Although your retirement capital and your discretionary capital are different in many respects, there’s one way in which you need to look at them the same. I’m talking about the level of asset allocation. I’m talking about diversification. I’ve already referred to diversification in this book, and I’ve gone over it extensively in my previous two books, in addition to hammering home the point every day on Mad Money, but it’s important enough for me to remind you again. I’m sure you know that you need to be diversified, although some of you who are new to investing might not be entirely sure what that means. When I say you must be diversified, I mean that your investments shouldn’t overlap. If we’re talking about a portfolio with five stocks in it (five stocks is the minimum number required for a good nonprofessional portfolio and ten stocks is the maximum), no two stocks in that portfolio should occupy the same sector. They shouldn’t be in the same business. So if you own Bank of America stock, you shouldn’t also own Citigroup stock. And it’s not just about competitors. If you have some General Motors, you shouldn’t also own Goodyear tire, even though Goodyear makes more than just tires these days. The reason is that you don’t want all of your eggs in one basket. If there’s a huge downturn in the economy and people buy fewer cars, then two of the five stocks in your portfolio will go down, the two that depend on people buying cars to make money. Because 50 percent of a stock’s movement depends on its sector, you can’t afford to have more than 20 percent of your capital in any given sector.
When you’re figuring out whether you are diversified, you have to look at your retirement fund and your discretionary fund together. This is very important. If you’re not diversified when you look at both portfolios as one, you have to sell something in order to diversify. One last point on diversification: I’m about to explain stocks, bonds, and different types of funds. Don’t think for a minute that you need to be diversified across different kinds of investments. It would be insane to invest 20 percent of your portfolio in stocks, another 20 percent in bonds, another 20 percent in mutual funds, and so on. This is not what diversification means.
As long as you keep all of this in mind while we go over your potential investments, you will be less likely to lose money, which is just a pessimistic way of saying you will be more likely to make a great deal of money over the long term.
Stocks and Bonds
What’s the difference between stocks and bonds, and when do you want one or the other? A stock is figuratively a tiny piece of a company. When you buy a share of a business, you become a partial owner, with emphasis on the word “partial.” Unless you’re running a big activist hedge fund and you buy a big piece of the company—think 5 percent to 10 percent—you don’t get to be involved in the decision-making process at the company. Activist hedge funds buy enormous pieces of companies and push management around until it does something to increase the value of its shares. All your ownership actually entitles you to is a seat at the company’s annual meeting and maybe a cup of coffee and a bagel or Danish at the snack table. (At TheStreet.com’s annual meeting we cut out the Danish because nobody comes anyway.) You don’t buy stock so that you can tell a company what to do. You buy stock because you expect that stock to make you money by going higher or by paying you a dividend, preferably both. I know this firsthand. At my hedge fund I bought 4 percent of Dow Jones and went to the board meeting and spoke about closing a division, Telerate, before the company plowed $800 million into it. I said that the division was a total loser—it helped people trade bonds, a business Bloomberg had already won—and should be closed. Despite my multimillion-dollar stake, the chief executive officer dismissed me with a laugh. Of course, I got the last laugh because the division was closed soon after, a total waste, and later on the company was sold to Rupert Murdoch’s News Corp. Murdoch was someone the company and its board of directors hated, but they could do nothing to avoid him because the company had squandered so much money in many failed attempts to grow that his offer to buy the company was the only real one on the table.
Bonds are a totally different story. Most people think of bonds as stable, conservative investments that give you a fixed amount of income. That’s generally true, but that tells you nothing about what a bond is and very little about who should buy bonds. A bond is actually a kind of loan, expressed in complicated terminology to make things more difficult for regular people who want to invest in order to convince them that they need professional help. In reality, bonds aren’t that complicated. When a company or a government wants to borrow money, it doesn’t have to go to the bank and apply for a loan. Instead it can issue a bond. The company or government that creates and sells the bond is therefore called the “issuer.” If they were regular people borrowing money, they’d be called the “borrower.” See, not complicated. Whoever buys the bond becomes the bondholder, which is what we in the real world would call the “lender.” Unlike regular loans, bonds don’t pay interest. Instead, a bond issuer (borrower) will pay what it calls the coupon (the interest) to the bondholders (the lenders). Like a regular loan, at some point in the future the bond reaches its maturity date and the bond issuer has to pay the bondholder the principal, which is the amount of money the issuer originally borrowed. If you’re looking for a good analogy, a bond is kind of like an interest-only loan, where you pay only the interest (the coupon) every year. If you got a thirty-year interest-only mortgage, at the bond’s maturity at the end of thirty years you would have to give back all the money you had borrowed at the beginning of the loan. See, all of this is simple stuff. What’s not so simple is keeping track of all the various kinds of bonds, which I’ll explain later. Not only are bonds incredibly complicated when you stop talking about bonds and start talking about agency paper, convertibles, bills, notes, and munis, but it’s also tedious trying to invest in them yourself.
So let’s have some fun instead of lingering on bonds for too long. Suppose a company goes bankrupt. Would you rather be a share-holder in this company or a bondholder? Obviously, you’d rather not have anything to do with the company, but in this situation it’s better to be a bondholder than a shareholder. When a company goes bankrupt, the creditors take over, and the bondholders are the creditors. It’s possible that shareholders of a bankrupt company will lose their whole investment, because even though individual shareholders don’t have any personal liability to the bondholders, they do own a piece of paper (or, as happens now, a virtual piece of paper because nobody gets actual stock certificates anymore) that represents part of a company with a lot of debts that can’t be paid. Remember that the bondholders are in charge when a company goes bankrupt. Until then, they have no say in how a company is run.
But back to the subject at hand. Beyond knowing the difference between stocks and bonds, you really need to know how to use them, and more than that, who should use them. Let’s start by talking about stocks. There are a lot of ways to own stocks. You can invest in individual stocks or you can invest in a mutual fund, a hedge fund, or an exchange-traded fund that owns stocks. Everyone should own stocks, except for wealthy retirees who can afford to support themselves comfortably past the age of 100. Everyone who wants to get rich and stay rich must own some stocks. But not everybody should own individual stocks. In fact, most of you might be better off getting your stock exposure somewhere else. Of course, some advisors think that picking your own stocks is a terrible idea.
The great thing about the tech boom at the end of the 1990s was that it encouraged so many people to get into the stock market. The worst thing about the tech boom at the end of the 1990s was that it encouraged so many people to get into the stock market without knowing the slightest thing about stocks, except that they never stop going higher. This dot-com-inspired boom created a huge class of people who understood the promise of stocks and gained firsthand experience of just how bad owning stocks could be in 2000, 2001, and 2002. Many of those brand-new, first-time investors from the 1990s really soured on stocks. I’m sure the plethora of accounting scandal
s—Enron, WorldCom, and HealthSouth come to mind—added insult to injury. Everyone felt burned by stocks when a rash of scandals gave the impression that while regular people were losing big, the market was a perpetual playground for the superrich and super-unethical. Many people went from being excited about stocks to being disgusted with stocks. But the past few years have been good ones, and if you want to build lasting prosperity, owning stocks is a must.
I’ve seen a lot of people who really got burned by the dot-com bubble go through this transformation. They decided that since they lost money, no one else could make money either. These embittered souls go in one of two directions. They either stop trying to outperform the market by buying index funds, or they abandon the market for good. The latter group swear off stocks entirely because they’re too risky, or the game is rigged, or the market’s impossible to understand, or every stock that ever goes up is just part of another bubble that will eventually burst and cause tremendous heartbreak, so why bother at all? Many people have gone in that direction. No matter what their argument against owning stocks in general might be, their objection is always based on the same idea: I lost money in the market, and if I lost money, how could anyone else ever make money? You can tell this concept has won out in the fast scheme of things because of the huge decline in self-directed trading and investing and an amazingly large and ever-expanding bulge of money fund assets—sidelined cash that, as I write, stands at more than $4 trillion dollars. That’s unconscionable, but it is the legacy of the burn-and-bust moment at the turn of the century. Then there’s the index fund crowd that still believes in owning stocks, but not picking them. Their attitude is just another example of sour grapes (I hear Aesop was the Warren Buffett of his day). You can still read columns by people who think something like this: Only a tiny minority of mutual funds consistently beat the indexes, and if the pros can’t do it, it’s no wonder I screwed up, so you’ll screw up too! These types know that stocks are winners, but don’t believe anyone can consistently tell good stocks from bad, so they give up and smugly buy an index fund. Then they act like those of us who pick stocks are dopes for even trying. They can call us dopes all the way to the bank.
These are all people who leaped to get in near the top of the market in 1999 and 2000 and quickly got burned out of the market in 2000, 2001, and 2002. If you sign up for incredible, almost magic gains, which is exactly what most people thought they were signing up for back in 1999, and instead you get one heartbreaking loss after another, you’ll probably feel like somebody gave you a false bill of goods. You’ll feel cheated. You’ll want to accuse the whole world, or everyone who was encouraging people to get in on the stock market action, of committing fraud. Of course, that is generalizing from a few years of intense personal experience. Sure, the market was down in 2000, 2001, and 2002, but it was up over 20 percent a year from 1995 through 1999, so if you take a long-term perspective, you can see that even though it was terrible to be a regular-guy investor from 2000 to 2002, that fact really doesn’t say a lot about the performance of stocks, or your ability to pick winners.
I’ve always been a champion of owning stocks and managing your own portfolio. Although people claim that it’s impossible to consistently outperform the market, making more money year after year than you would make if you simply invested in an S&P 500 index fund, I think that’s baloney. I’m living proof that it’s possible. We thrashed the S&P at my hedge fund, and if you’d been one of our clients, your investment would have compounded at 24 percent annually after fees, assuming you’d been with me the whole time. From 1987, when I started the fund, to 2001, when I retired, the S&P 500 gained an average of 16.1 percent per year. That’s sustained, consistent outperformance. It’s possible because it happened. The same people who tell you to just give up and buy an index fund, which I’ll talk more about later in this chapter, will say that in any given year 80 percent to 90 percent of actively managed mutual funds under-perform the S&P 500. Because these funds are run by professionals, how can you, an individual who invests on the side, possibly do better than the pros, who are paid fortunes and have years of experience? That’s more garbage. If you do all the necessary homework, which I’ve explained in great detail in my two previous books, you can pick your own stocks and run your own money well enough to do better than the pros who run most mutual funds. I don’t recommend that everyone do this, but don’t let anyone tell you it isn’t possible.
Of course, mutual funds can only rarely beat the benchmarks. A mutual fund, if it’s good, will be managing a lot of money, and the more money you have under management, the harder it is to beat the market. First of all, once a mutual fund gets big enough, every time it buys or sells a stock it ends up moving the stock because the fund needs to buy an enormous amount of shares to make any difference in its portfolio. When you buy a ton of stock—I’m talking multimillion-dollar positions here—you dramatically increase the demand for that stock and prices go higher. Selling an enormous position increases the supply, and that drives down prices. So mutual funds are anything but nimble. You, on the other hand, won’t cause a splash, at least as long as you use only limit orders and not market orders to buy.
When you tell your broker, electronic or human, to buy or sell a stock, you’re placing a market order. You’re also giving your broker a license to rip you off, for he now has permission to get you a bad price, and that’s exactly what will happen almost every time. You need to understand that your broker isn’t there to look out for your best interests. He’s there to generate commissions. So whenever you buy or sell a stock, place a limit order—it’s the easiest thing in the world and doesn’t cost you a penny more. You just tell your broker the price you’re willing to pay if you’re buying, and the price you’re willing to take if you’re selling. It’s that simple. If you don’t place a limit order, expect to be confused and angry, because you’re paying more than you expected, or selling for less. With a limit order, sometimes you won’t be able to get your stock, but you’ll never buy for more or sell for less than you wanted.
The other problem mutual funds have that individual investors don’t is that when they have a really successful year, they’ll get a lot of new people flooding them with money. So any fund that’s really good will be hobbled unless it closes itself off to new investments, and the companies that run mutual funds hate that because they make their money by charging investors fees as a percentage of their invested assets. More assets means more profits for the mutual fund. Once a mutual fund gets really enormous, it becomes more and more like an index fund with high fees. This is what happened to Fidelity’s Magellan fund, which Peter Lynch used to manage. Magellan was one of the few mutual funds that consistently beat the market by really large margins, but too many people invested too much money in it, and ever since then it’s had trouble beating the market (although the latest manager has finally had some better-than-market performance). You are not a mutual fund and you should not aspire to be one with twenty or thirty stocks under your own management. There’s no way you’re going to end up investing billions of dollars (and if you do, that’s a High-quality problem to have), but if you actively manage your own money, you can beat the market with a handful of stocks you pick and follow, and take gains when you think the time is right. Even hedge fund managers are constricted by assets. I think that if I were allowed to start a fund to actively manage only my own money, I’d do better than I had when I was running my hedge fund, because I wouldn’t have to worry about producing short-term results, meaning daily results, to keep my clients happy.
If anything, an individual investor managing his or her own money has a leg up on the mutual funds. So don’t let anyone tell you that you can’t beat the market by picking your own stocks. That said, you shouldn’t try to do this unless you are ready to put in the time and work necessary to win at stocks. My standing rule is that in order to do well, you absolutely must spend at least one hour a week doing homework on each stock you own, in addition to doing
a lot of research before you buy. That research includes actually listening to the company’s conference calls, reading its quarterly and annual reports, and familiarizing yourself with the market’s current attitude toward the stock, which you can do by reading articles about it, looking at its recent performance, and looking at the performance of companies in the same business. I also believe that you have to tap Google fairly regularly to read any articles about the stock around the nation and the globe. This is a time-consuming process, but you can do all of this online. You shouldn’t try to own more than ten stocks because any more than that and you practically have a second job keeping on top of them.
I need to be very clear about this, because even though I repeat these rules practically every night on my TV show, people still don’t listen. So I’m going to give you a better explanation of them, with more of a “glass half-empty” perspective. If you try to manage your own money and invest in your own stocks, and you don’t listen to the conference calls or you don’t read the quarterly reports or you don’t do every single piece of homework necessary, you will not do well. You won’t beat the market, and you’ll probably lose money. I can’t make it any clearer than that. People really hate listening to the conference calls and reading the company’s filings with the SEC, the annual 10-k filings and the quarterly 10-q filings because this is the most time-consuming part of your homework. It’s also the most important part. You cannot cut corners. Be honest with yourself: if you don’t have the time or the inclination to do this work, then I’m begging you, please don’t try to invest in individual stocks. I’ll tell you all about other investments that can still make you money, but owning stocks without homework just isn’t on the table.
Jim Cramer's Stay Mad for Life Page 12
