Practicing Significance

Glorifying God by fulfilling your own unique purposes through the never-ending

action of acquiring, using, and sharing diverse resources.

Investing

“I will not abandon a previous approach whose logic I understand, although I find it difficult to apply, even though it may mean foregoing large and apparently easy profits to embrace an approach which I don’t fully understand, have not practiced successfully, and which possibly could lead to substantial permanent loss of capital.”   Warren Buffet

“There are two times in a man’s life when he should not speculate – when he cannot afford it, and when he can.”   Mark Twain

“Many people fail simply because they conclude the fundamentals do not apply in their case.”   Unknown

“The three basic drives of man are greed, love, and greed.”   Unknown

Introduction

Almost every investor wants to become financially free through brilliant investing.  However, as discussed in other lessons, financial freedom doesn’t come from brilliant investing, but from the basic rule of:  Save 10%, give 10%, live within the other 80%, and have no debt.  Once you have that self-discipline, successful investing will come more easily.  

Avoiding Financial Disasters

A few words to the wise before continuing … successful investing will seldom overcome financial disasters.  For that reason, avoiding financial disasters (as discussed in other Practicing Significance lessons) should take even higher priority than investing. Some disasters are:

· Health.  No amount of money can make up for having a debilitating health problem.  Maintaining health and having proper types of health and disability insurances are mandatory.

· Family.  Divorce will cost more than bad investments, and bad family relationships are much more painful than bad investments.  Preventative maintenance for marital and family relationships is more important than brilliant investing.  If remarriage is an issue, prenuptial agreements should be considered.

· Employment.  The most important financial asset for most people is their job.  Go to extraordinary lengths to keep your job and improve your skills in case you need to find another job.

· Waiting.  Most people wait too long to plan and execute the necessary actions for financial freedom.  Save 10%, give 10%, live within the remaining 80%, and have no debt. Don’t delay any longer!

First Things First

The first principle of investing is to only invest “surplus” money. Therefore, before investing you should:

· Be spending less than you make.

· Be saving 10% and be giving 10% of your income.

· Have no high-interest or short-term consumer debt.

· Have an emergency savings fund, and have an account with money saved for future major purchases.

· Be maximizing your contribution to your pension fund, especially if there is a company match or tax advantage.

After these are done, the rest can be invested.

Next, spend an adequate amount of time evaluating your investment motives. I believe that Biblical motives include: supplementing your income in old age, providing for the well being of your family, and meeting future needs for God’s kingdom. Suspect (and likely causes for failure!) motives are pride, greed and envy. Before beginning an investment strategy, review the lessons on Purpose, Goals, and Life Plan to make sure you are working toward your overall objective and avoiding pitfalls.

Investing In Your Employer

You are already dependent on your employer for your income, health insurance and pension contributions. You substantially increase your risk by holding or buying more of your employer stock in your pension or stock portfolio. Be Careful!

K.I.S.S. (Keep It Simple, Stupid!)

Many would-be investors get overwhelmed by the complexity of investing.  For the vast majority of us, it is best to keep it simple by investing only in those things we can understand, according to our long-term goals, and within our risk tolerance.  Even Warren Buffet does so, as he so eloquently states in the above quote.  By doing so, we will not only sleep better, but will probably have better results.  If your investment strategy can’t be understood by your spouse, it is probably too complicated.  Likewise, if a potential investment is too complex or too illiquid, it may be too risky for you. The overall goal and challenge is: Have investments that grow and produce income on an after tax basis higher than the rate of inflation while minimizing risk.

Basic Terminology

A general discussion concerning investing necessarily starts with a discussion of certain words and terms.  For purposes of time and clarity, the following is brief and basic:

Yield; Dividend Rate; Interest Rate:  These terms indicate the amount of percentage annual income that can be expected from the investment.  Example:  A stock that pays 4% dividends or a savings account that pays 4% interest will have an annual income of $4 for every $100 that is invested.  Stock dividend rates can be increased or decreased without notice whenever the board of directors deems feasible.  Interest rates are subject to change per terms of the investment. 

Growth Rate: The annual percentage growth (or loss) in value of a particular investment. 

Total Return: The sum of the Dividend Rate plus Growth Rate.  Example:  A stock that pays 4% dividends plus grows in value at 5% per year has a total return of 9%.   When these numbers are reported in various financial reports, they may or may not include fees and costs – it is very important to compare these numbers on an after fee/cost basis if at all possible.

Tax Rate: The “marginal” tax rate for you, including applicable federal, state, and local income taxes.  This is the total percentage of tax that you pay because of the investment, not the average tax rate for all of your income.  In other words, it is the tax rate you will pay on the last dollar you earn this year.  Marginal tax rates might be as low as 15% to as high as 55%.

Before Tax Return: Equals the Total Return before any taxes are applied.

After Tax Return:  For most investors, this is the key measure of performance.  After Tax Return equals the Total Return after your Tax Rate is applied.  For some investments, like some municipal bonds, the After Tax Return is usually equal to the Before Tax Return.  For almost all others, the After Tax Return is much less than the Before Tax Return.  Since tax rates are different for different investors, After Tax Returns are different for each investor for the same Before Tax Return.

Inflation Rate:  Inflation means that prices are increasing.  The annual inflation percentage is the rate that prices increase, or conversely the annual percentage rate that money loses its value.  The government publishes data concerning certain inflation numbers (i.e. consumer price indices), most of which are not pertinent to you.  What matters to you is the inflation rate for the goods and services that you use.  For example, if you are 70 years old, you are probably more concerned with the increase in prices of medicine and medical services instead of the increase in prices of stereo equipment.  Whether the rate of inflation is high or low, it is cumulative and depletes the value of your money over the course of the years.  Inflation is one of your worst enemies!

Deflation:  In many respects, deflation is the opposite of inflation.  Deflation is a period when prices fall, or conversely when money increases its value.  Deflation in itself isn’t bad, but when it occurs during a weak economy it can spiral into a depression.  As a gross simplification, deflation defeats most of the investment principles used over the past 70 years.  In a time of deflation, most experts recommend owning treasury bills or US government backed securities.

Liquid, Liquidity, Illiquid, Illiquidity.  These terms relate to how hard it is to convert an investment to cash or to get control of it.  As an example, cash is perfectly liquid; equity in your home or, an investment in a partnership, hedge fund, or option contract may be very illiquid.  Liquid investments usually have lower risks and more defined outcomes.  Illiquid investments usually have higher risk, less government regulation, and more undefined outcomes.

Investing Concepts and Information

There are many fundamental concepts to investing.  The following are some of the more pertinent ones:

Perfect Investment:  The perfect investment would have the following characteristics.  However, since there are no perfect investments, the investments you will make will have varying positive and negative attributes:

· High current cash yield

· High total return

· Always liquid (can be converted to cash immediately)

· No risk

· Tax free

· No commission or brokerage fees

· Totally understandable and predictable

Investment Goals:  We all have different goals concerning investing.  Some may want to maximize income, while others may want to maximize growth and minimize income.  Some may want to minimize risk, while others are more concerned about maximizing total return.  Before any investment decisions are made, each person should be very clear about their goals.  Some facts to take into account include:  age, health, amount available to invest, investment options, etc.  Further, it may be sub-optimal to determine your investment goals prior to doing your life plan, estate plan, and all of your personal financial planning.

Diversity: There is an old saying, “You make money by investing in one thing and you keep money by investing in many things.”  Studies show that diversity is the best way to reduce risk.  Most advisors recommend that investments be spread among different types of investments, different mutual funds, different managers and advisors, different countries, different companies and industries, different amounts, and made over time (dollar cost averaging).  Mark Twain is reputed to have said, “I am not so concerned about the return on my capital as the return of my capital.” Diversity is the method that is most commonly used to maximize total return while reducing risk of losing capital.  Many companies are currently using the terms such as Portfolio Management or Asset Allocation to make diversity sound fancy.  Remember, diversity is a tool to accomplish your financial goals - diversity is not your goal.

Ladder:  Many investment advisors recommend using a ladder strategy when investing in CD’s or bonds.  This means to split your money into equal parts and buy instruments with varying lengths of time to maturity.  As an example, if you have $10,000, buy $1,000 year bonds with maturities of one year, two years, etc.  Every year when a bond comes to maturity, roll the ladder by buying another bond with a maturity of 10 years.

Stop Loss: When investing in stocks or mutual funds, it is highly recommended to employ the concept of limiting your losses.  Many investment advisors advise that whenever a stock or mutual fund is purchased that a stop loss is put on at a level of 7-10% below the buy price.  If the price of the stock drops to that level, it is automatically sold.  Properly used, stop losses will keep you from losing lots of money.  History shows that stop losses have been very useful in overcoming psychological barriers to selling.  It is very difficult to use stop losses for bonds because prices are not readily or regularly published.  Not using stop losses has been a primary cause for the financial mistakes most of us have made.  Stop losses are one of the best protections from allowing a long-term conservative strategy to turn into a long-term disaster. You should probably have a stop loss in place for every stock and mutual fund!

Capital Preservation:  For retirees and people who have no way to overcome losses of their assets, it is very necessary to have capital preservation as the primary goal.  The primary ways to preserve capital are:

· Make low risk investments

· Diversify using the methods listed above

· Use stop losses without fail

Liquidation Preference: Liquidation preference is a financial term for the order that investors get paid when a company goes bankrupt.  The further down the order you go, the higher the risk.  For that reason, interest payments and returns should be higher the lower on the liquidation preference chain.  Typically, payments in a bankruptcy or other liquidation get paid in this order:

· Costs of the bankruptcy, including lawyers.  If any money is left, then

· Secured holders, typically banks.  If any money is left, then

· Bondholders in preference order.  Many companies have several types of bonds, some of which have preference over others.  If any money is left, then

· Preferred stockholders.  If any money is left, then

· Common stockholders.

Investment Advisors/Managers:  (See Practicing Significance lesson on Financial Advisors) Investment advisors are available as individuals or as representatives of companies (often stock brokerages).  Qualifications for investment advisors vary dramatically.  The fees charged by investment advisors are typically at a set rate, an hourly rate, or (more typically) 1-2% of the asset value that is being managed. A good investment advisor will: understand your goals, help you diversify your investments, and provide excellent investment ideas.  The cost for investment advice is high; however, the cost of ignorance may be higher.  It would not be unusual for an investment advisor to recommend a mutual fund, with the total fees for the advisor and fund to total 3-5%.  In a low interest rate environment, it is very hard to overcome these fees.

Past Results:  Many investments have a notice saying, “Past performance is no guarantee of future results.”  Instead most of them should have a notice saying, “There is no correlation between past results and future results.”

Various Investments

Following is a brief description of various investments that are available to everyone.  The list is in order from what is often considered the less risky types of investments to the more risky types of investments, although results are always dependent on the exact investment which is chosen.  Total returns are generally higher with risk, but there is not always a strict correlation between risk and return.  This list does not include insurance since insurance should not be used as an investment.  As used solely for the following descriptions, inflation means the inflation rate over a period of time as generally perceived by the total market.

Cash: Cash is not taxed, but does lose value every year because of inflation.

Savings Accounts: Offered by banks, savings & loan companies, and credit unions.  Often FDIC insured and is taxable.  The after tax total return is typically less than inflation. 

Money Market: Offered by banks and most financial entities.  May or may not be insured.  May or may not be taxable.  The after tax total return is typically less than inflation.

Certificates of Deposit (CD’s):  Typically done with an FDIC insured bank for terms of several months up to several years.  When done with an FDIC insured bank, these are virtually risk less up to $100,000 per bank.  Some non-FDIC insured companies offer these at somewhat higher rates, but it is hard to determine what the risk is.  The interest on CD’s is generally taxable when it accrues, not when it is received.  The after tax total return is typically slightly less than inflation. 

Bonds:  Bonds or notes are debt instruments issued by some government or business entity that is supposed to pay interest at various intervals, and at the end of the term of the bond the principal is also returned.  Bonds are usually transferable during the life of the bond.  It should be noted that during the term of the bond, the value of the bond might increase if market interest rates decrease and the value of the bond might decrease if market interest rates increase.  The longer the term of the bond, the more effect a change in market interest rates will have.

· US debt: (treasury bills or t-bills are 3-12 months; treasury notes are 2-10 years, treasury bonds are 10-30 years):  Issued by the US government and are considered risk-free to recover principal.  The government has been trying to offer different types of bonds and some of the new ones are very interesting.  These are generally taxable at some point in time, and the after tax total return is typically less than inflation.  Two interesting inflation-adjusted types of instruments are the Inflation-adjusted Savings Bonds (I-bonds) which are limited in the maximum amount which can be invested; and the Treasury Inflation-Protected  Securities (TIPS).  The face value of TIPS is adjusted for changes in the consumer price index, so interest income will rise with inflation. Unfortunately, TIPS can produce phantom income in the amount added to face value, and like other bonds, can have their value reduced if interest rates rise. TIPS may be purchased commission-free at www.treasurydirect.gov or through various bond funds.

· Municipal bonds: Issued by different local government entities such as schools, water districts, and cities.  Are typically tax-free for the entities in which they are located and for the federal government.  These bonds may or may not be insured, and may or may not be rated by a rating agency.  The risk varies tremendously between issuing entities.  The term for these bonds is generally 10-20 years.  It is possible for the issuing entity to default.  In an effort to reduce risk, some people invest in municipal bond mutual funds.  The after tax total return is typically near inflation at the time the bond is purchased.

· Corporate bonds: Issued by corporations.  Are taxable.  Are usually uninsured, but are usually rated by a rating agency.  Bond terms can be very complex, including the security level of the bond compared to other debt of the company.  Some corporate bonds can/must be converted into company common stock.  History has shown that corporate bonds are often much riskier than even the most sophisticated investors can predict, and many defaults do occur.  For instance, if a company goes bankrupt, the bondholders usually get back only a fraction of their investment.  Bonds of companies that have high risk and are below investment grade are called high-yield or junk bonds.  In an effort to reduce risk, some people invest in corporate bond mutual funds or buy bonds that are short-term or intermediate-term.  Assuming that default does not occur, the after tax total return is generally more than inflation at the time of purchase.

· Bond funds:  Mutual funds that pool the money of many investors in order to diversify risk by buying lots of different types of bonds.  Bond funds do not necessarily perform like bonds.  However, bond funds usually go up in value when interest rates drop, and go down in value when interest rates rise.  If a bond fund owns or buys bonds in a company that goes bankrupt, the value of the bond fund can be greatly diminished.  Many bond funds invest only in certain types of bonds.

Annuities: (See Practicing Significance lesson on Life Insurance and Annuities for more detail.) An annuity is a contract between two parties.  Usually an individual contracts with a company (often an insurance company) for the company to pay the individual payments in return for the individual giving the company an upfront payment.  Annuities have such varied terms that it is hard to even summarize terms and risks.  In general, fixed annuities pay a stated interest rate, while variable annuities pay interest rates based on the results of investments made by the annuity holder.  Payments from the annuity are usually at least partly taxable.  In some annuities, the principal is paid back at death, but in some the principal is lost at death.  Since the principal is growing on a tax-deferred basis, this investment has some tax advantages.  Assuming that default does not occur, the after tax total return is generally near inflation, although some annuities that are keyed solely to the stock market may have negative returns.  The government does not guarantee annuities, so if the company goes out of business, the entire value of the annuity may be lost.

Preferred Stock: Is a hybrid instrument with some characteristics of bonds and some of common stock.  Usually preferred stocks pay a set dividend over some period of time, and then the stock may or may not be convertible into common stock.  Often, the issuing company has a one-time right to redeem the preferred stock at the issuing price after several years.  The terms of preferred stocks are highly variable.  Assuming that default does not occur, the after tax total return is generally more than inflation.

Common Stock (Equities): The owners of a corporation own shares of common stock.  These owners vote at shareholders’ meetings or by proxy, may or may not get dividends, and are last in line if the company is liquidated.  As the net value of the company goes up or down, the value of the common stock goes up or down.  However, the actual price (not value) of the stock goes up or down based on the supply/demand thoughts of the market taking into account given general market conditions, economic conditions, views on the future of the company, etc.  Shares that can be purchased on some exchange by the general public are known as “publicly-traded”, and are regulated by the Securities and Exchange Commission.  Some companies pay dividends which are currently taxed at a very favorable rate.  Many people believe that over a long period of time, the total returns from common stocks are higher than the other investments listed above. Over a very long period, the stock market results reflect the results of American companies. If they are good or bad in the future the stock market will reflect it. Historical results are not the key! Results are very dependent on the time period, the purchase price, the companies picked, general economic conditions, and a myriad of other conditions.  Gains or losses on common stock are based upon the time period that they are held, but if held for more than one year, are taxed at a very favorable rate.  There are many ways to invest in common stocks, including:

· Index funds/stocks/ETF’s:  These are generally very low cost funds or tracking stocks that mirror an index such as the Dow Jones average or S&P 500.  Some popular ETF’s are “SPY” which tracks the S&P 500 and “QQQ” which tracks the NASDAQ 100. Because of their low cost and good diversity, these are becoming very popular.  The value of investments in index funds goes up or down depending on the performance of the stocks that are being mirrored.

· Mutual funds for common stocks:  These are funds that usually pool money from thousands of investors and invest in common stocks of lots of companies.  Mutual funds invest in certain industry sectors, in certain size companies, in foreign countries, or in a mix of these.  Although mutual funds are an important aid in diversification, results are dependent on the trading style of the fund manager or the objectives of the fund.  Mutual funds typically charge different types of fees which can total up to 2% per year.  “No-load” funds do not charge a fee to get in or out, while “load” funds do.  However, all mutual funds charge fees to cover expenses and other costs.  Because of these charges, it is difficult for mutual funds to perform as well as index funds.  In fact, in most years, more than 60% of the mutual funds do not beat the indexes they are tested against.  Mutual funds are often classified as some mix of growth and income, where the defining difference is the amount of dividends paid by the stocks owned in the fund.

· Individual company stocks:  This is typically a high risk investment because there is no diversity.  Buying stocks in many different types of companies and industries can reduce risk.

Real Estate: Although this is listed next to last many people would contend it is not the riskiest in this list of investments.  Studies have shown that the vast majority of Americans have the bulk of their net worth tied up in the equity of their home.  Therefore, the vast majority of Americans are real estate investors who are highly concentrated in one investment.  There is a huge variability of results from investing in personal homes, rental property, or raw land.  Like all investments, the results of investing in real estate depend on timing, expertise, luck, and inflation.  One interesting way to invest in real estate is to buy shares in REIT’s (Real Estate Investment Trusts) or in REIT index funds.  These are companies traded on the stock exchanges that own apartment houses, offices, malls, or real estate mortgages.  The dividends that are paid are usually high, but are taxable at higher rates than dividends on common stock.  The share prices go up and down just like stock prices, and have many of the risk aspects of common stock.  One advantage of investing in real estate through REIT’s is the ability to quickly buy and sell in small increments.

Hedge Funds:  Hedge funds are non-regulated private investment pools that use sophisticated trading techniques such as short selling, market-neutral positions and arbitrage.  These funds used to be owned only by wealthy people, but they have become available to people of more modest means.  I classify these as extremely risky not because of the results of these funds, but because they are not regulated, have very high fees, and results are highly dependent on management.  The best hedge funds are excellent, the worst are disastrous.  No two funds are alike because they all have very different strategies. As of 2005, some hedge funds have become publicly traded and allow shareholders in relatively small investment amounts.

Choosing Your Investments

History shows that final after-tax returns are more influenced by how capital is allocated between types of investments than by which specific investments are chosen.  As an example, it is more important to decide how much money is allocated to municipal bonds vs. index mutual funds than deciding which municipal bond or index fund is chosen.  History has also shown that as people age, it is usually wiser (and more necessary) that they allocate more money toward investments which generate income and have lower risk than toward investments that might grow, but have higher risk.  How these two ideas and other ideas previously mentioned are specifically implemented varies from person to person based on their resources, needs, other incomes, risk tolerance, knowledge, and on how they view their life purposes and goals.   

Every financial decision seems to be accompanied by fear and greed. In Wealth to Last, the authors suggest using these ten principles of decision-making:

· Evaluate your motives

· Analyze the numbers

· Consider your witness

· Avoid “get-rich-quick” mentality

· Give to the needs of others

· Never co-sing a loan or act as surety

· Avoid indulgence

· Prepare for decreases

· Seek Godly counsel

· Seek God’s peace

Monitoring, Buying, and Selling

As complex as it is to invest money, it may be even harder to know when to uninvest. The most important step is to monitor your investments on a regular basis, meaning at least monthly. Since you will be investing according to a well-defined plan, the purposes of monitoring are:

· Rebalance the portfolio between types of investments as values vary.

· Rebalance investments to meet income needs.

· Check to see if stop losses have been triggered on any of your stocks.

· One or more of your investments has gotten too risky because of new information and you desire to sell. Risk may have been changed because of world or economic events, industry trends, or even because the price has risen too high.

Conclusion

Successful investors usually know the terminologies and follow basic concepts of investing.  No investor can know too much.  All of us are limited in our investment endeavors by the investments available and the knowledge we can acquire about them.

Additional Resources

National Association of Investors Corp., 877-275-6242 www.better-investing.org

American Association of Individual Investors 800-428-2244 www.aaii.com

Motley Fool’s School www.fool.com/school

Foundation for Investor Education www.siainvestor.com

Wealth to Last, by Larry Burkett and Ron Blue

You’re 50, Now What, by Charles Schwab

Common Sense on Mutual Funds, by John C. Bogle

The Future for Investors, by Jeremy J. Siegel

DISCLAIMER:  The content presented herein is presented as general information and is not intended to be a comprehensive overview of all of your financial options.  Nor is it meant to imply any endorsement of any type of financial plan, product or service.  Investing and spending money is a complicated and serious process that is constantly affected by conditions in the marketplace and changes in tax law and government policies.  There is no guarantee that an investment product bought today will perform the same from year to year.  You should research your choices as thoroughly as possible and, when in doubt, consult a trusted professional advisor.