Personal Finance Strategies

Personal Finance

Investing and Wall Street, Part I

By Dr. Mark Skousen, Grantham University

“The typical investor has usually gathered a good deal of half-truths, misconceptions, and just plain bunk about successful investing.”

                -- Philip A. Fisher, Common Stocks and Uncommon Profits

The following are excerpts from “Investing in One Lesson,” by Mark Skousen, published by Regnery Publishing, 2007, copyright © by Mark Skousen. Reprinted by permission. The material is updated through 2011. For a copy, go to: http://www.amazon.com/Investing-One-Lesson-Mark-Skousen/dp/1596985224

Investing your hard-earned savings is a challenging and rewarding experience, and can provide much needed income when you retire, -- including potential profits to buy a house or start a business. At the same time, investors often make serious mistakes, and this module is meant to help you be a better investor.  

You will be introduced to new terms and concepts in this module. You may want to read through the information twice for it all to soak in; but stay with it. This is key information every person can learn and use to their benefit.

Has Wall Street Become Another Las Vegas?

When I teach investments to college students, I begin the discussion by holding up two pieces of paper. In one hand, I hold up a lottery ticket, and in the other hand I hold up a stock certificate. I ask, “Are these two pieces of paper mostly the same, or are they mostly different?”   

The students usually make good arguments on both sides. 

Given the volatility and wide variety of risks involved in selecting stocks, some observers refer to the stock market as a glorified gambling hall. Several years ago Business Week labeled the financial markets part of the “Casino Society:” People bet on anything, without regard to fundamentals and real values. 

I have a book in my library entitled Wall Street: The Other Las Vegas, by stock market expert Nicolas Darvas, who calls the market “a gambling house peopled with dealers, croupiers and touts on one side, and with winners and suckers on the other.”

Many of my fellow economists feel the same way. I talked with Milton Friedman, the famous monetarist and defender of the free market, soon after the October stock market crash in 1987. He, too, labeled the stock market a casino that had little to do with the real economy. “The stock market is grossly overvalued as it affects the economy,” he told me. His remarks reminded me of the statement of another Noble Prize economist, Paul Samuelson, who said, “The stock market has predicted nine of the last five recessions.” 

If the stock market is essentially a gambling hall that serves no social or economic function other than the pleasure of rolling the dice, some social philosophers have suggested that it be abolished, or at least highly taxed and regulated. The Marxists see no value in the stock market, which they regard as a bourgeois pleasure dome. The old stock exchange in Leningrad was made into a museum by the Soviet authorities. Now that Leningrad has been transformed back into St. Petersburg, the Russian stock market is thriving again. 

The famed British economist John Maynard Keynes, an avid speculator himself, regarded the stock market as a game of chance whose outcome is unpredictable and often irrationally acted upon by “animal spirits.” Market uncertainty leads to waves of excessive pessimism and optimism, potentially damaging business expectations in the real economy. Keynes and his followers recommended the introduction of a “substantial government transfer tax” on all stock transactions to discourage speculative fever. Other economists and even some Wall Street analysts recommend a higher tax on short-term stock profits to encourage more buy-and-hold investing. Many governments do in fact tax short-term capital gains at a higher rate than long-term gains.

Is the stock market a casino? 

Outward appearances can be deceiving . Peter Lynch, famed fund manager of the Magellan Fund and author of One Up on Wall Street, once observed, “Although it’s easy to forget sometimes, a share of stock is not a lottery ticket. It’s part ownership in a business.” There are essential differences between gambling and the stock market, between Las Vegas and Wall Street.

But, as I have demonstrated in my book, the differences are sometimes elusive…  

Therein lays both danger and opportunity. The financial markets can be used as a gambling vehicle, as they were in the early 20th century with the bucket shops (betting sheets on stocks that operate purely as a bet, with no stock ownership involved). Indeed, many technical trading systems are based on mathematical formulas similar to betting schemes. Moreover, the derivative markets (options and futures markets) have become so removed from the fundamentals of a company’s business that they have all the appearances of a gigantic gambling casino. The stock options market in particular has become the main focus of this gambling mentality.   

Differences between Wall Street and Las Vegas

Of course, there are a number of differences between the stock market and a game of craps or blackjack: 

First, in gambling, for every winner there is a loser. That’s not necessarily the case in investments. A company may increase in value due to intelligent business decisions, and the price may rise accordingly. An investor may hold a stock for a year, and sell it for a 30% profit to another investor, who may in turn hold it for a year and sell his shares for a 20% profit. This can go on indefinitely if the underlying company’s value and price steadily rises, which some stocks do. Admittedly, the first seller has “lost” the potential gain of another 20%; but he has put his money to use somewhere else, possibly earning even more.  

Second, in a gambling casino, the odds are set in every case, slightly in favor of the house, while an investor can substantially change the odds in his favor through superior knowledge or technique. Jesse Livermore, the speculator, learned this: “My great discovery was that a man must study general conditions, to size them so as to be able to anticipate probabilities. I was no longer betting blindly, but earnings my successes by hard study and clear thinking.” Admittedly, gamblers can increase their chances of winning through card-counting methods and other techniques, but such methods, if they are too successful; will lead the house to deny the player an invitation to gamble. However, in the investment markets, a top performing speculator is not limited by his success. 

Third, investors can make money in the stock market over the long term, while gamblers tend to lose the longer they stay in a game. The odds favor the house in a game of craps, blackjack or roulette, so that the longer you stay in the game, the greater your chances of losing. That’s why most gamblers walk away from the table once they achieve a significant profit. (Poker is an exception to this rule: Luck is involved, but intelligent poker players can win more often than they lose in the long run, and can improve their game through experience and skill.) In the stock market, investors have earned a positive return on their money over the long term. 

This assumes that investments are in a free-enterprise country that encourages ownership in stocks; the threat of onerous regulation makes long-term strategies risky in controlled economies. In addition, it should be noted that shareholders can also lose in the long run if they buy expensive stocks with high P/E ratios. The longer they hold the stock, the more likely that they will lose as the stock comes back down to more reasonable valuations. 

Fourth, the stock market has traditionally been a good leading indicator of nationwide economic performance. The S&P 500 stock index is used as one of ten leading economic indicators in the United States, and similar indexes are used in other countries. This is because the stock market is an active participant in the economy’s capital stock. Action in Las Vegas, a small sector of the entertainment industry, does not qualify for similar recognition.

Fifth, stock market activity -- as well as the value of a nation’s currency -- reflects national optimism or pessimism. Nations whose economies are performing well are likely to experience a bull market in stocks and a strong currency. On the other hand, nations facing serious economic troubles are likely to suffer from a bear market and a falling currency. 

Sixth, and most importantly, while a casino represents pure consumption, the stock market represents the capital market, which is crucial to a modern developing nation. Remember that stocks are issued initially to raise capital for a company providing goods, services and employment. Even the secondary market for stocks can benefit the company, especially if it offers stock or stock options to its employees. Invariably, countries without a stock market are backward and underdeveloped in their standard of living. If the stock market were abolished in major industrial nations, or discouraged through confiscatory taxation, you might see massive layoffs and a depression as the sources of capital dried up. Many new company expansion plans would come to a quick halt. Granted, companies could raise investment funds from the bond market, or through bank loans, but the cheapest and most liquid form of capital -- issuing stock to the public -- would no longer exist.

In short, despite the appearance of a gambling mentality in the stock market, the securities market plays a crucial role in a nation’s capital development and business expectations. 

Nevertheless, it is interesting to note that many successful investors have been gamblers in their youth--John Templeton, John Kluge, and Warren Buffett, for instance. As Forbes magazine reported in its 1990 survey of the Forbes 400 Richest People in America, “Successful business people often turn out to be avid gamblers. Whether the game is poker, bridge, blackjack or the horses doesn’t matter; what matters is the game itself. The essence of these games -- the systematic weighing of risks against rewards against mathematical probabilities -- is the essence of business itself.”

With the growing popularity of poker games on television and the Internet, Las Vegas and other gambling Meccas as vacation destinations, and “mad money” shows on prime time cable networks, it should not be surprising to see a gambling mentality entering the financial markets. 

How to Reduce Your Risk and Increase Your Chances of Success

Several conclusions can be drawn about the world of investing. 

A company’s stock is far more volatile and risky than the underlying firm because every business owner and shareholder have the capability of selling all or part of their shares at any time in the continuous auction we call the stock market. 

Many variables influence a share price, often in a perverse way . Company fundamentals (including changes in technology) determine the long run value of a stock, but in the short term, which can vary from a day to several years, stock prices can jump all over the place depending on fads, insider knowledge, economic and political events, trading systems, and recommendations by respected analysts and economists.  

The stock market is being used more and more as a casino or gambling house , encouraged by mindless technical charting games that are becoming more and more popular. Day trading and computerized programming are increasing in popularity. In a laissez faire environment, where investors from around the world can move money from one place to another or from one investment to another, the stock market could become an increasingly dangerous place to invest your life savings.

Beware of government policy . Changes in macroeconomic statistics can significantly affect your portfolio, no matter how successful a company is, and today more than ever monetary policy by central bankers can help or hurt your position. Furthermore, the Fed’s policy toward interest rates and the money supply can create a treacherous boom-bust cycle that can whipsaw your investments and test your discipline. 

Be a Contrarian Investor? 

What can an investor do to profit from these characteristics of Wall Street? 

One strategy that is often suggested is to be a “contrarian” and “bargain hunter.” The idea of bargain hunting, of buying cheap stocks and avoiding expensive ones, has been around for a long time, and advocated by many intelligent investors and behavioral economists, including J. Paul Getty, Bernard Baruch, John Templeton, Peter Lynch, Michael Price, David Dreman, and Eddie Lambert. Even Ben Graham wrote of the advantages of being a contrarian, of buying less popular undervalued stocks and avoiding well-touted overvalued ones. Contrarian investing is a popular strategy for identifying tops and bottoms of markets, and profiting from mindless technical trading systems, but as with any strategy, there are no guarantees, and frankly, it isn’t that easy.  

Creating a Diversified Portfolio

A better approach for most investors, and students new to Wall Street, is to have a diversified portfolio of stocks, bonds, mutual funds, and other assets, so that no matter what’s happening in the world, you are protected. 

A well-diversified portfolio does not guarantee that you won’t lose money, but it reduces your chances of losing and increases your chances of making money over the long run. 

Many well-respected investment advisors recommend this approach. Wharton Professor Jeremy Siegel, author of the classic work, Stocks for the Long Run, has demonstrated that dividend-paying stocks do better than the market as a whole with less risk. (I am a big fan of dividend-paying stocks in my newsletter.) 

Princeton Professor Burt Malkiel, author of the classic work, A Random Walk Down Wall Street (now in its 10th edition), suggests that a well-diversified portfolio of stocks, bonds, foreign investments, and commodities (like gold and silver) will do well in any environment.

A diversified portfolio of “non-correlated” investments has the following advantages: 

No need to time the market -- besides, it doesn’t work over the long run. To make timing work, you have to been right most of the time when you sell and when you buy. The vast majority can’t do it consistently. Besides, you don’t need to time the market to be successful. 

Use dollar cost averaging . Malkiel showed that dollar-cost averaging actually does better in a volatile market (like now) than a steady rising market. He came up with an example: If you invested $1,000 a year for five years, you would have $6,167 in a volatile (bear-bull) market versus only $5,915 in a steadily rising market.

Rebalance yearly.  Sell off your big winners and buy your biggest losers in your portfolio. Malkiel found that from January 1996 until December 2009, annual rebalancing between a stock and bond index provided lower volatility and higher return.

Diversify, diversify, and diversify. Malkiel uses the following extremely conservative portfolio: 50% bond fund, 25% stock index fund, 25% international stock index fund. He argues that simple diversification increases your returns with less risk (volatility).

Cost matters. Use non-actively managed index funds by Vanguard or other low-cost mutual fund service. The vast majority of actively-managed accounts underperform the market indexes over the long run, especially because they cost more to run. 

Personal Finance

Investing and Wall Street, Part II

Putting It All Together

Index funds, dollar-cost averaging, rebalancing, and diversification -- Malkiel showed the following chart to demonstrate how a conservative investor would fair during the “lost decade” when the stock market fell from 2000-2010.

Here’s something amazing: A $100,000 portfolio of 50% bond index, 25% US stock index, 25% international stock index, with $1,000 monthly contributions, and annual rebalancing would give you a portfolio valued at $250,000 in ten years. 

Imagine how much better you would do if you added an emerging markets index fund and gold to your portfolio.

I recommend these books for further reading:

Burt Malkiel has simplified his recommendations in a new book: The Elements of Investing (Wiley, 2009). 

Alexander Green said pretty much the same thing in his excellent book The Gone Fishin’ Portfolio (Wiley, 2009).  He warns that investors make four major mistakes: 

Being too conservative , so that your hard-earned savings don’t keep up with inflation.

Being too aggressive , so that you end up losing your shirt by investing in Enron or some other disaster. 

Trying to time the market . Study after study has shown that nobody has a crystal ball and can consistently time the market. 

Unwisely turning your money over to a money manager who loses your wealth, slowly or quickly. (Look what happened to investors who turned their money over to Bernie Madoff.) 

Investing can be one of the most frustrating experiences in life, what to do? 

Alex Green suggests you create a “Gone Fishin’ Portfolio,” and then……go fishing! 

Alex has created a portfolio of ten no-load mutual funds that has consistently beat the market in bull and bear markets, that requires no trading whatsoever. Think of it as a permanent portfolio fund, similar to what Harry Browne created in the 1980s, only with less risk.

The funds are all available through Vanguard or a discount brokerage firm like Schwab. It’s easy to set up. The funds include the right combination of stocks (foreign and domestic, including emerging markets), inflation-indexed bonds, real estate and commodities, etc. I call it “non-correlated” investing, and it’s the same technique used by David Swenson at Yale University to run the highly successful Yale Endowment Fund. And you can do it without using a broker and without requiring you to forecast the economy or the stock market. 

Investing in Gold and Silver

If there’s one omission in Alex’s portfolio, it would be gold and silver coins bought through a reputable coin dealer (I recommend several in my newsletter.) Alex recommends mining shares and commodity stocks, which I think it vital, but I also think you need to take physical possession of gold and silver as part of your permanent portfolio to protect you in survival times of financial Armageddon. Gold and silver, although volatile in the short term, have proven to be good inflation hedges over the long run. 

The Permanent Portfolio Fund

There is a well-diversified no-load mutual fund that serves as an “investment for all seasons” called the Permanent Portfolio Fund (symbol PRPFX). It has been around since 1982 and is rated five stars by Morningstar, its highest rating. 

Financial advisor Harry Browne created the permanent portfolio concept in the late 1970s, arguing that a balanced portfolio of stocks, bonds, cash, and gold would hold up well no matter what happened. “Stocks, bonds, gold, and cash combine to provide balance and safety, one that will do well in any economic environment,” he states.   “A permanent portfolio should let you watch the evening news or read investment publications in total serenity. No actual or threatened event should trouble you, because you’ll know that your portfolio is protected against it, whether it be inflation, deflation, recession, or war.” 

Browne’s strategy is to invest equally -- 25% in each category -- into four investments: growth stocks, bonds, precious metals, and cash (T-bills or money market funds).   I believe that this approach gives too much weight to hard assets, such as gold and silver, which have been volatile. 

The Permanent Portfolio Fund, created originally by Harry Browne, has a similar mix:   25% precious metals (20% gold bullion, 5% silver bullion); 10% Swiss franc bonds yielding less than 2%; 15% real estate and natural resource stocks, foreign and domestic; 15% aggressive growth stocks; and 35% in government securities, including T-bills. 

Since inception in 1982, the Permanent Portfolio Fund has had an average return of 7%. In the past ten years, the Permanent Fund has gained an average 12% per year, compared to 3% for the S&P 500 Index (including dividends).

If you are a conservative investor, my recommendation is that you create your own “permanent” portfolio, choosing from a list of mutual funds that invest in

(1) domestic stocks, preferably those that pay dividends;

(2) foreign stocks, including emerging markets;

(3) interest-paying government and corporate bonds;

(4) hard assets, such as gold, silver, energy, and real estate. 

Incorporate these funds into an Automatic Investment Plan (AIP) or a dollar-cost averaging program with your broker. If you wish to maintain a further degree of stability, consider adding a bond fund, prime rate fund, or money market fund to your portfolio. 

And, if you are concerned that the world is headed for disaster, consider adding gold and silver coins to your portfolio as disaster insurance. Buy gold or silver coins from time to time and squirrel them away in a safe deposit box or home safe. 

Investing In Yourself

Graduating from college is one of the best investments you can make in yourself and your family’s financial future. Outlining a plan to pay for your education will make your academic journey less stressful and more productive. Each student has options in financing a college education.

Options in financing your education include but are not limited to:

Tuition reimbursement

Employee tuition reimbursement is an excellent way for a company to build for its future while acquiring employee loyalty. Several companies will only provide tuition reimbursement on classes that can further employee development within the organization. The federal government will allow for employers to provide up to $5,250 tax-free to each employee. Tuition reimbursement funds can provide for coursework, fees and textbooks associated with the employee’s academic journey.

Scholarships

A scholarship is a form of gift-aid designed to pay for the costs associated with her education. Similarly to grants, scholarships do not have to be repaid like Title IV loans. Scholarships do not have to be repaid like Title IV loans. Scholarships may be based on financial need or other criteria such as academic merit. Generally scholarships are meant to be attributed toward the cost of tuition but can also be applied to books.

There are thousands of different scholarships available to assist students seeking higher education each year. Scholarships can be split into two main categories: school-sponsored scholarships and privately sponsored scholarships. School-sponsored scholarships are those that a particular educational institution offers to its incoming students. Common types of school-sponsored scholarships are academic scholarships, which grant money for exceptional student performance and need-based scholarships, which provide grants for students who may not have the means to pay for college.

A privately sponsored scholarship is a grant given to a student by any other individual or organization for any purpose. Often private scholarships have very specific criteria for eligibility, such as, the student is a member of a certain race, religion, gender or field of study, while others have no specific guidelines. Generally a student must have displayed superior performance in some area-such as academics, volunteer work, essay writing or other extracurricular activity. Several websites serve to report which students are eligible for which scholarships such as fastweb.com.

School based Payment Plans

A payment plan can provide a valuable alternative to the traditional lump sum semester payments you are required to fund to cover educational costs. By participating in a payment plan a student can spread educational costs by paying those costs on a monthly basis. Affordable monthly payments enable all students to meet their financial obligations without the need to liquidate assets, deplete savings or undertake excessive borrowing through interest bearing loan programs. Payment plans can be used to finance all or any portion of your educational costs.

Part-time jobs/Family Members

For individuals who have the time a part time job can help supplement payment for school. Some family members may be willing to assist with higher education aspirations.

Title IV Funds

The term “Title IV Funds” refers to the following Federal financial aid programs: Direct Unsubsidized Federal Stafford loans, Direct Subsidized Federal Stafford loans, Direct Federal PLUS (Parent) loans and Federal Pell Grants

Title IV funds are financial help for eligible students to pay for education expenses at an eligible postsecondary school. Federal student aid covers such expenses as tuition and fees, books and supplies, and transportation. Aid also can help pay for other related expenses, such as a computer and for dependent care.

Who receives federal student aid?

Be a U.S. citizen or an eligible noncitizen

Have a valid Social Security number

Maintain satisfactory academic progress in postsecondary school, and

Show you’re qualified to obtain a postsecondary education by:

A high school diploma or General Educational Development (GED) certificate;

A high school education in a home school setting approved under state law;

Passing an approved ability-to-benefit test (if you don’t have a diploma or GED, a school can administer a test to determine whether you can benefit from the education offered at that school);

Completing six credit hours or equivalent course work toward a degree or certificate; or meeting other federally approved standards your state establishes.

Applying for Financial Aid:

Complete the Free Application for Federal Student Aid

For FAFSA on the Web, go to www.fafsa.gov. Using FAFSA on the Web is faster and easier than using paper. If you need a paper FAFSA, you can download a PDF from www.fafsa.gov or order one from the Federal Student Aid Information Center at 1-800-4-FED-AID (1-800-433-3243). You can apply beginning Jan. 1, 2011; for the 2011–12 academic year and have until June 30, 2012, to submit your FAFSA. But you need to apply early! Check with the schools you’re interested in for their deadlines.

Review your Student Aid Report (SAR).

After you apply, you’ll receive a Student Aid Report, or SAR. Your SAR contains the information reported on your FAFSA and includes your Expected Family Contribution (EFC). The EFC is an index used to determine your eligibility for federal student aid. Review your SAR information and make any corrections or changes, if necessary. The school(s) you list on your FAFSA will get your SAR data electronically.

3.       Contact the school(s) you might attend.

Make sure the financial aid office at each school you’re interested in has all the information needed to determine your eligibility. If you’re eligible, each school’s financial aid office will send you an award letter showing the amount and types of aid (from all sources) the school will offer you. You can compare award letters from the schools to which you applied and see what aid you can receive from each school.

Grants
Federal Pell Grant	Grant: does not have to be repaid	Available almost exclusively to undergraduates; student may receive up to 2 consecutive maximum awards in a year if attending school year-round	$609–$5,550 for 2010–11
Iraq and Afghanistan Service Grant	Grant: does not have to be repaid	For students who are not Pell-eligible; whose parent or guardian died as a result of military service in Iraq or Afghanistan after Sept. 11, 2001; and who, at the time of the parent’s or guardian’s death, were less than 24 years old or were enrolled at least part-time at an institution of higher education	Maximum is same as Pell maximum; payment adjusted for less-than-full-time study

Loans
William D. Ford Direct Stafford Loans Direct Subsidized Loans	Loan: must be repaid Undergraduate students: • For loans first disbursed on or after July 1, 2010, and before July 1, 2011: 4.5% • For loans first disbursed on or after July 1, 2011, and before July 1, 2012: 3.4% • For loans first disbursed on or after July 1, 2012: 6.8% Graduate students: 6.8%	Undergraduate and graduate students enrolled at least half-time Must demonstrate financial need	$3,500–$8,500, depending on year in school	The U.S. Department of Education is the lender and pays interest on the loan while you are in school at least half-time and during grace and deferment periods Between 10 and 25 years to repay, depending on amount owed and type of repayment plan selected
William D. Ford Direct Unsubsidized Stafford Loans	Loan: must be repaid 6.8%	Undergraduate and graduate students enrolled at least half-time Financial need is not required	$5,500–$20,500 (less any subsidized amount received for the same period), depending on year in school and dependency status	The U.S. Department of Education is the lender The borrower is responsible for paying all interest on the loan starting on the date the loan is first disbursed Between 10 and 25 years to repay, depending on amount owed and type of repayment plan selected
Direct PLUS Loans (for parents and graduate and professional degree students)	Loan: must be repaid 7.9%	Graduate students enrolled at least half-time and Parents of dependent undergraduate students to help pay the cost of their child’s education Financial need is not required Must not have adverse credit history	Cost of attendance (determined by the school) minus any other financial aid received; there is no minimum amount	The U.S. Department of Education is the lender Loan is unsubsidized (you are responsible for paying all interest)
Loan Consolidation
Direct Consolidation Loans	Loan: must be repaid Fixed rate is based on the weighted average of the interest rates on the loans being consolidated, rounded up to the nearest one-eighth of 1% Cannot exceed 8.25%	Borrowers with multiple federal student loans	Depends on the amount of the loans	Combine multiple federal student loans into one loan A parent loan cannot be consolidated with the student’s loan(s) and become the student’s responsibility to pay

http://studentaid.ed.gov/students/attachments/siteresources/Funding_Education_Beyond_HS_2011-12.pdf

StudentLoans.gov is the federal student aid site that will walk you step by step through the loan process (http://www.studentloans.gov). One of the first things you will need to complete is a Master Promissory Note. You will find information on this process on the site listed above. Allow yourself approximately 30 minutes to complete this form. It will ask you for personal information:

Permanent address

Mailing address (if different from your permanent address)

Telephone number

Email address

You will also be asked for employer information and reference information for two people that you have known for three years. The first reference should always be a parent or guardian.