The 5 Reasons Why I am Gradually Moving More of My Money to Exchange Traded Funds

In the recent months I have begun moving more and more of my money to index funds/exchange traded funds. Below I list the 5 main reasons why I have chosen to do this.

1. Picking Stocks Takes Time

I love researching and picking my own stocks, especially when they turn out to be big winners. However, in order to pick the right stocks it takes time and patience.

When I pick stocks I am very meticulous in my research. I only pick stocks that appear to be a great companies at a good value.

Finding these stocks takes time.

In order to free up time for my other ventures, I have begun investing more and more into exchange traded funds, also known as ETF’s.

2. My Chances of Beating the Market are Slim

I know that the chance of me beating the market as a whole is slim. While I love researching and picking stocks, it is highly likely that my returns will be subpar, or right at the market at best.

Instead of hoping to match the market and maybe beat it, I have instead chosen to invest my money into the very funds I am trying to beat.

This goes hand in hand with #1 listed above. Why spend so much time matching the market when I can buy an ETF in the market?

3. Diversification is Simpler

Trying to diversify a portfolio with many stocks can prove to be a difficult challenge. This is another reason I have chosen to invest more in ETF’s.

Consider this: I have one Total Stock Market ETF and on Total Bond Market ETF. It is much easier for me to balance this portfolio than if I am juggling with 20 different stocks and bonds in my portfolio all at one time.

4. Keeping Track of Stocks Takes Time

I noted above that picking stocks takes time, but tracking your own stocks takes even more time.

In order to maintain your portfolio, you need to have some idea of how your stock positions are performing.

So you need to stay updated on the stock’s news and know when a good exit point for you will be.

I have lost out in some instances where I waited too long to sell a stock. As a result, I am still holding some stocks that have proven to be losers which brings me to #5.

5. It’s Hard to Cut Losses

With individual stocks it is hard to cut losses and move on. This is something that I have struggled with.

I currently own some stock in 3D Technology (DDD) which has dropped 39% since I bought in about a year ago.

What is holding me back?

If I had to guess, it would be the loss aversion theory in action. I wrote a post about loss aversion which you can check out here.

Do you pick your own stocks or do you opt to invest in an exchange traded fund instead? Why did you choose one over the other? 

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What is Financial Freedom?

As you know this blog has been inspired by financial freedom. While there are differing opinions about what financial freedom, this article will present financial freedom from my personal perspective.

What is financial freedom to me?

Financial freedom to me is having enough money to live without ever really having to work again. Now this does not mean you never have to work again. Instead it means that you work on your own terms.

You never have to worry about the stress of losing your job. You don’t have to worry about whether you have clients or not. When you are financially free, work no longer becomes a requirement in life but rather a choice.

How would you get there?

There are a number of ways to achieve financial freedom. The most effective way is by building passive income streams. This is done in a few ways shown below.

Have Your Money Make You Money

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Build up enough cash so that it will generate money-almost like planting your very own money tree.

The first way to build a passive income stream is to build up enough cash so that it will generate money. Use your cash to purchase dividend paying stocks or bonds which pay you interest. You could also purchase annuities which would pay you over the life time of the annuity.

For example, if you have $5 million in cash right now you could invest in bonds which pay out 5% a year. Just by having those bonds alone, you will generate $250,000 a year in interest income!

Imagine, $250,000 in your pocket and you don’t have to do anything at all! You can accomplish this with dividend paying stocks as well.

Stocks pay a wide range of dividends, and are not quite as reliable as bonds for paying you out every month.

But stocks do have the advantage of appreciating in value over time, so that when you sell the stock you have a chance to make more money.

I don’t have $5 million to put away, what should I do?

Fair enough. Most of us do not have $5 million in liquid cash at our disposal at any time. So what should you do instead?

Create a Business which Produces Cash with Minimal Effort

While I was writing that subheading, it sounded a tad bit scammy. Just like one of those spam emails which tell you how some guy makes $5,000 a day just by clicking a few buttons.

There are people out there with legitimate businesses that do not require much effort on their part.

They do this by doing one of two things

1)      They automate their business so they don’t have to do most of the work or,

2)      The create a product which they can sell to the masses

In order to accomplish number one listed above you would do a few things. First you would have to build a business up from scratch (if you can’t buy one initially).

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Automating your business by hiring employees is one method you can use to become financially free.

Then you would look to hire employees to help do the menial tasks that you don’t want to do. Then finally you would hire a manager to help oversee the employees and take care of the higher level duties that you don’t want to do.

This leaves you to plan for the future and grow, and takes you away from the day-to-day tasks that you would be doing at any typical 9 t
o 5 job.

For the second item, you would create a product that you only need to create once or can be created by others, and sell it to the masses.

Key Point: Learn How to Separate Time From Money

The key to building a passive income business is separating your time from money. Most jobs will pay you for every hour you work.

It has been engrained in us that we get paid when we work and don’t get paid when we don’t.

What if you did get paid when you didn’t work? How would you like to get paid when you didn’t work? When you are sleeping? When you are on vacation?

If you have an automated business, you will no longer trade your valuable time for money.

There are a ton of ideas to help you build up passive income streams. One of the best books to help you understand the different types of business systems is “The Millionaire Fastlane” by MJ Demarco.

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Check out The Millionaire Fastlane, one of my favorite business books that I’ve read recently

In that book he lays out the “Five Fastlane Business Seedlings” which are business systems which produce passive income for the owner. Those five systems are

  1. Rental Systems
  2. Computer Systems
  3. Content Systems
  4. Distribution Systems and,
  5. Human-resource Systems

If you want to find out more, check out the book on Amazon. It really is a great resource and I would recommend it to any entrepreneur or wantreprenuer looking to get started.

My Top Three Reasons for Wanting to Achieve Financial Freedom

I have told you what financially freedom is to me. Know I want to elaborate on why it is my goal to achieve financial freedom.

Reason #1: I want to have the freedom to do what I want when I want

If I want to sleep in until 12 I can.

If I want to meet friends for lunch on the other side of town at the last second I can.

If I want to go on vacation at the drop of a hat I can.

I would also have freedom to pursue hobbies that you enjoy but would never really make you money.

For example, I enjoy playing basketball and golf. I am not really good at either one of those. I could play those whenever I want.

Reason #2: I want to explore the world

Many folks don’t have to be financially free to explore the world, but I think it would be pretty amazing being able to travel all over without a timeline to get home like you would when you work.

I have never traveled much, and I think it would be great to be able to see the world.

Being financially free would allow me to travel on my own time, and have the money to do so.

Reason #3: Spend more time with those I love

I am personally not a workaholic. I’ll admit it.

I will work really hard doing the job the needs to be done. Once it is complete I go home and do the things that I want to do.

It’s not even that I am lazy, but I just like to enjoy life and do those things that I want to do.

I don’t want to feel obligated to go into some place five days a week for the next 35 years of my life.

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You now know my reasons for wanting to achieve financial freedom. What are yours?

I enjoy spending time with family and friends, and financial freedom will allow me to do this.

Down the road when I have kids, I want have the ability to spend time with them. I want to be a part of their life.

I don’t want to be at work all of the time and come home and be too tired to spend time with my family.

This is what financial freedom is to me. This is why I want to achieve it. What is financial freedom to you? Why do you want to achieve financial freedom?

Photo Credits (in order)

Flickr/Shari’s Berries, Flickr/Phil Whitehouse, Flickr/Kalyan Chakravarthy

Six Reasons Why You Shouldn’t Pick Your Own Stocks

When I first started investing, it was an overwhelming experience. I didn’t know where to get started and figured that I could just start investing in individual stocks.

I didn’t have a real strategy behind why I was doing what I was doing. I just picked a company that looked like it would be a good investment, and bought into it.

It wasn’t until I started to do some actual research and read up on books that had to do with investing in the market that I realized that I was probably better off not picking individual stocks.

As a matter of fact, practically everyone is better off investing in an index fund or ETF instead of picking their own stocks.

In this article you will discover six reasons why you are better off not picking your own individual stocks.

1. You don’t have the expertise to pick stocks

Picking stocks can be a difficult challenge. It takes a considerable amount of time to understand the market and to learn how to read a company’s financial statements.

Not only do you have to analyze a company’s financial statements, you also have to have a good understanding of a company’s behavior and how it affects the bottom line.

In addition, there are many schools of thought on how to pick stocks. Choosing between these various methodologies can be difficult and overwhelming. Not only that, but some of these methodologies just flat out don’t work.

2. You don’t have time to pick your own stocks.

I know you lead a busy life. If you want to pick your own stocks it will only add to the daily tasks that you to do.

It takes a significant amount of time to manage your own investments. You always need to keep an eye on your individual stocks in the event that something unusual does happen.

You also have to keep track of earnings announcements and other press releases by the company to make sure they are staying on the right track.

Most people don’t have the time or simply don’t want to take this much time with their investments.

3. You want to get rich quick.

Investing in the stock market won’t make you a millionaire overnight. Sure, some people became millionaires during the internet boom of the late 90s, but these people are the exception to the rule.

There were also many people who lost a ton of money in the 90s following the same strategies. They just ended up on the wrong side of the coin.

4. You don’t have the patience

In order to invest in individual stocks, you need to be extremely patient.

You have to be careful with your investment because it is easy to panic if your stock starts to plummet out of nowhere.

Investing in the stock market takes years of patience and discipline. If you aren’t willing to put in that time and effort, don’t pick your own stocks.

5. You don’t enjoy picking stocks

This one seems fairly obvious but if you don’t enjoy picking stocks, don’t pick your own stocks.

However, a lot of people don’t know if they enjoy picking stocks until after they have bought their first stocks. They realize how much time and stress is involved but by the time they realize it, it is too late.

One thing I would recommend is to use a stock market simulator game for a few weeks or even a few month.

Practice picking stocks and tracking companies in your free time. If you actually enjoy finding stocks and tracking them, maybe you are fit to pick your own stocks.

If you don’t enjoy this process, then don’t even think about picking your own stocks.

6. You want to beat the market

Let’s just clarify one thing: you will not beat the market. Many people don’t beat the market.

Professional money managers rarely beat the market. If they can’t do it, what makes you think you can?

According to Brad Barber of UC Davis and Terrance Odean of UC Berkeley, only 1% of active traders beat the market. They concluded that the more frequently people trade, the worse they ended up doing.

Sure it’s fun to imagine being the next Warren Buffett or Peter Lynch, but chances are you won’t be one of those guys.

What should you do instead?

If you aren’t picking your own stocks, what should you do with your money?

My recommendation for those investors is to invest in a total market ETF. My personal favorite is the Vanguard Total Stock Market ETF (VTI).

By investing in this ETF you will have a diversified portfolio which also has extremely low fees compared to other mutual funds.

The Importance of Low Fees

Picking a fund with low fees is important to me and it should be important to you too.

Many actively manage funds have high fees. This means you will have to pay more money which will end up eating into your return on investment.

The kicker is this: most managed funds don’t beat the market.

Remember what I said above about beating the market? Most fund managers fail to beat the market consistently. Why pay more fees for something that’s not even going to give you a higher rate of return.

Why do you benefit from investing in a Total Stock Market Fund?

By investing in a total stock market fund, you experience a couple of benefits.

First, there is much less management on your part. All you have to do is put your money into this fund and sit back and let the stock market do the work.

You don’t have to spend a bunch of time analyzing individual stocks and tracking your portfolio.

Second, there is much less stress by investing in a total market fund. Because your investments are diversified, you don’t have to worry about a single company destroying your investment portfolio.

But what if I really want to pick my own stocks?

Now you know that you shouldn’t pick your own stocks. But what if you still have an itch to pick some individual stocks. What should you do?

One thing that you could do is invest a large percentage of your portfolio in the total stock market fund, and use the remainder to pick your own individual stocks.

This is a strategy that I personally use. I enjoy picking stocks but I don’t like the stress that comes with putting all of my eggs in only one or two baskets.

What I do is invest 60% of my portfolio in the total stock market fund (along with some bond funds) and I use the remainder to invest in individual stocks.

I still get the enjoyment of picking my own stocks, but I don’t have to deal with the risk of having all of my money investing in only a few companies.

Do you pick your own stocks or invest in a market fund? 

Your Fear of Losing Will End Up Costing You Big Time

I was discussing the stock market with one of my co-workers the other day, and we were talking about how stocks are generally overvalued and how the market will have to come back down eventually.

He said “This is why I don’t want to invest in the market right now. Everything is just too high and it’s going to fall eventually. I would rather wait for things to come down to get started.”

I don’t blame him for not wanted to invest everything in stocks right now, but he could invest a small portion of his money in stocks and put the other portion into other forms of investments. Keep in mind, he didn’t invest in the market when it was high in 2007, but he also didn’t invest in 2009 when it hit rock bottom.

It’s not unusual for first time investors to have this mentality

Many first time investors hesitate when it comes to investing. Personally, I spent a couple of years dreaming of investing but never took the leap of faith. What was holding me back those two years is the same thing that holds back many first time investors: loss aversion.

The loss aversion theory explains why many people are afraid to get started. People will make excuses as to why they don’t want to invest in the stock market because they are scared of losing money.

But, this begs the question, when exactly do you plan on investing in the market?

What I saw with my co-worker was a classic example of the loss aversion theory in action. He was so afraid of losing money in the market. As a result, he has not investing in the stock market at all in the past 8 years.

So you may be wondering “What exactly is the loss aversion theory?”

The theory states that people have a tendency to value gains and losses differently. So if something is presented in terms of gains and losses, people are more likely to pick the item based off the gains presentation.

Why do we value gains and losses differently?

This is due to the fact that people strongly prefer to avoid losses rather than acquiring gains of the same amount. In some studies, they have showed that the pain of losing is almost twice as strong as the pain of gaining.

In one example, people were given the option of risking $5,000 to make $10,000 on a flip of a coin. Many people would forgo the gain just so that they didn’t lose any money.

Think about that one for a second. If you could flip a coin and make $10,000 or lose $5,000, would you take that chance? Truth is, you really should take that chance. 50% of the time your will come out ahead with $10,000. What do you think you would do in this situation? Why?

How can you apply loss aversion theory to investing?

The thing about loss aversion is this: it causes people to stay in stagnant positions just so that they don’t have to risk losing any money. Due to the fact that people are so afraid of losing, they will stay in a position that is worse in the long run.

For example, some individuals would stick with losing investments over a long period of time because they don’t want to realize losses. As a result, they will ride down with a sinking ship so that they don’t have to experience the pain of losing…until it is too late of course.

To make matters worse, some people will actually invest more money into a losing stock to average out the cost of their investment. This makes it seem as though the stock hasn’t lost as much value.

How can you avoid the loss aversion bias?

Above I have illustrated two situations in investing that are subject to the loss aversion bias.

The first one being new investors who just don’t get started because they are afraid to lose money.

The second one being experienced investors who hold on to losing stock positions because they do not want to realize losses, which would turn paper losses into actual money losses.

How can new investors avoid the loss aversion bias?

For new investors, it is important to realize that there is some risk to investing in the stock market. You need to understand that your investments may lose value in the short term.

What you also need to know is that the market has been upward trending for the past 130 years and more. You can’t let your fear of losses hold you back from investing.

Another way to hedge your losses is to make sure your portfolio is well diversified. Make sure you have your money invested across a range of stock indexes, bonds, and other investment types. This will help limit your losses over the long haul and make you less likely to lose your money.

Finally, you need to stop worrying and accept the fact that you could lose money. You need to grow comfortable with the fact that your portfolio will have extremely high days and extremely lows days. The most important thing is to weather the storm and not panic on those bad days.

How can experienced investors avoid the loss aversion bias?

My advice for experienced investors is quite different from new investors. New investors are afraid of losing money from the get go whereas experienced investors are afraid of realizing losses on certain investments.

For experienced investors, you need to maintain a long term view of investments. It is important for you to understand how a loss will impact your portfolio as a whole.

One way you can avoid holding on to a losing stock for too long is to place a stop loss order on that stock. This will force you to sell your stock once it hits a certain low point.

Another good thing to remember is that selling investments at a loss will actually help you. When you sell at a loss, you will be able to offset any short term and long term taxable gains.

Final word to experienced investors

Do not hold onto a stock longer than you should. If there are legitimate, solid indications of a sign to sell your stock now, you should absolutely sell.

Now, this doesn’t mean every time a tv pundit tells you a stock is a sell that you should sell it. However, if a company is going through turmoil and revenues and profits are way down, then you should probably sell before it is too late.

You don’t want to hold on to a stock just because you hope it will go up in value. You shouldn’t buy a stock which you hope goes up in value, so why would you have that mentality for a stock you currently own?

What do you think?

What do you think about the loss aversion theory? Have there been times where you didn’t do something because you were afraid of losing? Can you apply this theory to other areas of your life?

Should you pay off your mortgage or invest your money?

Suppose you win the lottery and you win just enough to pay off your mortgage. Should you pay off your mortgage? Or would you be better off investing that money?

In order to answer this question, we must weigh a number of factors. The most important factor deals with your risk profile. You will also want to consider how your current investments are allocated. There are numerous other factors that you must consider. Before we get to all of those factors, let’s make a few assumptions.

Let’s assume the following:

Yeah, I know the saying about people who assume. However, for purposes of answering this question in as full of detail as possible, I need to assume a few things before we dive in and discover my opinion to this question.

The following assumptions are being made:

  1. You have 25 years left on your mortgage so you have a long timeline left to pay it off.
  2. You are in the 25% federal tax bracket, and will remain there for the foreseeable future.
  3. In addition, your state income tax rate is 8%
  4. You current mortgage rate is on par with national averages at 4.5%
  5. You have $200,000 left on your mortgage
  6. You expect the average rate of return of the stock market to be 8% over the next 25 years.

With those assumptions being made, we have the foundation to truly evaluate what you should do with your lottery winnings: invest in the stock market or pay off your mortgage?

Tax deductions make your interest rate lower

The first item that you must consider is that your interest rate is really not the 4.5%. Why is this true? The United States has favorable tax deductions available to homeowners, so your actual interest rate will effectively be lower. What would be the effective interest rate based on our assumptions above?

Your effective interest rate after considering the mortgage tax deduction would actually be 3.105%. How did we arrive at that number? Using this handy calculator at Bankrate, you can easily calculate what your interest rate will be after your mortgage tax deduction.

Go ahead and play with the calculator a bit. It is interesting to see how much the mortgage tax deduction will actually help you. In this example it is almost like cutting 1.4% off your interest rate on your loan!

Paying off your mortgage means no mortgage tax deduction

Why is your interest rate important? This will help us in making our final decision whether to invest our money or pay off the mortgage.

If you choose to pay off your mortgage, you will no longer be eligible for the mortgage tax deduction. You will have to pay more in taxes as a result. But, you won’t be making mortgage payments anymore!

So it looks like a win for paying off you mortgage, doesn’t it? But wait, it can’t be that simple. Well…I guess we have to consider a few other factors before making our big decision.

The opportunity cost of paying off your mortgage

Paying off your mortgage would be a great relief. However, there is an opportunity cost to paying off your mortgage. Ah, opportunity cost, that word you used in economics and never thought you would see again.

By paying off your mortgage, you are foregoing other options with your lottery winnings. What specific opportunity costs can you think of by paying off your mortgage?

The biggest opportunity cost to me is that you will not have that money to invest. This is the biggest opportunity cost in my opinion, so hear me out.

By paying off your mortgage you are taking all of your money off the table to get rid of a huge debt, which can be a relief. However, you will not be able to do anything with that money once to pay off your mortgage.

This brings up an age old question: Should you invest or pay off your debt?

Generally, you would rather invest any extra money when you can achieve returns which are higher than the interest rate on your debts. For example, let’s say you have a loan with 2% interest. Let’s also say that you can make an investment which will return 5% in the next year.

If you choose to pay off your loan, the money will be gone for good. However, if you choose to go with the investment, your money will appreciate by 5%. Now you will have to pay 2% on your loan. As a result, you end up with a net positive return of 3%. Simple enough, right?

The answer is staring you right in the face

Let’s go back to our original example and decide whether you should pay off your mortgage or invest in the stock market.

Based on the assumptions being made, you will be able to achieve an average annual return of 8% in the stock market in the next 25 years. During that same time period, you will be paying an effective interest rate on your loan of 3.105%. You do the math. What will be your total net return of this decision?

Got your answer? Okay good.

I’m sure you answered 4.895% you smart cookie. For simplicity sake, let’s just say you will get an average net return of 4.9% if you decide to invest in the stock market and keep your mortgage as is.

This is precisely where I would stop and not even consider paying off the mortgage. I’m a numbers guy, and the numbers are telling me one thing: INVEST! However, I know that many people aren’t as into the numbers as I am, so I will lay out a few other factors that will help you make your decision.

Factor one: Your risk profile

Your decision will depend heavily on your risk profile. If you like to take on risks and live life on the edge, you would want to invest in the stock market regardless. You don’t care about the fluctuations of the markets, you live for this sort of thing!

Even if you have a moderate risk profile, you would likely opt to invest in the stock market as opposed to paying off your mortgage. Sure, paying off your mortgage would feel good, but you know there is a very good probability the market will return around 8% in 25 years’ time.

If you are extremely risk averse, you will take the sure thing and pay off your mortgage. What if the stock market crashes tomorrow and you lose all your money? You don’t want to take that risk no matter how unlikely it is. You want a sure thing, and the only sure thing is today. You would get rid of that mortgage.

Based on your risk portfolio, what would you do in this situation? Would having a shorter time horizon make you more likely to pay off your mortgage?

Factor two: Asset allocation

Another factor you have to consider is your asset allocation. This will depend on how many assets your had just before winning the lottery.

If you have very few investments, and you choose to pay off your mortgage, you are essentially putting all of your eggs in one back: real estate. This will throw your asset allocation all out of whack, and you will have a high risk exposure to the real estate market. This risk is even higher when you consider you are putting all of your money into one single asset: your home.

If you have few investments and choose to invest in the stock market, you are better able to spread your risk out among number companies, funds, and indexes.

However, if you already have many investments you would not be as impacted by choosing either option. We would assume that you already have a well-balanced profile. Paying off your mortgage wouldn’t expose you to asset allocation risk.

Factor three: Interest rates

In the example above, I illustrated that if you had a low interest rate you would be better off investing in the stock market. I did not consider the factor of higher interest rates.

The interest rate on your mortgage will affect whether or not you choose to invest your money or pay off your mortgage. Logic says the higher the interest rate on your mortgage, the better off you are to pay off the mortgage.

Other factors to consider

Psychological effect of paying off your mortgage early

Paying off your mortgage is a huge accomplishment. For many people, paying off debt is a rewarding experience. You will sleep better at night knowing that your will not have to make to monthly payments every month.

You will no longer have to worry about whether you will have enough money to make mortgage payments. The only payments you will have to make will be for insurance, property taxes, and any miscellaneous repairs and other expenses.

You will have excess cash to invest

While you won’t have the initial $200,000 to invest when you first pay off your mortgage, you will have an extra $1,000 to invest.

While you are deferring compounding interest on your investments, you will also be reducing your risk over time. Having this extra money each month will give you some flexibility for investing and give you extra cash flow every month.

Question to consider:

Would you borrow 3.1% to invest in the stock market?

Answer: for me the answer is a definitive yes. That is basically the decision you are making if you do decide to take your lottery winnings and invest them in the market (again, using our assumptions about market return made above).

What do you think you would do in this situation? Do you think you would pay off the mortgage or invest your money? What other things must you consider before making this decision?

I made 59% on one stock in nine months, here’s what I learned

Yesterday when I was checking my stocks, I was pleasantly surprised when I saw one of my stocks was up nearly 20% for the day. Not only that, but the stock had climbed nearly 60% since I initially bought it in September of 2013.

The stock that I’m referring to is Williams Company (WMB). When I bought the stock on September 5, 2013 I paid $35.10 for 15 shares. Yesterday (June 18, 2014) I had sold the 15 shares at $55.90 per share. This resulted in a 59.3% return on this stock in only nine months!

Lesson learned

Why did I buy WMB in the first place?

When I bought the stock in the first place, I was looking for a high dividend paying stock. When I found WMB it was paying out dividends around 4.5%.

In addition, the stock seemed to be trading at a low price at the time. It seemed like a no brainer to buy this stock. My thinking was flawed, which I will get to in a minute. Regardless, I bought 15 shares at $35.10 and watched the stocks grow over the coming months.

Why did I sell WMB yesterday?

I sold WMB for a number of reasons, the most important being to lock in my gains.

I made over $310 or about 59% on my investment, and I didn’t want to lose out on locking in that money for good.

Currently, WMB seems to be overvalued. The stock has a PE ratio around 96, which is ridiculously high when compared to similar companies in its industry. Now seemed to be a good time to get rid of a stock which will probably drop off in a matter of time.

The flaw in my thinking

When I bought WMB I was under the impression that I was getting the stock at a reasonable price. The stock was trading close to its 52 week low. Truth is, the stock wasn’t really that cheap when looking at its PE ratio.

While the PE ratio was on par with other companies in WMB’s industry, that was not really a sign that it was a stock to buy. I didn’t do much research before jumping into this stock. Honestly, I got lucky that it shot up the way it did.

I held on and reaped the benefits and got out on my own terms

I had actually though about selling WMB on multiple occasions. The reason I held on was because the stock’s value was continually increasing.

I realized that I needed to sell the moment the stock jumped 20% in one day and I made over 50% in less than a year. Sure, the stock could keep going up but I don’t want to take that risk.

Take home message

When it comes to investing you need to recognize when you are lucky and when you were actually skilled. Too many people think they have the secret formula to making money in the stock market.

At the end of the day it’s safe to say that I got lucky with this stock. I invested on a flawed premised and I am grateful that I made the money that I did, but I don’t feel like it was because of some skillful move.

 

Learn the trading mistake that I made, corrected, and ended up increasing returns by 32%

A few months ago, I bought some shares of Apple stock. Being new to investing and not wanted to risk too much, I only bough a couple of shares at an initial price of $461 for a share.

During this time period, Apple had not even announced the release of the iPhone 5s and 5c, so the shares were still trading at a pretty low price. Following the announcement of their next generation of phones, shares shot up to $500 a share, and I was pretty happy with myself. I made a good stock pick which went up $40 and was looking to climb higher.

Not long after, shares began to drop again. Because sales of the new iPhone in China didn’t meet expectations, the share price dropped. They dropped to as low as $550 dollars, and I started to get uncomfortable in my Apple stock position. When shares came back up, I sold my stock at $465 for a meager gain of $4 per share.

Two weeks later, I realized I made a big mistake, and ended up buying a couple more shares of Apple’s stock at $478. I’m still holding those shares at the moment which are currently priced at $633. What mistakes did I make that I want to pass on to you?

1. “Invest in great companies at good prices”

The situation with Apple was a perfect representation of Warren Buffet’s quote above. Apple shares were trading at a very low price. The price-to-earnings ratio was only around 12. Compare that with the S&P 500 which averages around 15 and is currently at 19.2 as of May 31, 2014. Apple was trading at a bargain at the time, and is still at a very cheap price. Considering the brand and the great products Apple puts out, you would expect their PE ratio to be much higher. This is a sign of a stock that you want to keep in your portfolio and hold on to for a while.

2. Don’t be affected by daily fluctuations, meaningless news surrounding the company, and investor expectations and fears which make stock extremely volatile in the short term.

I sold my Apple stock because I was reading too much news about the stock and let other people’s opinions about the stock price influence my investing decision. Instead of trusting my research and my own judgment, I let other’s judgment scare me into selling my stock. I knew the stock was selling at a bargain, but I was more influence by what was happening on a short time frame. Apple’s stock jumped up $40 and subsequently dropped $50. I panicked and sold the stock for a meager gain because I didn’t want to lose money. Trust your judgment and research.

3. Have a long-term horizon when investing in great companies.

You are not going to make a bunch of money quick by investing in great companies, but you can get returns which can potentially beat the market. People who make money on short-term investments are more so lucky than anything else. Use a long-term approach, and invest in great companies which are undervalued. Chances are, the share price will bounce back up and you will make some nice gains as a result. Just look at my position in Apple’s stocks. They have jumped up 32% since I rebought shares, and I couldn’t be happier.

Conclusion

Learn from your mistakes and don’t let the market decide what the value of your investment is. If you own a home, do you call your broker every day to see what the value of your home is? If someone offered you a low-ball price on your home based on the price your neighbors were selling their home, would you take it? Probably not, because we don’t live in homes with a short-term outlook. Why should you with your stock positions?

 

Day Trading = Financial Suicide?

One method of making money in the stock market is day trading. Day trading rose in popularity in the late 1990s when investors could double or even triple their gains within a matter of hours. With returns like this, it was hard to resist the temptation of becoming a day trader yourself.

In this day and age, you do not get the returns that you could have gotten in the 90s, but the temptation to day trade is still there. Markets have been booming ever since the Great Recession. Since the market bottomed out in 2009, the S&P 500 has returned 172% and the Dow Jones Industrial Average has returned 131%. Due to the increase in markets at such a rapid rate, investors today have been able to day trade and achieve solid results.

As a matter of fact, I just recently read an article on a 16 year old who began day trading and had thus far achieved decent results. In 2012 her stocks returned over 34% vs the S&P 500 which only returned 12%. While it is not impossible to achieve those results, it is hard to maintain such rapid rate over a long sustainable time period.

Jason Zweig discussed the topic of day trading in his commentary to The Intelligent Investor. He discussed that while some trades make money and some trades lose money, your broker will always make money. In addition, he goes into detail about the true cost of trading over such short time periods.

The Costs of Day Trading

  1. Your own eagerness to buy and sell stock will lower your return. Zweig call this cost “market impact.” While this cost doesn’t show up on any of your statements, it can cause you great losses. Let’s say you are eager to buy a stock, and you end up paying an extra 10 cents per share to get it. If you buy 500 shares of that stock, you just cost yourself $50. On the flipside, if you sell the stock too soon, you can also lose out on significant gains.
  2. Brokerage fees eat into gains. Many brokers will charge you anywhere from $4 to $9 to make a trade, no matter how many stocks you purchase. Assuming you pay $7 per trade, you will pay a total of $14 to buy and subsequently sell a stock. If you purchase $1000 worth of stock, this will eat into 1.4% of any gains you make.
  3. Taxes, taxes, taxes. When you buy and sell your stocks frequently, taxes can eat into your gains significantly. Any gains you make on stocks you sold within a year are taxed at your ordinary income rate, which could be up to 39.6%. Compare that to the maximum rate of 20% you pay for gains for stocks held on to for over a year, and you could be paying significantly more in taxes.

Research Study

Zweig also cites a study done by professors of Finance Brad Barber and Terrance Oden at the University of California. In this study, the professors studied 66,465 households with accounts at large discount brokers from 1991 to 1996. What they found was those that traded the most (portfolio turnover of 21.5% a month) had an average return of 11.4% vs a return of 18.7% for those who had the lowest turnover (portfolio turnover of 0.19% a month). In addition, those who had the lowest turnover actually had a slightly better return than the market average. The chart below shows a visual representation of this study.

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Questions/Comments?

Have you ever day traded? What are your experience with day trading? Please leave a comment below. I’m interested to hear your opinion. 

Quote of the Day

The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, no more. Thus the investor who permits himself to be stampeded or undly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared mental anguish cause him by other persons’ mistake of judgment.

 

– Benjaman Graham in The Intelligent Investor

What grocery shopping can teach you about picking stocks

Imagine your average trip to the grocery store. You go through the ads and various coupons and figure out what items are on sale. If there are products that you have a preference for, you will go ahead and buy them for a bargain. It makes sense. When you like a product and see it selling at a lower price than usual, you will buy it. That begs this question: why should the approach the stock market any different?

When buying stocks, the first thing you want to do is identify companies that you like. Good companies can be defined in any ways. This depends on personal preference, but for me, a good company is one with good management in place. In addition, it is a company that has had steady growth over the years. Companies that have historically paid dividends are also another plus in my book. Finally, invest in what you know. Peter Lynch advises this in his book “One Up on Wall Street” which provides great insight on how he made 29% a year over the span of 20 years.

I suggest that you make a list of good companies that you like based on the criteria above. It doesn’t have to be a long list, be it should be long enough so that it gives you options in investing. Track of these companies over time. When these companies become “cheap” buy as much stock as you are comfortable buying. Cheap can be defined in any number of ways. I personally view cheap companies as one that have a low PE ratio. A low PE ratio has historically been one that is under 15. I use this as a base for deciding the value of a company. I also compare their PE ratio to the historical PE ratio of the company as well as the average PE ratio for other companies in their industry. You can also use price-to-book ratio and price-to-sales ratio when valuing a company.

When you combine you knowledge of great companies with the valuation metrics, you will greatly increase your chance of succeeding in the stock market. As Warren Buffett once said: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”