MoneyBahn Investment Education

Are You Investing for Cash Flow or Capital Gain?

2011-05-04T23:59:00.000-07:00

If you understand the question in the title of this article, then you understand two of the most basic concepts in investing and the answer is easy. If you don't understand the question, read on for a bit. By the end of this article, you will have a good idea of why investing for cash flow may be much more attractive than what most investors do (investing for capital gains).

Capital Gains - If you invest for capital gains, your goal is to sell something for more than you bought it. In order to receive the gain, you typically no longer own or control the asset.

Cash Flow - If you are a cash flow investor, your goal is to receive a series of cash payments from your investment, and you typically still own or control the asset.

This is a very, very simplified description of the different between cash flow and capital gain investing, and you can read any number of books that go into the details. Depending on what kind of investing you are doing, you probably have to have a completely different approach depending on which kind you are doing.

Most Investors are Capital Gains Investing
Most investors who are putting away money into their Roth or 401(k) retirement accounts are doing so in some kind of mutual fund. While it is easy to do, and usually requires very little input, you have no control over the mutual fund, and you only make money if the value of the fund goes up and you sell part or all of your mutual fund investment.

If you needed to live off of that retirement fund, and you are having a very good year, you don't have to cash in your principle, only some of your profits. Not all years are good, and in some years the value will go down.

A more aggressive investor may actively trade mutual funds or even individual stocks, but the same problem remains in that you have to sell something at a higher price than you bought it in order to get some of your cash out.

Cash Flow Investing and the Stock Market
The story is different for cash flow investors, especially those who use covered calls and other more sophisticated methods to invest. Unlike the typical mutual fund or individual stock investor who only gains if the price goes up and part of the investment is sold, a cash flow investor can use a combination of calls and stock purchases to create an investment that can be made to create a cash flow without selling part of your investment.

It isn't magic, it is a different way to invest than what most investors do. For example, in a covered call, you use your own money to buy the stock, but you sell the call to another investor. Several things can happen, and they are mostly good for the covered call investor. Without going into detail, the investor can make money of the stock goes up in price, if the stock price doesn't change, and sometimes when the price goes down. In any case, as soon as you create a covered call, you have cash flow in the form of the money you got from selling a call to another investor.

How is this possible?
The key is that when you create a covered call, you are using some money from other investors, and this money is the source of your initial cash flow. In the best case scenario, you can take cash out of your investment to spend it while not touching your original investment at all.

What Should I Do If I Want to Know More?
If you want to know more, there are many resources that you can use to learn in depth about this kind of investing, and how you can be taught to make the kinds of trades you need to make in order to invest for cash flow. If you want to know more, subscribe to the mailing list and you will be sent additional information on how you can receive many free hours of training that will give you the tools to become a cash flow investor.

How to get better returns on your mutual fund

2011-04-22T10:08:00.000-07:00

One of the surprising truths about investing is that the average person can often beat the performance of financial experts. This isn't because the experts are incompetent, it is because the financial industry is set up to provide benefits both to themselves and to their customers. One of the places where you can easily see this is in mutual funds.

Mutual funds are one of the most popular ways to invest in the stock market, and one of the easiest. If you have a 401(k) type plan, you typically can choose from a number of mutual funds. Once you decide on which funds to use, you can leave the rest up to the financial professionals who manage those funds. You would think that if the financial industry spends lots of money hiring seasoned experts to manage these funds, that the results would be a lot better that what you can do on your own. The sad fact is that this is not at all true.

The easiest way to compare mutual funds is to compare their performance to a reasonable benchmark. If you use the S&P 500 index as a reasonable benchmark for mutual funds that focus on stocks of large companies, than most mutual funds don't measure up.

According to the Motley Fool, over the long term an S&P 500 index fund such as the one run by Vanguard index fund has outperformed over 90% of all domestic equity (stock based) mutual funds over the past five years.

For some data to back up this claim, I looked at a Smart Money article that compared the Vanguard S&P 500 index fund (VFINX) to other funds in the same category, and over the last 10 years, it ranked 11 on a scale of 1 to 100 (data for period ending 4/21/2011). The return over the last decade wasn't huge, about 2.7%, but it was still better than about nine out of ten in that same category.

Why index funds do better
All mutual funds have overhead and administrative costs, but those costs are minimized for an index fund. Instead of spending money on staff to make trading decisions, an index fund only has to mimic the performance of that index. The difference shows up in the expense ratios, which you can get for any fund that you may want to use.

Over time, even a small difference in expenses can make a huge difference in returns. For example, in the Motley Fool article, the average mutual fund in the same category as the Vanguard S&P 500 index fund charged about 1.3% per year in expenses, compared with about 0.19% for Vanguard, about a 1% difference per year. If you invested $100,000 and got an average of a 5% return per year, over ten years, that it would grow to $159,966 in the Vanguard index fund after expenses, but the average mutual fund's expenses would have cut that down to $143,800. In other words, investing in the Vanguard index fund would have put over $16,000 extra dollars in the investor's pocket after 10 years.

More mutual fund disadvantages
The story is actually worse than this example. The Smart Money article showed that most alternatives to the index fund did not perform as well, so if you chose a competing fund in the same category, not only would you have higher expenses, but likely a lower performance. In the previous example, if the average fund returned a half percent less than the index fund, after 10 years the investor would receive $137,024, a difference of almost $23,000.

What this means for you
If you know that all mutual funds are not equal when it comes to their performance and their expenses, then there are a few things you should do before you invest in mutual funds:

- Compare the fund's performance to the S&P 500

- See if the performance over the last few years beats the S&P 500

- Find out what kind of expenses the fund has

If the performance beats the S&P 500 even after you consider the expense ratio, then maybe that fund is worth considering. Otherwise, your easiest mutual fund course would be to stick with an S&P index fund until you find something better.

Better options than mutual funds
While mutual funds may be a great option for someone who doesn't want to take the time to learn how to invest, there are many better options available, but only if you are willing to take the time to educate yourself.

Future articles will discuss how investing is a skill that can be learned and that the average investor can learn to invest on their own and get better returns than even the best mutual fund. If you want to make sure that you get notified when new articles come out, please join the mailing list , follow me on Twitter, or connect with me on Facebook.

Related finance and investing sites

2011-04-20T16:31:00.000-07:00

MoneyBahn.com' creator has launched other sites that may be of interest to you. Mortgage311.org addresses issues that that concern homeowners who face threats of foreclosure, problems with refinancing houses with reduced market value, and who have mortgages that are under water.

The site offers tips, advice, and insights about underwater mortgages and what a homeowner can do if they have negative equity and owe more on their house than the house is worth.

MoneyAndMinds.com is a wide ranging site about the brain, and how the structure and biases of the brain influence your financial decisions.

If you are interested in a different kind of risk, How-to-Bet.com discusses a number of issues related to online gambling, including signs of a problem gambler, common legal restrictions, and the role of emotion the perception of probability.

Using key online tools to organize MoneyBahn fans

2011-04-20T12:15:00.000-07:00

Going online with a new idea is a lot easier if you take advantage of available free online resources like the ones I described in the article Ten Free Social Media Things You Can Do. While I wrote that article in the context of organizing aviation safety professionals around a specific issue, it is no different than what I'm doing with MoneyBahn, where my aim is to organize individuals who are looking for insights into how to develop as an independent investor.

Within a day of deciding to start this resource, I mapped out a way to combine numerous new and existing online resources like LinkedIn, Twitter, Facebook, YouTube, and iTunes, as well as tools like Feedburner, and mailing lists. The goal wasn't to inject MoneyBahn into every possible corner of the web, but to make it easy for anyone who is interested to keep in touch. If you are reading this, you probably use one or more of these services and tools regularly. If you have any suggestions on how you would like to see then used, please leave a comment below.

MoneyBahn Launches

2011-04-20T08:56:00.000-07:00

MoneyBahn was started as a financial education site for people who don't want to act like a typical investor who relies on mutual funds and financial advisors to make their decisions for them. If you think that you can do at least as well as the Wall Street experts who keep getting paid millions when their customers lose billions, than this is the place for you.

If you have money to invest, either in a 401(k), Roth, or other retirement account, or if you have other significant paper assets, and you want some guidance about where you can learn how to be your own best investment advisor, then keep watching this space.