The Nature of Investing

Generally speaking, an investment is something you put time or money into and get a return from. For example, we talk about investing in a personal relationship. We also talk about investing in the stock market. For this chapter, we will use the financial definition of investing: a financial asset you contribute money to and from which you receive an interest payment, a dividend, or an increase in the market value over time (or all three). You use money from your savings to invest:

With your Disposable Income, you can either spend it or save it:

Unless you hide your cash in the ground, you will take your savings and invest it somewhere you will get a return.

Keeping these equations in mind, it is hopefully apparent that the more disposable income you save, the more you are able to invest. But where to invest?

Risk and Reward

On Wall Street, the standard saying is “risk follows returns.” By choosing a lower risk investment (such as U.S. Treasury Bonds), you will receive a lower return. Treasury Bonds are considered the safest investment possible because the U.S. has always paid those bonds back (except for debts from the Revolutionary and Civil Wars, but that’s another story). Almost all long-term interest rates are influenced by the rate on the U.S. Treasury Bonds, which are considered a “risk-free” return.

In terms of risk, the three traditional investment instruments are stocks, bonds, and cash. We can analyze each in terms of risks and rewards. On Wall Street, risk is measured by beta (the Greek letter β), which measures the volatility or deviation from the average historical return of an investment.

Stock prices are negatively correlated with recessions. Below, you can see a chart showing the prices and volatility of the general stock market. The grey bars are recessions, so it is easy to see their impact on the stock market. The S&P 500 is a general index of the overall stock market. It was created and is maintained by the financial company Standard and Poors, which is a major credit rating company. The index consists of the prices of 500 stocks out of the 3,700 public companies listed on American stock exchanges, and the composition of these 500 selected companies reflects the composition of the entire market.

Adding bonds tends to lower both risk and potential return. The following chart shows the maximum gains and losses on various portfolios consisting of all stocks (on the left) through a series of mixed stocks and bonds to a portfolio consisting of all bonds (on the right). As you can see the maximum gains and losses are greatest with an all stock portfolio.

Finally, some investment advisors suggest you should hold up to 10% cash in your portfolio, either for emergencies or to take advantage of bargains that may arise in the market. This should not be kept in a checking account but in a money market fund. The current annual return on money market funds is 1.7% (Vanguard Prime Money Market Fund).

How Return on Investment is Calculated

Inflation can have a large impact on your investment, so it is important to understand how that works. Let’s say you have cash and save it by hiding it in your mattress. Your money gets less valuable every day by exactly the rate of inflation because money is something we need to buy goods and services. If you hide your savings in a mattress and the rate of inflation is 2%, your money is depreciating in value by 2% per year. The same thing happens to money you keep in a checking account that pays no interest. Your money is depreciating at a rate of 2% per year. Even further, the money you receive as a dividend or interest on your investment is also depreciating at the annual rate of inflation. The real quest, then, is to find an investment that gives a return greater than the rate of inflation.

In order to be able to compare the return on all sorts of different investments, like buying stocks or buying a Picasso, we use the same measure to calculate returns. The return on an investment comes from two areas: dividends or interest paid and the price appreciation. For example, you may put your savings in stocks and get a dividend of 2% per year plus the stock price may have increased by 8% over the course of a year. Thus, your total return for that year would be 2% + 8% = 10%. Alternatively, those investors who buy gold or a Picasso do not get any interest or dividends but receive returns from the price appreciation of their asset over time. If you bought gold today at $1,600.00 per ounce and after a year its price was $1,700.00 per ounce, your annual return would be:

The general calculation of a return on investment (ROI) is the appreciation in the price (value) of the investment (asset) over a year plus any dividends or interest earned during that year, compared to the original cost of the investment (asset). The calculation is thus:

This calculation will yield a decimal which is then expressed as a percent annual return. The general formula is expressed as a backward-looking calculation:

Now, here’s an example. Let’s say you purchase 100 shares of Apple stock at $5.00 per share. At the end of one year, it is now selling on the stock market for $6.00 per share. In addition, you receive a dividend of $1.00 from Apple during the year. Your return could be expressed like this:

If your investment is held for multiple years, you would use the total price appreciation of the asset plus add up all the dividends and calculate your total return. You would then divide the total return by the number of years you held the asset to get the average annual return. This annual return allows investors to compare the annual returns for all sorts of investments that are dissimilar, such as paintings, antique automobiles, collectibles, and stocks and bonds.

However, there is one more complication to consider: taxes on your profits from investments. The profits you make from the price appreciation of an asset is called a capital gain, and it is taxed when you sell the asset to realize the gain. Taxation of the capital gain is different if you own the asset for less than one year (a short-term capital gain) or own it for more than one year (a long-term capital gain). A short-term capital gain is just added to your regular income on your tax return and taxed at your regular income tax rate. On the other hand, if you sell the asset after owning it for more than one year, you will be taxed at the long-term capital gains rate. If your total taxable income is $39,375 or below, a single person will pay 0% capital gains tax. If their income is $39,376 to $434,550, they will pay a 15% capital gains tax.  Above that level, the rate jumps to 20%. The tax rates (or brackets) are somewhat different for married people. Tax laws give an incentive to hold investments over one year.

Historical Returns on Various Investments

Vanguard Mutual Funds, a not-for-profit, has created historical returns of various portfolios that are made up of different mixes of stocks and bonds going all the way back to 1926. Below are the returns of those different allocations.

Income

An income-oriented investor seeks current income with minimal risk to principal and is comfortable with only modest long-term growth of principal. They have a short-to mid-range investment time horizon.

Balanced

A balanced-oriented investor seeks to reduce potential volatility by including income-generating investments in their portfolio and accepting moderate growth of principal and is willing to tolerate short-term price fluctuations. They have a mid- to long-range investment time horizon.

Growth

A growth-oriented investor seeks to maximize the long-term potential for growth of principal and is willing to tolerate potentially large short-term price fluctuations. They have a long-term investment time horizon. Generating current income is not a primary goal.

We can actually trace the historical returns on stocks and bonds going all the way back to 1870. The historical returns do not, of course, guarantee that the same returns will happen in the future, but most of the stock market investors are wise, and wise investors demand certain minimum returns in order to take the risk on investments.

In their 2019 study of investment returns, The Rate of Return on Everything, 1870–2015, Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M Taylor calculated returns on stocks, bonds, and housing in 16 developed nations going all the way back to 1870. As Thomas Picketty notes in his book Capital in the Twenty-First Century, housing is important in all developed nations, since it represents approximately one-half of the wealth in a typical economy (2021). Here is a graph of the real rates of return in the world:

The Portfolio Theory of Investing

Asset allocation is spreading out your investment in various financial assets to maximize your profit while minimizing your risk. However, as I stated before, in order to achieve a higher return, you must take a higher risk. A low risk portfolio would be invested in all bonds, and from 1926 to 2018 achieved an average annual return of 5.3% with low volatility. A moderately high risk portfolio would be invested in all stocks, and from 1926 to 2018 achieved an average annual return of 10.1% with much higher volatility.

Professional stock pickers are merely making educated guesses as to which stocks will appreciate the most over the next year. This is because no one can accurately predict the future. Wall Street is myopic in their focus on short-term returns. In contrast, Warren Buffet, Chair of Berkshire Hathaway, has always focused on long-term profits.

Even with all their computer models and data dumps, not a single active stock picker has consistently beaten the overall rise or fall of the market, as measured by the stock market indexes of the Dow Jones Industrial Average, the S&P 500, or the Nasdaq. Therefore, the only way to achieve consistent average returns is to invest in a broadly diversified portfolio of investments. As mentioned before, a portfolio of 100% stocks has achieved a 10.1% average return over the 90+ years from 1926 to 2018.

As a small investor, you will not have enough money to diversify by buying stocks yourself. Experts say you should have a minimum of 20 diverse stocks in a portfolio. Instead, you should invest in a mutual fund that contains all S&P 500 stocks. Almost every mutual fund company has a fund that is exactly that. Currently, you do not need to invest in bonds due to their lower returns. However, when you get within five years of retirement, you will need to rethink that strategy.

Finally, in your portfolio allocation, you do not need to invest in a global stock portfolio. This strategy was popular over fifteen years ago because when the U.S. was in a recession, Europe was not in a recession. This is no longer true. Globalization has connected world economies, and now European and U.S. Economies are procyclical. Another reason you do not need to invest in a global stock portfolio is that a portfolio of European stocks have consistently underperformed the S&P 500 by about 1% annually. Europe does not have the high-flying tech stocks like Apple or Google that are included in an S&P 500 mutual fund. In any case, most of the largest European companies like Nestle, BMW, or Mercedes are also listed on the U.S. stock exchanges.

Investing in Money Markets

Money market mutual funds are alternatives to savings accounts or certificates of deposit in banks or credit unions. Their annual returns are higher than bank and credit union savings accounts, but your funds do not have the government guarantee of the FDIC or CUIC. Money market mutual funds invest your money in bonds, and these returns fluctuate with the market. Vanguard Mutual Funds reports that the ten-year average annual return on its money market fund was .42%. Unless you want to park your money and not really invest it, you do not need to put your investment dollars in a money market fund.

Investing in Bonds

You can find quotes on bond yields and prices in The Wall Street Journal or on FIRNA’s Market Data Center. A bond is basically an I.O.U. or promissory note. A government or a company issues bonds in order to borrow money directly from investors. This is cheaper than borrowing from a bank because the bank adds overhead and profit to its loans. A bond is a promise to pay interest to the investor every year and then to pay back the investor at the end of a specified time period. A bond’s time period is also known as its length, term, or maturity. For example, the U.S. Government issues Treasury Bonds in order to finance the ongoing annual deficit. Currently, a newly issued 10-year Treasury Bond would likely have the following characteristics:

• Face Value Amount or Par: $1,000

• Coupon or Yield: 0.7%

• Maturity or Term: 10 years

This means that the owner of the bond will receive interest payments every year of $7.00 until maturity and will receive the $1,000 back at the end of the ten years. The interest payment is calculated as $1,000 X 0.007 = $7.00.

The current 0.7% yield of the 10-year Treasury Bond is extremely low and was manipulated by the Federal Reserve Bank in the last two recessions. The Fed purchased trillions of dollars’ worth of Treasury Bonds and, due to supply and demand, brought down long-term interest rates. Even though the investor may have purchased the Treasury Bond when it was first issued, they do not have to hold the bond for the next ten years. They can sell the bond in the secondary market. On average last year, $600 billions’ worth of Treasury Bonds were bought and sold every day in secondary bond markets. The U.S. government is constantly issuing new Treasury Bonds to finance the fiscal deficit and to refinance existing Treasury Bonds as they mature and must be repaid. The total amount of outstanding U.S. Treasury Bonds is the National Debt and is currently about $18 trillion. According to the Brookings Institute, as of April, 2020 of the $18 trillion outstanding U.S. Treasury Bonds:

• $3.5 trillion were held by U.S. households, companies, and governments

• $3 trillion by asset managers

• $2.5 trillion by the Federal Reserve

• $2 trillion by banks and insurance companies

• Nearly $7 trillion (40%) were held overseas, mostly by foreign central banks

When bonds are sold in the secondary market, the price at which the investor buys them may not be the Face Value of Par (typically $1,000). That is because the price adjusts to reflect the current interest rates in the marketplace. For example, in the table below, you see that although the coupon remains constant at the same annual payment as when the bond was first issued, the marketplace bids up or down the price to achieve the desired yield:

You may have read in The Wall Street Journal that bond prices and bond yields move in opposite directions. This is because the coupon is fixed at the issuance date of the bond and when the price goes up, the yield goes down and vice versa.

The above example used a fixed dollar amount for the interest paid annually on the bond. However, the coupon is an actual interest rate that will be paid annually, and the yield fluctuates the same way as in the table above:

The U.S. Treasury issues Treasury Bonds of many different maturities for their different borrowing needs (e.g. tax anticipation, long term deficits, etc.). The daily yields of these treasuries are depicted in a yield curve. The yield curve is published every day in The Wall Street Journal.

The graph above shows that the historical yields of 10-year U.S. Treasury Bonds have been significantly higher in the past.

Because inflation is a component of nominal interest rates, we can use the 10-year Treasury to see how the market anticipates the rate of inflation in the future. In 1997, The Treasury Department began to issue what are called Treasuries with Inflation Protection (TIP) in response to investor demand. In addition to the coupon yield, the Treasury protects the TIP owners by increasing the principle of the bond after the end of the year, based on inflation. The Consumer Price Index is used as a gauge for inflation, thus guaranteeing that the purchasing power of the bond-holder’s original investment will not decrease.

Nominal interest rates on regular 10-year Treasuries have both a time-value of money component (the real interest rate) and an inflation component. 10-year TIPs contain only the real interest rate. Therefore, using the difference between the yield on the regular 10-year Treasury Bond and the 10-year TIP, we can accurately gauge expected inflation. Below, I have added a graph showing the two different yields. For current quotes, visit The U.S. Department of the Treasury.

There are other types of bonds besides U.S. Treasuries. Bonds are classified according to the type of issuer:

• Treasury Bonds

• Corporate Bonds

• Municipal Bonds

• Federal Agency Bonds

• State Agency Bonds

Corporate Bonds

If a company is solid and financially secure, bonds they issue will have a lot of demand. Citibank, Amazon, General Motors, and all other large public companies issue bonds, because the yield they pay is much cheaper than borrowing from a bank. The yields on 10-year top rated corporate bonds (rated AAA) has been, on average, 1.3% above the 10-year Treasury bonds. You can see the difference between 10-year Treasury Bonds and 10-year AAA Corporate Bonds in the graph below. The higher yield is due to the fact that corporate debt is not as safe as U.S. Treasury Bonds.

Companies that are less financially strong also issue bonds but must offer higher interest rates to entice investors. Even some very risky ventures can offer bonds but may have to offer yields of 10% or more. Bonds with a yield of 10% or more are called junk bonds. For example, Donald Trump offered junk bonds to refinance his casinos in Atlantic City at a 14% interest rate. The casinos went bankrupt, and the bondholders lost 50% of their money and ended up taking over ownership of the casinos.

Municipal Bonds

Cities and townships can issue bonds to borrow for projects they want to undertake, such as a new sewer treatment plant or a new school. However, in all states except Hawaii, cities, townships, and states cannot borrow money to finance operating deficits the way the federal government does. They must have balanced budgets every year.

Investors in municipal bonds get a break from the IRS; interest on municipal bonds is tax free (federally, but often not on state income tax). Bond issuers can then pay a lower interest rate. For example, if the municipality anticipated paying 8% on their bonds, and the average federal income tax rate is 25%, the tax-free yield that is equivalent would be .08 X .75 or 6%. This is an approximation, of course, because the final yield is determined in the municipal bond market and depends on current interest rates and the credit worthiness of the issuer.

Federal Agency Bonds

There are many federal agencies that also issue bonds. This could be to build highways (Federal Highway Administration) or to provide mortgages to residential housing buyers (Freddie Mac and Fannie Mae). Most of these Federal Agency Bonds have a U.S. Government guarantee behind them. The yields are low and comparable to U.S. Treasuries. Because of the federal guarantee, investors have a big appetite for these types of bonds. During the past two recessions, the Fed bought trillions of dollars of Fannie Mae’s and Freddie Mac’s bonds, and now the rates on home mortgages (around 3% for a thirty-year mortgage) are the lowest they have ever been.

State Agency Bonds

States have to build highways, regional sewage treatment plants, and other projects. In addition, states often guarantee the bonds of their public universities, so the colleges can borrow at a much lower rate. Interest on some state bonds is exempt from state and federal taxes. When buying state bonds, ask if a particular bond issue is exempt from federal and/or state income taxes.

Bond Ratings

Standard and Poor’s and Moody’s are financial services companies that provide risk ratings on bonds. The risk is whether the bond issuer will default on either the interest payment, on repaying the principle, or both. These ratings range from AAA to DDD for Standard and Poor’s and from AAA to C for Moody’s. New bond issues almost always will ask one of these agencies to provide a rating. Bonds with a rating of BBB- (on the Standard & Poor’s) or Baa3 (on Moody’s) or better are considered investment-grade. Bonds with lower ratings are considered speculative and often referred to as high-yield or junk bonds.

Investing in Stocks

Quick tip: Yahoo Finance is a good place to get price quotes on stocks and their historical price charts.

Most students who have taken my financial literacy courses have wanted to learn as quickly as possible how to become a millionaire (or preferably a billionaire) by investing in stocks and bonds. If this is your goal, lucky for you, as I can show you how to do it. However, you need to know how to evaluate stocks and bonds, and it takes time. To whet your appetite, in the next chapter, I show you how to become a millionaire by investing wisely in the stock market early in your career and then being patient. First, however, you need to understand how to evaluate stock prices.

The most used tool for assessing stock prices (that is, whether the market is overvaluing or undervaluing a stock) is the Price/Earnings Ratio (P/E Ratio). This is the simplest formulation of this ratio:

Last year’s earnings per share means the total net income of the company divided by the outstanding number of shares. For example, the closing price of one share of stock you are looking at is $20.00 per share, and the earnings (or net profit) per share is $2.00. The P/E Ratio would look like this:

That means you are paying $10.00 for every $1.00 in earnings, or to put it another way, you are receiving $1.00 return for every $10.00 you invest. Your ROI could then be calculated like this:

To see if a P/E Ratio of 10 is a good, we need to look at the historical averages of the stock market’s P/E Ratios. I have summarized a few similar historical P/E Ratios below:

To calculate what returns these P/E averages would give, plug the known numbers into the formula and solve for the unknown price. Then you can calculate the annual return. To simplify, we can assume that the earnings are $1 per share.

If we paid $15.50 for one share of this company’s stock to own $1 per share of net earnings, our ROI would be:

In order to reconcile this with numbers we saw above, we need to add to use this formula:

The price appreciation of stock is a direct function of the annual growth in earnings per share, and the average annual dividend paid on the S&P 500 stocks is approximately 2%. However, P/E Ratios are volatile. Below is a chart of what is known as the trailing P/E Ratio of S&P 500 stocks from 1929 to 2019. The trailing P/E Ratio is an historical P/E Ratio; that is, it is calculated as such:

Note the volatility of the historical P/E ratio. It certainly gives us pause to think that we could predict the value next year with this tool, even though we have already discussed previously that the average of the trailing P/E Ratio from 1872 to 2015 is 15.5. Nevertheless, this data gives us the base for expected P/E ratios in the future. However, there are serious theoretical and practical flaws in projecting this historical P/E Ratio into the future, even on the average.

Calculating the ROI for the average of the One Year P/E Estimate, we get the following:

Using the trailing P/E Ratio as a principle forecasting tool is flawed, due largely in part to the real world. Investors do not buy a stock for its past earnings but for its expected earnings and dividends. Simply, buying stock today does not entitle you to past earnings or dividends, but you will receive a proportionate share of future net earnings and dividends. Given an historical P/E Ratio of 15.5, investors are looking to buy a share of stock at a P/E Ratio of 15.5, but the earnings that are used to calculate the P/E Ratio are expected earnings based on the following year’s earnings. This P/E ratio is usually called the P/E Estimate and is calculated as follows:

Real world investors price stocks this way, causing a lot of the trailing P/E ratio’s volatility. Let’s say investors estimate that next year’s earnings will be $1 per share. If they want to buy a share at the average P/E Ratio of 15.5, they would pay $15.50 for each one.  Now, let us say that they paid $15.50 for each share and were wrong about their estimate of next year’s earnings. The trailing P/E Ratio would be quite different from a P/E Ratio of 15.5. If the investor overestimated next year’s earnings and the earnings per share were $.50, the trailing P/E Ratio would look like this:

If, on the other hand, the investor underestimated next year’s earnings and earnings per share were $2.00 instead of $1, the trailing P/E Ratio would be this:

Estimated P/E Ratios can vary significantly across industries. Let’s say professional investors were able to accurately predict the one-year future earnings per share of the S&P 500 and that they were looking for a 6.5% return. The one-year P/E Estimate would be constant at approximately 16.5 times earnings. The high volatility of the one-year P/E Estimate simply attests to the fact that it is impossible to accurately predict future earnings.

The calculation of the ROI for the CAPE 10-year Price/Earnings Ratio is:

The Cyclically Adjusted 10-year Price Earnings Ratio (CAPE Ratio) is based on the average inflation-adjusted earnings from the previous 10 years. Nobel Laureate Robert J. Shiller created this ratio with economist John Campbell and detailed this in his book, Irrational Exuberance (2000). Shiller uses an inflation adjusted (or real earnings) 10-year average is to smooth out the cyclical volatility of corporate earnings over periods of the business cycle. Divide today’s closing stock price by the 10-year real earnings per share and you have the CAPE 10-year P/E Ratio.

Below is a graph of the CAPE 10-year P/E Ratio compared to long-term interest rates. Note that even though the average CAPE 10-year P/E Ratio is 16.5 for the period 1818 to 2013, it is still quite volatile a measure of the value of stocks.

The Current One Year P/E Estimate

Note that on all the graphs above, the values of all three P/E Ratios are significantly above their long-term averages. This is also true as of January 2020:

What does this mean? Well, first of all, let’s see why the P/E Ratio I recommend to watch (the P/E Estimate) is so high. According to John Butters of FactSet, one year prior (January 18, 2019), the forward 12-month P/E ratio was 15.5. Over the following 12 months (January 18, 2019 to January 17, 2020), the price of the S&P 500 increased by 24.7%, while the forward 12-month Earnings Per Share estimate increased by 3.8%. Thus, the increase in P has been the main driver of the increase in the P/E ratio:

This means that prices of the S&P 500 stocks are overvalued which usually leads to a correction through a drop in S&P 500 share prices. We will have to watch the stock market to see if that is true.

In a recent New York Times article, Robert Shiller notes that his CAPE 10-year P/E reached 33 in January 2018 and was 31 at the time of publication (2020). He further pointed out that it has only been as high or higher at two other times, 1929 and 1999. In 1929, the high CAPE 10-year P/E immediately preceded the Stock Market Crash, during which the stock market lost 85% of its value. Likewise, in 1999, the high CAPE 10-year P/E ratio preceded another Bear Market; stocks lost 50% of their value. According to Shiller, some pundits blame exceptionally low interest rates for the stock market highs. However, states that low interest rates do not correlate well with the CAPE 10-year P/E Ratio. The opposite is also true; high interest rates do not correlate well with subsequent market crashes.

Shiller attributes the current Bull Market to what John Maynard Keynes describes as Animal Spirits. According to Shiller, he has seen a proliferation of narratives since 1960 of “going with your gut” as opposed to “using your brain” to make decisions. This attitude includes people like President Trump (“I have a gut and my gut tells me more sometimes than anybody else’s brain can tell me.”) and inexperienced entrepreneurs in Silicon Valley. It fuels the mania in the market. This is not the method of investing that Shiller advocates: “We have a stock market today that is less sensible and less orderly than usual, because of the disconnect between dreams and expertise (2009).”

However, no matter the outcome of the S&P 500 share prices, no one can accurately predict the timing of the market over the long term. For those investing in the market over the long haul, especially those who are putting regular amounts each month in their retirement plan, the best strategy is to stay the course. As we saw above, over the long term, the S&P 500 has returned on average 10% per year.

The S&P 500 includes five hundred companies, but six of them play an outsized role. These are:

• Meta (Facebook)

• Amazon

• Apple

• Netflix

• Alphabet (Google)

• Microsoft

David J. Lynch discussed this in a recent Washington Post article:

…with a combined market value exceeding $7 trillion, these six companies account for more than one-quarter of the entire S&P 500. That explains how so few companies can lift an index of 500 stocks. Since the S&P 500 is weighted by each stock’s value, or market capitalization, gains by these larger companies have a greater effect than gains by an equal number of less valuable companies (2020).

These six companies led the S&P 500 Index from a drop of 35% during the pandemic to a return to near its all-time high on February 12, 2020. It took about six weeks to fall into a Bear Market (defined as a drop of 20% or more from a previous high), and this was the fastest drop in history. The S&P 500 Index then climbed back in 126 days to where it was before the Pandemic Recession. This is likewise the fastest recovery from a bear market in history, according to The Wall Street Journal.

Bubbles and Busts in the Stock Market

As much as the professional stock traders would like us to think that they are rational analyzers of expected future cash flows and P/E ratios, there is still a great deal of speculation, gambling, and herd behavior in the stock markets. For example, take a look at the activity of Tesla’s stock just since the beginning of the year 2020:

There is no rational reason for the stock to rise almost 250% in 2020. Tesla had been announcing good news about vehicle deliveries, but there was no reason to expect earnings per share to increase 250% anytime in the near future. Tesla stock is clearly in a bubble. Tesla, of course, is just one of many instances of speculation and gambling in the stock market. Bitcoin went from under $1 per coin in December 2016 to almost $20,000 per coin in December 2017, an increase of 2,372%. It then dropped to under $5,000 per coin and now trades around $9,500 per coin.

Qualcomm was a chip maker for smart phones, and its stock jumped from $5 per share to over $90 per share in just the one year (a 2,619% increase) because investors saw it as the only major supplier of chips. When competition entered and the dot.com bust happened, Qualcomm dropped to a price in the mid-teens. Fortunately, it stayed viable and over the next 20 years, the company has grown, and the stock is now approaching $90 again. We are not going to spend a long time on bubbles, so for classic analysis of historical bubbles and busts, read Manias, Panics, and Crashes: A History of Financial Crises, Seventh Edition, by Robert Z. Aliber and Charles P. Kindleberger.

Investing in Commodities

I recently was with a good friend of mine who is a retired finance professor. Prior to teaching at Temple University, he had a career as a stock trader at a big investment house. While we were talking, he was constantly looking at his cell phone. After a while, I asked him what was so interesting on his phone. He told me now that he was retired, he was trading commodities. Wow, I said, have you made any money? Not yet, he replied.

Commodities are generally unprocessed goods used to make other things. They do not have a dividend as stocks and bonds do, so the only return is its increase (or decrease) in value. Here are some examples:

• Grains (wheat, corn, soybeans)

• Metals (gold, silver, copper)

• Meat (beef, pork bellies)

• Oil

• Natural gas

• Foreign currencies

Commodities prices are determined by the interaction of supply and demand in the marketplace, and they are often subject to large price swings. Droughts increase the prices of grains and meats. The fracking of oil and natural gas in the U.S. caused a dramatic drop in the world price of oil and gas.

Gold is somewhat special in that its only practical use is for jewelry, but it is seen as a store of value in good and bad times. Investors turn to it for safety when the stock market drops (especially during recessions). Likewise, when bond returns decline, safe asset investors turn to buying more gold, increasing its price. When inflation accelerates, the price of gold tends to rise, because it takes more dollars to buy an ounce of gold. Gold’s price gyrates; when there are wars, natural disasters or recessions, it increases in value and vice versa. However, it does not evidence huge returns over time. For example, during the Great Recession, stocks dropped 30% but gold only rose 5%. When stocks roared back over the next couple of years, gold did not rise much at all. However, the performance of gold in the Pandemic Recession has been extraordinary. It has increased 25% since the beginning of 2020. I believe we can attribute this to the amount of fear and uncertainty caused by the Pandemic, since the price of gold always reacts to fear. See the graph below for the price of gold since 1970. The big spikes are in recession years.

Because of their volatility, commodities are a risky investment, and you should consider them like betting on a roulette wheel at a casino. Many factors outside of your control affect the price of commodities.

Investing in Art

The stories most of us hear about art investments come in headlines about the eye-popping prices of fine art at auction houses. In 2015, the most expensive Picasso ever sold, “Les Femmes d’Alger (Version ‘O’)” went for $179 million at Christie’s Auction House.

In 2019, a “lost” Leonardo da Vinci was sold to the Prince of Saudi Arabia for $450 million, although experts disagreed about its provenance.

Despite these prices, the ROIs are quite mundane. In the 2015 article, “Does it Pay to Invest in Art? A Selection-Corrected Returns Perspective,” a group of finance professors from top universities examined the returns on 32,928 paintings sold repeatedly at art auction houses from 1960 to 2013. They found returns (adjusted for selection bias) to be 6.3% annually. They conclude that art is just not a good investment compared to stocks and other assets. They also computed returns on other assets and compared them to the investment returns for fine art, or what we might call investment art. For most of us, we will almost assuredly not even get what we paid for a piece of art when we sell it. When we buy art, we are paying the retail price which is typically double what the gallery paid for it. If we are going to sell it to a gallery, we will receive a wholesale price from the gallery. If we sell it on eBay, it depends on the fads of the day. So, if you want to buy art to hang on your wall, buy something because you love it, not because you expect to make money from it.

Day Trading

Many brokerages now advertise to individual investors to get them started in trading stocks online. These include not just places like TD Ameritrade, E-Trade, and Robinhood, but also major mutual funds such as Fidelity Investments. Due to competition, online trading now has zero trading fees, and the ease of trading online is incredible. Several online stock brokerages are criticized because they make stock trading feel like a video game and give customers access to large credit lines to trade with.

With these options, can we as individual investors do better than the actively managed mutual funds by picking our own stocks? The answer is a resounding no! Mark Hulbert in his Wall Street Journal article, “When Day Traders Do Well, It’s Probably Just Luck,” says:

There’s little doubt that day trading has mushroomed in popularity in recent months, or that some day traders have produced extraordinary profits. According to statisticians, however, there’s also little doubt that most of these day traders’ good performance is due to luck. They essentially would have just as good a chance of success going to the casino (2020).

Investing in Stock Options

An option is a right to buy or sell a specific amount of stock at a specific price of a specific company (or group of companies). Options always have a set time period in which they may be exercised.

In his Wall Street Journal article, “More Investors Play the Stock-Options Lottery”, Randall Smith reports that due to individual investors jumping into the market, stock market volume has more than doubled since the year 2000. However, the volume of stock options trading has grown to more than six times what it was in 2000 (2020). According to the Options Clearing Corporation, the average daily trading in options on stocks was about 21,000,000. On September 13, 2020, the Wall Street Journal reported that options trading on shares was 120% of the buying and selling of stock shares. These options are mainly on high-tech companies that are flying high right now, directly as a result of COVID-19 and the switch to online shopping. Further, the Wall Street Journal reported that share values optioned by small investors was $500 billion.

 There are two main types of options: Call Options and Put Options. A Call Option gives you the right to buy shares of a stock. A Put Option gives you the right to sell shares of a stock. If you decide to invest in options and are convinced that the price of a certain stock will go up, you will buy a Call Option. The way you make money is to wait until the stock price goes up and then exercise the right to buy at the lower price. Alternatively, the price of the option will rise as the price of the stock rises, so you do not have to even exercise the option to reap your profits. You can just sell the option on the market at a higher price. If you are convinced that the price of a certain stock will go down, you will buy a Put Option. The price of the Put Option will rise when (and if) the price of the stock drops, and you can reap your profits just by selling the option in the market.

Let’s look at an example of a Call Option. On January 1, you purchase 100 Call Options to purchase Apple stock at $250 per share to expire on March 31. The price of the options is $2 each.

If Apple stock rises to $255.00 the options price will typically rise by the same amount.

You sell the options on the market, and your profit and return are thus:

The value in buying options rather than Apple stock is that your returns are multiplied. If you bought 100 shares of Apple stock at $250, and its price rose to $255, your profit and return can be expressed like this:

Looks great, huh?

The problem is that your timing could be off. If Apple does not rise in price by March 31 (or drops in value by March 31), your Call Options will expire as worthless, and you will lose your $200. The $2.00 per option that you paid is called the time premium or premium, and it decays or decreases the closer you get to the expiration date. This means that the option that you paid $2.00 for is worth $0 on the expiration date if the stock price has not risen above your exercise price.

For every buyer of a Call Option, there must be someone willing to sell a Call Option. There will be some sophisticated investors on the other side of your Call Option betting that Apple stock will not go up (or will decline) in price by the end of March 31. According to Smith’s Wall Street Journal article, online brokers such as TD Ameritrade and E*Trade are aggressively promoting options trading to small investors. It is much more profitable to them to sell options as opposed to stocks. My advice for the individual investor is to stay away from options. Think about it this way: if about two thirds of individual investors lose money in options, you would do better to place your money on red or black on the roulette wheel at your local casino. On that bet, your odds are 50/50, and you double your money if you win.

Buying Your Company’s Stock

Sometimes, if you work for a large public company, you are given the opportunity to buy your company’s stock. If you believe your company is doing well and will do well in the future then you should buy some of their stock. This could be an especially good deal if the company sells it to employees at a discount or helps finance the purchase for you out of a payroll deduction. However, the general rules of portfolio investing apply here. Do not put more than 5% or 10% of your investment in your company’s stock. The rest of your savings should be in an S&P 500 Mutual fund.

Perhaps a cautionary tale that is relevant here is the Enron employee pension fund. Enron was an energy company headquartered in Houston, Texas. In the late 1990s it almost single-handedly deregulated energy markets through lobbying and reaped huge profits by buying and selling electricity and natural gas. However, it was fraudulently hiding losses that it was making in other diversified investments, and when that was discovered by the Wall Street Journal, its stock tanked. It declared bankruptcy in December 2001. Enron had encouraged its employees to invest their entire pension fund in Enron stock. Consequently, when Enron went bankrupt, not only did all the employees lose their jobs, but they also lost all their pension funds.

Investing in Real Estate

The most accurate way to look at the returns on real estate is to look at the publicly traded Real Estate Investment Trusts (REITs). There are two general classifications of REITs: Equity and Mortgage. Equity REITs buy properties and manage them for profits. Mortgage REITs lend money to investors who buy real estate. According to the National Association of Real Estate Investment Trusts, the average annual returns on REITs during the period 1972 to 2019 are as follows:

• All REITs: 11.78% annually

• Equity REITs: 13.2% annually

• Mortgage REITs: 9.4% annually

Obviously, if you want to invest in a REIT, it makes more sense to invest in an Equity REIT, due to the higher historical average return. However, if you want to become a sophisticated REIT investor, you should realize that almost all Equity REITs invest in only a single sector of the real estate market, e.g. office buildings or apartment buildings. Investors, especially institutional investors, want to be able to tailor their exposure or spread their exposure to specific segments of the real estate market; they can do this by buying into a REIT that only invests in shopping centers, for example.

As a beginning investor, you will not have enough money to buy a properly diversified portfolio of REITs along with a properly diversified portfolio of stocks. You will be able to diversify safely by investing in a mutual fund that holds all of the S&P 500 stocks, including a good number of real estate stocks. Diversity is the key to reducing risk.

The Biggest Investment Mistakes

Meir Statman, in his Wall Street Journal article, “The Mental Mistakes That Active Investors Make”, has a good catalogue of the biggest mistakes that active amateur investors make (2020). According to Statman, the biggest mistake of all is believing that you can beat the market (achieve annual returns in excess of the appropriate market index). Here are just some of the indices that are used as benchmarks of how your stock picks performed:

There are also appropriate indices that track a mixture of stocks and bonds. When you invest in a mutual fund, its quarterly and annual reports should inform you of the appropriate index to measure its performance against.

The only reason to invest in individual stocks or a specified portfolio of stocks is if they will beat the market. Broker fees or fees for an actively managed portfolio of stocks will be significantly larger than those for a passively managed mutual fund that invests in, say, all S&P 500 stocks. Therefore, if your fund cannot beat the S&P 500 fund, you should put your money in the S&P 500 fund and save the fees.

Statman goes on to say that for amateur investors, the best bet is low-cost index funds. Statman then asks, if amateur investors cannot beat the market, even when they invest in an actively managed mutual fund, why do so many try? He blames it on our minds. The mental shortcuts we use to make decisions, according to Statman, turn into mental errors. Below are some common errors.

Framing

According to Statman, amateur investors think of stock trading as a skill that improves with practice, like surgery, carpentry, or driving. However, this is not the case, because the amateur investor has millions of other professional traders working against them. Whereas a rising stock market can be a win/win for every investor, it would be better to frame an individual stock trade as a war. For everyone buying a stock, there is someone selling the stock. What does the seller know that the buyer does not? Also, the returns that amateur investors achieve in their trading should not be compared to zero, which is often what they do. The returns should be compared to the appropriate benchmark index, which for stock portfolios is most likely the S&P 500 Index.

Overconfidence

When asked, 80% of people think they are above average in intelligence and good looks. Of course, this is a statistical impossibility. One cause of overconfidence by amateur stock traders is that they see stock trading as a skill akin to plumbing or carpentry, instead of something more competitive, like tennis. Playing against Rafael Nadal would soon erode your confidence.

Faulty Benchmark or Anchor

If we were looking to sell our house, we would look at the prices of recently sold houses in our immediate neighborhood in order to set our asking price. Amateur investors often do the same with stocks; that is, they hold the belief that the 52-week high and low of a stock define its range of trading and buy the stock at or near its low and often sell a stock at or near its 52-week high. Unfortunately, according to Statman, this strategy fails to beat the market.

Flip of a Coin

Even if an amateur investor invests in only mutual funds, some move their money regularly to the fund that beat the market last year. This is a losing strategy. As I will detail later, research has shown that out of 3,000 mutual funds to invest in, no one beat the S&P 500 more than two years in a row. While there are some mutual funds that beat the market, it is not consistently the same fund doing so. Picking the fund that will actually perform better than the S&P 500 next year is no better than the flip of a coin.

The Availability Heuristic

The amateur investor makes decisions on the information currently available to them. This information is limited. Often, the information that is available are newspaper articles about a high-flying stock or mutual fund. There is a high correlation between news coverage of a particular stock and trading in that same stock. There are plenty of stocks we do not hear about and plenty of information we do not know. Even worse, a stock’s price per share is a function of next year’s expected earnings. How accurately can an amateur investor predict next year’s earnings?

The Thrill of the Hunt

Fidelity Investments, one of the largest mutual funds, found in a survey that 54% of amateur investors enjoy the thrill of the hunt. Further, 53% enjoy learning new investment skills, and more than one half enjoy sharing trading news with family and friends. It’s for fun and profit.

Generally, I almost always hear about the wins but not the losses of friends who talk to me about their amateur trading. As is typical in situations of incomplete information, this used to give me the feeling that I was less than competent when a stock I bought was a loser. Having since become much more aware of the actual statistics involved, I do not feel so bad anymore when I lose, and I do not feel superior when I make a winning bet on a stock. However, given the lack of information of amateur investors, they are better off at the roulette wheel.

How to Learn From Investment Mistakes

If you make an investment mistake, learn from it instead of just beating yourself up. Everyone makes investment mistakes. You can recover. Behavioral economics tells us that many amateur investors hold onto stocks that have declined, hoping they will rise again to at least break even. The reason for this is loss aversion. When you sell the stock, you have to admit your mistake and feel the loss. A diversified portfolio like an S&P 500 Mutual fund, will surely rise again with the market, but more than likely this will not happen for a start-up or a small company. A diversified portfolio will sooner or later deliver average returns, but a single stock could go bankrupt. If a stock is significantly down, and the company has fundamental financial issues, dump it and move to a better (diversified) portfolio.