Friday, May 13, 2011

Stocks or Mutual Funds?

Are Mutual Funds or Stocks a better deal for the long term?

We have talked here before about stock-picking and why I think it can be a risky proposition.  Most folks think you can get ahead in the market by picking stocks, and sometimes this works, and sometimes it doesn't - in a horrible way.

People see a stock rising, and then want to buy it.  But that is buying high.

Then the stock starts to tank.  They "hold on" thinking it might come back, and then it goes lower than what they paid for it.  Their dreams of avarice are foundering on the rocks of reality.

They then panic.  Sell it all before it goes down to nothing!  So they sell low and lose money.

Using Greed and Fear as your investment guides, the average person could end up churning their account down to zero in no time.

But all that being said, back in 2005, I started to feel that these Mutual Funds were a pig-in-a-poke.  I had several IRAs, 401(k)s, and SEP plans from over the years, mostly rolled over into IRAs invested in mutual funds with Fidelity, Vanguard, and American Funds.  I thought I was diversifying my portfolio, until someone pointed out to me that the various mutual funds were probably invested in the same stocks, and thus my portfolio was probably not as diverse as I thought.

And of course, these mutual fund companies take out fees - sometimes hefty fees, that really cut into your rate of return on your investments.

I decided to take out a nominal amount ($25,000) from my Fidelity Equity Income II account and roll it over into an e*Trade Account as an experiment.  At least I could understand what I was investing in!

But for some reason, Fidelity rolled over the whole balance, and I took that as a sign, and let it ride.

e*Trade shows your "gain" only in terms of the price paid for the stocks currently in your portfolio, versus their market price.  This does not take into account any dividends or profits you made in trading.

It is my one gripe with e*Trade and Ameritrade - they have no easy way to figure out if you are really getting ahead or not.  And perhaps this is by design - most people probably lose money trading, and they don't want to make that apparent.

But if you go through six years of monthly statements (!!) you can calculate the amount put in versus the current market value, and come to some conclusions.

The original rollover amount was $57,918.42 in May of 2005.  Since then, I have added $6300 in IRA contributions, mostly for 2009-2011 for a total of $64,218.42 contributed.

As of the date of this writing, (May 13, 2011) the balance is showing as $84,890.15 with a gain of $5492.65 and a basis of $79,246.51

This means we have received dividends and cashed in profits of $15,028.09 over the last six years, in addition to gains showing of $5492.65 for a total gain of $20,520.74 or a 31% gain in six years.

That works out to about 5% a year, which isn't a heck of a lot.  My Savings Bonds were doing better than that, until recently.

However, the Dow Jones Industrial Average has increased by about 20% in this same period (due to the crash of 2007).  So we are outperforming the DOW.

If I had left the money in Fidelity Equity Income II, it would be worth about 15% less by now.  That is to say, it would be worth about $50,000.  Ouch.

So overall, moving the money from Fidelity was a good idea.  Or at least it worked out well.

And that is the rub.  Never confuse getting lucky with being brilliant.  I was lucky in that at least $10,000 of that gain was from the sale of one stock - Avis, which I bought at 74 cents a share and sold at $12 a share.

On the other side of the coin, my investments in GM, Fannie Mae, and Fleetwood, all went down to zero or nearly zero in value.  I also invested in an obscure OTC car parts re-manufacturing company, which pretty much went belly-up as well (the theory being that with the recession, more people would be repairing cars than buying them).

I was lucky, not brilliant.  Most of the stocks I invested in were pretty tame stuff - old line companies with pretty traditional businesses.  The so-called "Blue Chip" stocks that pay dividends like clockwork.  United Technologies, Kraft Foods, that sort of thing.  Of course, GM was a "Blue Chip" once and look where that got me.

I also put $20,000 into a CD with WAMU, which thanks to FDIC insurance, did not drop down to nothing.

The more esoteric investments I have made have not done well.  Vesta Wind Systems seemed like a winner, given all the windmills going up all over the world.  But it has dropped 40% in value and stayed there.

On the other hand, I thought that LEDs are the future of the post-incandescent bulb world (and NOT the CFL, which is a stop-gap measure).  And I think I guessed right here, as the LED light bulb is slowly taking up more and more shelf space at LOWE's and HOME DEPOT, and CFLs suck, anyway.  So my investment in CREE (CREE) which makes LED lamps including streetlamps, went up 76.92%.  And yes, I sold about half of it early on.

More traditional companies like Pfizer seemed like a good bet, until I realized that they have no real new products in the pipeline - and everyone else realized that as well, and the stock tanked 30%.

Good old GE seemed like a good bet, but was hampered with a poor performing NBC and other assets, and dropped about 40% in value.  But it appears the company is fundamentally sound, otherwise (and wildly profitable, if you've read the papers) and I bought some of their Corporate debt as well.

3M and Dow did similar dips, but have recovered.  My Ford stock tanked, then recovered and then made a small profit, so I sold it.

I even bought stock in BMW, the world's most profitable car company.  And it has done well, although for a while, it did drop down with everything else, in 2009.  Not as much, though.

Exxon/Mobil would seem like a good bet, given their wild profits and the nature of the oil industry.  It has done "OK" but that is about all I can say.

If there is a pattern here, it is that a lot of stocks tank and that is scary.  And for the most part, I usually hang on to these stocks, rather than panicking and selling them, particularly if they are paying dividends.

Bank of America seemed like a good stock, as they are one of the largest banks in the world.  They have branches everywhere and other than their unfortunate acquisition of Countrywide Mortgage, seemed to be well-run.

The stock tanked, so I doubled down my bet and bought more (buy low, sell high, not vice-versa).  The stock pays a nominal penny-per-share dividend, which the government is limiting them do as part of the bailout program.  The bank was profitable and working its way through the morass of bad debt in Countrywide.  The Directors want to pay more in dividends, but are being prevented from doing so by the government.

I think that once the debt morass of Countrywide is sorted out, the bank will take off - like having a load of bricks removed from your trunk.  So I tripled-down my bet on BoA and bought even more.

A gamble?  Perhaps.  But the key is to spot stocks that you think are artificially low, not the ones that "everyone" is buying because they have already gone up in value.

2012 will tell if my BoA gamble pays off.

But overall, I am trying to invest for the long-term.  I do not trade very much, other than to buy stocks as I make more contributions to the account, and as dividends come in and put more cash in the account.  I trade perhaps less than once a month.

It is tempting to think that you can "make money" by buying and selling stocks - trying to time the market, so to speak - but for the amateur investor, all that ends up happening is that they churn their own account down to nothing.

I don't have any hard or fast rules for investing - no "formula" or "system" - both of which I think are suspect, and basically superstition.  However, when I see a stock take off in value (like two to three times its purchase price), particularly when the acceleration is sudden, I usually sell off my initial investment portion.  So, if I had $5000 invested in ACME Corp, and it shoots up to $15,000, I sell $5000 and "lock in" some of that gain - or at least get my money back.

On the other hand, if a stock tanks, there is little point in selling it at the nadir.  If you invest $5000 in a stock and it goes down to $1500 in value, you don't get much by cashing out of the stock.  The best you can do is to sit tight and hope that it recovers.  And if the company is otherwise sound and paying dividends, why not hang on to it?  All that the drop in price means is that you overpaid for the stock.

Think of it this way.  Suppose you go out to buy a car.  You go to the used car dealer and the slick salesman sees you coming and snookers you into paying $5000 too much for a used car, charging you $10,000 for an old Corolla.  You get home and realize that the car is only worth only $5000 book value.  You've been had!

Now at that point there is not a lot you can do, other than to grin and bear it.  Selling the car in a panic for $4000 on the premise that "it might go down further in value" is even more foolish.  You've already taken your lumps, why punish yourself further?  And closer investigation reveals that, while you overpaid for the car, it is a soundly built Corolla and will give you many good years of service, if driven carefully.

So you might as well keep the car, even though it "dropped in value" from what you overpaid for it.  The fundamentals are sound and the remaining value is sound.  If you sold the car, what you would most likely do is go out and buy the same car again - or one like it.

In a similar way, dumping a stock because you overpaid for it (buying in a bubble market, not doing research, etc.) is not always a good idea.  Because if you sold the stock at a huge loss, you probably would just go out and buy a similar stock (or the same stock) again, because now it is "bargain priced".

Now of course, I am talking about a self-directed IRA here, where taxes don't come into play - yet.  If this were an after-tax account, I might be tempted to sell off the "loser" stocks at the end of the year so I could realize the losses and deduct that from my income and lower my tax bill.  But losses in an IRA are not tax-deductible.

And of course, there is always the possibility that the Corolla you were sold has a connecting rod issue and the engine will blow in 100 miles - leaving you with nothing.  A bad buy might just be a bad buy.  I "rode" the GM stock all the way down this way, rather than selling out early, on the premise (gamble) that the company might turn things around without bankruptcy, and thus preserve the share price.

As it turned out, they wiped out all the shareholders and started over.  The bond-holders, on the other hand, made out pretty good, particularly those who bought GM debt at its nadir.

But that is another aspect of investing - assuming that you are going to lose money and not freaking out when it happens.  During the go-go 1990's, everyone's portfolio went up, up, up.  And young kids in jester hats would go on TeeVee and say "buy stocks" and the TeeVee people would nod sagely with a straight face, instead of saying "excuse me, but why are you dressed like a clown?"

And for many folks, the idea of losing money in their 401(k) was an anathema.  And when the tech crunch came, they panicked.  And when the recession came, they freaked out.  And yes, I know people who "sold it all" in February of 2009 for a quarter of what they paid in, and thus locked in their losses.  What did they invest in with the pitiful remainder?  Yup.  Gold.

This 401(k) thing is going to be a nightmare, at least for a lot of us.

You can't make money ameliorating losses.  And yet the financial websites abound with advice on selling stocks when they tank.  "Stocks are not forever," one adviser chirps, "when they go down in value, sell them before it is too late, and at least get some of your money back!"

But such advice, if followed regularly, will result your churning your account down to nothing, as you panic whenever a stock goes down.

For example, my 3M stock (MMM)  took quite a dip right after I first bought it, and was worth about 28% less than the purchase price - for some time.  Using the "stop loss" method of investing, I would have sold that and taken a 28% loss right away - only to end up buying some undervalued stock, such as, well, um, say, ahhhh… 3M?

Yes, because the stock came roaring back and is now worth 28% more than I paid for it.  A huge return on investment?  Perhaps not, but given the things that have happened in the last three years, fairly respectable (and outperforming the DOW).

Speaking of DOW, as in DOW Chemical, that has once again dropped in value to a negative 15% of purchase price.  Again, the sages would say "Sell!  Sell!  Sell!" because you "are losing money" on the stock.

So you sell it and buy what?  Well, Dow Chemical looks attractive at its current price.

You see where this is going?  The financial "experts" look at price charts and the DJIA as the indicia of investing, without thinking about overall value, profits, dividends, and P/E ratios.  The almighty stock price is touted as the end-all of investing, and according to them, the only thing you need to know about investing is what the stock price was for the last three months - or even the last three hours.

So what do I take away from all this?  Getting lucky is more likely to result in big gains than being brilliant.  Trying to out-smart the market is trying to out-smart a lot of people who are way, way smarter than you are.

The best you can do is diversify your investments (I have 38 different equities in my e*Trade account) and also put your money mostly into fairly conservative, dividend-paying, solid investments, rather than the trendy tech-stock du jour.  Hang on for the long-term, and don't mico-manage or churn your own account.  Visiting your trading site more than once a month is probably just a temptation to meddle.  Often, leaving well enough alone (benign neglect) is the best answer.

My biggest winner, AVIS (2,340.03% gain) was the result of a modest trade of $750 done on a whim.  I did not check the status of the stock for six months, at which point it had shot through the roof.  If I had checked that trade daily, I likely would have sold out of it long before I should have.

And yes, I did eventually sell off half my investment in it.  When stocks go up, up, up, there is a big chance they will go down, down, down.  AVIS seems to be holding its value, so yes, maybe I should have "held onto it" - but that sort of thinking is just the flip side of "sell it all before it drops down to nothing!" mentality.  The Greed side of the Fear Coin, so to speak.

Will my account continue to go up in value?  Maybe.  Maybe not.  There will be more market disruptions, that is a given.  Things will go up, then down.  You have to ride the wave, to some extent.

Right now, things are up, and some are saying that perhaps the market is ahead of itself.  Perhaps.  More of us are saving and trying to fund our retirements.  And with paltry 0.5% savings account rates, many are hoping to jump-start their retirement accounts (or recover from the debacle of 2009) by investing in equities.  And I think that is one reason why the market is fairly exuberant right now - people are pumping money into it.

This sort of volatility illustrates, however, why it is so important to cash out of the market more and more as you get older, and put more of your money into safer harbors, even if they earn little or no interest.  You cannot afford to be on the down side of a market cycle in the midst of your retirement.  By the time you are retired, most of your investments should be in safe harbors, not in risky things like stocks.

At age 50, more than half my portfolio is in fairly safe investments - paid-for Real Estate.  While it may drop in value somewhat, like the old Corolla, it will have some value and can generate income in rents.  There is no point in selling it, as I would just have to buy something else.

As I get older, my goal is to put more money into safer harbors.  And the IRA has a neat mechanism for doing this.  Once you reach retirement age, you have to take out a certain percentage of your IRA and pay taxes on it.  This is a good opportunity to cash out the equities and put that money into a CD or money market account.  Spend some, save the rest.  Over time, you will end up cashing out all of the risky equities and have a safe and secure retirement.

At least that is my plan.  Of course, when a man makes plans, God laughs.