How much do I need to begin investing in stock?

[Dystopian]

Hi,

I'm interested in investing in stock. I don't have a great deal of money saved up at the moment (only 19) but I have a reasonable steady income.

I just cant figure out how much I need before I start. I'm going to start buying through discount online brokers (TD Waterhouse) which costs £12.99 a trade meaning I ultimately have to make £24 on top of the initial investment to break even, which isn't bad. I cant get onto thinkorswim.com because it only takes American accounts, which is annoying because it looks really good.

I was thinking of investing £100 just to begin with so I can get a feel for it (I have no prior investing experience) but you can't exactly diversify your portfolio with £100. I don't want it to be a wasted £100 either, but I can't expect much of a return from it can I? Should I wait until I have £5k to invest?

What would you all say?
Thanks

[timhau]

13 pounds a trade sounds expensive; my account is at the online arm of a "regular" bank, and I pay a minimum of 10€ for all Nordic markets (and at least double that for UK, Central European and US markets) which isn't the cheapest deal around. I don't know how expensive UK banking is in general, but I'd look around a bit more if I were you. As a general rule, I try to avoid purchases where I'd pay more than 2% in fees.

Do you need to have actual money involved in getting a feel for investing? The Financial Times (http://www.ft.com) has a pretty nifty portfolio service available for free, in which you can set up a fictional portfolio; the quotes are delayed by 15-20 minutes, and it has stocks not only from the London Stock Exchange but from various international major (and minor) exchanges as well.

As for returns, unfortunately for most of us the greatest obstacle to making a lot of money on the stock market is the lack of capital. An investment of £100 isn't going to make you rich in the near future; if you make a good buy and it doubles in a year, you'll have £200, if you invest in a good dividend stock, you'll be looking at something like £4-5 in dividends in the next 12 months. But if you keep at it and especially if you manage to minimize disastrous purchases, you're young enough to see compound interest work its magic (or as the local saying goes, "Time is money; long time is lots of money").

[Modified]

Yeah, those are expensive trades, but I have no idea what is usual in the UK.

I trade in minimum chunks of 200 x the trade cost, but that's just me. It's a nice round number - a 1% price change to break even.

[Trakar]

As someone has mentioned, getting your feet wet through any one of many numerous stock simulation set ups while you save up money to actually invest is probably a better move. At a 100 pounds you aren't generally going to get much of a feel for anything other than how quickly such an amount can be eaten up by fees and costs.

Personally, I wouldn't recommend the market right now, especially for small investors, whose entire bankroll is within the daily volitility range of many stocks, but that's me.

[Dunstan]

This is my all-purpose entry level investing advice:

1) Pay off all credit card debt. (This sounds obvious, but a few years ago a friend of mine bragged about his stocks going up, and later in the same conversation complained about all the credit card interest he was paying. Borrowing at 10%+ to invest in the market is not very bright.) You may also want to pay off any other loans (e.g. student loans, car loans) even ahead of time assuming there aren't penalties for doing so, depending on the interest rate.

2) Build up an emergency fund of 6-12 months' worth of expenses: enough to pay your food, rent, utilities, etc. if your job and other sources of income went away. (This doesn't have to be in a bank account, if you have a money market account you can quickly and easily and cheaply withdraw from.)

3) Max out your contributions to any tax-advantaged retirement plans available in your jurisdiction (401ks and IRAs for Americans, RRSPs, whatever). Even if your employer doesn't match the contributions, the fact that the taxman is offering to subsidize your investment makes this a no-brainer.

4) If you still have extra savings, now you can think about opening your own separate investment account. Where you go from here really depends on your preferences. I don't recommend buying individual stocks unless you affirmatively enjoy the process of researching companies and tracking share prices. Some people do, and good for them. I'm content to buy some index or mutual funds that match my risk/return goals, diversify among domestic and foreign stocks, and don't soak up much in fees. If you do want to get into individual stock-picking, you're on the right track in paying attention to the transaction fees. I think that timhau's advice is sound: you may want to just try a "fictional" portfolio for trading until you're able to trade in sufficient quantities that the fees don't drown out any possible gains.

[Chaos]

5) Do not invest any money that you cannot afford to lose.

[The Central Scrutinizer]

Hi,

I'm interested in investing in stock. I don't have a great deal of money saved up at the moment (only 19) but I have a reasonable steady income.

I just cant figure out how much I need before I start. I'm going to start buying through discount online brokers (TD Waterhouse) which costs £12.99 a trade meaning I ultimately have to make £24 on top of the initial investment to break even, which isn't bad. I cant get onto thinkorswim.com because it only takes American accounts, which is annoying because it looks really good.

I was thinking of investing £100 just to begin with so I can get a feel for it (I have no prior investing experience) but you can't exactly diversify your portfolio with £100. I don't want it to be a wasted £100 either, but I can't expect much of a return from it can I? Should I wait until I have £5k to invest?

What would you all say?
Thanks

Accumulate cash. About 6-12 months of living expenses. After that, accumulate investment cash. I'd say $20,000 before investing in individual securities. Buy great companies, whose business you understand, for less than they are worth, no matter what industry. Don't worry about diversifying or anything like that. Ignore the market, inflation, interest rates, etc. Buy shares with the idea that you are going to hold on to them for 20-30 years.

If you don't feel comfortable with the above, dump it in an index fund (DJIA or S&P 500) and forget about it. Buy when stocks in general seem undervalued. When they are overvalued, don't be afraid to sit on cash. You don't have to invest.

[A.A. Alfie]

Two cows and a bull

[Hindmost]

DO NOT under any circumstances listen to the people on CNBC or any other investment programs. They all have an agenda and they are not going to reveal it to you while the cameras are rolling. You have to dig deep into the companies you are looking to buy and figure out if there is reasonable trends the associated markets to buy the stock or mutual funds.

Do not trust the first broker you are working with...there is no reason to believe that person is intelligent and knows what they are doing. Learn everything for yourself first.

If you live paycheck to paycheck...don't invest in stocks.

Stay away from futures and options trading. The only person that would likely make money is your broker.

Big red flags:

Anyone telling you:

1. it's different now.

2. The market is guaranteed to head straight up once XXX are in office.

3. Housing prices are going to continue to increase into the far future.

4. Price/earning ratios don't mean much anymore.

5. You need to invest in annuities.

6. Any other trite generic statement about what you "should" do or "shouldn't" do.

glenn

[timhau]

2) Build up an emergency fund of 6-12 months' worth of expenses: enough to pay your food, rent, utilities, etc. if your job and other sources of income went away. (This doesn't have to be in a bank account, if you have a money market account you can quickly and easily and cheaply withdraw from.)

This is essential if you want to be a successful investor. You'll want to sell equities because you find them overvalued, not because you need the cash because your refrigerator gave up the ghost the same week that you had to take your cat to the vet. You'll never want to find yourself in a position where you have to sell.

And since reading good books never hurt anyone, I'll throw in a couple of recommendations: Burton Malkiel's A Random Walk down Wall Street is a good read, even if you don't buy his idea that everyone should invest in index funds; Benjamin Graham's Intelligent Investor is old and it occasionally shows, but still well worth reading (and you'll get the famous Mr. Market (http://news.morningstar.com/classroom2/course.asp?docid=145661&page=4) analogy from the original source). I also liked James Montier's The Little Book of Behavioral Investing, which is an entertaining little book that gives some insight into the ways people act like morons and/or lemmings in the stock market, for the simple reason that when the push comes to shove, it's really very, very hard not to.

[roger]

12.99 pounds doesn't sound bad? Okay, with 100lbs to spend, you have to get a 29.8% return to break even. In comparison, the stock market is expected to earn 3-4% per year over the next few decades.

You need to get your trade expenses down under 1% for this to make any sense whatsoever. Recall the vast majority of individual investors under perform the market, so expect worse results than that 3-4%. I can say with near certainty that you fall into that bracket because you are asking such a simple question (not an insult, just an observation) that you pretty clearly have almost no finance experience.

edit: I should fill in the blanks. A minimally diversified portfolio should probably have around 5 stocks. You want your minimum buy to be $3000 to be keep the trade cost manageable. That means 15K, minimum. Anything less than that and you are just giving your money away to the broker and the investors betting against you. Personally, I love people like that, because I depend on bad investing decisions to provide stocks at low prices, but I can't be giving you advice that loses you money.

[The Central Scrutinizer]

I would also add that you need to have the temperament for investing. Most people say they do, but most people don't.

If you buy $20,000 of Coca Cola, and 6 months later it is worth $10,000, your first thought should be "buy more", not "sell". This assumes, of course, that nothing has materially changed about the business and that all the reasons you bought it in the first place are still true.

[Tiktaalik]

This is my all-purpose entry level investing advice:

1) Pay off all credit card debt. (This sounds obvious, but a few years ago a friend of mine bragged about his stocks going up, and later in the same conversation complained about all the credit card interest he was paying. Borrowing at 10%+ to invest in the market is not very bright.) You may also want to pay off any other loans (e.g. student loans, car loans) even ahead of time assuming there aren't penalties for doing so, depending on the interest rate.

2) Build up an emergency fund of 6-12 months' worth of expenses: enough to pay your food, rent, utilities, etc. if your job and other sources of income went away. (This doesn't have to be in a bank account, if you have a money market account you can quickly and easily and cheaply withdraw from.)

3) Max out your contributions to any tax-advantaged retirement plans available in your jurisdiction (401ks and IRAs for Americans, RRSPs, whatever). Even if your employer doesn't match the contributions, the fact that the taxman is offering to subsidize your investment makes this a no-brainer.

4) If you still have extra savings, now you can think about opening your own separate investment account. Where you go from here really depends on your preferences. I don't recommend buying individual stocks unless you affirmatively enjoy the process of researching companies and tracking share prices. Some people do, and good for them. I'm content to buy some index or mutual funds that match my risk/return goals, diversify among domestic and foreign stocks, and don't soak up much in fees. If you do want to get into individual stock-picking, you're on the right track in paying attention to the transaction fees. I think that timhau's advice is sound: you may want to just try a "fictional" portfolio for trading until you're able to trade in sufficient quantities that the fees don't drown out any possible gains.

This. No debt, retirements funds, emergency fund first. That 6 - 12 months living income I put in a money market, on which I've continued earning interest, although at a reduced rate - never lost a penny. I put about $12,000/year in that & will be able to put a substantial downpayment on a house when I buy in the next couple years (or possibly buy outright).

After that, it depends on what you want to do. Do you want to stick the money somewhere & not do much with it or do a lot of active management? I chose the former - don't have time to fool with it on a regular basis. 10 years ago I stuck $2500 in a mutual fund tracking alternative energy companies - it didn't do much at first, but now it's taking off. I haven't done anything with it, it was money I thought I could afford to lose, a gamble. Working out okay now...

[timhau]

edit: I should fill in the blanks. A minimally diversified portfolio should probably have around 5 stocks. You want your minimum buy to be $3000 to be keep the trade cost manageable. That means 15K, minimum.

... if you want to go in all at once, but there's no reason why you should.

[drkitten]

... if you want to go in all at once, but there's no reason why you should.

Diversification. Otherwise you risk overexposure to a single stock.

[timhau]

Diversification. Otherwise you risk overexposure to a single stock.

Temporarily, yes. But how much added risk do you get for buying your oil stocks now, drug companies around christmas and techs after Easter?

[Ladewig]

5) Do not invest any money that you cannot afford to lose.

Did you mean to say that you should carefully consider the risk before investing? I ask because what you said indicates that people should not buy CDs or put money in savings accounts.

[Ladewig]

This is my all-purpose entry level investing advice:

1) Pay off all credit card debt. (This sounds obvious, but a few years ago a friend of mine bragged about his stocks going up, and later in the same conversation complained about all the credit card interest he was paying. Borrowing at 10%+ to invest in the market is not very bright.) You may also want to pay off any other loans (e.g. student loans, car loans) even ahead of time assuming there aren't penalties for doing so, depending on the interest rate.

2) Build up an emergency fund of 6-12 months' worth of expenses: enough to pay your food, rent, utilities, etc. if your job and other sources of income went away. (This doesn't have to be in a bank account, if you have a money market account you can quickly and easily and cheaply withdraw from.)

3) Max out your contributions to any tax-advantaged retirement plans available in your jurisdiction (401ks and IRAs for Americans, RRSPs, whatever). Even if your employer doesn't match the contributions, the fact that the taxman is offering to subsidize your investment makes this a no-brainer.

4) If you still have extra savings, now you can think about opening your own separate investment account. Where you go from here really depends on your preferences. I don't recommend buying individual stocks unless you affirmatively enjoy the process of researching companies and tracking share prices. Some people do, and good for them. I'm content to buy some index or mutual funds that match my risk/return goals, diversify among domestic and foreign stocks, and don't soak up much in fees. If you do want to get into individual stock-picking, you're on the right track in paying attention to the transaction fees. I think that timhau's advice is sound: you may want to just try a "fictional" portfolio for trading until you're able to trade in sufficient quantities that the fees don't drown out any possible gains.

yes.

[drkitten]

Temporarily, yes. But how much added risk do you get for buying your oil stocks now, drug companies around christmas and techs after Easter?

Quite a bit if Deepwater Horizon gets eaten by a grue tomorrow.

The point of diversification is to limit risk through decorrelation. E.g. if DH gets eaten by a grue, lots of people will bail out of oil stocks and put their money into something else (like, say, drug companies). The effect is that on Friday, oil stocks will be down (costing you money) and drug companies will be up, and you'll end up paying more when you buy at Christmas (again, costing you money).

If that's an acceptable level of risk to you, go ahead and buy oil today. I'm just pointing out that it IS a risk.

[drkitten]

Did you mean to say that you should carefully consider the risk before investing? I ask because what you said indicates that people should not buy CDs or put money in savings accounts.

Those aren't 'investments' in a meaningful sense, primarily due to FDIC insurance.

Prior to FDIC insurance, that would actually have been good advice.

[Chaos]

Did you mean to say that you should carefully consider the risk before investing? I ask because what you said indicates that people should not buy CDs or put money in savings accounts.

Okay, clarification: Do not invest any money into inherently risky assets that you cannot afford to lose.

Not sure what you mean by "buy CDs" - I was clearly talking investment, not consumption.

[Giggywig]

Okay, clarification: Do not invest any money into inherently risky assets that you cannot afford to lose.

Not sure what you mean by "buy CDs" - I was clearly talking investment, not consumption.
A CD can also be a "certificate of deposit." From wiki:

A certificate of Deposit or CD is a time deposit, a financial product commonly offered to consumers by banks, thrift institutions, and credit unions.

CDs are similar to savings accounts in that they are insured and thus virtually risk-free; ... They are different from savings accounts in that the CD has a specific, fixed term (often three months, six months, or one to five years), and, usually, a fixed interest rate.

[DevilsAdvocate]

Hi,

I'm interested in investing in stock. I don't have a great deal of money saved up at the moment (only 19) but I have a reasonable steady income.

I just cant figure out how much I need before I start. I'm going to start buying through discount online brokers (TD Waterhouse) which costs £12.99 a trade meaning I ultimately have to make £24 on top of the initial investment to break even, which isn't bad. I cant get onto thinkorswim.com because it only takes American accounts, which is annoying because it looks really good.

I was thinking of investing £100 just to begin with so I can get a feel for it (I have no prior investing experience) but you can't exactly diversify your portfolio with £100. I don't want it to be a wasted £100 either, but I can't expect much of a return from it can I? Should I wait until I have £5k to invest?

What would you all say?
ThanksSkip it. For £100 with a £12.99 buy in fee, you would be better off at the roulette table. Listen to the advice above.

At your age, I would just bank it (which has a very small return) so that I would not have to use credit. NOT using credit (except for large purchases) is usually a better (and more assured) return than INVESTING.

Take advantage of retirment plans and any discounted stock options your company provides (if there are any). These have, on average, much larger returns than random investing or even diversified investing.

If you ahve done this and just have some extra cash to invest, stick it in a well performing high-risk fund. That risk will be well below stock picking, and probably won't have such a high (percentage-wise) buy-in fee. You are young and can take some risks with extra cash, but you are probably better off with a fund rather than gambling with stocks (especially considering the high trade costs compared to your investment).

Sitckig money into stocks is a gamble. It comes and goes, and you average about even (up if you are lucky, down if not, but on the average about even). Putting some money into stable funds generally gets steady growth and over time, and from a young age to an old age that can build up to a lot.

Of course I don't know anything at all about this stuff. So listen to what the other poster's have said.

[The Central Scrutinizer]

Sitckig <sic> money into stocks is a gamble.

I've honestly never understood this line of thinking.

Yes, spinning a roulette wheel and randomly buying whatever pops up is certainly a gamble. But buying stocks is no more a gamble than walking out your front door in the morning.

[timhau]

But buying stocks is no more a gamble than walking out your front door in the morning.

Well, it could be, if all you ever buy are companies teetering on the brink of bankruptcy, in the hopes that they turn it around and your stocks become instant ten-baggers. Rather than investing, I'd call that stock market lottery.

[jimtron]

I'm far from an expert on investing, but I'd highly recommend the Bogleheads Forum (http://www.bogleheads.org/forum/index.php) for advice.

Bogle (http://en.wikipedia.org/wiki/John_Bogle) is the founder of Vanguard, a very highly regarded investment company. Bogle is a proponent of index funds instead of individual stocks.

[jj-158]

... inherently risky assets

How do you find out which assets are inherently risky, and which are not?

[Professor Yaffle]

Given Dystopian's recent thread about his problem with gambling, I would advise him to steer clear of dabbling in the stock market personally. By all means invest by using some sort of fund manager (or whatever you call them) who can keep you sensible, but I wouldn't get into doing it all yourself.

ETA: If you have the personality that is easily addicted to things such as lottery tickets, slot machines, chocolate candy bars, etc. this doesn't mean that you can't ever trade on the stock market it just means that it might be a good idea to avoid some of the higher risk trading and stick with more slow and steady options such as mutual funds, CDs, and the like. Your rewards are likely to be better over time and you aren't likely to experience the ups and downs that go along with activities that closely resemble gambling.http://yourstocksnshares.com/stock-market-investment-information/risk-of-stock-market-gambling

[jj-158]

I've honestly never understood this line of thinking.

Yes, spinning a roulette wheel and randomly buying whatever pops up is certainly a gamble. But buying stocks is no more a gamble than walking out your front door in the morning.

The stakes are a bit different.

[The Central Scrutinizer]

I'm far from an expert on investing, but I'd highly recommend the Bogleheads Forum (http://www.bogleheads.org/forum/index.php) for advice.

Bogle (http://en.wikipedia.org/wiki/John_Bogle) is the founder of Vanguard, a very highly regarded investment company. Bogle is a proponent of index funds instead of individual stocks.

If you're going to invest in an index fund, what is there to read? :confused:

[drkitten]

How do you find out which assets are inherently risky, and which are not?

If your assets are guaranteed by the US Federal government, they're not risky.

[drkitten]

If you're going to invest in an index fund, what is there to read? :confused:

Which index fund and why.

For example, do I want to be in an index "fund" or an index ETF? If I decide I like the index ETF for whatever reason, should I pick SPY or QQQQ?

... or do I want to index something other than the S&P 500? Maybe I want a small-cap index instead? Maybe I want to be in a commodities index like SLX? Or maybe I want to be in both (diversification!), but I'm not sure how much SLX mirrors QQQQ.

[The Central Scrutinizer]

Which index fund and why.

For example, do I want to be in an index "fund" or an index ETF? If I decide I like the index ETF for whatever reason, should I pick SPY or QQQQ?

... or do I want to index something other than the S&P 500? Maybe I want a small-cap index instead? Maybe I want to be in a commodities index like SLX? Or maybe I want to be in both (diversification!), but I'm not sure how much SLX mirrors QQQQ.

I'd pick the DJIA and call it a day. Saves a lot of time.

[drkitten]

I've honestly never understood this line of thinking.

Yes, spinning a roulette wheel and randomly buying whatever pops up is certainly a gamble. But buying stocks is no more a gamble than walking out your front door in the morning.

This is simply not true. Even if you follow Buffett's advice to the letter, you're still going to lose money in the short run. In many short runs. You're actually going to lose more money over more short runs following Buffett's advice to the letter than you would following Bogle's, although Buffett's advice has more upside potential over the infinitely-long term. (But who of us has infinitely long to wait to get our money?)

Simple example of where "buying stocks is a gamble" -- if you have $20,000 to play with and a ten-year old daughter, where do you put the money to maximize the amount you'll have when she goes to college in eight years?

Buffett's "advice" would be to "buy a great company at a great price" and then hope like hell that the prices is good in seven and a half years. I use the scare quotes deliberately, because that's barely better advice than "put it on the horse with the blue-eyed jockey and hope like hell."

And, I admit, I'm misrepresenting Buffett here (that's a closer description of the Buffett theologians); Buffett himself would probably actually take a page from Bogle and tell you to buy a low-cost equity index fund, or to buy a low-cost equity index fund with part of it and keep some in the highest-interest long-term CD ladder you could find. Precisely because Buffett recognizes that his investment strategy carries with it significant risks of short-term losses.

... but that's another way of saying that even Buffett recognizes that buying stocks is a gamble.

[drkitten]

I'd pick the DJIA and call it a day. Saves a lot of time.

Which one? There are probably fifty DJIA index funds out there....

[roger]

This is simply not true. Even if you follow Buffett's advice to the letter, you're still going to lose money in the short run. In many short runs. You're actually going to lose more money over more short runs following Buffett's advice to the letter than you would following Bogle's, although Buffett's advice has more upside potential over the infinitely-long term. (But who of us has infinitely long to wait to get our money?)

Simple example of where "buying stocks is a gamble" -- if you have $20,000 to play with and a ten-year old daughter, where do you put the money to maximize the amount you'll have when she goes to college in eight years?

Buffett's "advice" would be to "buy a great company at a great price" and then hope like hell that the prices is good in seven and a half years. I use the scare quotes deliberately, because that's barely better advice than "put it on the horse with the blue-eyed jockey and hope like hell."

And, I admit, I'm misrepresenting Buffett here (that's a closer description of the Buffett theologians); Buffett himself would probably actually take a page from Bogle and tell you to buy a low-cost equity index fund, or to buy a low-cost equity index fund with part of it and keep some in the highest-interest long-term CD ladder you could find. Precisely because Buffett recognizes that his investment strategy carries with it significant risks of short-term losses.

... but that's another way of saying that even Buffett recognizes that buying stocks is a gamble.
Well, the option here is, well, options. Put your money in LEAPS and you have a well defined maximum exposure to loss while still receiving the upside of a market/stock increase. Trade risk for maximal profit. Daughter is guaranteed her college fund. Heck, you might even take a flutter on a major market crash and you just might end up being able to send her to Harvard vs the state college.

[drkitten]

Well, the option here is, well, options. Put your money in LEAPS and you have a well defined maximum exposure to loss while still receiving the upside of a market/stock increase. Trade risk for maximal profit. Daughter is guaranteed her college fund. Heck, you might even take a flutter on a major market crash and you just might end up being able to send her to Harvard vs the state college.

Um,....

If LEAPS really could allow me to "trade risk for maximal profit," that would be neat, since usually reducing risk reduces profits and vice versa.

Similarly, if your idea of sound financial planning involves "take a flutter on," might I suggest the blue-eyed jockey at Aquaduct?

Quite frankly, I think this is terrible advice for the situation I described. Options in general are a negative sum game -- for every dollar you win, someone else loses (and vice versa), and both of you pay fairly substantial commissions for an investment that is mathematically indistinguishable from a coin toss. So you're basically guaranteeing that I'll make a substantial loss up-front (in the purchase of the LEAPS) with a 50/50 chance that they'll be worth anything at all when the options expire. As an alternative to simple stock ownership, LEAPS generally don't do at all well. This page shows that (http://www.cboe.com/Strategies/BEL-CallsAsStockAlternative.aspx); in order to make the performance at all similar, they had to put the simple equity investor into a highly leveraged margin situation in order to inflate both his costs and his risk exposure.

... but high costs and high risks are generally what I don't want if I'm looking at a medium-term investment like college tuition.

[Ziggurat]

I'd pick the DJIA and call it a day. Saves a lot of time.

The DJIA is a pretty damn narrow index. The S&P 500 is a better option, but it's only large-cap. The Wilshire 5000 is the broadest widely-used stock index. It gets a fair amount of mid-cap stock exposure, so that's what I'd suggest if you're looking for a single stock index fund.

[Ziggurat]

If you're going to invest in an index fund, what is there to read? :confused:

The biggest thing to read up on is asset allocation. How much stocks vs. bonds? How much large cap, mid-cap, and small cap? How much international? You can play with different balances, all with index funds. Plus, of course, once you've picked your allocation, even with a given index, there are still differences between funds. Different expense ratios and fees, different minimum purchases, different terms, different customer service, etc.

Edit: I used to peruse the Boglehead forum some years ago. They turned me on to I bonds as a good place to store emergency funds, and I managed to buy a few at 3% before the fixed rate dropped. They aren't as attractive as they used to be, but it's still a good place for emergency money: you can cash them in at any time after about a year, they get better interest rates than at least the majority of money market funds, and tax on the compounded interest is deferred until you cash them in. So there's plenty you can learn on that forum besides just investing in index funds.

[drkitten]

The DJIA is a pretty damn narrow index. The S&P 500 is a better option, but it's only large-cap. The Wilshire 5000 is the broadest widely-used stock index. It gets a fair amount of mid-cap stock exposure, so that's what I'd suggest if you're looking for a single stock index fund.

You think? But TCS thinks exactly the opposite.

Gosh, with two such articulate proponents saying directly opposite things,.... if only there were somewhere I could go for additional information. :D


...

.... which, of course, is exactly why I would want to read the Bogleheads' take on things.

For what it's worth, I tend to be on Ziggy's side in this particular debate, which is why I own Cubes instead of Diamonds....

[Ziggurat]

You think? But TCS thinks exactly the opposite.

In fairness, TCS just said he'd pick the DJIA, he didn't say why.

[drkitten]

In fairness, TCS just said he'd pick the DJIA, he didn't say why.

Fair enough. I merely jumped on the disagreement to stress (again) that there's room for discussion, and therefore for informative reading, in the question of which index you want your fund to track.

[roger]

Um,....

If LEAPS really could allow me to "trade risk for maximal profit," that would be neat, since usually reducing risk reduces profits and vice versa. That's what I meant. You are giving up some risk, but losing the chance for maximal profit.

Similarly, if your idea of sound financial planning involves "take a flutter on," might I suggest the blue-eyed jockey at Aquaduct? I would think the term 'flutter' would suggest it wasn't part of the sound financial advice part.

Options are insurance. You can participate in some of the upside of the market. If you choose not to be in the market at all (buy CDs or whatever), I would certainly not argue against it. However, the risk of buying an index (which is what I believe you recommended) is far in excess of the risk of buying LEAPS.

Perhaps we are miscommunicating. Say you have 50K to invest. You can either put the 50K into a S&P 500 index (say), or buy LEAPS representing 50K worth of the index. Which means you are not putting up 50K, but some small fraction of that money.

At worst you will lose that premium. It is, however, entirely predictable and you can plan for it. Whereas if you bought the index, what's your realistic maximal loss? I'd say under 100%, as total destruction of the stock market is extremely unlikely, but how's 30% or so sound as a reasonable number. Your LEAPS commissions should be well under that 30% or it is a bad investment, of course.

Anyway, I think it's terrible advice to invest in the market with money you need in 8 years. Well, 8 years is long enough that maybe we can moderate that to bad? I dunno, someone else can play the adjective game.

We've gone through this before. The link you supply makes the point I am making. You are trading risk (you are lowering your risk, I don't get where you think you are increasing it), in return for not getting the same maximal return you would get if the market ends up going up.


So you're basically guaranteeing that I'll make a substantial loss up-front (in the purchase of the LEAPS) with a 50/50 chance that they'll be worth anything at all when the options expire.Where did 50/50 come from? Deep in the money LEAPS have far greater than 50% liklihood of being in the money on expiration. A 35 call on a $56 stock means it has to fall $21 for it to become worthless. How is that 50% likely? Suppose I'm deeply conservative and buy a $10 call. Is a $46 fall 50% likely?

This page shows that (http://www.cboe.com/Strategies/BEL-CallsAsStockAlternative.aspx); in order to make the performance at all similar, they had to put the simple equity investor into a highly leveraged margin situation in order to inflate both his costs and his risk exposure.?? The LEAPS are not margined in this example, the stocks are. They chose to compare margin to LEAPS because the cash outlay is the same, I guess. Seems like a bad example for comparing purchasing stocks vs LEAPS. This should underscore the safety vs performance of LEAPS, you get nearly the same performance as a margined investor, but you face reduced risks compared to straight stock buyer. How cool is that?

Figure it out with buying the actual stock vs buying the LEAPS. With the LEAPS, you are committing far less capital (and thus, the rest of your cash is your cushion). If your LEAPS are out at expiration, the stock will be so far down that you have also lost a ton with the straight stock purchase.

In the link, the LEAP is at 35. So, if the stock is at 35 at expiration, you would have lost (5600-3500)= 2100. With the LEAPS, you would have lost 2425, a modest increase. But, say the stock was at 31. At that point you would have lost 2500 with the straight stock purchase, but still the 2425 with the LEAPS. That trend continues - the lower the stock price the greater the loss with straight stock purchase, but the LEAPS do not change.

In the opposite direction, yes, the LEAPS will always underperform the equivalent stock. But, that is the tradeoff. You limit your risk - you will never lose more than $2425 no matter what happens to the stock, in exchange for giving up some of the profit to the seller of the LEAP.

To me, this is a near ideal strategy in such a situation (the situation being you want to be in the stock market). You lower the amount of profit you can make, but you can safely put your money to work knowing no matter how badly things go, your risk exposure is limited, and little Sally will be able to pay for Harvard.

edit: it should be pointed out that this is not advice for the OP; if you have never invested before you should not be getting into options. It was more an abstract response to the idea of investing money that you know you will absolutely need in 8 years, a terrible idea if I ever heard one.

edit2: I'm really suprised at your objection, drKitten, as we have had this exact discussion before, and you made exactly my point in the Martingale thread not a day or so ago. Paying for home insurance reduces your maximal profit (sale price of house - purchase price of house - insurance payments). You are trading risk for profit - the insurer takes on your risk, but also takes part of your profit. It's a wise investment for you because you can't afford the worst case, and it's a wise investment for the insurer because the occasional payout is spread across the thousands of policy and the return on the float. You know that, of course. This is structured the same way. The (institutional) LEAP seller is insuring you against total or catastrophic loss, and in return gets the time limited use of your money as float. Both people win. You keep characterizing it as both people losing.

[roger]

If you're going to invest in an index fund, what is there to read? :confused:
As a Buffett disciple, you should be able to answer this yourself :)

He has written about expected return of the market and trying to time purchases. So, for example, your erstwhile investor might think she can time purchases, and then learn about monthly dollar averaging and the poor relative performance of market timers. OTOH, she may have read what Buffett has written about PE ratios in the market and the value of keeping cash on hand when prices are high, and decide to invest less when the PE ratio is historically high, and go all in when the market crashes. I'm not saying either of those choices are right, or the only available reasonable choices, but it's certainly a topic worth researching, yes?

[The Central Scrutinizer]

This is simply not true. Even if you follow Buffett's advice to the letter, you're still going to lose money in the short run. In many short runs. You're actually going to lose more money over more short runs following Buffett's advice to the letter than you would following Bogle's, although Buffett's advice has more upside potential over the infinitely-long term. (But who of us has infinitely long to wait to get our money?)

Simple example of where "buying stocks is a gamble" -- if you have $20,000 to play with and a ten-year old daughter, where do you put the money to maximize the amount you'll have when she goes to college in eight years?

Buffett's "advice" would be to "buy a great company at a great price" and then hope like hell that the prices is good in seven and a half years. I use the scare quotes deliberately, because that's barely better advice than "put it on the horse with the blue-eyed jockey and hope like hell."

And, I admit, I'm misrepresenting Buffett here (that's a closer description of the Buffett theologians); Buffett himself would probably actually take a page from Bogle and tell you to buy a low-cost equity index fund, or to buy a low-cost equity index fund with part of it and keep some in the highest-interest long-term CD ladder you could find. Precisely because Buffett recognizes that his investment strategy carries with it significant risks of short-term losses.

... but that's another way of saying that even Buffett recognizes that buying stocks is a gamble.

Why are you investing for college when the kid is 10? Why weren't you investing when they were 0?

If you want a sure thing, put your cash in CD's.

But from the perspective of a single person like me, stocks are no gamble at all. And yes, I have an infinitely long term.

[The Central Scrutinizer]

Which one? There are probably fifty DJIA index funds out there....

The one that tracks the DJIA. If there are 50 of them (which there are probably way more), I guess I would toss a coin.

[The Central Scrutinizer]

The DJIA is a pretty damn narrow index. The S&P 500 is a better option, but it's only large-cap. The Wilshire 5000 is the broadest widely-used stock index. It gets a fair amount of mid-cap stock exposure, so that's what I'd suggest if you're looking for a single stock index fund.

Is there something wrong with "narrow"?

[NewtonTrino]

Is there something wrong with "narrow"?

Nothing but it's theoretically safer to diversify as much as practical.

[The Central Scrutinizer]

The biggest thing to read up on is asset allocation. How much stocks vs. bonds? How much large cap, mid-cap, and small cap? How much international? You can play with different balances, all with index funds. Plus, of course, once you've picked your allocation, even with a given index, there are still differences between funds. Different expense ratios and fees, different minimum purchases, different terms, different customer service, etc.

Edit: I used to peruse the Boglehead forum some years ago. They turned me on to I bonds as a good place to store emergency funds, and I managed to buy a few at 3% before the fixed rate dropped. They aren't as attractive as they used to be, but it's still a good place for emergency money: you can cash them in at any time after about a year, they get better interest rates than at least the majority of money market funds, and tax on the compounded interest is deferred until you cash them in. So there's plenty you can learn on that forum besides just investing in index funds.

Ah yes, "asset allocation". One of the cornerstones of Modern Portfolio Theory.

"Modern portfolio theory is asinine." - Charles T. Munger

[The Central Scrutinizer]

You think? But TCS thinks exactly the opposite.

Gosh, with two such articulate proponents saying directly opposite things,.... if only there were somewhere I could go for additional information. :D

http://www.berkshirehathaway.com/letters/letters.html :)

[The Central Scrutinizer]

Anyway, I think it's terrible advice to invest in the market with money you need in 8 years.

Underlined for emphasis.

edit: it should be pointed out that this is not advice for the OP; if you have never invested before you should not be getting into options. It was more an abstract response to the idea of investing money that you know you will absolutely need in 8 years, a terrible idea if I ever heard one.

Underlined again for even more emphasis.

[The Central Scrutinizer]

As a Buffett disciple, you should be able to answer this yourself :)

He has written about expected return of the market and trying to time purchases. So, for example, your erstwhile investor might think she can time purchases, and then learn about monthly dollar averaging and the poor relative performance of market timers. OTOH, she may have read what Buffett has written about PE ratios in the market and the value of keeping cash on hand when prices are high, and decide to invest less when the PE ratio is historically high, and go all in when the market crashes. I'm not saying either of those choices are right, or the only available reasonable choices, but it's certainly a topic worth researching, yes?

Agreed. I guess I was thinking more narrowly. You pick an index, and you "buy" it when it is undervalued. Why does one need to read a 400 page book for that? :)

[roger]

Underlined for emphasis.
Actually, it's terribly written. I didn't mean invest in the market, but going all in buying stocks directly. There are alternative methods to invest in the market without the total risk exposure, despite the good dr's objections.

[The Central Scrutinizer]

Nothing but it's theoretically safer to diversify as much as practical.

Why? To protect against the downside is the reason most often given. Of course, when you diversify, you are also protecting against the upside. You understand that, right?

I've tried to explain this a thousand times to people, put they don't get it. The most recent example - an organization I belong to has about $500K to invest. One of the people on the board said we should spread that across 50-100 stocks. I said I would be perfectly comfortable with 4-6. The following brief conversation then took place:

Them: So what if your 4-6 stocks go down 50%?
Me: What if they go up 50%?
Them: <Blank stare>

Nothing against "them", but to date, no one has been able to answer that question.

[Ziggurat]

Is there something wrong with "narrow"?

Yes: it's higher risk.

[The Central Scrutinizer]

Actually, it's terribly written. I didn't mean invest in the market, but going all in buying stocks directly. There are alternative methods to invest in the market without the total risk exposure, despite the good dr's objections.

I'm a stock guy. I don't do options and other things, because I really don't understand them.

Certainly, as a Buffett disciple, you can understand my position. :)

[The Central Scrutinizer]

Yes: it's higher risk.

In both directions, right?

[roger]

Nothing but it's theoretically safer to diversify as much as practical.
It's theoretically, and practically, less safe to diversify as much as practical.

Where safe/risk is defined as underperforming the market, not so much just total loss.

There are several reasons for this. First, if you own 1000 stocks, a doubling of one of them is essentially meaningless to your bottom line. Second, if you own 1000 stocks, you have the costs of 1000 transactions, and the costs of maintaining research on those 1000 stocks. Third, and this is the point that is missed, is that "diversification" DOES NOT mean "uncorrelated". Buying more stocks can reduce performance because the stocks are somehow correlated. This is very well backed up in with a lot of peer reviewed studies. It's pretty hard to pick more than 10 stocks that aren't correlated in some important but obscure ways.

As an example of good diversification, look at Buffett. Yes, he owns a lot of different businesses. But look at what he owns. Super-cat insurance is a big one - he insures against major catastrophes like coastal hurricanes, and is on the hook for multi-billion dollar payouts if they occur. But what else does he own? Brick making companies. A mobile home company. Furniture companies. Kinda all the stuff you need to buy if a huge hurricane came through and wiped a city off the map. In this case we have inverse correlation, a good thing.

But in general once you start getting over 10 stocks/businesses, you cannot predict the correlations that do exist, and sooner or later you will get bitten by a correlation you did not realize exist.

Sure, you could get pleasantly surprised by a correlation if everything is going up, but chances are you will just pat yourself on the back for being a savvy investor in picking all these very different, well diversified businesses which are all doing so well. You won't recognize the correlation until there is a crash.

Charlie Munger, being far pithier than me, just calls it doworsification. Same idea, less typing :)

[roger]

I'm a stock guy. I don't do options and other things, because I really don't understand them.

Certainly, as a Buffett disciple, you can understand my position. :)
That's fine. We all have our areas of expertise - straying from them would be stupid.

I will point out that Buffet has acquired huge swaths of stock via writing options (a recent example being BNI), and currently has massive derivatives out insuring people (okay institutions) against possible future drops in the S&P 500. They are valid instruments if used right. It's really no different than buying or selling insurance in the way that Buffett (and I) do it - something we might expect Buffett to know a tiny bit about.

drkitten would tell him he's an idiot, I guess?

[The Central Scrutinizer]

That's fine. We all have our areas of expertise - straying from them would be stupid.

I will point out that Buffet has acquired huge swaths of stock via writing options, and currently has massive derivatives out insuring people (okay institutions) against possible future drops in the S&P 500. They are valid instruments if used right. It's really no different than buying or selling insurance in the way that Buffett (and I) do it - something we might expect Buffett to know a tiny bit about.

drkitten would tell him he's an idiot, I guess?

An interesting point. Buffett calls derivatives implements of financial mass destruction, or something like that. And yet, he owns derivatives. I get the feeling that Buffett thinks the world would be a far better place if derivatives didn't exist. He has spoken often about how most people who own derivatives can't even explain how they work! As you know, goal #1 when he bought Gen Re was unwinding their derivative positions.

So yes, they are valid instruments if used right. It's just that most people don't use them right. :) Which is maybe why he has $50 billion and others don't.

Anyhow, I don't think Dr Kitten would call Buffett an idiot. I would hope he(?) is more learned than that.

[Ziggurat]

It's theoretically, and practically, less safe to diversify as much as practical.

Where safe/risk is defined as underperforming the market, not so much just total loss.

There are several reasons for this. First, if you own 1000 stocks, a doubling of one of them is essentially meaningless to your bottom line.

Irrelevant. All this means is that variance is reduced. But that's the whole point: reduce risk. Expected performance won't change because of diversification.

Second, if you own 1000 stocks, you have the costs of 1000 transactions, and the costs of maintaining research on those 1000 stocks.

Not in a mutual fund you don't. And if you pick a market index fund like the Wilshire 5000, you're going to closely match the market. Which is better than most stock investors will do.

Third, and this is the point that is missed, is that "diversification" DOES NOT mean "uncorrelated". Buying more stocks can reduce performance because the stocks are somehow correlated. This is very well backed up in with a lot of peer reviewed studies. It's pretty hard to pick more than 10 stocks that aren't correlated in some important but obscure ways.

Sorry, but that makes no sense, and contradicts your earlier claim. Correlations reduce the effectiveness of diversification, but they don't need to reduce performance at all.

But in general once you start getting over 10 stocks/businesses, you cannot predict the correlations that do exist, and sooner or later you will get bitten by a correlation you did not realize exist.

And that's better than not diversifying... how? If you aren't diversified, you don't even need hidden correlations to get bitten.

Oh, and what Buffet does is not an option for the vast majority of investors.

[Ziggurat]

In both directions, right?

Yes. That's why I said higher risk, and not lower expected performance.

[The Central Scrutinizer]

Oh, and what Buffet does is not an option for the vast majority of investors.

Why not?

I hear this claim a lot, but don't know the answer. The only thing I can think of is his ability to buy entire companies. But, you realize he wasn't born with $50 billion, right? Any idea how he made it?

[drkitten]

Why are you investing for college when the kid is 10? Why weren't you investing when they were 0?

Because I didn't have the cash when they were 0? Perhaps I had kids in graduate school and I only just now got the tenure-track position that gives me a reasonable savings amount. Perhaps it's an inheritance from my great-aunt Prunella who had the poor manners to die last month instead of in 2000. Perhaps my daughter is actually my step-daughter and I wasn't around when I was zero.

If the best advice that Buffett disciples can offer is "go back in time ten years," then that's even less useful than the blue-eyed jockey.


If you want a sure thing, put your cash in CD's.

But I don't want "a sure thing." I want to pay for my daughter's education. Is "a sure thing" the best way to do that? Is a slightly more risky bond index fund the best way to do that? Is the best way to invest in a diversified portfolio of equities, or should I just buy a stock I like and hope that 2018 isn't in another downturn?



But from the perspective of a single person like me, stocks are no gamble at all. And yes, I have an infinitely long term.

And there, if you needed it, is a demonstration that Buffett's investment strategy, as interpreted by his cultists, is completely useless to anyone living in the United States. Or in the reality-influence part of the universe, for that matter. Please tell us what life is like in the Kingdom of Narnia....

[drkitten]

I've tried to explain this a thousand times to people, put they don't get it.

There's a reason for that.

You're simply wrong. Even Buffett points this out (remember that he actively recommends index funds for smaller investors -- if you can't buy enough of a company to take an active and influential role in the management, you're better off just buying and holding an index. This is another piece of Buffett's wisdom his disciples often neglect to share.)





Them: So what if your 4-6 stocks go down 50%?
Me: What if they go up 50%?
Them: <Blank stare>

Nothing against "them", but to date, no one has been able to answer that question.

I can answer that. What happens if your 4-6 stocks go down 50% and you need the money?

Unless you're Buffett-style rich, you can't count on not needing to tap into your investments for emergencies. (Even if you have the recommended six month "emergency fund," that can still disappear in seconds when the wrong wire shorts out or someone decides to sue you.)

At Buffett's level, money is just a way of keeping score; he can pay for almost anything without making a dent in his portfolio. He keeps playing the game because he likes it, not because he needs or wants more money. (He's admitted as such several times.) At the level of mere mortals, I invest because I want more money. I want more money because I might need more money, and I have the time and patience to make more money now (before I actually need it).

[drkitten]

The one that tracks the DJIA. If there are 50 of them (which there are probably way more), I guess I would toss a coin.

Cool. Let me introduce you to DrKitten's Marvelous DJIA-Tracking Index Fund.

It tracks the DJIA. It also charges you 10% front-end fees, 20% back-end fees, and an annual management fee of 50%.

And you also get a cool toaster oven out of it if you invest $5000 or more.

[The Central Scrutinizer]

Because I didn't have the cash when they were 0? Perhaps I had kids in graduate school and I only just now got the tenure-track position that gives me a reasonable savings amount. Perhaps it's an inheritance from my great-aunt Prunella who had the poor manners to die last month instead of in 2000. Perhaps my daughter is actually my step-daughter and I wasn't around when I was zero.

If the best advice that Buffett disciples can offer is "go back in time ten years," then that's even less useful than the blue-eyed jockey.

So you had no income at age zero? How did you eat?

But I don't want "a sure thing." I want to pay for my daughter's education. Is "a sure thing" the best way to do that? Is a slightly more risky bond index fund the best way to do that? Is the best way to invest in a diversified portfolio of equities, or should I just buy a stock I like and hope that 2018 isn't in another downturn?

There are no "sure things". Sounds like you need to read up a bit more about investing. If you don't want to do the work, just put your money in an index fund.

And there, if you needed it, is a demonstration that Buffett's investment strategy, as interpreted by his cultists, is completely useless to anyone living in the United States. Or in the reality-influence part of the universe, for that matter. Please tell us what life is like in the Kingdom of Narnia....

I would never invest the way his "cultists" do. He would be the first one to tell you not to.

[The Central Scrutinizer]

You're simply wrong. Even Buffett points this out (remember that he actively recommends index funds for smaller investors -- if you can't buy enough of a company to take an active and influential role in the management, you're better off just buying and holding an index. This is another piece of Buffett's wisdom his disciples often neglect to share.)

Show me a single time he ever said people should only invest in companies where they can take an "active and influential role in the management". Just once. This should be interesting....

As to index funds, you got that part wrong too. That's why I never shared that bit of wisdom. His position on index funds, which I have accurately shared, is that if you don't want to (or can't) do the work required for investing in individual shares, then put your money in an index fund.

I can answer that. What happens if your 4-6 stocks go down 50% and you need the money?

Then you have 50% less money. What if they go up 50% and you need the money? Anyone? Bueller.....Bueller....

Unless you're Buffett-style rich, you can't count on not needing to tap into your investments for emergencies. (Even if you have the recommended six month "emergency fund," that can still disappear in seconds when the wrong wire shorts out or someone decides to sue you.)

Do you think Buffett was born with $50 billion? A lot of people seem to have that idea. Remember, there was a time in his life when he had a lot less and was putting 3 kids through college, and yet he somehow managed to make it by following his own advice.

At Buffett's level, money is just a way of keeping score; he can pay for almost anything without making a dent in his portfolio. He keeps playing the game because he likes it, not because he needs or wants more money. (He's admitted as such several times.) At the level of mere mortals, I invest because I want more money. I want more money because I might need more money, and I have the time and patience to make more money now (before I actually need it).

Yes, he doesn't need more. And I, and most of the other people in this forum, invest because I want more money. So what is your point?

[The Central Scrutinizer]

Cool. Let me introduce you to DrKitten's Marvelous DJIA-Tracking Index Fund.

It tracks the DJIA. It also charges you 10% front-end fees, 20% back-end fees, and an annual management fee of 50%.

And you also get a cool toaster oven out of it if you invest $5000 or more.

I'll pass. Why pay those high fees?

[Ziggurat]

Why not?

I hear this claim a lot, but don't know the answer. The only thing I can think of is his ability to buy entire companies. But, you realize he wasn't born with $50 billion, right? Any idea how he made it?

Because it took a lot of work, time, AND talent (and possibly some luck too). Most people who try what he did at the start won't have anything like his level of success. Which is why, not surprisingly, there aren't many other Warren Buffet types. If most people could do it, there'd be a lot more people who DID do it.

[drkitten]

So you had no income at age zero? How did you eat?

Student loans.


There are no "sure things".

Then why did you offer me one?

[drkitten]

I'll pass. Why pay those high fees?

Because you can't be bothered to look at the different DJIA index funds to see whether any of them have a better fee structure.

I believe you specified you were using a coin flip to decide which one to buy into. How much does your coin know about front-end fees?

[lomiller]

You pick an index, and you "buy" it when it is undervalued. Why does one need to read a 400 page book for that? :)

I’d suggest it’s a lot easier to see when a company is undervalued then when an index is undervalued. With rare exceptions trying to say “this index is undervalue so I’ll buy now” just won’t work as well as putting money in when the cash is available.

I’m probably going to get a lot of disagreement but for my own situation I don’t agree with the “keep X months worth of cash on hand”. Most of the time I do have cash or cash equivalents available, but it’s primary for opportunities, not emergencies. It may not be quite as secure as cash but for emergencies I have lines of credit sufficient for more then sufficient for year’s expenses. These cost me nothing if I don’t need them but allow me to put my cash to work if I see an opportunity.


Yeah there is more risk, but it doesn’t seem unmanageable to me. If it’s not enough, chances are I need to start looking for a cheaper place to live so the house would have to go regardless.

[roger]

Irrelevant. All this means is that variance is reduced. But that's the whole point: reduce risk. Expected performance won't change because of diversification.Relevant. Note I defined risk as underperforming the market. Given that you have frictional costs that the market does not have, reducing variance increases risk (of underperforming).



Not in a mutual fund you don't.Check the fee schedule. Brokerage fees, staff, all cost money. Increasing the risk of underperforming the market.

And if you pick a market index fund like the Wilshire 5000, you're going to closely match the market.We are talking specifically of individual stock picking. It is tautological that an index will, well, match an index (actually they underperform by a few tenths of a percent, but I'm interested in practical, not academic differences)



Sorry, but that makes no sense, and contradicts your earlier claim. Correlations reduce the effectiveness of diversification, but they don't need to reduce performance at all.Correlations increase risk and reduces profit. Ask anyone that was largely invested in tech stocks around 2000 or so.



And that's better than not diversifying... how? If you aren't diversified, you don't even need hidden correlations to get bitten.I did not say do not diversify. I specified 10 stocks, which is accepted as a good value for diversification in the investing world. I said overdiversification (the usual number offered is in the range of 10-20 stocks for an individual investor) increases risk and reduces profit. Actually, 20 is the given number, but that comes from MPT, which has a lot of practical problems.

Also, I am assuming non-efficient markets. We will never agree if you hold markets are efficient (I have no idea if you do or not).

Oh, and what Buffet does is not an option for the vast majority of investors.Which is why I said earlier that he recommends that 99% of people buy index funds.

To summarize: buy an index fund if you want a near guarantee of tracking the market and/or believe in efficient markets. If you believe companies can be valued independently of their stock price, and you are individually picking stocks, buy 10 stocks or so, no more than you can keep up with. DO NOT try to diversify by buying a bunch of different mutual funds - you will inevitably end up with some stocks overrepresented, some underrepresented, and a weird mix of correlations in sectors, etc.

[roger]

I’d suggest it’s a lot easier to see when a company is undervalued then when an index is undervalued. With rare exceptions trying to say “this index is undervalue so I’ll buy now” just won’t work as well as putting money in when the cash is available.That's interesting, as I would say the exact opposite. We have decades worth of economy's performance, and have tracked PE ratios to the performance. It holds (with some variance by decades) that our GDP grows at a constant, low rate, and that the stock market growth tracks the GDP closely, and that the market returns to the PE that reflects the GDP growth (I think the # is around 17, but I don't do PE style investing). Each week when I get Value Line they print the market's PE, and of course you can get it for free. It's a small matter to see if the # is higher than normal or lower, and invest accordingly.

Note: this is me thinking out loud. I'm not a PE style investor, and it's been awhile since I read the specifics. i have books where I can look it up, but I'm off to an appointment for now.

[roger]

An interesting point. Buffett calls derivatives implements of financial mass destruction, or something like that. And yet, he owns derivatives. I get the feeling that Buffett thinks the world would be a far better place if derivatives didn't exist. He has spoken often about how most people who own derivatives can't even explain how they work! As you know, goal #1 when he bought Gen Re was unwinding their derivative positions. There are derivatives, and then there are derivatives.

All a derivative is is a contract that bases it's value on something else.

So, I bet you $100 the Colorado Rockies will win this weekend. That's a derivative. Money changes hands based on some other event.

If sports events were reliably predictable, you can see how that contract would be easy to value.

Okay, now I say the rockies do poorly in the rain, so I want a clause written in where the payout varies based on the weather prediction 24 hours before the game.

Then, you say the rockies do better at higher elevation, so you want to alter the payout based on home/away.

then, I say the Rockies do better when there is a large audience, so I want payout adjusted based on predicted ticket sales.

Then, you say.....

You get the idea. Each of these clauses, ostensibly intended to better value the contract, actually make it impossible to value. Who could put a dollar value on this contract, even if you know that the Rockies have reliably won 80% of their matches against this weekend's competitors for the past 10 years?

Okay, companies like general Re have multiple volume BOOKS for derivatives. This collection of assets has a 300 page contract with another collection of assets. Many of those "assets" are derivatives, which are themselves 300 page books with other companies. It's impossible to even figure out who owes what to what when things come due, let alone put a dollar value on what you own.

Options are super simple forms of derivatives, much like house insurance. You'd be smart to own house insurance, but probably dumb if your insurance agreement ran to 3000 pages and included things like how much water falls in Alaska this year and whether the Mets make the pennant race.

[lomiller]

That's interesting, as I would say the exact opposite. We have decades worth of economy's performance, and have tracked PE ratios to the performance. It holds (with some variance by decades) that our GDP grows at a constant, low rate, and that the stock market growth tracks the GDP closely, and that the market returns to the PE that reflects the GDP growth (I think the # is around 17, but I don't do PE style investing). Each week when I get Value Line they print the market's PE, and of course you can get it for free. It's a small matter to see if the # is higher than normal or lower, and invest accordingly.

Note: this is me thinking out loud. I'm not a PE style investor, and it's been awhile since I read the specifics. i have books where I can look it up, but I'm off to an appointment for now.

Sure it’s a useful indicator, but PE has some serious limitations as well.

To know what a company is worth you need to know what its price is now and what it’s earnings will be in the future. You can ballpark that by looking at current earnings and growth but that’s an approximation only.

If you want to understand what a companies future earnings are likely to be you need to look at it’s business. What products does it sell, what does it cost to make them, what who are it’s competitors and how do their prices/margins compare, is market share likely to go up or down, are margins likely to go up or down, how big is the market it’s selling into, etc. How do you ask any of those questions about an index?

The point of indexes is that if you are not in a position to answer any of those questions when you invest in an individual company you are working off the same type of information you would investing in an index so you may as well spread the risk around as widely as possible Also, if you are buying individual stocks you are competing against people who are in a position to answer all of those questions so if you just work off PE or other such historical metrics you are at a serious disadvantage.

[drkitten]

Sure it’s a useful indicator, but PE has some serious limitations as well.

Well, that's the point of using it to measure indices.

You're basically relying on the Law of Large Numbers to rescue your lazy ass.

Some companies will have a low P/E because they're not worth much and the smart money is bailing on them. Some will have a low P/E because they just got handed a big lawsuit and the backers are nervous. Some companies will have a low P/E because they're pushing the earnings envelope hard and upward. Some companies will have a low P/E because there simply aren't a lot of buyers out there.

But when the 500 companies out there that comprise the index nearly all have a low P/E, that's generally tracking a market-wide phenomenon, not because someone has successfully sued all of the world's industry.

Which is why looking at P/E ratios for an index makes sense. If the S&P 500 has a high P/E but the Russell 2000 has a low one,.... that may be an investment opportunity.

[lomiller]

Well, that's the point of using it to measure indices.



Yes, I think that sums it up pretty well. Just to be clear I wasn’t arguing against indexes or PE, I’m saying trying to pick when a whole index is undervalued doesn’t really make sense. Perhaps if it’s an index for a specific industry you happen to understand, but just because the index it above ot below it’s historic PE doesn’t necessarily mean it’s over or under valued.



Which is why looking at P/E ratios for an index makes sense. If the S&P 500 has a high P/E but the Russell 2000 has a low one,.... that may be an investment opportunity.

Or it may be an indication of some underlying economic issue, like say small companies still having trouble getting the credit they need. While larger companies are positioned for rapid earnings growth as the economy moves out of recession.

[drkitten]

Or it may be an indication of some underlying economic issue, like say small companies still having trouble getting the credit they need.

... which is exactly why a value investor would want to go into small companies.

While larger companies are positioned for rapid earnings growth as the economy moves out of recession.

You're, um, making roger's point for him.

Don't confuse value investing with growth investing; the two are almost diametrically opposed in terms of style, temperment, and approach. If larger companies are positioned for rapid earnings growth, it is also common knowledge that they're positioned for rapid earnings growth, and they're (demonstrably) priced accordingly, which is why the P/E ratio is higher. So the effect is that if you buy the large company index, you're paying more for any given dollar of earnings than you would with the small company index, which means that from a value investor's perspective, you're overpaying.

Since we expect the credit issues are a product of the business cycle and will therefore fix themselves as the business cycle fixes itself, you're buying a substantially similar opportunity for long-term growth at a deep discount. The temporary credit problems are the investment opportunity; the problems are temporary, but the low purchase price you got lasts forever.

[roger]

Yes, I think that sums it up pretty well. Just to be clear I wasn’t arguing against indexes or PE, I’m saying trying to pick when a whole index is undervalued doesn’t really make sense. Perhaps if it’s an index for a specific industry you happen to understand, but just because the index it above ot below it’s historic PE doesn’t necessarily mean it’s over or under valued. But, that's the point. I apologize for not providing cites in my post, I'm doing this off the cuff, but they exist, I'm not just making this up. Let me do it in powerpoint form to hopefully make it clearer. But first, I'm talking about buying Indexes using PE, not individual stocks.

1. The country's GDP has grown slowly and predictably over the last century.

2. The stock market, in terms of Earnings (the E in PE) has grown slowly and predictably, in the same amount of the GDP, over the past century (I leave why that would be so as an exercise for the reader - it's pretty obvious that this must be so)

3. The stock market's price (the P) has varied somewhat compared to the GDP, but over time it corrects back to a constant relative to earnings of around PE=15.

4. Therefore, if PE is low compared to historical averages, we can say the market is undervalued (assuming there is nothing that permamently destroyed point #1 recently) since we feel confident that the GDP isn't suddenly going to drop.

5. Likewise, if PE is high compared to historical averages, we can say the market is overvalued since we feel confident that the GDP isn't suddenly going to jump 10 points.

Tons of studies have backed this up as historically true. Will it hold true in the future? Well, it doesn't make any economic sense to pay more than 15x earnings or so for a super solid company unless the GDP starts growing at a tremendous rate. And we have no evidence that that is going to happen. Remember the 90s, when people like Blodgett were touting the "new economy", and PE ratios were up in the 30s? Ya, that worked out well for everybody, didn't it. :) Note where the market normalized at: around PE=15.

It's a pretty simple relation. Historically you can make 5% or so risk free in bonds, so you need more than that to compensate for the risk you take in the stock market. A 15 PE for a solid company is about where everybody settles on - it's absurd to wait 30 years for you to be paid back (PE=30), but if the PE is 10, say, people are going to leap for that action (once credit is available) and push P back up. Things balance out pretty well around 15 (in the long term). For simplicity I left out dividends and cost of credit - they contribute to making 15x about right for investors.

Sorry that I don't have a specific cite right now, though Malkiel's Random Walk Down Wall Street and more particularly Irrational Exuberance by Robert J. Shiller are the typical sources. The latter in particular has plenty of graphs comparing GDP to PE ratios over time.

It's not rocket science. If you see people paying 30X earnings for a robust but stolid company like JNJ, you can be very sure they are caught up in a bubble, as it makes no sense to wait 30 years to make your money back from a company like JNJ. JNJ is huge - it's not suddenly going to grow at such a rate that it makes a 30x current earnings reasonable. OTOH, if people are only paying 8x, buy that puppy now so long as the prospects for JNJ are undiminished over the long term - you will almost never find a better deal.

Of course that requires you to know something about JNJ. Fortunately, when buying indexes, all you need to know is the country's GDP - it stands to reason the country is not going to suddenly double the GDP or half the GDP in the next 5 years. So, for indexes, we look to the PE.

[Ziggurat]

Relevant. Note I defined risk as underperforming the market.

Then you've got a bizarre definition of risk.

Given that you have frictional costs that the market does not have, reducing variance increases risk (of underperforming).

And this is one example of why it's a bizarre way to define risk. Say I've got two investments: one of them has a 100% chance of underperforming the market by 1%, and the other has a 50% chance of beating the market by 10% and a 50% chance of losing all your money completely. You have defined the second investment as less risky. Not only is that a nonstandard definition, it's one which makes no sense.

Check the fee schedule. Brokerage fees, staff, all cost money.

If you buy mutual funds directly from the major mutual fund companies, there are no brokerage fees. And it's easy to find mutual funds with no loads either. There's an expense ratio (which can be quite small - I think it's less than 0.2% for some of Vanguard's index funds), but that's not quite the same thing.

DO NOT try to diversify by buying a bunch of different mutual funds

Well of course not, because getting a bunch of different mutual funds generally doesn't provide you with more diversification. But a total stock market fund will give you more diversification than a DJIA index fund. A large cap fund plus a small cap fund will give you more diversification than a large cap alone. Adding an international fund will provide more diversification than a portfolio without much international exposure. Etc, etc. Depending on the funds you pick, having a few mutual funds can make a lot of sense, but I'm not claiming that simply adding more mutual funds provides more diversification.

I am claiming, however, that a total market index fund is going to have lower risk (under the STANDARD financial definition of the word, not yours) due to diversification than pretty much any sample of 10 stocks.

[drkitten]

Then you have 50% less money. What if they go up 50% and you need the money?

Then I have the money I need and some additional money that I didn't particularly need.

in other words, I'm trading the chance of the chance of having something I want but don't need against the chance of not having something I actually need.

To anyone except a Buffett disciple, that's almost the definition of a stupid, risky investment.



Do you think Buffett was born with $50 billion? A lot of people seem to have that idea. Remember, there was a time in his life when he had a lot less and was putting 3 kids through college, and yet he somehow managed to make it by following his own advice.

Yeah. He got lucky in that he never hit a bad patch when he needed the money and never had it.

To quote C.S.Lewis, "[Buffett's art] then seems to teach men that the best way of being happy is to enjoy unbroken good fortune in every respect. They would not all find the advice helpful."

Nor would they find that helpful advice about the best way of being wealthy.

[drkitten]

That's what I meant. You are giving up some risk, but losing the chance for maximal profit.

I would think the term 'flutter' would suggest it wasn't part of the sound financial advice part.

Options are insurance. You can participate in some of the upside of the market. If you choose not to be in the market at all (buy CDs or whatever), I would certainly not argue against it. However, the risk of buying an index (which is what I believe you recommended) is far in excess of the risk of buying LEAPS.

Perhaps we are miscommunicating.

Ah. Yes, I did misunderstand what you were recommending; I thought you were suggesting that I put the entire savings into options.

But running the numbers, I still don't see why putting X% of the money into options --- which you yourself admit are simply a way of leveraging the volatility of the underlying instrument -- can't be matched simply by putting Y<X% of the money directly into the underlying instrument. You will pay substantially less commission, benefit from any dividends that will be paid out, and benefit much more from any expected upside. If you don't expect the upside in the first place,.... well, a) you shouldn't buy that instrument or its options, and b) the option won't hold its value nearly as well as the underlying instrument.


Anyway, I think it's terrible advice to invest in the market with money you need in 8 years. Well, 8 years is long enough that maybe we can moderate that to bad? I dunno, someone else can play the adjective game.

Again, "go back in time ten years" is hardly useful advice. If you want to suggest that there is no acceptably low-risk way to beat what income I can earn on my money by putting it in a cookie jar, say so.

You'd be wrong, of course. TIPS bills will at least keep pace with inflation, which the cookie jar won't. A well-diversified quality bond portfolio is likely to pay out most of face value at maturity and provide me with the interest.

There are a lot of ways that I can earn a risk-free 2% on my money (I can get a five-year CD paying 2.9% or a three-year one paying 2.2% in a single phone call right now, at a time of near-historic lows). (And, yes, FDIC insurance makes that risk-free according to the actuaries and accountants.)

A few more phone calls and I could probably put together a portfolio giving me a 90% chance of earning at least 4-5% on my money (which would give me about $15,000 for the little tyke's college fund), with less than a 1% chance of an actual loss.

But none of those phone calls would be to a Buffett disciple. They demonstrably don't even understand the question I would be asking....

[lomiller]

But, that's the point. I apologize for not providing cites in my post, I'm doing this off the cuff, but they exist, I'm not just making this up. Let me do it in powerpoint form to hopefully make it clearer. But first, I'm talking about buying Indexes using PE, not individual stocks.

1. The country's GDP has grown slowly and predictably over the last century.

2. The stock market, in terms of Earnings (the E in PE) has grown slowly and predictably, in the same amount of the GDP, over the past century (I leave why that would be so as an exercise for the reader - it's pretty obvious that this must be so)


Wouldn’t that depend on there being fixed relationship between earnings and economic output?

I.E. Intel generates ~$10 billion in earnings off ~$40 billion in sales while Ford generates ~$6 billion of ~$130 billion in sales. If the earnings off economic activity can vary on a company scale why would it not be able to do so economy wide?


In any case even if we accept that earning must track GDP we don’t have an economy wide stock index so there is no guarantee that an individual index will return to it’s historic PE or that if it does it will do so based on it’s P rather then it’s E.

Back to my previous example maybe small companies can’t get the credit they need to invest now so earning growth will be slow over then next few years while larger companies can get credit and are therefore better positioned. In the extreme you could well see small company earnings decline mid-large company earnings grow and neither have their price move at all while there PE comes back to their historical values.

I’m not suggesting that will happen of course just saying that it’s not as clear as you imply which if either of these indexes is under or over it’s “real” value.

[drkitten]

Wouldn’t that depend on there being fixed relationship between earnings and economic output?

Not really. Again, the law of large numbers comes to your rescue here.



In any case even if we accept that earning must track GDP we don’t have an economy wide stock index

This makes no sense. The "earnings" that are tracking GDP are the earnings of the index under study -- and the observation that the earnings of that
particular index's earnings tracks the overall GDP is an empirical finding.
And a well-supported one.

so there is no guarantee that an individual index will return to it’s historic PE or that if it does it will do so based on it’s P rather then it’s E.

This doesn't make sense, either. If you're suggesting that company earnings can fall while the wider GDP remains more or less constant -- again, you're bucking the law of large numbers. Since the wider GDP is more or less the sum of the earnings of the individual companies, you'll almost always see the GDP track the median earning change of any large group of companies under study (unless you've very carefully cherry-picked an unrepresentative sample).

[DevilsAdvocate]

I've honestly never understood this line of thinking.

Yes, spinning a roulette wheel and randomly buying whatever pops up is certainly a gamble. But buying stocks is no more a gamble than walking out your front door in the morning.I see the thread has progressed, and I haven't read it all. Stocks, in general, are fine. I have money in stocks. I expected many or most people do.

I was addressing buying stock with limited funds, as the OP suggested. The stock market can be a fine investment. But individual stocks are a risk. They are a gamble.

I have a friend who put tens of thousands of dollars into Enron stock, and it vanished. I have a friend who had several thousands of dollars to invest—he played the stocks and made a whole bunch of money and then lost almost all of it. I have a friend who put a bunch of money into a few stock for retirement, they all tanked and her retirement funds are mostly gone. I have put money in stocks and made a whole bunch and lost a whole bunch.

If someone has a little money to invest, and they put it all in a stock, then it is a gamble. That individual stock is going to go up and down, and you don’t know where it will end up. Even if you track the events of the company, you will be behind because the stock value is not based on the value of the company, but on what people think of the value of the company, so you have to track not just the company but also the Street perception of the company, and you have to be ahead of the Street.

If you don’t do all that, then putting a bit of money into a stock is spinning a roulette wheel. And even if you do al that, putting a bit of money into a stock is still pretty much spinning a roulette wheel.

The “roulette wheel” is the reason that people like me put money into investment funds that spread the money over a bunch of stocks and other investments. Diversification reduces risk. If you want to be as safe as walking out your front door, stick your money in the bank. If you want to take a gamble on big gains or losses, buy a stock.

[manxman]

Ok, so when you guys invest, what risk factor are you prepared tostand, the loss of all monies, or due to diversification a certain percentage, what about short term markets.

[drkitten]

Ok, so when you guys invest, what risk factor are you prepared tostand, the loss of all monies, or due to diversification a certain percentage, what about short term markets.

Speaking personally, I'm prepared to stand almost any risk factor as long as the long-term outlook is sufficiently positive. But I've also got a well-paying job that is contractually guaranteed to me for as long as I want it, which allows me to be less risk-averse than most investors.

Similarly, my time horizon is more or less infinite, because I know that I will not be forced to retire in a down market. And I don't have any other time-sensitive expenses (e.g. no kids to educate, my health insurance is quite good, etc).

[manxman]

Well in that case, playing these markets may siut you.

http://sports.betfair.com/

I find statistically weak punter activity to bet against, i.e. i make book sorta.

Pick any week this year or 7 to 10 day period, and i will show you what i mean.

[jimtron]

These lazy portfolios are worth a look:
http://www.bogleheads.org/wiki/Lazy_Portfolios

Check out Rick Ferri's Core Four portfolio--he co-authored this book:
http://books.google.com/books?id=cXXqM8b5e_AC&dq=The+Bogleheads%27+Guide+to+Retirement+Planning&ei=mvGuSoeiNY_CNtj08aEN