Warren Buffett has written a very interesting and timely article in the New York Times today. For those unfamiliar with Warren Buffett, he is one of the world's greatest investors, having made his fortune in the stock market. He now runs the corporate conglomerate Berkshire Hathaway.
In the article, Buffett compares the current budget deficit to those of years gone by. As a percentage of GDP it's twice the previous non-wartime record. It gone up to 13% where the previous high was 6%.
He also points out that US net debt has risen from 41% to 56% of GDP and questions at what point the country's credit rating will be put at risk. Sooner or later other countries will perceive the United States as credit risk if debt levels keep rising.
Lastly Buffett discusses the risk of rising inflation as a result of all this. All of this debt must be financed and with the prospect of the Government printing more money, inflation may soon follow.
From an investor's point of view, it begs the question how do we protect our investments from inflation? I will write more about this in the future.
Click the following link to read Warren Buffett's op-ed piece entitled The Greenback Effect.
I'm a big fan of the returns the big Ivy League endowment funds have been able to produce over the years. Yale has been able to produce a compound return of almost 16% over a 20 year period. Harvard produced a compound return of just over 14% over the same time frame. So it is with interest that I study the asset allocation of these funds each year.
However, as a small investor, I've always felt that I was unable to replicate the asset allocation of these endowment funds. They have been reducing these exposure to listed equity investments in recent years thereby making more difficult for an investor like myself to approximate what their investment portfolio contains.
But just recently, I read an article on the Kiplinger website (The Ivy Endowment-Fund Portfolio) where a simple portfolio is put forward which aims to copy the diversification and risk management techniques employed by the ivy league schools. The best part is that because the portfolio is composed of 10 exchange traded funds, the average investor like myself is able to buy these ETF's directly on the stock market.
The diversification achieved and low cost of using ETF's in an investment portfolio have been discussed at length many times the world over so I wont go into the arguments again here. Suffice to say that I'll be taking a closer look at the asset allocation recommended in the article to see whether it's worth incorporating some of the investment ideas into my own portfolio.
There are different approaches to saving money. Whether it's saving for a short term goal or saving for your retirement, people go about it in a variety of ways.
I admire those who have a set amount which they put aside each week (or each month) before they spend any money. I call these people conscious savers. It's a regular savings plan. The money is normally deducted from their pay or taken out of their bank account at the beginning of each period.
This sort of approach works for these people because there is a risk that if the money is not put aside immediately, it will get spent. It's a smart move and it lends itself to better long term planning, whether that planning relates to reducing debt or investing for the future or saving to buy a house or whatever.
Unfortunately, I'm not that disciplined. In fact my approach is the exact opposite. I tend to pay all of the bills and spend what I need to each month and only at the end of each month does what's left over get added to our savings.
Fortunately, that works for us. We don't have extravagant tastes and lead a fairly middle of the road existence and our income has always been such that we've been able to add enough to our savings each month to pay off all of our debts, including our mortgage and accumulate a reasonable investment portfolio that will someday become the foundation of our financial freedom.
Despite our success in the past at just following a saving what's left over approach, I do wonder whether a more conscious approach would put us further ahead over the long term. Maybe the extra financial discipline would enable us to save that little bit extra and help us reach our financial goals earlier.
The downside, as I see it, is that we may feel more constrained at living this way. There may also be more stress on our relationship if we attempt a more rigid approach to our personal finances.
You have your budget in place. You're spending less than you earn. You've started to save money on a regular basis and you're starting to accumulate a handy little pile of cash. So what's next? It's time to start thinking about another very important part of personal finance - investing.
Investing is the mechanism by which you will make your money grow. It is the act of buying assets which will grow in value and/or produce income over the years to come. Investing your current and future savings at a reasonable rate of return will help build wealth in order to reach your future financial goals.
But how do you get started with investing? Today I'd like to discuss a broad group of investment strategies which advocate a relatively simple and hands off approach to investing.
While most us us have heard of legendary investors like Warren Buffett, there is a theory floating around which says that the average investor wont do anywhere near as well as Warren Buffett. In fact they will struggle to beat the average because the average itself is made up of a bunch of average investors. Even more importantly, just to earn a return equal to the average should be considered a success.
This is where approaches put forward by The Coffee House Investor and others come to the fore. In a nutshell, they advocate the use of asset allocation and low cost Index Funds or Exchange Traded Funds (ETF's) to build your investment portfolio. Asset allocation is used to diversify across asset classes thereby spreading risk and reducing volatility. Index Funds and ETF's are used as a low cost way of ensuring an investor captures all of the return of a particular asset class - this is the very idea behind index funds.
You can see some of these types of portfolios in action at the Lazy Portfolios section of the Market Watch website.
Or for a more in depth discussion of the Ultimate Buy & Hold Portfolio from the Lazy Portfolios mentioned above, read The Ultimate Buy-and-Hold Strategy by Paul Merriman at FundAdvice.com.
The stock market is plummeting. I can't believe the turnaround in investor sentiment in the last year or so. The Dow was over 14,000 just 18 months ago and now it looks like it might go down below 7,000 again. I know the economic outlook is not as rosy as it used to be but has the underlying value of the companies which make up the Dow really halved?
You could well argue that the stock market was overvalued 18 months ago and that it's really just approaching fair value now. I can't claim to be an expert on valuation of equities markets so this may well be the case - but even if it is the case, it still food for thought.
A patient investor who's willing to hold onto some cash when markets are racing out of control, will eventually be rewarded with better value. And that's where we are now. Stocks are on sale - they're 50% off.
Now I wont pretend that I'm not worried about the financial crisis. I have no idea how bad it will get or how long it will last. But I suspect that in 5 or 10 years time stock market investors (particularly value investors) will look back at this period as one of the best buying opportunities of a generation.
Having said that, I think investors should tread warily. I would stick to companies in sound financial shape - low debt and strong cash flows. And be prepared to see the market price of your investment continue to fall. But take comfort in the fact that it's almost impossible to pick the bottom and that you're still buying a quality business for half of what it sold for less than 2 years ago.
I should point out that I'm an private investor managing only my own money. I'm in no way qualified to give financial advice. You definitely should not take any of what you read on this blog as personal financial advice. See a professional. I could be spectacularly wrong - maybe the world really is coming to and end.
A little while back, in my post about building wealth, I mentioned that I thought it was important to re-invest any income derived from your investment portfolio. It is an example of the compounding effect at work. Today I'd like to share my thoughts on dividend reinvestment plans (sometimes referred to as DRIPs). Dividend re-investment is touted by many a being a great strategy for growing your investments over the long term.
What Is A Dividend Reinvestment Plan?
When a company declares and pays a dividend, investors would normally receive that amount in cash. Under a DRIP, an investor can opt to forgo the cash payment and instead receive the equivalent amount in company stock.
As an example, if you own 100 shares in a given company and that company declares a dividend of $1 per share, you would be entitled to a cash payment of $100. But if that company offered a dividend re-investment plan and you decided to participate in the plan then you could take the $100 in shares. If the company's stock was trading at $50, you would receive 2 shares under the DRIP.
Advantages Of Dividend Reinvestment
Participation in these schemes allows an investor to acquire more stock an a company without paying brokerage fees. This means it can be a low cost way of increasing your ownership of an investment. Even though only a small quantity of stock is accumulated each year, this can add up over a number of years.
To make it more attractive, some companies offer stock in their DRIP's at a discount to the current market price (around a 5% discount or so). This can make the plan an even more cost effective way to add to your holdings.
Disadvantages Of Dividend Reinvestment
The main issue I have with these plans is that you may not necessarily be investing your funds in an investment which represents the best value at any given time. I like the idea of re-investing the income from my stock market investments. It creates a compounding effect whereby the amount reinvested increases the income the following year and so on. But I like to choose where I invest my hard earned cash. I prefer to take all of the income received over a given period then plow it back into the opportunity which represents the best value at that time, or perhaps even invest in a new idea.
Another thing to consider is the additional paperwork required. You will need to track each purchase for tax purposes. As your portfolio starts to grow and the number of holding increases, you will need to track the issue of shares twice or sometimes 4 times per year for each holding.
When you put your money into a savings account at the bank, it is on the understanding that you will earn some interest on that deposit. It's your reward for letting bank use your money for a while. Alternatively, you could say it's the cost a bank incurs when borrowing your money. Dividends are a little bit like interest but with a number of subtle yet important differences.
A dividend is a payment a company makes to its owners (stock holders) out of any profits it makes in a given period. Dividends are normally paid either quarterly or half-yearly.
While the interest you receive on your deposit in a savings account is typically agreed up front (ie. the interest rate is advertised), the amount a company pays out in dividends is a little more fluid. The payout may fluctuate from year to year. If the company is successful, the the amount will normally go up each year. However, when profits falls, so does the dividend - and if things get really bad, there may be no payment at all.
Another thing to consider about dividends is the chance of capital appreciation (or capital loss). In order to receive a dividend, you must first buy stock in a given company. You may consider this to be the equivalent of making a deposit in a bank savings account. However, when it comes time to take your money back out again, there can be a big difference between a bank and a shareholding.
With a bank account, you would expect to receive back the same amount of money as you deposited, plus your interest (not withstanding the present economic climate). But with a stock market investment, you need to sell your shares to get your money back. And for this, you will be at the mercy of the markets. Stock prices may have gone up - but as we have seen over the past year, they can also go down.
Now it's is not all down and gloom with dividends. History tells us that provided you invest in good quality stocks for the long term, then your dividends, along with some capital growth, will exceed the interest you could get in the bank. Just be aware that a much longer time horizon is needed. Most investment professionals recommend 5 years or more.
I know that get rich quick schemes are enticing. The lure of making money fast is too tempting for some people to resist. Maybe there are some methods out there which you can use successfully to generate significant wealth over a short period of time. However, I suspect there is either a certain amount of luck, a large amount of risk involved or both. In fact the cynic in me suspects that the only people getting rich from some of these schemes are the promoters.
My plan to build wealth is simple. Spend less than I earn, save the rest and invest my savings in quality investments. I said the plan was simple not easy. And I can't claim it as my own either. It is essentially the story laid out in George Clason's personal finance classic, The Richest Man In Babylon. If you haven't read this book, I think you're missing out.
This deceptively simple formula does take considerable commitment though. Obviously it helps if you can maximize your earnings. This might be through developing your career or maybe via a more entrepreneurial approach.
Controlling expenditure is where most of us run into trouble though. A budget is one of the tools which is critical for managing money in this context. Knowing where your money goes is the first step to controlling your expenses.
Then, by putting a savings plan in place, ensuring that cash is being put away out of harm's way on a regular basis, you'll start to build up some capital to start up your investment portfolio. Untold numbers of books have been written on the subject of investment but the main point I want to make here is that you should strive to re-invest any income derived from your investment portfolio. Use the power of compounding to your advantage.
One of the key features of a personal finance plan is the section aimed at building wealth. And investing in the stock market can be a great way to accumulate wealth over the long term. And there are plenty of options to help you get started. You don't need to go out and buy a heap of shares straight away. In this post I'll examine some of the ways you can go about investing in the stock market.
Get A Good Adviser:
First off, find yourself a good adviser. The adviser could be a financial planner or a stock broker or even your accountant. This person must be trusted and must know you current financial situation well and understand what you future financial goals are. Finding the right person is especially important when you're just starting out. A financial planner could be useful if you're looking generally at investments as part of your overall financial plan. A stock broker is more useful when you're looking at making specific stock market investments.
Mutual Funds:
But you don't need to jump straight in. Rather than holding stock of individual companies, you may like to invest via a mutual fund. The managers of these products pool investors' funds together and buy a range of different stocks. One advantage of this approach is that you can achieve a level of diversification even if you don't have much to invest. In fact an investment in one mutual fund may gain you exposure to the stock of 60 to 80 companies or even more.
One thing to be aware of however, is that even though you're spreading the risk across different businesses and industry sectors by using a mutual fund, you are taking on specific risk associated with that mutual fund. Make sure you do your research before choosing a fund and get professional advice if need be. Another way of mitigating the specific risk is to consider buying more than one fund. It's all about eggs and baskets.
Investment Clubs:
This is something I've not yet tried but I'm quite interested in. An investment club is a group of stock market investors (or any sort of investors I guess) who pool their resources - both financial resources and brain power. The idea is that each member of the group contributes funds to the club and the members meet on a regular basis to make investment decisions.
To my way of thinking this has a couple of advantages. By putting your money together with others, you'll collectively have more buying power. This means you can diversify your investments more broadly. Instead of being able to buy stock in one company every one or two months by yourself, you may be able to make two or three purchases each month as part of a club (or even more depending on the number of members).
The other advantage is that you'll be making joint decisions. This means there will be more ideas on what stock you could buy and more people to filter out the poor ideas. Collectively you should be able put together a good stock portfolio over time.
The main disadvantage I can see is that because it's a group thing, you'll need to make sure it's a group of like minded people. Do they all share your investment philosophy? Are they long term investors or short term traders? Will their preference be value stocks or growth investing? And the more people involved, the harder it will be to gain a consensus.
Invest Regularly:
Whatever method (or methods) you choose, my preference is to invest regularly. It's like a regular savings plan. And by spreading your investment activities out over time you can avoid putting all of your money into the market at the very top. Detractors of this approach would argue that you will also avoid buying at the bottom of the cycle as well - thereby not buying as cheaply as you may have. There is some merit in this argument, however, timing the market is notoriously difficult so I'll leave the decision to you.
What is the definition of personal finance?
Personal finance is a remarkably broad subject. The simplest way to define personal finance might be to take a look at each of the topics which come under the personal finance umbrella.
Record Keeping.
One of the fundamentals of personal finance is record keeping. It provides the foundation for everything else to build on. Keeping records means keeping track of all of your financial transactions. This includes what you earn, what you spend, what and where your savings (if any) are, insurance, and the list goes on. Record keeping can be as simple or as complex as you like. Some people will be thrive on tracking every individual cent that gets earned, saved and spent on a daily basis. Others will find this way too much overhead and will instead record approximate figures on a weekly or even monthly basis. Most people will find a working solution somewhere between these two extremes.
However you decide to do it, the main thing is to keep at it. Record keeping will enable you to understand what your financial position is now and how you've progressed over time. It will also provide valuable input into the planning process.
Budgeting.
Budgeting could be considered the counterpart of record keeping. The two go arm in arm. Budgeting is the practice of estimating future income and expenditure. To create a budget you would normally offset your expenses against your income month by month for the next year (and beyond). That way you can see what the surplus or shortfall is each month. This can help with planning your investments or by identifying where your future cash flow problems might lie.
Financial Position.
Another key area of personal finance is your financial position. Knowing this is key. When used in conjunction with your record keeping and budgeting, your statement of financial position is a key tool in meeting your financial goals. In it's simplest form, it's a document which lists your assets and your liabilities and which will hopefully show a surplus on the asset side. Even if it doesn't show a surplus of assets, it will provide you with a starting point on your road to freedom from debt.
Credit and other forms of Personal Debt.
And speaking of debt, this is another broad topic within personal finance. Not many of us can go through life without resorting to some sort of debt. Whether it's a mortgage to fund the purchase of a house, a personal loan to buy the car of our dreams or credit card debt to be used for day to day living and the odd larger consumer purchase, most of us will be in debt at some time or other.
But there are different types of debt. Borrowing money to finance investments can be a powerful wealth generating tool. However payday loans and other forms of cash advance are normally to be avoided if at all possible.
Saving and Investing.
Saving money is something we should all aspire to. It could be saving enough money to put aside in an emergency fund to provide a financial buffer in unforeseen circumstances. Or it might be saving for the kids' education or maybe even an overseas trip. And saving ties in nicely with budgeting. Saving is what we can do what the money which our budget tells us should be left over each month.
Then once you've accumulated some savings, you may look at how to invest them. Investing is a complex area with many complex investment products available. You might buy shares, real estate or a mutual fund. You can even invest in non-financial asset like art or wine providing you know what you are doing. Investing is how you take your accumulated saving and put them to best use to grow your wealth over the long term.
Insurance.
What does insurance have to do with personal finance? Well, what's the point in doing all of that hard work to get your personal finances in order just to see some catastrophic event wipe it all out? That's why insurance is such an important part of personal finance. Whether it's your house, your car, your income, your health or even your life, you need to make sure you have enough insurance for the worst case scenario.
Tax.
Nobody likes paying tax, but with some careful planning and good advice, you can at least minimize the amount of tax you need to pay. I'm sure most people would agree that we pay more than enough tax already. And by organizing our personal finances better, we may be able to reduce our taxes freeing up more money to save and invest.
Retirement Planning.
For some people this is what it's all about. You need to make sure that nest egg has grown large enough to support you once you stop paid employment. By putting the right strategies in place earlier in life you can help ensure you have a comfortable retirement.
Mastering each of the above topics should put you well on the way to living large in retirement.
Estate Planning.
They say that death and taxes are the two certainties in life. While nobody likes to think about their own mortality, it's important to consider your estate. How should it be distributed? Do you have any special wishes? Is your will up to date? A little planning and forethought may at least remove some of the financial worries from this difficult time.
I think the topics above cover this broad subject area reasonably well. In future posts, I will refer back to this "What Is Personal Finance" post often as I drill down on each of these topics.
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