Two Secrets New Investors Should Remember When Managing Their Money
A lot of the content on the Investing for Beginners site deals with the finer details of nuts-and-bolts wealth building; learning about SEP-IRA contribution limits or creating a family limited partnership. For a moment, on this Tuesday afternoon, I want to step back and, for a moment, focus on some broader principles that can serve you well in your quest for passive income.
The Stock Market Is Merely an Auction Through Which Business Owners Buy and Sell Their Equity in Companies
It is not always rational, nor does the stock price reflect the actual intrinsic value of the business despite being reasonable most of the time.
Use this to your advantage. Periods of intense fear and avarice will grip the public markets because public markets involve humans with all of their conflict, irrational emotions. In a recent article explaining the definition of value traps, I gave an example of a situation that most definitely did not fall into that category. For the sake of simplicity, I'll repeat the example I gave there:
Coffee giant Starbucks is a fantastic case study. Prior to the [2008-2009] meltdown, the enterprise had a rock-solid balance sheet and after-tax profits that were exploding. When the economic storm clouds appeared, families were suddenly losing their houses, investment banks began imploding, and the Dow Jones Industrial Average started collapsing, this incredibly lucrative business, pumping out huge amounts of profit and cash flow, declined from a high of $20.00 per share in 2006 to a low of $3.50 in 2008; a figure that represented less than 8x earnings on its prior-year figures and a 12.5% after-tax earnings yield. This is a company that had so much expansion room left, it had been growing at 20%+ without dilutive equity infusions for decades; with an entire world left to conquer as it expands into China and India. It was a once-in-a-lifetime opportunity to become an owner in the premier coffee vendor on the planet. Those who took advantage of it not only collected $1.66+ in cash dividends in the years since, but have watched the stock climb back to $51+ per share. With a current dividend rate of $0.64 per share following the board of director's decision to send more money to owners, that means someone, somewhere out there very well could be collecting an 18%+ cash dividend yield on cost for the shares bought at the absolute bottom (remember - there has to be a buyer and seller in every transaction; it's the nature of an auction).
A few times in every investor's life, he or she will see something like this happen; perfectly wonderful companies with strong balance sheets and rock-solid competitive business positions that generate obscene profits being given away in the streets as everyone runs in a panic, shedding assets they had paid much higher prices for only days, or years, prior.
In 1973-1974, for example, some of the best companies in the world sold for 3x or 4x earnings. In 1929-1933, scores of companies, at one point or another, traded for less than the cash the firm had in the bank, assigning a negative value to the enterprise, its factories, its real estate, and its intellectual property.
Index fund investors (which I believe should be a vast majority of the people reading this right now) can take advantage of this basic truth, too. While you stick to a disciplined dollar cost averaging plan, buying regularly through market highs and lows, there is nothing stopping you from increasing your contributions during times of total panic above and beyond your normal financial independence plan. There were several people in my own inner circle who took advantage of the advice I gave during the last crash, running down to Human Resources to increase their 401(k) contributions. I even know of more than one person who took second and third jobs, solely investing the additional money in the stocks everyone else was dumping! If the world falls apart and you are convinced the country will survive, it might not be a bad thing to exploit the situation for your own family's advantage.
For those of you for whom something like the Vanguard S&P 500 index fund is your preferred mechanism for compounding your money, skip eating out and use the cash you save to buy more shares. Pick up a night shift at a local convenience store. You think I'm kidding but history has shown events like this only happen once every few decades. Be ready to seize opportunity when it knocks.
Costs and Taxes Matter
This is a theme I've repeated for a decade and a half but you need to understand it. Costs matter. Taxes matter. In another article I wrote earlier this week called 7 Ways to Lower Your Family's Investment Tax Burden, I explained how paying attention to small things, like asset placement tax strategy or the holding shares in such a way that your heirs can avail themselves of the stepped up basis loophole, can add millions of dollars in additional net worth to your family coffers.
The same goes for avoiding or minimizing the frictional expenses you are likely to encounter, which act as a hidden investment tax.