Wednesday, May 19, 2010

Investing in STOCKS

What are you buying when you buy Stocks?

Should you invest in stocks? Well, chances are, you already have. If you have a 401(k) or IRA or other investment account, it probably is invested in a Mutual Fund, which, in turn, is mostly invested in stocks or as they like to call them,  "Equities."   And which stocks you are invested in, well, you might not even know.

And like most Americans, you wonder sometimes whether these things are worth anything, or, if in fact, the whole game is rigged.

Stocks can have a higher rate of return than other investments, it is true, but unlike other investments, they can drop down in value to ZERO in a real hurry, and stay that way.

Even if you bought a condo in Las Vegas and paid cash for it, chances are, it is still worth about half what you paid for it. And you could still rent it out to a Casino worker for some amount of money. It is not worth "Zero" now.

But if you bought GM stock a few years back, well, it ain't worth bubkis these days - not even enough to justify paying a discount brokerage to sell it.  In fact, today, it is worth ZERO.

And yet, for many people, their only investment is a stock portfolio.   Is this a good idea? Probably not.   There are a number of reasons why you should Diversify your portfolio, so you are not totally invested in "all one thing."   If one investment goes "bust" then you still have something else to rely upon.

The problems with stocks themselves are numerous, but mostly the problem is that they lack transparency, and as such, we tend to value them by how much other people think they are worth. Let me explain.

1. Stocks Prices are often confusing and misleading. People like to say things like "Bill Gates is worth Upteen Billion Dollars" basing this on his number of Microsoft shares, multiplied by the share price.  But of course, if he sold his huge chunk of that company, the share price would plummet. He would not get the "full retail" value of his "investment."   So who pays that top dollar for the last share sold? Well, chumps like you and me, who get in on these deals last.

"Market Capitalization" is another phony number thrown around, calculated by multiplying the share price by the number of outstanding shares. For some companies with wildly over-valued stocks, this number merely points out the ridiculousness of the share price, as the "Market Capitalization" exceeds the GDP of some countries. The only value in that number is to illustrate how overpriced a stock can be. If someone started selling off a big chunk of a company, the share price would drop precipitously. It is only the small investors, buying that last share, that drive prices up so high.

2. Many people own stock and never pay for it - or pay much for it. Founding shareholders in a company put in a little cash, their "sweat equity" and maybe ideas and get huge chunks of stock. They pay little or nothing for it. They wait for people like you and me to "invest" and then ride the wave. Others, who work for the company, have "stock options" which grant them the right to buy shares at little or no cost. More on that later.

3. Like the Government, they can always print more. Want to raise capital? Print more stock shares. Of course, this dilutes everyone Else's investment. How do you think the company comes up with those shares for the stock options? They don't buy them on the open market, they just print more!

4. Whose looting the company? A lack of transparency in most companies makes it easy for executives to loot the company and walk away with most of the cash. And you'll find out about it in the papers, most likely. Sure, the SEC will investigate, and maybe someone will go to jail. But how does that help you?

5. Ratings agencies and Analysts know little more than you and I. Up until the moment Enron went belly-up, most stocka analysts were ga-ga about the stock and very few people were sounding the warning bells. The lack of transparency made it difficult for them to know what was going on.

6. Markets can change dramatically, rendering a company worthless overnight. Technology changes and markets change. What was a hot product one day is yesterday's news the next. Often a company has little or nothing in the way of tangible assets to back up the price of the stock. Once liquidated, there is little left to pay back investors.

7. Most Companies are wildly over-valued: When a company is liquidated and assets returned to investors, most get pennies on the dollar. The value of the physical assets and even intellectual property are not worth all that much, it turns out. Rusty old factories and office leases just aren't worth much to anyone. When buying an "Equity" you really are just buying the right to receive dividends, and for many companies, which pay no dividends, there really is no "there" there, other than the premise that some other person will pay you even more later on for your shares.

8. Stock Values are largely based on what other people think. We buy and sell shares at the market price. The market price is based on a consensus of what everyone thinks the stock is worth. To some extent, this is a false value. We assume that people smarter than us are setting the stock price, no doubt based on some detailed analysis. And you'd assume wrong. In terms of price to earnings ratios, most stocks are wildly over-valued. The amount that the pay in dividends compared to the stock price is paltry - you'd do better in a savings account. People assume that the share price will go up over time and that someone else will pay them more for the stock. Sometimes this happens, sometimes not.

9. The value of the Stock is often just in control. One way to cash out in a stock investment is when some other company takes over the company you are invested in. Stocks represent the ownership of the company, and thus the control over it. So you may be "bought out" as an investor by another company. But guess what they are going to pay you in? That's right - more stock! So Acme Corporation buys Widgets International, and pays for it by printing up a fresh batch of shares, which they exchange for your Widget shares. You just have to hope that the Acme stock is worth something to someone else.

10. Stock Options force executives to pump up share prices. If the bulk of your income is in Stock Options, then your number one goal in life is to make the share price of your company as high as possible. Screw real profits. Screw dividends. If you can get people to think the company is worth trillions, you can sell your Stock Options for a ton of dough - often millions or even billions of dollars. The problem with this model, as we all know too well, is that it moves an executive's focus from running the business to running the share price. And the underlying business suffers as a result. It encourages poor management, if not outright fraud.

So given all that, why do people invest in stocks and why do most investment gurus tout equities? Well the answer is pretty simple.  When you go to the store and all they are selling is horseshit, what else are you going to buy?  And if all the investment "gurus" can advise you on is horseshit, what else are they going to say?

If your only tool is a hammer, well, every problem looks like a nail, as they say.

During the 1990's a group of young people formed "Motley Fool" and made a name for themselves by appearing on financial programs in jester suits, telling everyone to invest in Stocks. Stocks, Stocks, Stocks, they chanted, like a mantra. And in the go-go 1990's, it all made "sense."

No one bothered to think about why they were taking serious financial advice from a guy in a clown suit.  They are still around, but I don't see them wearing the clown suit much these days.

Investment gurus have to advise you to invest in stocks, for the simple reason is that it is the only game in town.  As I have noted before, in order to make a name for yourself as an investment guru, you need to offer some startling or unorthodox advice.  You have to sell the sizzle, as they say.   And that ain't gonna happen if you say "invest in savings bonds" or "pay off your mortgage."  You'd be laughed out of the millionaire investment-guru booksellers club.

And similarly, investment gurus can't say things like "buy Real Estate" even during the Real Estate boom, as it was a local phenomenon and they had little actual experience with it.  Being a landlord and stuff? Messy.  Takes Work.  Takes TALENT.   Buying stock?  Takes a click of the mouse.  Makes you look like a genius.

So all the financial shows concentrate on stocks like it was the only game in town, because it is - for them.  And they want you to think so, too.  The day-to-day pulse of the DOW is touted like it was the financial heartbeat of the country.  Buy this, sell that, watch this.  You should be looking at stocks all day long and studying their trends and movements.

They are selling the premise that you can make money from nothing. T hat you can create real wealth without work, labor, or effort. That merely watching numbers on a screen and making choices is a way of creating wealth.  But the reality is, the most you can reasonably hope for in an investment is a reasonable rate of return.  The idea that you can get "rich" buying and selling stocks is largely illusory.

Some folks invest this way and some gurus sell investment systems - looking at graphs and charts as though they can tell you the underlying value of the company - without bothering to actually understand what the company is about or how it is run.  All that matters to them is the trending in pricing.  This sort of "analysis" totally misses the boat most of the time, as important trends in pricing are often determined by the operations of the company.

And others are more number-oriented, concentrating on company profits, dividends paid, and the like.  Quarterly reports are their mantra, and what the company did last month is more important than overall trends.  So long as the company reports record earnings, they will shout "BUY" to their viewers. And that sort of mentality is why Enron kept reporting phony profit reports.

And Joe Citizen buys into this, reading financial pages that talk about nothing but Stocks, watching financial news programs that talk about nothing but Stocks, buying financial advice books that talk about little but Stocks. Stocks are sexy, Stocks are in, Stocks are dramatic. Even when the financial news shows (or networks, now) cover things like bonds, they tend to treat it as a boring topic - with the story usually assigned to the intern or the bond geek you never see.

Yes, there are people who become billionaires in "the market". But the Warren Buffets of the world do more than simply buy and sell stocks. They buy and sell companies, often re-working them, spinning off divisions that management was too lazy to realize were a hindrance or would be worth more as a separate entity. Or they merge to marginal businesses to make one profitable one. They really are adding (or trying to add) value to the equation. These sort of "investors" are not just clicking a mouse and buying or selling a share, they are running a company (or ruining it, depending).

Does this mean you should NEVER invest in stocks? Don't be an extremist. It only means that if all your assets are tied up in one thing, you could be in for a world of trouble. And for personal investing - the money that you will need to live on for the rest of your life, having it all in Stocks could be a big mistake, particularly as you get older.

And the irony is, most older people in this country are the ones who watch the financial channels and read the financial pages. The people who should have the least interest in the market are the ones watching it most closely. If you are watching a financial channel and monitoring stock prices when you are 70, something is seriously wrong with your portfolio. By that age, you should have only 30% of your investments in Stocks, and even that small percentage should be in safe, dividend-paying blue chip companies.

At age 50, I have about half my investments in pretty safe things. Some bonds, some life insurance, and a big chunk of un-mortgaged Real Estate. Yes they can go down in value, particularly Real Estate, as we have seen. But they won't drop off to NOTHING overnight, or perhaps ever. Unless a huge plague hits America and kills off half the population, people will still need a place to live.

But Stocks? I have some in my portfolio that went from $50 a share to ZERO and stayed that way. Granted, others skyrocketed, but those are few and far between. And every skyrocket has an apogee and then a messy re-entry.

FDIC insured savings is another good place to park money as you get older. Not exciting. Nothing to "advise" people about. No ticker or stock chart to watch. No "Buy" or "Sell" decisions to make - nothing, in short, for a guru to advise you about. Nothing to talk about on TeeVee. No books to sell. But as you get older, a sizable part of your portfolio should be in something that cannot go away, no matter what.

Many folks are investing in Gold right now, convinced it is a stable investment. It is true that Gold will never "go away" as an investment, like stocks can do. But you can still lose nearly half your investment in a big hurry, when commodity prices plummet. I suspect once the market stabilizes and people realize that life will go on as before, that Gold will drop in value to about $600 an ounce, and those folks who paid $1200 will be crying. There is a LOT of Gold in the world, and the supply will increase accordingly, when prices are so high.

Again, this is not to say minerals are a bad investment, just that buying them when they are high is probably not a smart move. They were a good investment to make - five years ago. Today, you should be selling, in my opinion.

So, should you invest in Stocks?   Sure.  But don't put everything there.  And as you get older, you should be in the market less and less.