the pudding. Put your money in the market and let it go to work. Don’t fret about-about getting the timing right, or right price on the stock. Just put it in the market, stay diversified for the long term and you can really do well for yourself.
Dave: Set it and forget it. Albert Einstein, a pretty smart guy talked about what he termed the “eighth wonder of the world” which is compounding interest. When someone like that says something like that, it is something I am going to take notice of.
Everything that Andrew was just talking about was right on the money. There are tons of stories out there with examples like that. You hear about people that invest $20,000, $50,000 or even $1,000 and forget all about it and then 30 years later they remember or a family member discovers it and it is half a million or more. This is the power of compounding interest.
When people start to get in trouble in the market is when they try to get too cute, or fancy. Try to control the company when the can’t. Just let the company do their job.
It is our job to find a good company to invest in and their job to run it. If they don’t do a good job running it then we sell it and move on.
Recommendations for options using stocks that pay a dividend but it isn’t enough to buy a full share and how to utilize DRIP compounding.
Dave: There are several ways to go about looking at this. First of all the effects of compounding takes time. Next, you have dollar cost averaging adding to your positions which will continue to increase the dividends that you get paid. Which in turn will increase the shares that you will be buying with the reinvestment of the dividends.
Another factor is the consistency of the dividend payment is going to increase your returns over time as well.
You also have to remember as a young person you have a long way to go and time is on your side. And as you continue to add to your positions you are going to continue to add to the dividends that you will be receiving.
An example is a company that I bought a few years ago. Its dividend is not big, only $.13 per share per quarter. The stock is trading at around $24 currently and I have about 100 shares of that company. So when I am paid my dividend the reinvestment is not enough to buy a full share. But it continues to add to my position and grow the value of my investment.
When you look at a graph of the effects of compounding, the early years are kind of flat. But as you get towards the end of the investment you see the graph jump straight up. And that is the effect of compounding. It is a slow burn but it eventually gets white hot.
Andrew: From my understanding, you still earn a partial dividend for partial shares. For example, if you have a share and a half you would get a dividend plus a half. So the compounding would continue. And it wouldn’t matter if you bought one share or a hundred shares. The reinvestment would continue for the partial shares as well.
Can you talk about investing in different geographies?
Dave: There can be advantages to investing in stocks internationally. But I will be honest when I say that I have not delved into them much myself.
For several reasons, I have not invested internationally. First being the political risk or unrest that has to be taken into consideration. For example, look at what is going on in Europe right now with the Brexit mess. There is a lot of uncertainty there right now.
Another thing to take into consideration is the potential for financial shenanigans with companies. Here in the US, we have the SEC to govern the financial reporting that is required by all companies here in the US.
Look at all the funny business that is going on with Volkswagen, Deutsche Bank and recently Fiat Chrysler. That kind of manipulation is harder to do here in the US. Not impossible but harder.
Frankly, I don’t have enough knowledge about companies overseas to speak intelligently about them.
I am a value investor and one of the things that Warren Buffett talks about quite a lot is staying within your circle of competence. And investing outside of the US is out of my circle of competence at this time.
Andrew: I will say that I am very pro-US, for a couple of reasons. First, if I buy a stock outside of the US the country I am invested in would tax me on those capital gains. And then when I brought the money back here my fabulous government would tax me again.
So there is a double taxation effect that goes on when you invest internationally. Which is one factor of why I don’t dip into international stocks.
Another reason is that even though there is competition for manufacturing jobs outside of the US. Most of the capital invested into companies is still here in the US. And by understanding that having this capital in the market is what is enabling these businesses to grow.
So corporations turn to the market for funding and the capital is already here. It just tends to perpetuate itself and lead to more growth.
That being said there would be some advantages and disadvantages to finding some international plays, values or opportunities. But of course, you could also look at some international ETFs.
When you look at some countries like Russia or Brazil where there are some really depressed prices. You could find some businesses for a great price. But if you don’t want to buy an individual company. You could find an ETF to represent those countries or sectors.
Political risk is a very valid concern. As political events go, so go the markets. Recently we have seen huge shifts in the market with the changes in political shifts.
What I will say is in many of the great investing books that I have read and that I consider classics. Things that I base my investing foundation on. Politics are always there and they are a factor in the short term. But in the long term, the market is not affected.
Businesses will continue to be businesses and governments may shut down. They may go bankrupt but business will continue to happen because that is the core essence of human interaction.
Business exchanging money from one person to another and so long as you believe in this idea. That business will always happen you don’t have to worry about the end of the government, the end of America.
As long as you are confident in the fact that business will always continue. Then you invest for the long term you will always come out on top. Maybe you will find yourself a millionaire.