DividendiumBlog

Do the No Lose Stocks and Long Shot Options Investing Strategies work?

2010-06-07T18:44:00.000-05:00

The intent of the No Lose Stocks (NLS) and Long Shot Options (LSO) strategies is to:

1) Protect my core capital, and yet
2) Still expose me to unlimited upside gains

Over the past few years we have experienced a large drop in overall market value and then a subsequent large gain in market value.

In October of 2007, the Dow Jones Industrial Average (DJIA) hit a high of about 14,000.

Roughly 17 months later, in March of 2009, the DJIA hit a low of about 6,600, a drop in value of roughly 53%.

Then roughly 13 months later, in April of 2010, the DJIA hit a high of about 11,200, a rise in value of roughly 69%.

These large moves are the kind of thing that these strategies were designed to capture, so I did some analyzing of the historical data to see whether or not the strategies actually did what they were intended to do.

Was core capital protected?

Happily, the answer to this is yes.

NLS protected my core capital by using put options that covered the entire initial value of the stocks that I purchased.

And LSO only used the interest that I gained on my core capital to purchase options that were likely to expire worthless.

Since the market dropped 53% and then only went up 69% from the low, that is still an overall drop of about 20%. The market still needs to gain another 25% (not including the most recent drop in value) to get back to 14,000. So anyone that purchased at the 14,000 level is still in a losing position.

But since my capital was completely protected, I did not lose any of my core capital in these market gyrations.

Exposed to unlimited upside gains?

This turns out to be not as good as I had hoped.

Although the market fell 53%, it then rose 69%. So in a perfect trade, an investor could have bought at 6,600, and then sold at 11,200 for a 69% gain in 13 months. Ideally NLS and LSO would allow me to get at least a piece of this gain. But that didn't happen to the level that I hoped it would.

No Lose Stocks

With NLS, since the puts were paid for by the dividends, if the dividends were cut, then I could take a loss. I wanted to limit that loss to be less than 3% per year, so I avoided any trades where the dividends accounted for an overall loss in the trade of more than 3%.

But when a stock falls in value, the management will normally try not to cut the dollar amount of the dividend. So as the stock price falls, and the dividend dollar amount stays constant, the dividend yield goes up.

For example, a $50 stock with a $1 annual dividend has a ($1/$50) 2% dividend yield. If that stock falls to $25, then the dividend yield goes to ($1/$25) 4%. Due to my 3% loss limit, I would have taken a trade on this stock at a 2% yield, but would have avoided the trade at a 4% yield.

I analyzed all the trades from the beginning of the service to now, August 2008 to May 2010. I was looking for trades that met my 3% loss limit, needed to go up less than 50% annualized, and that had a gain on invested capital of more than 6%.

If a stock needed to go up more than 50% annualized to make a profit, then I assumed it was probably better to play that stock as a Long Shot Option trade instead.

6% is what I think the market returns over the long-term. I also think that 6% market "return" is only due to inflation, so I want a return of more than that on my investments.

NLS Analysis Results

In the time-frame of the 69% gain there was only 1 closed trade that would have resulted in an annualized gain of more than 6%.

The trade was on TWX, which had a large surprise upside move. From October 2007 to May 2010, this stock went from about $12.50 to about $34, a 172% gain. This is the same time period where the DJIA had an overall drop of 20%.

If I looked at trades that had not yet closed, and only considered the maximum profit they could have made so far if I had sold at exactly their respective peak, then from from January 2009 to May 2010, there were 10 trades that had a max profit of more than 6%, with 3% or less annualized risk, and 50% or less stock move to make a profit. 9 of these trades were in the late January 2010, early February 2010 time-frame.

The majority had less than 15% required annualized percent to profit. The max profits were from 7% to 18%, averaging around 10%. And all had "days to expiration" of less than 220 days.

So because of the tendency for dividend yields to go up when the market drops, NLS will probably not do well in the environment where the market is recovering from a large drop. The environment where NLS should do well is the one where we are in a bull market and making new highs, like TWX did.

I hesitate to draw too many conclusions from the unclosed trades since they haven't had their full run yet, but it looks like I should only consider investing in the trades that need less than 15% annualized percent to profit. If those trades don't exist in a given month, then the opportunities just aren't there and I just shouldn't invest in the NLS strategy that month. And if the stock is not making new all-time highs (as opposed to just trying to attain previous highs), then I should consider selling my position when it has a 10% or more gain.

Long Shot Options

With LSO, the idea is to buy the cheapest options with the interest earned off of my core capital. The service only picks options that have ask prices of less than $0.20.

If I have a $100k account, and the interest rate is 1%, then I have $1k per year, or $83 per month, to spend on cheap options. If the interest rate is 3%, then I have $3k, or $250 per month to spend on options. So the interest rate has a very large effect on how many options you can buy. Also note that for the same money I can buy 4 x $0.05 options versus 1 x $0.20 option.

I ran an LSO Calls analysis and an LSO Puts analysis for the entire life of the service. A "winner" trade was one where the trade made more than 6% on the invested capital at any point.

For example, if I wanted to buy a $0.05 option that had a year long expiration date, that would cost $5 for the 100 options + $2 in transaction fees (open and close), for a total of $7. If the interest rate on my savings was 1%, then it would tie up $700 of my capital to put on this trade. So in order for this trade to be a winner, the option itself would need to be worth more than 6% of $700 at the expiration date. Or in other words, the $5 option would need to appreciate to $42 or more.

Note, I didn't limit this one to value at the expiration date only. I'm looking at the maximum profit possible. So this is not a conservative estimate.

LSO Calls Analysis

Of the total trades (6548), the ask prices fell out like:
$0.05 - 249
$0.10 - 859
$0.15 - 1715
$0.20 - 3725

Of the winners (247) the Ask price of the options fell out like:
$0.05 - 2.4% (6)
$0.10 - 16.2% (40)
$0.15 - 23.89% (59)
$0.17 - 0.4% (1)
$0.18 - 0.4% (1)
$0.20 - 56.68% (140)

The average gain on invested capital per trade (assuming a 1% interest rate return on savings) was:
$0.05 - 3.58%
$0.10 - 2.02%
$0.15 - 0.94%
$0.20 - 0.98%

If the interest rate return on savings was 3x higher, then the average gain per trade would also be 3x higher. So for example, for a 3% interest rate return on savings, you get a 10.8% return for .05 options.

Notice that the return on the $0.15 and $0.20 options was less than the 1% that it cost to get those returns. So at least for this time period, these trades did not produce a profit.

Also notice that the 249 x $0.05 trades cost $1245 over the entire approximately 2.5 years, or roughly $500 a year. So at 1%, that would require an account of $50k to be able to buy all of the $0.05 trades. And since only 6 out of the 249 were winners, it would be extremely damaging to the returns if I didn't buy all 249 of the trades and missed one of the 6 that was a winner. The return on invested capital for the winners ranged from 25% to 300%.

The "Percent to Profit" didn't seem to matter.

The time of the option did have some effect, but not much. Longer was slightly better.

The stock having dropped a significant percentage (75%) recently was also a factor in producing a gain.

So for me, this means that I need to concentrate on buying all of the $0.05 call option trades available in any month. And look for ways to get my no risk interest rate on my core capital to be a little higher. At 1%, I'd be getting a 3.58% return. But at 2%, I'd be getting a 7.16% return, which would be higher than the 6% that I'm targeting.

However, again, these return values are the absolute highest possible, and assume the investor sold at the very peak of the option's worth. Since that is not probable, these are probably higher than what I would actually make in returns.

I'm curious to see how these kinds of trades do in the next bull market though, like the NLS trades, these should do better in that type of market as well.

LSO Puts Analysis

The results of this analysis were abysmal.

Of more than 2500 trades, only 5 made a return of more than 6% on invested capital. And those were all $0.15 or $0.20 options. So this strategy was not able to pay for itself and did not produce a gain over the given time period.

This is not too surprising though. The time period here is November 2008 to May 2010. So this only catches the tail end of the decline that started in November 2007 and went to March 2009. So I can't really say if this is a good strategy or not.

My guess is that it is not a good strategy. I'm thinking that the return profile probably mirrors the LSO Calls, which means there would probably be a few trades that would win, but the great majority would lose. And so the few that would win would need to make up for all the ones that lost and then some to average a 6% return overall. Since puts have a natural limit to how much of a return you can make (the stock can only go to zero, no lower), there is a cap on the returns that each put could make, and so I don't think you would see the 300% returns on invested capital needed to get that average 6% return.

Summing Up

My main concern of protecting my core capital was definitely covered by these strategies. So I'm happy with them from that perspective.

NLS didn’t do as well as I thought it would in the recent run up, but I suspect that it will do better in a market environment where stocks are making new all-time highs. The same goes for LSO Calls, although I think I will concentrate my investments on the $0.05 options regardless of how high a percentage the stock must rise to make a gain.

LSO Puts didn't really get tested in an environment where it would be expected to do well, so I don't know whether or not it is a good strategy. I'll have to wait for a future down market to find out.

What does it mean to be risk-averse?

2010-01-09T11:00:00.001-06:00

In a recent blog post on using a HELOC to save interest costs on your mortgage, I mentioned that I had basically converted my $10k emergency fund into a variable rate HELOC. A reader called me on that and asked how I could do that and still claim to be risk-averse, so I figured it was time to explain what I mean by "risk-averse".

The Yardstick

My main financial goal right now is to build my savings to a point where my investment income will cover my monthly expenses. Let's call that point "financial independence". At that point, I can still work if I choose to, but a job will no longer have any control over my life. I will be in control, and control over our own lives, or autonomy, is a very big component of our happiness.

Not too long ago, I figured out that I could attain this goal of financial independence in a reasonable amount of time without any investment gains at all simply through saving a large percentage of my income and by lowering my monthly expenses. So when I'm looking at some financial move, I check that move against this goal. So for me, "risk" is anything that could endanger this goal, or push out the timeline that I'm currently looking at.

For example, investing my savings in the buy and hold strategy is risky from this perspective because the market could go down unexpectedly, generate large losses, and push out my timeline. So I avoid that strategy and instead go with strategies like No Lose Stocks and Long Shot Options that guarantee very limited losses compared to my overall savings.

Applying this yardstick to the HELOC, the worst case scenario would be that the bank cancels my HELOC, and I need the $10k for an emergency. If that happened, I would pull the $10k from an IRA. I currently have both a Roth and a Traditional IRA. The Roth IRA allows you to withdraw money that you have deposited without paying income tax or penalties, so that option would only cost me $10k. The Traditional IRA requires paying taxes and a 10% penalty when you make a withdraw, so that option would cost me about $13.5k. A loss of $10k or $13.5k is not going to significantly affect my timeline. Seen from this light, not having a $10k emergency fund in cash is not a risk because it doesn't endanger my goal.

Cheap Happiness

Before anyone goes off thinking that financial independence requires a huge salary, or that it means I'll be "rich" when I am financially independent, I'd like to point out that my goal will be attained on a fairly small amount of money. A central theme of happiness research is that wealth, stuff, and money are not requirements for happiness. So I'm voluntarily keeping my spending and accumulation of stuff low, which won't affect my happiness, in order to achieve my goal, which will affect my happiness.

Since I don't plan to be rich when I'm financially independent, that might affect which IRA I should be withdrawing from in the case of an emergency. The purpose of a Roth IRA is to get tax-free income (and you don't have to wait until you're 65). To be financially independent, I only need enough income to cover my monthly expenses. If my monthly expenses are low enough, then I probably won't be paying much in taxes anyway.

When I reach my goal, I won't have any FICA taxes to pay, so I'll already need 7.5% less income than I currently do. Then the standard deduction for 2009 is $11,400. The personal exemption is $3650, and so for my wife and I, that's $7300. Total that's a currently allowed tax-free income of $18,700 per year (which gets indexed for inflation). So if I can get my monthly expenses under ($18,700/12 months) $1558.33, then I'd be paying zero taxes. That might seem crazy low, but I keep track of all my spending in a budget and my current monthly expenses are $2600, $800 of which is a mortgage payment (principal and interest only). So after I pay off the mortgage, my monthly expenses will be only only $1800. So if I were financially independent in the current tax environment, and didn't have a mortgage, I'd be paying 10% in taxes on about $250 a month, or $25 a month.

Monthly expenses of $2600 would require a savings fund of $780k earning 4% per year. Monthly expenses of $1800 would require a savings fund of $540k earning 4% per year. So by paying off my mortgage, I can become financially independent for $240k less than otherwise. In addition, that $800 that used to go towards my mortgage, will instead go towards my savings and my goal.

What this has really made me consider is whether or not I need to pull all the deposits to my Roth IRAs out and pay them against my mortgage. If I don't need the tax-free income later, then I might do better to get the reduced monthly living expenses now in order to achieve my goal faster.

Insurance

Since a very large financial loss would jeopardize my savings and my goal, I maintain insurance to protect against those kinds of losses. Generally, though, I only insure against risks that I can't quantify or that after quantifying prove to be too big to bear.

A loss that would be too big to bear would be the loss of my house for example. If my retirement fund is only $540k, and my house is $180k, then replacing my house out of pocket would be a large financial burden. So I will maintain homeowner's insurance even after the mortgage is paid off.

Risks that I can't quantify include health costs and accidental damage to other people's property.

For health risks, I maintain health insurance, but I'm only concerned with insuring against catastrophic loss. So I have a high-deductible HSA plan that covers costs 100% after the deductible is met in any given year.

For accidental damage, it's possible that I could be at fault in a car accident with a number of vehicles or with a very expensive vehicle. Either way I can't really quantify what the upper bound of that amount would be, so I maintain the highest levels of liability insurance. But I don't carry any collision insurance on my car or my wife's. I know how much those cars are worth and how much it would cost to replace them, and we can cover those costs out of pocket.

Currently we also have life insurance, but the amount is only enough to get the survivor to the financially independent point. We don't maintain "lottery" level life insurance. And the policy is term life. So once we get to the point that we are financially independent, this insurance will be dropped as it will no longer be needed.

Getting back to the emergency fund and HELOC question again, at a mortgage rate of 4.625%, keeping the $10k in my bank account instead of paying down my mortgage would cost me $38.50 per month. Essentially, that $38.50 per month would be an insurance premium that guaranteed me $10k in coverage. Putting that in perspective, I pay $40 per month for homeowner's insurance and that protects me from more than 10 times as much loss. So for me, the better option here is to pay down the mortgage and take the relatively small loss in IRA funds if it ever comes to needing the emergency fund.

Risk-averse, not Loss-averse

There is a difference between being risk-averse and being loss-averse. I am risk-averse when it comes to risks related to my happiness. However I'm willing to risk losing small amounts of money (a few thousand) if it means I can more quickly get to my financial independence goal and reduce my happiness risk. So I regularly try out different things that might lower my monthly expenses in the long run.

For example, I recently tried out Cricket wireless because they are cheaper than my AT&T plan. Unfortunately the Cricket service reception at my house is too poor for me to use it. I spent $85 trying that out. But I had set that money aside to lose, so it wasn't a risk to my happiness. This is similar to what I do with Long Shot Options. You could look at the service and say that I'm losing money every month since I'm spending the interest earned on my core capital on options that will most often expire worthless. But my perception of this is that I'm not losing my core capital, or endangering my goal, and so my expectations are not violated.

Perception

I read an interview with Taleb recently that talks about how he manages the perception of loss.

At the beginning of the year he sets aside a certain amount of money to cover any surprise expenses, like lost or damaged property, parking tickets, speeding tickets, or any other annoyance. At the end of the year, anything left goes to charity. So if he does get a parking ticket, it's no big deal because he's already paid for it, and expected not to have that money anyway. His day isn't ruined.

In fact, he may have a better day than someone else would. Consider the situation where you're driving around trying to get a parking spot so you can get into a show before it starts. Time is running out, but there are just no spots left, except the handicap ones, or maybe some other ticketable spots.

For Taleb, I imagine the answer is simple, just park in a ticketable spot and enjoy the show. If it turns out he doesn't get a ticket, it's that much better, but there's no pain if he does get a ticket. For someone else, they'll probably drive around until they've already missed part of the show. Maybe park very far away, or risk it and park in a ticketable spot. Then throughout the show, instead of enjoying themselves, they'll be wondering if they've been ticketed yet. They won't be enjoying the show at all.

Wrapping Up

So the trick is to quantify your risks and potential losses to make sure they can't harm you. If they can harm you, then insure against them. Then mentally reframe a potential loss as the expected scenario, and become used to that as your reality. Then you can live life without worrying about losses. Any losses you suffer will be expected, and any non-losses will be pleasant surprises.

Its about managing your expectations and not defying them. In my opinion, the worst thing to risk is your happiness.

Where Can I Find Ex-Dividend Calendars?

2009-12-21T18:20:00.001-06:00

I went searching recently to see if I could find all the ex-dividend calendars out there. Here's what I found:

Dividendium.com - Ex-Dividend Calendar - My site of course showed up. I give the actual payout, a fair list of stocks, and the ability to download the listings as a spreadsheet. One thing I found is that I'm missing some stocks from my listings. So I need to fix that. If you notice a stock missing from my listings, email me about it.

UPDATE: I have added a new feature to the dividend lists. If you scroll to the bottom of the dividend lists there's a message that says "Notice a stock missing? Add it!". Clicking this will allow anyone to add a stock symbol that's missing from the lists.

TheStreet.com - Ex-Dividend Calendar - Quite good. It gives the actual payout, and a pretty thorough list of stocks. The only complaint I had is that if you check it on the weekend, it doesn't default to the upcoming Monday, you have to actually click on Monday's date.

FullDisclosure.com or Earnings.com - Ex-Dividend Calendar - Really thorough list of stocks. Maybe too thorough. It also gives the actual payout. Here also you need to click the Monday's date if you're looking on the weekend.

Ex-Dividend.com - Ex-Dividend Calendar - You have to click the "Search Date" button to see the data, and it's only AMEX stocks.

DividendInvestor.com - Ex-Dividend Calendar - You have to click "Go" to get the data for the selected date. Also it looks like knowing which stocks are in the list is a subscription only thing. But they still give their "AllStar Ranking" for each of the stocks, so if you wanted to, you could use any of the other ex-dividend calendars to figure out which stocks those were by matching up the payout amounts and closing prices.

Dividend.com - Ex-Dividend Calendar - Gives the annual dividend, rather than the actual payout for the given ex-dividend date. And there are stocks going ex-dividend that are missing from the list.

DividendStocksOnline.com - Ex-Dividend Calendar - You have to click the month you want to view. And then it lists all the days in the month. It also only lists the annual yield percentage, and only lists stocks with a 4% yield or higher.

DividendInformation.com - Dividend Calendar - You have to click the "Dividend Calendar" tab. You can change the date by clicking the calendar icon. But I think they are listing the data by paid date, and not by ex-dividend date. So maybe if you looked a month into the future, you could use it to figure out when an ex-dividend date might be.

DividendsCalendar.com - Dividend Calendar - This lists stocks by their dividend payout date, not the ex-dividend date. It also seems to be only historical as it has no data beyond December right now.

If you're wondering why I might find it worthwhile to list out the competition, here's a previous post I wrote about acknowledging the competition and using that pressure to get better, so that's pretty much the reason for this post.

If you know of or find any other ex-dividend calendar websites, feel free to post them in the comments.

Where Can You Get A High Safe Rate Of Return On Short-Term Savings?

2009-11-30T21:01:00.000-06:00

Lately, I've been looking for a way to earn more money on my savings. The 1.25% I'm getting right now just isn't cutting it. But, I'm very risk averse, so I'm not sticking the savings in the market. And some of the savings I'm earning interest on will be needed in less than a year, so I can't tie the savings up in a long-term CD for example.

A buddy of mine has a similar problem. He's a partner in a business and so has to keep a large amount of cash on hand to pay his quarterly taxes. So he was also looking for a way to get a better return on these savings, and he stumbled upon something called "Mortgage Cycling".

I had read about this a long while back, but it wasn't something I could take advantage of at the time. But circumstances have changed, and I'm now in a position to put this strategy into effect for my own savings. Here's how it works.

Mortgage Cycling

First, you must have a mortgage, and it must be one that you actually need to have. Meaning you couldn't afford to live in your house without the mortgage. So this isn't for people who have paid off their house. They're already in a better position than this.

Second, you must be able to get a Home Equity Line of Credit, or HELOC. The requirements for a HELOC (at least in Texas) are that you must have more than 20% equity in your house. Or stated otherwise, your mortgage plus the HELOC cannot be more than 80% of the home's market value. (This was the circumstance that prevented me from taking advantage of this in the past.)

Third, you must have some amount of money left over at the end of the month. This would be the savings you want to earn a higher return on. As part of our budget, my wife and I set aside money each month for large annual or bi-annual expenses like car insurance, home insurance, life insurance, real estate taxes, Christmas gifts, and IRA deposits. We also have categories that we stash money away in for when we want or need to spend it later like car expenses, home expenses, medical/dental expenses, pet expenses, entertainment, and vacations. So in any given month we have up to $2k that basically goes in a bank account to wait until it's needed.

Now, the key to understanding this strategy is that you pay interest on your current mortgage balance each month. If you can lower that monthly balance, even temporarily, then you'll save money by not paying interest on the amount that you lowered it by. And that saved money is equivalent to making a higher rate of return on that money.

So say you owe $100k on your mortgage and your annual interest rate is 6%. That means for the current month, you would owe the bank ($100k * 6%/12) $500 in interest. If you paid an extra $2k against your mortgage, then your balance would be $98k, and you'd only owe $490 in interest. You'd have saved $10. Which is equivalent to earning an annualized 6% on the $2k.

Next month, you put another $2k against the mortgage, and you save another $10 per month. So this month you saved $20. With the $10 from last month, that's $30 total so far for the year.

Then as the months roll by, $30 becomes $60, $60 becomes $100, $100 becomes $150, and so on up to $780 total for the year in month 12. Month 12 is when I need some of the money that I've been saving to pay for real estate taxes, insurance, gifts, and IRA deposits.

At this point, I can take a draw against my HELOC, and pay those expenses with that. So now I have my mortgage, plus a debt on my HELOC to pay off. The HELOC will probably be a variable rate, or if not a variable rate, then a fixed rate which is higher than my mortgage. So in coming months, my $2k deposits will go against paying off the HELOC until it's paid back down to zero, and then the $2k deposits will go against my mortgage again.

Note though, that I'm not pulling out the full $24k that I saved up over the year. There were those other non-annual expenses (car, home, medical/dental, etc) that I didn't necessarily need to pull money out for. So those other savings are continuing to "earn" the 6% interest.

So where is that $780 then? Well, you're still making your regular mortgage payments, so the $780 actually went to pay down the value of your mortgage. So not only are you making a better return on your short-term (and/or long-term) savings, you're also paying off your mortgage faster.

How much faster? Well, paying $780 on a $100k mortgage each year is like making an extra mortgage payment each year, which would pay off the mortgage in about 25 years as opposed to 30 years.

Risks

There are a few risks, but they are remote in my opinion.

One possible risk is that your HELOC could be canceled. Maybe the bank goes out of business, or some other unforeseen circumstance occurs and your HELOC is not accessible. If that happens, then you wouldn't be able to immediately get the extra funds back. I see this as very unlikely to happen. If it did happen, then I'd borrow money some other way at the time, either opening another HELOC with a different bank or borrowing on a credit card, or whatever.

Another possible risk is that your variable rate HELOC's interest rate could shoot up. In this case, I would just pay down the balance on the HELOC as fast as possible. And if rates were really going up, then savings rates would also be going up, and I might consider switching to putting my savings in a savings account again.

Where to get a HELOC

So the only other question my buddy had was where to get the HELOC. My suggestion for any loan or savings product is to always check the credit unions in your area first. They have a natural advantage against the banks in that they pay less taxes. So the banks have to charge higher fees to make the same profit and provide the same service as the credit union.

It used to be kind of difficult to join a credit union. You used to have to satisfy some fairly tight restrictions to join. But it seems like lately anyone can join any of them by jumping through some fairly easy hoops. For example, in my area, there's a place called A+ Federal Credit Union. I think it was originally a teacher's credit union. But under the requirements now, you can get in if you have a kid in any of the schools around here. And if that doesn't get you in, then you can donate $10 to a charity fund they have for supporting teachers.

So basically, if you pay $10, you're in. They charge 1% of the Line of Credit Limit, plus about $150 to establish the HELOC. The current interest rate is 4.625% according to their webpage.

Another Credit Union in my area is Austin Telco FCU. They don't advertise their HELOC's very well...or at all really, but they pay all closing costs, so establishing the HELOC is free. The only catch with theirs is that you can only make 6 draws on the HELOC for the life of the HELOC. Since I'm only planning on doing 1 per year, that might work for me. They also say you can only open one HELOC per 12 months. So worst case, I just close the HELOC after 12 months and open another to get another 6 draws on the HELOC. Theirs is also variable, and it's 4.5% right now.

And still another Credit Union is University Federal Credit Union (UFCU). They have a fixed rate 6% HELOC, and the closing costs are not to exceed 3% of the Line of Credit limit.

So there's lots of options for establishing the HELOC and getting this strategy going.

Wrap Up

So there you go. A way to get a higher return on your short-term savings by paying off your mortgage faster and without tying up your money long-term.

[EDIT] Postscript

My buddy pointed out that there is another way to implement this strategy that hadn't occurred to me.

His implementation of the strategy would be to replace his mortgage with a HELOC. So he would get a HELOC for the amount of his current mortgage, and then pay off his mortgage. This would likely need to be done all at once by the bank as part of the closing. But as long as you owe less than 80% of the value of your house you should be able to do it.

For that particular implementation, you would probably want the interest rate to be fixed because you're likely going to have a large amount of debt sitting in the HELOC. The UFCU 6% fixed rate HELOC would work for this. The website says they have 5 to 15 year terms. So if you had less than 15 years left on your mortgage, you could switch to the HELOC and not pay off the debt on your house any faster than currently. Getting into specifics though, since the UFCU HELOC has 3% closing costs, you would need to make sure that you're going to use this strategy to save at least that much.

I played with some spreadsheet numbers quite a bit, and here's what I found out...

Of course, if your new HELOC interest rate is less than your mortgage interest rate, then you'll save money. Make sure to figure in the closing costs to the amount you would save in interest to make sure you're saving money overall.

If your new HELOC has a higher interest rate than your mortgage, then it gets a little less clear. The scenario I worked up was if your mortgage rate was 5% fixed and your new HELOC rate was 6%. And you planned to make extra payments throughout the year, and then pull out all the extra payments at the end of the year.

If your mortgage was $100k, you would need to make extra monthly payments of about $2500, and then pull out $30k at the end of the year. This would save you just over $3k for the life of the mortgage/HELOC, and so you would only just barely be making up for the closing costs on the HELOC.

If your mortgage was $50k, you would need to make extra monthly payments of about $1750, and then pull out $21k at the end of the year. This would save you just over $1.5k for the life of the mortgage/HELOC, and so you would only just barely be making up for the closing costs on the HELOC.

If you don't use this implementation of replacing your mortgage with a HELOC, and instead just augment the current mortgage with a HELOC, like in my original explanation above, then what you are really doing is paying off your mortgage faster. And that's where the savings come from. This happens to work out for me, but it's not going to be what everyone wants.

How can you pay less in taxes?

2009-11-23T17:01:00.000-06:00

I've been looking at my taxes for 2009 to see if I needed to make any last minute moves to lower my tax bill. One strategy that I use for this is called "bunching tax deductions" or just "bunching". But this year deserves a little extra consideration because of a new deduction for real estate taxes.

Standard Deduction vs. Itemized Deductions

Every year the IRS gives you an option. You can either itemize your deductions, or you can take the standard deduction. If you itemize, then you add up all of your tax deductible expenses for the year like real estate taxes, mortgage interest, sales taxes, donations, and medical expenses, and that amount is subtracted from your income.

So if you made $50k for the year, and you had $11k in mortgage interest, real estate taxes, sales taxes, and donations, then you would pay taxes on ($50k - $11k) $39k instead of on $50k. That's a simplified example, but that's the gist.

If you use the standard deduction, then you just take whatever number the IRS says is the standard deduction for that year, and you subtract that from your annual earnings. For 2009 the standard deduction is $11,400. So if you made $50k for the year, and you take the standard deduction, then you would pay taxes on ($50k - $11,400) $38,600.

You always want to pay less in taxes, so in the above situation, you'd take the standard deduction, and pay taxes on $38,600 instead of paying taxes on $39,000. That's a difference of ($39,000 - $38,600) $400, which at a tax rate of 15% would save you $60.

This is pretty much the standard procedure that everyone takes every year. The IRS forms even walk you through this decision and all the tax software out there does the same thing, so you always end up taking the better deal, itemized deductions or standard deduction.

But it always bugs me to see that $11k in deductions basically just get wasted. Enter bunching.

Bunching

Taxes are figured on an annual basis. So for a deductible expense to be counted on your taxes, you have to have paid the expense in the given tax year. This combined with the option to take a standard deduction gives us some room to maneuver and squeeze a little more money out of our tax deductions. We could for example, pay our real estate taxes in January 2010 instead of December 2009, and then pay our 2010 real estate taxes on December 2010. That would mean we bunched our real estate tax deductions and got a double deduction of real estate taxes for 2010.

So from the example above, if your real estate taxes were $3k per year, and you paid them in January 2010, then you would only have ($11k - $3k) $8k in itemized deductions for 2009. But you were already going to take the standard deduction for 2009, so that doesn't matter. However, you've now pushed that real estate tax deduction into 2010, so if you pay your 2010 real estate taxes in December 2010, you'll have ($11k + $3k) $14k in itemized deductions.

It's important to note here that the standard deduction is adjusted up for inflation each year. So 2007 was $10,700, 2008 was $10,900, and 2009 will be $11,400. So 2010 will likely be higher than $11,400, like maybe $11,900. But $14k is still higher than $11,900. So you would take the itemized deductions instead of the standard deduction, which would mean paying taxes on $2,100 less, which would save you $315 in taxes.

Some mortgage holders will allow you to tell them when to pay your real estate taxes, but I self-escrow so I can make sure the taxes are paid when I want them paid. I don't want to miss out on $315 just because of a procedural mess up at my bank.

Note that my example revolves around bunching real estate taxes, but you could bunch any deductible expenses. You could pay your last mortgage payment of the year in the next year to bunch the mortgage interest. You could postpone a medical expense into the next year. You could bunch your charitable donations into the same year. And so on.

So that's bunching. You choose to "bunch" deductible expenses you would make anyway by paying them all in the same calendar year and attempt to get your itemized deductions above the standard deduction for the next year, or rather for every other year. So you would use the standard deduction for 2009, then bunch in 2010, then standard in 2011, then bunch in 2012. And then according to the Incan calendar the world ends, so it doesn't matter after that.

Real Estate Tax Deduction

The catch for 2009 is that there was a change to the tax law for 2008 and 2009 that now allows up to $1000 (for married couples, $500 for singles) to be deducted for real estate taxes even if you take the standard deduction. So if you pay at least $1000 in real estate taxes in 2009, then your standard deduction would actually be ($11,400 + $1,000) $12,400.

But if we "bunch" our real estate taxes into 2010, our standard deduction would still only be $11,400. The best would be if we could take advantage of this new deduction in 2009 and still do bunching for 2010. The way to do this is to only pay $1000 of your 2009 real estate tax bill in December 2009 and pay the remaining amount in January 2010. I'm guessing your mortgage holder would definitely not be open to this, so you would probably need to be self-escrowing to do this.

So from the example above, your 2009 taxes would be on ($50k - $12,400) $37,600, which would save you $150 over the $38,600 from before. And now your 2010 taxes would have ($14k - $1k) $13k in tax deductions. If the 2010 standard deduction is $11,900, then you would be paying taxes on $1,100 less than the standard deduction. Which would save you $165 over the standard deduction.

So in the bunching only situation, you saved $315 in taxes, and in this situation you save ($150 + $165) $315. So you pretty much just get the $150 a year earlier. That may seem trivial, but I prefer to keep my money as long as possible.

For some tax situations, moving $1000 in real estate tax deductions to 2009 may not leave enough bunched deductions in 2010 to get over the standard deduction. So in those cases, it may make sense to pay the 2010 real estate taxes in January 2011, and so bunch in 2011 instead of 2010.

WWDD - What Would Dividendium Do?

2009-11-14T10:52:00.005-06:00

(EDIT: I have consolidated all of the Saturday Selections posts into this post. They are below in chronological order separated by dotted lines.)

In the last post on the recent changes to Dividendium I said I would start posting what I would do with the Investing Strategies data. Note of course that these are just my opinions and let me state for the record that I don't have any more insight than any other person into how the market is going to move in the future. So take this all with a massive block of salt.

I'll be going through each Investing Strategy one by one, and referring to the trades by their Trade ID from the data spreadsheets.

These picks are from the 11/13/2009 spreadsheets.

Inflatable Dividends

My disclaimer here is that I do not personally use the Inflatable Dividends strategy. For my own investing goals this strategy is too risky.

I determined a while back that I could save my way to financial independence, and that I was happy with the time frame that saving alone would get me there in. So my focus is on not losing money, rather than on making gains. Any gains I make are just going to get me to financial independence faster, but I definitely don't want to get there slower. Inflatable Dividends exposes me to too much risk because there is a chance that the market could move against me, and I wouldn't be able to buy back the call in order to unwind the trade.

But if I put on the hat of someone that is willing to take the risks involved with this strategy, here's the thought process I would go through to make my picks from the Friday, 11/13/2009, spreadsheet.

I always look at the stock charts for the stocks first. I use www.bigcharts.com. I'm looking for stocks that don't look like they could fall at any moment. To me, this means that the stock price seems to be in a "range" for the recent past.

Recent past would be maybe double the amount of time to expiration. In this case there are 6 days until expiration, so I'm looking back about 12 days, or about 2 weeks to get a feel for how the stock is moving. Based on this alone I would kick out Trade IDs 1, 4, 7, 9, 12, 13, 14.

This leaves 2, 3, 5, 6, 8, 10, 11.

2 and 3 drop out because their ex-dividend dates are on Monday, so it was already too late to put those trades on when this data was posted. This is a minor bug in the service that I'll be fixing. It should be figuring in weekends when it determines if you could buy a trade based on the ex-dividend date.

I would also kick out 11 because it has a lot of news around it in the current environment. News can make a stock's price move erratically. For this strategy I want to have a stock that just plods along and pays out the dividend without stirring up any dust.

So this leaves 5, 6, 8, and 10. Next I verify that all of the stocks are actually paying dividends as Dividendium says they are. Dividendium takes an educated guess at what an upcoming dividend payment will be, so it's good to independently verify. I use the www.bigcharts.com "detailed quote" for this. In this case they all look good.

So those Trade IDs 5, 6, 8, and 10, in that order are the ones I would buy if I was using this strategy.

No Lose Stocks

I do use the No Lose Stocks strategy, but I make sure that I don't invest in trades that could lose more than 3% annualized.

The data in the spreadsheet is sorted by "Annualized Percent to Profit", which means I'm looking for the stocks that have to rise the smallest amount per year to give me a gain. Sometimes the gains needed seem really high, like 30%, but again, I don't know any better than anyone else where that stock will be in 2 years. So as long as I don't lose money on the transaction, I'm willing to "fish for luck" by putting my money where it might make gains, even if gains don't seem likely.

For this strategy, the first thing I look at is whether or not the stock has recently shot up in price and come to a very level price range. Trade ID 1 is a good example of this chart formation. If the stock has done this, then it usually means that the stock is a buyout target, which Trade ID 1 is. When I see this chart formation, I will usually check the news around the stock for the last year, and usually there will be an article talking about the stock getting bought out in the near future.

I skip these buyout stocks because the only scenarios I see are that the stock stays at the buyout price, or the buyout falls through and the price drops precipitously. With this strategy, I'm looking to buy dividend stock put combinations that can only go up. Since this situation is very unlikely to go up, it doesn't really fit. Also, once the buyout happens, the dividend is usually no longer going to be paid out. So skip Trade ID 1 and 3 (same stock for both).

Trade ID 2 is also out. The "Annualized Maximum Percent Loss No Dividend" is -27%, which means that if I do this trade and the dividend is cut or suspended or the stock is bought out during the trade, then I could potentially be losing 27% of my invested funds per year. That's way above my 3% loss tolerance stated above.

Trade ID 4 looks good. (Full Disclosure, I own an earlier expiration date of this same trade, which I purchased a while back.) I always like to check Dividendium's educated guesses on whether or not a stock has consistent enough dividends for this strategy, and whether or not the predicted dividends look correct for this particular trade. For Trade ID 4, the dividends look correct to me. Actually they might be a little low as it looks like this company has been raising it's dividend.

The other thing to look at with Trade ID 4 is the "Interest Rate Where Call Is Better (%)". For this one, that's 0.66%. So if you took the money you were going to invest in the Stock and Put and instead put that money in a savings account earning more than 0.66%, you would have enough to buy the call at the same strike price as the Put. The call being better assumes that the dividends are not raised over the life of the trade.

So in this case, if you like this trade, it might be better to stash your cash in savings and use the interest to buy the call. The call could very well expire worthless, so don't put anything other than the interest earned into the call. Also note that if you buy the call instead of the stock put combo, you have no dividend risk, meaning there's no possibility of loss due to the dividend being cut or the stock being bought out.

I used to prefer to buy the stock and put combo, mainly I think because it seemed cleverer, but I've come to see the wisdom in the simplicity of just buying the call. For this reason, I would buy the call for Trade IDs 4 through 13, and 16, since they are all cheaper given an interest rate of less than 1%.

Also note that since this strategy is essentially "fishing for luck", I want to spread my investable funds over as many of the stocks as possible to get the most exposure to possible gains. So I will buy as many 100 share and put combos, or 100 share call options as I have the funds to cover, and usually not double up on a particular stock. Occasionally, I'll double up if there aren't enough trades to put all my investable funds to work, or if a new trade has an expiration date further in the future.

The remaining trades, 14, 15, and 17 through 25 are all trades that would expire in less than a year, and have "Annualized Percent To Profit" values of more than 50%. It's entirely possible that these would produce a profit, but if I get this far down the list and still have funds left to invest, then I will normally switch to Long Shot Options.

Long Shot Options

As I said, I also use the Long Shot Options strategy. Again, I'm just fishing for luck here, so I want to spread out my investable funds as much as possible. I never buy more than the minimum 100 share call or put for any given stock.

I also never buy these trades with anything but the interest earned on my core capital because I'm expecting them to expire worthless most of the time. So if I have $100k sitting in a money market at 1.25%, that generates $1250 per year, or $104 per month.

Then each month when I get my account statement, I take the amount earned in interest, $104, and buy Long Shot Option plays until it's all used up. So in this case that would be 20 $0.05 trades or 4 $0.25 plays, or some combination of that. I try to split the money evenly between the calls and the puts because I never know which way the market is going to go.

When I look at these trades, I take a quick look at the chart to make sure it's not a buyout situation. Then I pretty much buy right down the line.

For the Calls, I'm looking for the "Percent To Profit Per Day Times Ask" that is the smallest. Basically, I want to pay the least amount for how much a stock has to go up per day to produce a profit.

Trade ID 1 is showing the buyout chart formation, and is indeed the subject of a buyout according to the news. (I usually look at the news stories for the stock on the stock quote page on either Yahoo or BigCharts.) So I would skip Trade ID 1.

Trade ID 2 is a well known stock, so I generally won't even waste the time to look at the chart for a well known stock as it's unlikely it will get bought out. As a bonus, Trade ID 2 is also 6 cents per share. I'm highly attracted to the idea of putting down a very small amount and getting back a nice return. Like when I put down 25 cents on a GM put not too long ago and made 400%. It makes a great story.

There's also the fact that I can buy more 6 cent trades than 25 cent trades, and so expose myself to more positive luck that way. But generally I will just go down the list and buy any of the calls that are not buyouts.

Trade ID 3 is a buyout. So skip that. Trade IDs 4, 5, and 6 are well known, and so I would just buy them. Trade ID 7 is not a buyout, so I would buy it. And so on.

For the Puts, I'm looking for the smallest "Percent To Profit Per Day Times Ask Divided By Max Profit". Basically, I want to pay the least amount for how much a stock has to go down per day to produce a profit, and moderate that by how far down that stock can go. Since a stock can't go below $0, there is a maximum amount of profit to be made on these trades.

I'd buy Trade ID 1, 2, 3, 4, and 5. Skip 6 and 7 because they are buyouts. And then buy 8, 9, 10, and so on.

Note that the stock for Trade ID 3 is one that I said I would buy above in calls as well. So I'm saying I would buy both a call and a put on the same stock. Since I don't know which way the market will go, I don't try to out guess it and so I'm willing to make trades that go both ways.

Wrap Up

So there's the selection of trades I would buy from the most recent Investing Strategies data. In future "Saturday Selection" posts, I'll be much more brief about my choices. I just wanted to give a general overview of my thought process on choosing trades from each of the strategies this time.

Saturday Selections

See the first installment of Saturday Selections for details on the criteria I'm using to make these picks.

These picks are from the 11/20/2009 spreadsheets.

Saturday Selections are what I'm going to call my weekly post about how I would use the Inflatable Dividends , No Lose Stocks , and Long Shot Options services that Dividendium publishes. This will be the second installment with the first installment having been posted last Saturday.

I'd just like to clarify that all of the services publish their data daily. So although I'm only giving tips on how I would use Friday's data each week, the data from any other day could be used, using the same criteria that I laid out in the initial installment. If I were to try to post my thoughts on every day's data, it would be too time consuming for me, and the posts would rarely get out early enough for subscribers to find any use in them. By posting on Saturday subscribers then have Sunday to review the post, and can take any actions on Monday's open.

Review

I won't do this every time, but I'm going to do a quick review of the trades I suggested last time for the Inflatable Dividends service. The suggestions from last time were 5, 6, 8, and 10 from the 11/13/2009 Inflatable Dividends spreadsheet.

All four stocks gapped up at the open on Monday and didn't come back down to their Friday's close at any point during Monday. If I can't buy a position the day after the spreadsheet is published then I don't buy it. If the same trade is in the next day's spreadsheet, then I consider it like I would any other trade in that day's spreadsheet. So I would not have actually purchased any of these trades.

Inflatable Dividends

There's only one trade in Friday's spreadsheet this week. This is probably due to the fact that option expiration just happened on Friday.

After looking at the chart for Trade ID 1, I would pass on this one. Option expiration is a month out, so I look back about 2 months to see how the stock has been acting. It's recently fallen from a long run up. That may mean that it's just taking a breather and will go higher from here, or it may mean that it's on it's way down. Either way it doesn't appear to be in a nice stable price range, which is what I would be looking for.

So for 11/20/2009 Inflatable Dividends spreadsheet, there are no recommended Trade IDs.

No Lose Stocks

Skip Trade IDs 1 and 2 since the stock is a buyout target. Then I would skip 3, 4, 8, 9, 10, 15, and 18 because they are all over my self-imposed limit of 3% max annualized loss. I would buy the call options for 5, 6, and 7 since that's cheaper than buying the stock and put in those cases. And since the rest require an annualized percent to profit of more than 50% I would move on to Long Shot Options.

So for 11/20/2009 No Lose Stocks spreadsheet, I would buy the call options for 5, 6, and 7.

Long Shot Options

Skip Trade IDs 1 and 2 since they are buyout targets. But otherwise I would just buy as I moved down the list until I used up the interest I earned on my funds last month.

So for 11/20/2009 Long Shot Options spreadsheet, I would skip 1 and 2 and buy until I ran out of earned interest.

Saturday Selections

See the first installment of Saturday Selections for details on the criteria I'm using to make these picks.

These picks are from the 11/27/2009 spreadsheets.

Inflatable Dividends

You'll notice that the size of the spreadsheet has expanded again back to it's original size. One of the subscribers said that he liked to have all the extra data to be able to consider some of the more exotic covered call dividend capture plays that Inflatable Dividends finds. So the top section of data is what Inflatable Dividends thinks are the best trades to make, with ex-dividend dates that are confirmed, and option expiration dates within the next month.

There's a disclaimer on the second section that says:

"DISCLAIMER: Trades listed below here do NOT follow the normal Inflatable Dividends criteria. These trades require in depth analysis before deciding to invest. The data below here contain many guesses made by Dividendium and should be highly scrutinized if used at all."

So I will not be considering any trades for Saturday Selections that come from the second section of data in the spreadsheet.

Jumping in to the picks for this week. If I was using this strategy, I'd skip the following trades because they haven't been in a good price range for more than twice the time until expiration: Trade IDs 2, 4, 6, 7, 8, 9, 10, 11, 12, 14, 16, 17, 19, 20, 21, 23, 24, 25, 26, 27, 29, 30, 31, 32, 33, 34

That leaves the following trades as ones I would pick: Trade IDs 1, 3, 5, 13, 15, 18, 22, 28, 35, 36.

I stopped looking after I found 10 trades that I would do, which means I stopped looking after Trade ID 36. So there may be others in the list that I would consider good as well.

No Lose Stocks

Skip Trade IDs 1 and 2 for buyouts. I'd buy the call options for Trade IDs 3 and 4 with interest on the money I would have used to buy the stock and put for those trades. I'd skip the other trades in favor of Long Shot Options as all the rest seem to be long shots anyway.

Long Shot Options

In previous posts, I have skipped options that were part of a buy out. That still seems practical for a call option, but a reader pointed out that buying the puts on buy out stocks might not be a bad idea. If the buy out falls through, then the put may pay off just from the people rushing out of the stock. And it might turn out that there was a good (or really bad) reason that the buy out did not go through and so the stock might fall even further.

So for the calls, Trade ID 1 is a buyout, so I'd skip that one, but then I'd just buy down the line.

For the puts, since I don't care about buyouts, I'd just buy right down the line.

Saturday Selections

See the first installment of Saturday Selections for details on the criteria I'm using to make these picks.

These picks are from the 12/4/2009 spreadsheets.

Inflatable Dividends

If I was using this strategy, I'd skip the following trades because they haven't been in a good price range for more than twice the time until expiration: Trade IDs 2, 3, 4, 5, 6, 7, 8, 9, 11, 13, 14, 15, 18, 19, 20, 21.

That leaves the following trades as ones I would pick: Trade IDs 1, 10, 12, 16, 17.

No Lose Stocks

Skip Trade ID 1 since it’s a buyout.

Skip Trade ID 9 because Trade ID 5 is the same stock and a better buy.

I'd buy the call options with interest on the money I would have used to buy the stock and put for Trade IDs 2, 3, 5, 6, 7, 8, 10. Trade ID 4 doesn't have a call option detailed because Yahoo wasn't reporting one, but BigCharts says the call at the same strike and expiration date has an ask price of $1.18. That figures to an interest rate of .71%, so I'd buy the call on that one too.

Trade ID 11 says the interest rate is -1, which means there is no interest rate at which the call is better than the stock and put, so I would buy the stock and put for Trade ID 11.

The remaining trades all require more than a 50% annualized gain, so I would skip them in favor of Long Shot Options.

Long Shot Options

For the calls, skip Trade ID 1 and 2 since they are buy outs, and then I'd just buy down the line.

For the puts, just buy down the line.

Saturday Selections

See the first installment of Saturday Selections for details on the criteria I'm using to make these picks.

These picks are from the 12/11/2009 spreadsheets.

Inflatable Dividends

If I was using this strategy, I'd skip the following trades because they haven't been in a good price range for more than twice the time until expiration: Trade IDs 1, 2.

So there are no trades that I would pick from this spreadsheet.

No Lose Stocks

Skip Trade ID 1 since it’s a buyout.

Skip Trade IDs 9, 12, and 13 because the same stock is used in a better buy.

I'd buy the call options with interest on the money I would have used to buy the stock and put for Trade IDs 2, 3, 4, 5, 6, 7, 8, 10, 11, 14, 16, 17, 18.

Trade ID 15 says the interest rate is -1, which means there is no interest rate at which the call is better than the stock and put, so I would buy the stock and put for Trade ID 15.

The remaining trades all require more than a 50% annualized gain, so I would skip them in favor of Long Shot Options.

Long Shot Options

For the calls, skip Trade ID 1 since it's a buy out, and then I'd just buy down the line.

For the puts, just buy down the line.

Saturday Selections

See the first installment of Saturday Selections for details on the criteria I'm using to make these picks.

These picks are from the 12/18/2009 spreadsheets.

Inflatable Dividends

Option expiration happened this past Friday, so there are no trades currently listed for this strategy.

So there are no trades that I would pick from this spreadsheet.

No Lose Stocks

Skip Trade ID 1 since it’s a buyout.

I'd buy the call options with interest on the money I would have used to buy the stock and put for Trade IDs 2 - 12.

Trade ID 13 says the interest rate is -1, which means there is no interest rate at which the call is better than the stock and put, so I would buy the stock and put for Trade ID 13.

The remaining trades all require more than a 50% annualized gain, so I would skip them in favor of Long Shot Options.

Long Shot Options

For the calls, skip Trade IDs 1 and 2 since they are buy outs, and then I'd just buy down the line.

For the puts, just buy down the line.

Saturday Selections

See the first installment of Saturday Selections for details on the criteria I'm using to make these picks.

These picks are from the 12/26/2009 spreadsheets.

Inflatable Dividends

If I was using this strategy, I'd skip the following trades because they haven't been in a good price range for more than twice the time until expiration: Trade IDs 1, 2, 3, 4, 5, 6, 8, 9, 12.

That leaves the following trades as ones I would pick: Trade IDs 7, 10, 11, 13, 14.

No Lose Stocks

Skip Trade ID 1 since it’s a buyout.

I'd buy the call options with interest on the money I would have used to buy the stock and put for: Trade IDs 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 23, 26, 27, 28, 30, 32, 34, 35.

The skipped Trade IDs in the range above were for stocks that were covered by better trades already in the list above.

The remaining trades all require more than a 50% annualized gain, so I would skip them in favor of Long Shot Options.

Long Shot Options

For the calls, skip Trade ID 4 since its a buy out, otherwise I'd just buy down the line.

For the puts, just buy down the line.

Saturday Selections

See the first installment of Saturday Selections for details on the criteria I'm using to make these picks.

These picks are from the 1/1/2010 spreadsheets.

Inflatable Dividends

If I was using this strategy, I'd skip the following trades because they haven't been in a good price range for more than twice the time until expiration: Trade IDs 2, 3, 5, 6, 8, 9, 12, 13, 14, 15, 16.

That leaves the following trades as ones I would pick: Trade IDs 1, 4, 7, 10, 11, 17.

No Lose Stocks

Skip Trade ID 1 since it’s a buyout.

I'd buy the call options with interest on the money I would have used to buy the stock and put for: Trade IDs 2 - 47.

The remaining trades all require more than a 50% annualized gain, so I would skip them in favor of Long Shot Options.

Long Shot Options

For the calls, skip Trade IDs 1 and 3 since they are buyouts, otherwise I'd just buy down the line.

For the puts, just buy down the line.

Saturday Selections

See the first installment of Saturday Selections for details on the criteria I'm using to make these picks.

These picks are from the 1/8/2010 spreadsheets.

Inflatable Dividends

If I was using this strategy, I'd skip the following trades because they haven't been in a good price range for more than twice the time until expiration: Trade IDs 1, 2, 3, 4.

That leaves no trades that I would take this time.

No Lose Stocks

Skip Trade ID 1 since it’s a buyout.

I'd buy the call options with interest on the money I would have used to buy the stock and put for: Trade IDs 2 - 22. Note there are a few repeats in there, and I would only buy the better trade (lower Trade IDs).

The remaining trades all require more than a 50% annualized gain, so I would skip them in favor of Long Shot Options.

Long Shot Options

For the calls, I'd just buy down the line.

For the puts, I'd just buy down the line.

Saturday Selections

NOTE: I've been posting these "Saturday Selections" for a bit now, and I think it's pretty clear what my criteria are and how I would implement them. So I'm planning to make this my last "Saturday Selections" post. If you would prefer otherwise, please let me know.

See the first installment of Saturday Selections for details on the criteria I'm using to make these picks.

These picks are from the 1/15/2010 spreadsheets.

Inflatable Dividends

Option expiration happened this past Friday, so there are no trades currently listed for this strategy.

So there are no trades that I would pick from this spreadsheet.

No Lose Stocks

Skip Trade ID 2 since it’s a buyout.

I'd buy the call options with interest on the money I would have used to buy the stock and put for Trade IDs 1, 3 - 28.

The remaining trades all require more than a 50% annualized gain, so I would skip them in favor of Long Shot Options.

Long Shot Options

For the calls, skip Trade ID 1 since it's a buy out, and then I'd just buy down the line.

For the puts, just buy down the line.

What’s changed on Dividendium?

2009-11-11T13:03:00.001-06:00

For a while now I have been working on making some improvements to Dividendium. Mainly these improvements are in the backend of the site, but some of them will be obvious from the frontend. Here’s a rundown of the new features…

Login

On all non-blog pages of the site, you’ll see a “Login” text box. This allows subscribers to the Investing Strategies services to access the content they subscribed to. There is no password. It’s just whatever email address you subscribe with. A subscriber can’t change anything from Dividendium, so it would only be an annoyance to make a user remember yet another password for logging into the site.

Dividends Search

The Dividends Search section of the site had lots of changes.

First, all regular Dividend Data and Investing Strategies services now have a web interface.

The web interfaces allow sorting of the data right on the webpage by clicking the headers of the columns. The columns for the Investing Strategies are all sorted by what I think are the most pertinent measures of a trade’s potential.

There are previous and next links at the bottom to move to the next or previous pages.
If you go to the “next” page, you’ll see some parts of the browser URL that are “hackable”.

http://www.dividendium.com/DividendsSearch.aspx?filter=&page=1&max=20

The “page=1” indicates that you are on the second page of the data. The pages range from 0 to however many pages of data there are. If you go too high, it just won’t have any data to show.

The “max=20” is how many stocks you want to show at a time. 20 is the default. If you change it to 200, then it will list 200. It may take a while to load the page if you go too high though. The number will be maintained as you click next and previous.

There’s also a new text box on the non-Investing Strategies pages that says “Get emailed when data is updated”. This allows anyone to get emailed when Dividendium’s dividend data is updated, which happens every weekday after the market closes.

On all the Dividends Search pages there is a link that says “Download CSV Data”. This allows you to download the current data in spreadsheet form (CSV is comma separated values and opens in Excel or pretty much any other spreadsheet program you want to use). So now you can download the daily dividend data and sort, parse, and collate til your heart’s content.

Under that is the “Historical Data” link. This link will take you to a list of the archived spreadsheets for previous days. So if you wanted to do some back testing or just see what the trades were on a particular Investing Strategy in the past, this is where you’d be able to find them.

The spreadsheets are listed by date, and the data in the spreadsheets is sorted the same as the default sort on the webpage. So the trades near the top are more likely (in my opinion) to be the better trades. I’ve also filtered out a lot of the trades that were not as good or that didn’t match the strategies as well. So the more recent spreadsheets are much shorter and smaller in size.

You’ll also notice in the most recent spreadsheets for the Investing Strategies there is a new column called Trade ID. I’ve received lots of requests for guidance or advice on which trades I would choose from the spreadsheets. So I’ll be posting what trades I would do, and probably will do in some cases, on Saturdays. That way subscribers can read over the info on Sunday before the Monday open. In order to avoid giving away the data that the subscribers paid for, I’ll be referencing the trades by their Trade ID.

Investing Strategies

All Investing Strategies (Inflatable Dividends, No Lose Stocks, and Long Shot Options) now have a 6 month free trial. I don’t want anyone to pay for something they don’t find useful.

The email delivery for the Investing Strategies has also changed. Emailing used to be done through Yahoo Groups, which was a royal pain to deal with as far as getting people signed up. It worked for the time being, but I’m very glad to be rid of it now.

The emails are also now personalized. So rather than receiving one email for each subscription, subscribers now receive one email total each day with all of their subscription links in it. The links will take you right to the data and automatically log you in. Or you can download the data right there from the email. And if you decide the subscription is not for you, there’s a cancel link right next to each subscription.

My intention was to make it as easy as possible to cancel a subscription. The easier I make it, the better the feedback I’ll get on whether or not people find a service useful.

Lastly, the No Lose Stocks Investing Strategy data is now updated daily.

Suggestions or Complaints

So let me know what you think of the new changes, or if you have suggestions for further changes feel free to send them to me via Contact Us or contact@dividendium.com.

When should we ignore the news?

2008-11-02T11:30:00.001-06:00

In past articles, I’ve talked about ignoring the news. The current environment seems to be a great time to practice that particular bit of self-preservation. A recent discussion with a good friend reminded me about how easy it is for us to fall into the herd mentality and build on each other’s fears.

My friend was wondering if he should change his financial behavior in response to the ominous things he was reading on the news sites, in particular CNN. My advice was to ignore the news and not to change his behavior. I told him his reasoned financial decisions should be made independent of the state of the economy. Whatever reasoning is used should be sound in any economy. For example, it’s always a good idea to spend less than you make and to have reserves like an emergency fund.

Reject the new

It turns out that the optimal strategy is always to reject the new, which includes new inventions, new medicines, new procedures, and of course news. It’s not that there is nothing of value in the news, but rather that what is of value is buried under lots of stuff that is of no value. Ask yourself when was the last time that a news article actually positively affected your investing? Personally, I can’t remember an instance.

If we take the optimal strategy of always rejecting the new in favor of the old, then we gain the benefit of time as a filter. Something that might seem like a great idea initially may eventually show its flaws. So if we wait until something is “old” we don’t waste time considering those things that didn’t stand the test of time.

Automation as defense

But if we stop reading or watching the news, then where do we get our investing ideas? My suggestion is that the news is so useless as an investing tool that you should ignore it completely. You should craft an investing philosophy that doesn’t require you to be familiar with the news. I would suggest an automated investing strategy.

By automating our investment decisions, we get to think rationally about what a good decision would be before we make the investment. Making that decision before we make the investment is really important because after we make the investment we’re emotionally involved and prone to making decisions without rational reasons.

The classic automated investment strategy is the index fund in a 401k. You put a predetermined percentage of your paycheck in to the index fund every month, and don’t vary regardless of the state of the economy. That’s a nice automated strategy that you don’t have to think about and you don’t need to know the news to execute.

Of course I’ve stated previously that I’m not a particular fan of the index fund. Given my risk averse attitude, my personal choice is to go with one of the strategies that I’ve been working on that are virtually immune to losses like No Lose Stocks or Long Shot Options.

Service updates

I started taking subscribers for Long Shot Options yesterday. I’m offering a 6-month free trial and then $9.95/month after that. The free trial is to let subscribers decide if the service is right for them. As always, I don’t want anyone to pay for anything they don’t find valuable.

I also further automated the No Lose Stocks strategy. I noticed that every time I got an email from the service and downloaded the spreadsheet, I would immediately sort the spreadsheet by “Percent to Profit”. I was looking for the stock that had to rise in price the least to give me a profit. Now however, the service presorts the spreadsheet by “Percent to Profit” and so all I have to do is open the spreadsheet and see if there are any trades to place. That’s one less thing I have to think about when I make my investments.

The Long Shot Options data is also presorted. First the data is sorted by price, then by expiration date, and finally by “Percent to Profit”. The idea is to look for the smallest priced options that have the longest time frame to surprise in and the shortest path to get to that surprise. The data is reported in two separate spreadsheets, one with calls, and one with puts.

Recent observations

At the risk of sounding hypocritical, I’ve noticed some recent (a.k.a. new) changes in the No Lose Stocks and Long Shot Options data. Before a couple months ago, there were maybe 10 to 20 trades that fit my personal criteria for a good No Lose Stocks trade. (I’m looking for stocks that only have to rise in price 10% to 20% to provide a profit.)

Currently there are zero stocks that meet my No Lose Stocks criteria. And when I look at the Long Shot Options data, I notice lots of possible call option trades, but very few put option trades.

It would seem then that the put options are very expensive right now. Or it could mean that the call options are very cheap. Either way, the automated strategies that I’m following are automatically directing me to buy what’s cheapest without my needing to think about it, which is exactly what I want them to do.

Who’s Better Than You?

2008-10-26T16:57:00.001-05:00

Much of the happiness research that I’ve read says we base a good deal of our happiness on our position relative to the others around us rather than on our absolute position.

So it matters more to our happiness for us to know that we have more food than the other guy, than that we have more food than we have ever had before.

The explanation I’ve read for this is that the best way to assure our evolutionary fitness in the past was to just be better than the people around us. The theory goes that if we were better than the people around us, then we would get chosen as a mate more often than they would and our genes would thus get passed down.

Our ancestors would then have that same inborn genetic desire to be better than the people around them thus keeping the cycle going. This I guess is the root cause of the need to “keep up with the Joneses”.

Can logic prevail?

That being said, logically we should realize that our absolute position is more important than our relative one. Logically we would be more satisfied with all the food we could eat, than with only two crusts of bread. But if we let our emotional brains make the decision, we would be more happy with the two crusts of bread, if everyone else only had one crust of bread, than with all the food we could eat, if everyone else had all the food they could eat plus a crust of bread.

So there’s a danger there that we need to watch out for. The danger of our brains tricking us into doing something that we know logically to be the wrong move, but that we can temporarily be emotionally tricked into doing. For example, we might logically know that it would be a bad idea to buy a new car, but when the neighbor comes home with his new car we feel that emotional twinge to go out and get one ourselves.

So what implication does this have for our investing?

One point is that we should try to avoid finding out if someone else is actually better off than we are. In this case ignorance really is bliss. If we don’t know if someone else is better off than us, then we won’t be tempted to make a bad decision to try to catch up with them.

So it is in our interest not to talk about our salaries because we might find out that they are not as high as the person we are talking to. As long as we don’t know the real numbers, we can imagine that we are paid more than the other person. And conversely they can imagine the same thing. But as soon as we both know the reality, then we’re both stuck comparing and then one wins and the other loses.

Don’t talk about investments

Along the same lines, it would also be a good idea not to talk about our specific investments. If we own a stock and we tell someone about that stock, then our egos are now affected by every up or down move of that stock. When we are evaluating whether or not to sell, we now have to decide what the guy we told is going to think. If we sell out now, and the stock jumps 50% he’ll know we were stupid and missed it. And if we hang on, and the stock falls 50% he’ll know we were stupid and lost all that money. So the best idea is to keep the specifics of our investments to us.

The strategies I’m advocating, No Lose Stocks and Long Shot Options, are very prone to this weakness. For most of the time, they are not going to generate returns. True, they won’t generate losses either, but people only want to tell us about the wins they make, not the losses. So we’re likely to hear lots of stories about stocks that went up large amounts, when our own investments have just seemingly languished.

But this is actually the reason these strategies work. The person on the other side of the trades, the one selling the options, is telling someone about how much money he makes each month selling options to some chump. And for most of the months that guy will be correct. Most of the time the options will expire worthless, and the seller will get to keep the money. But eventually the seller will get careless or greedy, and he’ll stretch too far. On that month or in that year, the strategy will pay off for us, and make up for all of the other losses and then some.

So if we’re following these strategies we need to realize that we are susceptible to being tricked into thinking that the strategies are not working, or that there is a better strategy out there. And we need to make sure to stay the course.

The best solution I have found is to avoid discussing specifics.

What’s another way to invest while avoiding losses?

2008-10-19T21:47:00.001-05:00

In the last article, I briefly discussed holding your wealth in something other than dollars and said that I was planning to hold mine in No Lose Stocks and “possibly some long shot calls and puts”.

I’ve been rereading Taleb’s “The Black Swan” lately and have been formulating some ideas for a new investment strategy I’m calling Long Shot Options.

The idea in a nutshell is to find the options that have to rise or fall the smallest amount over the longest time for the smallest price, and then buy them and wait. Most often these options will expire worthless. But my hunch is that maybe once a decade or maybe even more often, they will hit. And because they are so cheap, like $0.05 per share, when I buy them, I can buy lots of them for very little money and profit exponentially if they go up.

So let’s get into the specifics of why I think this might work.

Avoiding losses

One of the things that we find difficult to take is losing money, so I plan to only buy these options with the interest earned each month on my core capital. If I use only the interest from my account each month to buy whatever options are cheap that month, then the balance of my account will never drop. Occasionally it will jump up to a new higher level when I make gains or deposits, but it will never fall.

Avoiding losses can also be a relative gain. Consider that over the last couple months the S&P 500 has dropped 25%. Since I have been using the No Lose Stocks strategy, my own investments have returned 0% over that same period, meaning I haven’t lost any money. But compared to someone that rode the S&P 500 down to where it is, I have a relative 33% gain.

So we’re avoiding losses while still being exposed to the possibility of gains.

Overconfidence

One of the things Taleb discusses in his book is our tendency to overestimate how much we know. He talks about a psychology experiment where the participants are asked, for example, how many lovers Catherine II of Russia had. The participants are supposed to guess a range where they are 98% certain the answer is within the range.

If the participants set their ranges correctly, then only 2% of the participants should be wrong when the results are tallied. But when the answers are checked the percentages turn out to be 15% to 30% wrong. The participants are overestimating how much they know. They were given the opportunity to set the ranges as wide as they liked, and yet they still missed the mark.

What I take from this is that option sellers are doing the same experiment. The option seller is being asked to pick a range that the stock will not go to. Since the option seller is picking the range, I can then bet against that range with the knowledge that the option seller probably picked too small of a range.

So we’re able to use the option seller’s overconfidence against him.

Bad at predicting

Next consider that the option seller is predicting what the stock price will be in the future. He’s looking at the past and making predictions about how high or low the stock price will go from here and in how much time.

But he’s basing his decisions on past data and looking for occurrences that happen very infrequently. The more infrequently something happens, the worse we are at accurately predicting it. The reason being that we don’t have a large enough sample to accurately gauge the likelihood that it will happen again.

Consider if you saw something happen once in the last 30 years. You might believe that the thing happens once every 30 years. But if it then happened again the next day, the rate would be twice every 30 years or on average once every 15 years. And if it then happened again the day after that, the rate would be 3 times every 30 years or on average once every 10 years. Over a very long time, assuming the real rate stayed constant, any bunching of occurrences would eventually average out. That’s the affect of the law of large numbers.

But it means that for things with longer times between occurrences, or a low chance of happening, we are really bad at accurately predicting the real rate of the phenomena. So if we let the option seller pick what he thinks the rate is, and bet against him, he will probably underestimated the rate.

So we’re able to use the option seller’s weakness at predicting against him.

Picking on the most optimistic

The market bidding process means that when I buy my option, I’m buying it from the person that was willing to take the smallest amount of money for taking on the risk that the stock will go to that price. This means that I get to buy from the guy who is the most optimistic and thus the one who is most likely to be wrong.

So we’re able to pick the option seller most likely to be wrong in his prediction.

Income bias

We have a bias towards frequent rewards. This means we would prefer to get lots of small rewards rather than one large reward. Logically, we can reason that one large reward is better than a bunch of small rewards that don’t add up to the large reward, but psychologically we crave the constant positive feedback. So it makes it even more likely that the person selling the way out of the money options (which is a way to get constant positive income) is doing so irrationally and probably mispricing the risk he is taking in order to feed his need for a constant gain.

So we’re able to bet against the option seller’s weakness for frequent rewards.

History leaps

If we look at history we see that rather than being a smooth even progression, history often moves in leaps. A new discovery is made and then everyone quickly shuffles and readjusts to accommodate the new reality. This same thing happens in the stock market. When new information is discovered the price of the stock quickly reacts, moving either up or down depending on the information. These leaps are fundamentally unpredictable, so by looking for the longest option expiration we can get the highest chance of hitting one and profiting from it.

So we’re able to take advantage of history’s tendency to surprise us with new information.

Summary

With Long Shot Options we’re attempting to take advantage of the weaknesses of the option seller and the tendency of history to surprise us, all while avoiding losses to our core capital.

If you’d be interested in subscribing to the Long Shot Options service when it becomes available, drop me an email at contact@dividendium.com.

Who’s to blame for the “crisis”?

2008-10-12T21:31:00.001-05:00

I see this particular question asked quite a lot lately. I also see lots of different answers depending on the political leanings of the person answering. Among the culprits I’ve heard offered up are the President, the Fed, the consumer, the banks, Wall Street, China, the Congress, OPEC, the terrorists, and so on. But I’m starting to think that who’s to blame is not the right question to ask.

It seems to me that who’s to blame doesn’t change the situation. Sure it may make us feel better to be able to place blame and punish someone, and probably even just as importantly to say that it wasn’t our fault, but the problem will still exist regardless of who started it. And punishing someone now doesn’t prevent someone else from causing the problem in the future. A better solution would be to never give anyone the power to put us, the individual, in the situation again.

We can’t save the entire world from getting in this situation again, but we can take responsibility for ourselves and provide our own protection. And once we’ve made sure we’re secure, we might even be able to profit from future “crises”.

The “crisis”

I put “crisis” in quotes because it really hasn’t affected me, so I have trouble calling it a “crisis”. But then again, perhaps that’s because I’ve already done most of the things I’m about to suggest doing.

As I understand it, the problem is that our economy is stalling and people are losing faith in the economy. In response, the people are spending less, businesses are cutting back on payrolls and other expenses, banks are afraid to lend money, investors are taking their money out of the market and waiting on the sidelines, and the currency is being inflated to try to jumpstart the economy again. So in general there is less spending and the people and businesses that were depending on that spending are feeling some pain from that.

People spending less

If people cut back on their spending, then it reduces the income of the businesses that were getting that spending. But it also causes the people to get a bit grumpy about the lowering of their standard of living. People only cut back on their spending if they can’t afford to spend what they normally do. So one way to avoid this problem is to preemptively cut our own spending, and just spend less to begin with. I’ve mentioned a few times how our spending levels don’t really affect our happiness, so a lower spending level is going to leave you just as happy as you were at the higher one.

Businesses cutting back

If businesses are cutting back, it is possible that we could lose our jobs. But then it’s always possible that we could be fired or let go. A slowing economy is not the only reason that a company cuts back. So it would be prudent to always be prepared for an interruption in income. The standard suggestion of 3-6 months of expenses (not income) as an emergency fund will take care of this. And in dire situations, you could even fall back on your retirement savings. Any amount of time you take out of your retirement now will only add that time on to the end.

Banks not lending

If banks aren’t lending, then the fear is that people won’t be able to buy the things they need and businesses won’t be able to make payroll. Perhaps it’s my ignorance, but why are businesses depending on loans to make payroll? I would think a business would want to be more secure than that. Like perhaps having enough cash on hand to pay its payroll, ideally cash acquired from sales of its product. So from a business perspective, I would suggest weaning the business off of revolving credit and just paying the expenses from the income. It may make for a tight month, but after that first month, the payroll loans shouldn’t be needed any more, and all payments can be made from the income.

From a consumer perspective, I don’t see much of a problem. Perhaps a bank won’t make a loan on a house, or an education, but if that’s the case, then take the hint and wait a little bit to make that purchase. In the mean time, save up some money so you won’t have to borrow as much. If the loan is for a car, then I’ve already stated my thoughts on that. A loan is just a quicker way to get the thing that you want, while paying more for it. It’s always possible to just save up the money for the house or education and avoid the loans entirely.

Investors pulling out

If investors are pulling their money out of the market and waiting on the sidelines, that means that they expect to put that money back to work eventually. We can take the opportunity to buy the stocks at good prices with built in demand waiting on the sides for things to settle down.

My suggestions above have all been of the idea that we should take the initiative to keep our living standards as even as possible by not spending to our limits and keeping some reserves for rainy days. Not too long ago, and along the same lines, I realized I could plan a retirement that I could achieve solely through saving. Meaning I don’t need any investment gains to get there, so any investment gains I do make just get me there faster.

The effect this has had is that my investing style has become very risk averse. I’m only interested if I can severely limit my downside and have an unlimited upside. This is what I’ve been advocating with the No Lose Stocks strategy. And this is the same kind of investing that I advocate here.

As a quick example of the usefulness of this strategy, take a look back at the HNZ purchase that I mentioned a few articles ago. I bought the stock at $51.38, along with a Put option with a strike price of $60. The current price of HNZ is $41.58, a roughly 20% drop from the purchase price. And at one point on Friday, the price dropped to $38.43, a 25% drop from the purchase price. If I didn’t have the put I would have sold out by now and lost 20% to 25%, but I do have the put. So I’m able to just sit back and see what happens without any real worry.

Currency inflation

If the currency is being inflated, then the dollar savings that people already have are going to be worth less in the future. Many of the people who say this “crisis” is the fault of the Fed also blame this on our lack of a gold backed or commodity backed dollar. What I realized recently is that we individuals actually have the option to back our “dollar” with whatever asset we want.

For example, if you want a gold backed dollar, all you have to do is buy gold with your dollars. Then when you want to buy something, you sell a little gold, take the dollars and buy the thing. We actually do something very similar to this when using credit cards in foreign countries. Our home currency is converted to the local currency at the time of purchase. I don’t actually see any reason that specialty credit cards couldn’t provide this service in a wide range of commodities. But even if they don’t we can implement it manually just by converting all of our dollars into whatever asset we prefer to hold our wealth in.

This is the one area where I haven’t yet taken my own advice, but I’m in the process of remedying that. And the asset I’m planning to hold the dollars in is stocks, or more specifically No Lose Stocks, and possibly some long shot calls and puts. I used to make a distinction between my savings and my investments, but now that I can invest without losing money, I don’t see any reason to continue the distinction.

Conclusion

The “crisis” may be a problem for some people, but for those people who are prepared it’s a non-event, or even a possible chance to get some new assets at distress sale prices. So be prepared for “crises” and the problems turn into opportunities.

Is the market a scam?

2008-10-05T23:42:00.002-05:00

We are told, “the market always goes up”, but this statement ignores a few things that we might want to consider if we are going to be betting our savings on this “fact”.

First, there is the survivorship bias. This is the idea that when a company goes out of business or is purchased by another company, that company is no longer counted in the indexes. A poor company being dropped from the indexes raises the average value, so it looks like the market went up to anyone looking at the market’s history. But this understates the chances of an investor investing in a company that will later go bankrupt.

Second, it is possible that the increases in the value of the indexes are solely due to inflation. If the market was actually producing value, then the value of the market should be increasing compared to commodities.

Take gold for example. Technology makes it easier to mine gold now than it was in the past. Gold also does not decay or get used up, so the more gold that is mined the more gold there is. That means the supply of gold goes up every year. And further, there are no longer any gold backed currencies, so all the gold that used to back the currencies has also been sold to the market, further increasing the supply. Taken all together, this would imply that gold should actually be getting cheaper each year in real value terms.

Now take a look at the graph below. A dollar worth of gold in 1929 is worth $40 today. A dollar worth of the Dow Jones Industrial Average (DJIA) is worth $42 today. The values obviously haven’t moved in lock step, but they do seem to be tracking each other. But we already said that gold should be actually decreasing in value because of technology and increased supply, and that stocks should be increasing in value if they are actually producing value. What we’re seeing here is only a 5% difference, when gold should have been going down from the start, and businesses rising in value from the start.

Now think about this in terms of the companies that you’ve worked for. Have you ever seen a company that did not waste money? And who are the worst offenders, the big companies or the little ones?

In my experience, the bigger a company is the more likely someone in it is to exchange company profits for personal comfort and get away with it. The employee, manager, or CEO would rather ignore a problem and just sweep it under the rug than try to fix it.

In a smaller company these costs are harder to hide. But in a larger company the costs can be papered over and covered by some other income, like the proceeds from selling stock. And it would be prudent to point out that the indexes are really made up of the largest companies. So it’s not so far fetched now to believe that the stock market, or at least the indexes are only representing the effects of inflation and not any real added value.

When the music runs out

If this is correct, and the continuously rising market really is just a scam, then eventually the scam is going to end and reality is going to take over. Eventually the pyramid scheme will collapse.

I don’t know when this is going to happen, but inflation is probably speeding up, not slowing down, so it might be getting here faster than we expect. The $700 billion bailout bill will likely push the market higher because it will cause inflation.

I’ve been rereading Taleb’s book “The Black Swan”. In it there is a discussion about a Thanksgiving turkey. For 1000 days the turkey is fed like clockwork. Each day the turkey is fed the turkey comes to feel safer and safer. Each day brings the now regularly expected feeding. Then on day 1001, the day before Thanksgiving, the turkey gets the axe. Notice that the day the turkey felt safest was the most dangerous day.

If the situation you’re in is safe, then each day should confirm for you that you are safe and that your safety will probably last even longer. If the situation you’re in is not safe, then each day should tell you that you’ve pushed your luck just a little farther and it might give out all that much sooner.

The problem is it’s difficult to tell the difference when you’re in the situation. But one way to figure it out is to look for things that don’t follow physics or human nature. The turkey should have suspected something was wrong when he started getting “free lunches”. We should be thinking the same about the “free lunch” of a rising market and start looking for ways to protect our necks.

Exploit the loophole

With inflation and the markets, government has created a loophole. When a loophole exists you can temporarily get more than you would otherwise be able to. But the more the loophole is exploited, the faster it will close. So the longer and more extensive that government inflates the money supply, the closer we get to the loophole closing. The closer we get to “Thanksgiving” and the “axe”.

My opinion on this is that we should look to benefit from the loophole, but make sure we don’t end up paying later for the freebies that we got from the loophole. So taking a look at the chart above of gold and the DJIA crossing over each other tells me that I should be setup to take advantage of the rising prices of the DJIA, but also avoid losing the value I gained when the price of the DJIA falls back down. Personally, I do this with the No Lose Stocks strategy, so my profits climb with the stock, but don’t fall because of the Put.

A further way to exploit this loophole and/or protect yourself from the eventual fall is to short the dollar. I’m not saying to buy other currencies because I think they are all basically linked to each other. My advice is to buy the companies that are capital efficient as I explained in the last article.

Another protection would be to not lend value. Any time that you hold dollars you are lending the value of those dollars to someone else. Someone else is borrowing the thing you would have purchased with the dollars. But if inflation destroys the value of the dollars before you get to buy that thing, then you will have lost that value. So don’t hold dollars, don’t lend money (hold dollar denominated debt like CDs or bonds or personal loans), don’t sell Call options, and don’t sell cash covered Put options.

Selling Call options limits your upside. Basically you are letting someone else borrow your dollars to buy a stock. If inflation takes the stock to the moon, then your dollars will be worthless. Selling cash covered Put options is very similar because you are lending your dollars to someone else. You can’t put the dollars to work buying some commodity or stock, and again if inflation takes prices to the moon, your dollars will be worthless.

(I realize not selling call options goes against the Inflatable Dividends strategy, but this is my honest opinion. However I also realize that I can’t know everything and the strategy of using inflation to continue our economy may last for a lot longer, during which time the Inflatable Dividends strategy would be racking up profits.)

On the flipside, taking the opposite approach to these tactics would be good ideas in anticipation of high inflation. If you can buy commodities or stocks with your dollars, borrow money to invest, buy call options, or buy put options on stocks you own, then these would all be in line with profiting from inflation.

For a while I had an article up on how to use 0% credit cards to get cash advances and then deposit those in a high yield savings account. This is a nice way to generate some small “free” income. But from the perspective of inflation, it would be a better idea to take that same 0% loan and buy a No Lose Stock, or take the interest from the high yield bank account and buy a call option. I’m not advocating risking any of the money that was actually borrowed since you have to pay all of that back. I’m only advocating getting some one-way exposure to the effects of inflation.

Lastly, if you wanted to you could just buy gold or silver bullion coins and then buy gold and silver puts on those to protect the dollar value. There would be a cost (unlike with NLS where the stock’s dividend pays for the put option), but you might consider it like paying for insurance.

I’m just saying that we should be even more cautious now that we have pushed our luck as far as we have. The free lunches might soon be at an end.

Pay only for profits

After writing the post on HNZ the other day I started thinking about the idea of stop losses. Many of the gurus that I’ve read advocate using a stop loss. They advocate any where from 8% to 25%. The HNZ position that I have on has to rise 17% before I see a profit. But I only lose that 17% if I first gained it. If I was maintaining the same position with a 17% stop loss, I would stand the chance of losing the 17% even if I didn’t make any gains. I much prefer the idea of paying only for my profits and never paying for my losses.

Which broker is the cheapest?

2008-09-28T16:18:00.001-05:00

If our intent in investing is to generate a profit, then it is prudent to reduce our expenses as much as possible. One of those expenses is the commission on our trades and any monthly or annual fees.

Depending on your chosen strategy and account type, one broker might be better than another. I’ll be looking at this from the point of view of implementing the No Lose Stocks (NLS) strategy in a Traditional IRA account. The NLS strategy requires buying 100 shares of stock and 1 Put option contract on the same stock.

Broker summaries

Here is a summary of the pertinent data for each of the 4 brokers I considered:

Zecco (http://www.zecco.com):
- Stocks 10 free trades per month
- Options $4.50 + $0.50 per contract
- $30 account fee for IRAs (each account!)
- 0.1% interest on balances

TradeKing (http://www.tradeking.com):
- Stocks $4.95
- Options $4.95 + $0.65 per contract
- No IRA fee
- 0.9% interest in sweep money market account

Fidelity (http://www.fidelity.com):
- Stocks $10.95
- Options $10.95 + $0.75 per contract
- No IRA fee
- 2.45% interest on balances

InteractiveBrokers (http://www.interactivebrokers.com):
- Stocks $.005 per share which is about $0.50 per 100 shares, with a $1 minimum
- Options $0 + $0.70 per contract for > .10, .5 to .10 is .25 to .50 per contract. $1 minimum.
- $10 fee per month ($120 per year per each account), less transaction fees.
- 1.5% interest on balances greater than 10k

Fidelity vs. Trade King

Trade King beats Fidelity if you are only making one NLS trade per year. Trade King costs $10.55, while Fidelity costs $22.65.

Unless you are planning to keep a large amount of cash in a money market Fidelity seems to be a bad choice for the NLS strategy. Their higher money market interest rate is their only saving grace. But since my positions are completely protected by the Puts, I will be keeping as much of my money invested as possible to expose my portfolio to as much positive luck as possible. So I won’t be generating interest income.

Trade King vs. Zecco

Trade King beats Zecco for less than 6 trades per year. At 6 trades per year, Trade King would cost $63.30 and Zecco would cost $60. The average trade using NLS requires about $6500 and lasts for 4 months. With 6 trades per year, that’s about 2 trades per 4 months, which would require a maximum of $13000 in capital. So if you’re planning to invest more than $13000 using NLS then Zecco is better than TradeKing.

Zecco vs. Interactive Brokers

Interactive Brokers (IB) charges $2 per NLS trade with a minimum of $10 per month. So if you only do 1 trade in a month, then you pay $2 in commissions plus $8 in remaining fees. If you do 6 trades per month, then you just pay the $12 in commissions. So with 6 trades per year and 2 trades every 4 months that means you’re paying the minimum $10 each month. So that’s a total of $120 per year for IB. At that number of trades Zecco is still the better choice.

Zecco hits $120 at 18 trades per year. Assuming you split the trades up between months to be no more than 5 in a given month (or at least evenly split if more than 5), then at 18 trades or more per year, Interactive Brokers would be the cheaper alternative.

If you staggered the purchases to be 3 NLS trades every 2 months for a total of 18 trades in the year, and the average capital needed to fund a trade was $6500, you could do this with $39000.

Conclusion

So if you’re going to be investing in the NLS strategy with $39000 or more, Interactive Brokers seems to be the best choice.

Their software is a little complex, but once you figure out how it works, things move quickly.

If you need help, the NLS strategy is a specialized form of a “Synthetic Call” and falls under their “Combination” trades. So you can actually enter the stock and the Put you want and the total limit price you want to pay for both combined, then let IB go put the deal together.

Example Trade

I’m going to run through an NLS trade that I placed on this past Friday. I’m not recommending this stock. In fact, I’m not making any judgments about this stock at all. The whole point of NLS is that I am admitting that I don’t know what is going to happen, so I place multiple bets that have little to no downside and wait for one or more of them to hit. This is what I mean when I refer to fishing for luck.

The trade as reported in the NLS output on Thursday night was:

Stock: HNZ
Close: $51.38
Expected Dividend: $0.42 in December

Option: HNZML
Ask: $9.00
Strike: $60.00
Expiration: 1/16/2009

So I put in a limit order for ($51.38 + $9.00) $60.38. With 100 shares that requires an investment of $6038.00. Assuming the company does not cut their dividend, I expect to get a $0.42 dividend in December. So the minimum that I expect to get when I sell this stock is $60 plus the $0.42 dividend. That’s a ($60.42 - $60.38) $0.04 profit per share. At 100 shares, I should get $4.00.

Since I placed this trade with Interactive Brokers, the cost was $2, so I should net ($4-$2) $2 even if the stock goes down. That’s assuming they don’t cut their dividend. If they for some reason decide to cancel their dividend or pay it much later, then my maximum loss on the trade is $0.38 per share plus the $2 transaction fee, or $40. In percentage terms that’s 0.66% of the invested capital, so less than 1% of the capital is at risk.

And if the stock goes up more than 17% over the next 4 months, then I could make even more profit on this trade.

Where does the bail out path lead?

2008-09-21T15:30:00.001-05:00

Inflation has been the topic of a few of the previous articles on this site. One article talked about how inflation is a manufactured phenomenon, and that deflation is the reality. Another article talked about ways we can deal with inflation, like by trying to out run it. And still another article mentioned Buffett’s comments on inflation in his 1983 Chairman’s Letter, but didn’t go in to the idea too far.

Buffett’s ideas on inflation

Let’s remedy that last one. Buffett’s idea is that he assumes that inflation will continue, so he’s looking to make investments in companies that will benefit from inflation.

Consider two different investments [1].

One company, a candy maker, needs $8 million in machinery to produce its goods and earns $2 million a year in profits. That’s a 25% return on invested capital.

Another company, a screw maker, needs $20 million in machinery to produce its goods and earns $2 million a year in profits. That’s a 10% return on invested capital.

Now consider what these companies would sell for. For a buyer, the first company looks more attractive if the buyer can just buy the machinery. If the buyer pays $8 million, the buyer can make a 25% return on the invested money. Even if the owner of the candy company raises the price to $15 million, the candy company is still a better deal. Only when the candy company costs $20 million does the return on the new buyer’s invested capital become the same for the two businesses. In this case that return is 10% in both cases.

However, now consider that we believe inflation will continue and that the costs to these companies will also increase. Let’s say that costs double.

For the screw maker, that means that the $20 million in machinery is now $40 million. But they are also able to sell the screws for twice as much, so they make $4 million a year in profits. The return on invested capital is still 10%.

For the candy maker, that means that the $8 million is now $16 million. And they too are also able to sell their candy for twice as much, so they make $4 million a year. So the original purchase price of $20 million, plus the new $8 million in inflated costs means that the total invested capital is $28 million. With a profit of $4 million, that means that the return on invested capital is ($4 / $28) about 14%. That’s much better than the 10% of the screw maker.

If the buyer now decides to sell the candy maker, the buyer should expect to get $40 million for it, since that’s how much someone would pay for the screw maker. But the candy maker buyer only paid $28 million total as opposed to the screw maker buyer who paid $40 million total. The screw maker buyer can break even. The candy maker buyer gets a ($40 - $28) $12 million profit.

So in an inflationary environment, a business that can make a higher return on its assets is worth more than a business that cannot.

Why bring up inflation now?

The solution being proposed by Congress is to buy our way out of the current problems in the financial sector. The proposal is to buy the bad loans from the banks that have them with $700 billion. That money is basically going to come from nowhere. It will be printed up and given to the banks in exchange for something that is not worth $700 billion. The way we know it’s not worth $700 billion is because there isn’t anyone else willing to buy these things at that price right now.

This is basically the engine of inflation at work. If you add $700 billion dollars to the money sloshing around in the economy, then the prices of everything rise to account for the extra money that people can now use to bid on stuff.

Unintended consequences

There’s a further problem caused by this bail out though. The government has now tipped their hand. Now an investor believes that any scenario that results in a blow up of the financial sector can count on a bail out from the government. So the investors have an incentive to risk more because they benefit from all the gains, but don’t have to suffer all the pains.

The more investors believe this, the more they are going to rely on it. The more they rely on it, the more real risk they ignore because they expect the government to bail them out. Until finally the real problems are so big that the government won’t be able to paper over them with printed money and the full force of the pain will fall on the investors, and probably everyone else as well.

This problem comes from the government trying to subvert natural laws. These would be things that go against the laws of physics. For example, the law of conservation of matter and energy says that you can’t create matter out of thin air. It has to come from somewhere. So if you try to create money or value out of thin air, eventually that’s going to come back to bite you.

Natural consequences

When I was a kid my brother and I would horse around sometimes. Eventually we’d knock heads or something and go crying to mom. She’d give us hugs of course, but then ask us if we were horsing around like we knew we shouldn’t be. We’d guiltily acknowledge and she’d sagely intone "Natural consequences".

Mom was basically telling us that it was our own fault we got hurt and that the way of the world was that if you knew something was wrong, and you kept doing it, eventually you were going to get hurt.

Summing up

We’ve got the fact that deflation is the natural way of things, and that inflation is a manufactured phenomenon. We’ve got a way to profit from inflation by buying companies that make a higher return on their invested capital. We’ve got a government that is determined to use inflation as a problem solver until it no longer works. And we’ve got a reality that likes to knock our heads around to a harsher and harsher degree the longer we try to subvert it.

All that leads me to think that at some point the government is going to push inflation one step too far and prices are going to collapse and bring deflation back with a vengeance. I don’t have any insight into when that might happen. But if I follow my No Lose Stocks strategy then I should be able to benefit from the rise in prices due to inflation, and maybe even bet on the companies more likely to benefit from inflation (capital efficient companies). And if the prices do fall due to deflation, the Puts in the strategy will help me to keep my gains while other investors are scrambling to sell their investments.

[1] This example is basically the same example in Buffet’s 1983 Chairman’s Letter from the section called “Goodwill and its Amortization: The Rules and The Realities”, but you may find his version better, so consider taking a look at it. Do a search on the page for that title to find it. It’s in the appendix of the letter at the bottom.

How many histories are there?

2008-09-14T18:03:00.002-05:00

In Taleb’s book, Fooled By Randomness, there is an interesting take on analyzing history. He calls it summing across histories. His point is that regardless of the actual outcome, it’s the many possible outcomes that we should consider when determining after the fact if the right choice was made.

For example, let’s say a janitor buys a lottery ticket every day of his life and wins one of those times, thus making him rich. That outcome of him winning, even with buying a ticket every day, is highly unlikely to happen. If he repeated his life a million times, he would probably never win the lottery in all those other life paths.

On the flipside, let’s say a dentist drills teeth every day for a 30-year career and then retires with a large nest egg. If the dentist repeated his life a million times, it is highly likely that he would end with a large nest egg in the majority of life paths.

The point here is that when we analyze history, we shouldn’t let the actual outcome affect whether we consider a decision a good one or not. Rather we should consider all the paths equally and not give undue weight to a good result that wasn’t also highly likely to happen.

Hindsight bias

We aren’t too bad at acknowledging that there are possibilities in the future, but we are terrible at seeing the possibilities that existed in the past. In behavioral finance, this blind spot for the possible past paths is called the Hindsight Bias. A more common name for it is Monday morning quarterbacking.

Once we know the outcome we generally think that things could only have turned out the way that they did. For the lottery winner above, even though it is highly unlikely that he would win the lottery, and is a waste of $365 a year to play, if he wins, no one will tell him that he was stupid for playing. Instead, they will likely congratulate him and tell him he was smart for playing.

This is very similar to the way that mutual fund managers are treated. We see the returns they have generated in the past and assume that they must know something. They must have learned some skill or intuition that allows them to pick the right stocks at the right times. And we believe that this same skill will allow them to pick the right stocks at the right times in the future after we give them our money to invest. And we think this no matter how many times we hear the words “Past performance is no indicator of future results.”

Ignore the best-case

Summing over histories implies that we should pay more attention to the worst-case scenario (since we usually ignore it), and for the most part ignore the best-case scenario (since we usually over emphasize it, meaning we get greedy). It also implies that we should be looking to reduce the range of the possible paths to a range that includes only possible results that we are comfortable with.

So let’s look at two examples of what we might expect as possible histories from our investing. Since we have difficulty seeing the possible past histories, I’ll use two examples of real stocks, one that has gone well up to now, and one that has not. By using two examples with different outcomes, maybe we can make it clearer to our brains what we are missing when we only look at the actual outcome and not the possible outcomes.

Johnson & Johnson

One possible good path a stock could take in the coming 20 years is the path that Johnson & Johnson has taken over the last 20 years.

We want to believe that of course we knew 20 years ago that JNJ would still be around today and still be a strong brand with a high stock price. But at the time 20 years ago we couldn’t have known that. We may have believed we knew it, but there are many possible paths where JNJ could have taken a turn for the worse, and not ended up where it is today.

It might help if we briefly list off a few things that could have happened to derail the stock’s upward climb, but did not.

One possibility is that their products could have been the targets of multiple terrorist attacks. A few randomly poisoned bottles of baby oil could lead to massive recalls and a drop in sales as people prudently switched to a safer brand.

Another possibility is that their management team could have been embezzling funds like Enron or Tyco.

Another possibility is that some other company could have merely out competed JNJ and stolen market share from them.

So the path that JNJ has taken so far is really only one of many, and is actually an example of one of the better paths the company could have taken. Many other unsavory ones were just as likely 20 years ago (and even today).

The chart below shows the value of one dollar invested in JNJ over the last 20 years. One line represents the buy and hold strategy, and the other line represents the no lose strategy. With the no lose strategy the losses are completely removed , while the gains are only dampened. In this case we’re assuming a 15% lag in the profits for the no lose strategy. So if JNJ goes up 20% in a year, the no lose strategy only gains (20% - 15%) 5%.

With the buy and hold strategy we could have made 22 times our money over the last 20 years. So we start out with $100k, and we end up with $2 million. Seems pretty simple. Nice and easy. We know how great of a company JNJ is so we just drop the money down and wait 20 years. (But of course as pointed out above, we don’t know that JNJ is going to be a great company, we only think we do.)

With the no lose strategy we could have only made 5 times our money over the last 20 years. So we start out with $100k, and we end up with $500k. That’s not bad. It’s a return of about 8.2% a year over the 20 years. But it’s a far cry from the $2 million for buy and hold.

If we stopped our considerations here our biases would convince us that buy and hold is the better strategy. Buy and hold had a higher return over the long-term, but we’d be ignoring the possibility of a loss on the downside.

Fannie Mae

Now consider a possible bad path that a stock could take like the path that Fannie Mae has taken over the last 20 years.

There are probably a great many pundits saying that they knew that FNM would collapse one day, and another great many that said FNM could never fail because of it’s implicit government guarantee. But again, 20 years ago, we had no way of knowing what path FNM would take. The changes in interest rates, the wars or lack of wars, the changes in different countries’ governments and economies are all things that were unknowable. We couldn’t know these things and so we couldn’t accurately predict how they would affect FNM in the future (whether or not we now believe we could have).

The chart below shows the value of one dollar invested in FNM over the last 20 years. One line represents the buy and hold strategy, and the other line represents the no lose strategy. With the no lose strategy the losses are completely removed, while the gains are only dampened. In this case we’re assuming a 15% lag in the profits for the no lose strategy. So if FNM goes up 20% in a year, the no lose strategy only gains (20% - 15%) 5%.

With the buy and hold strategy we could have made about 20 times our money over the last 20 years, with a peak of as much as 45 times our money. However, the chart only shows FNM through January of 2008. If we pushed it forward to today, where the last FNM closing price is $0.74 per share, we would have a 26% loss from our original money. So over 20 years, if we started with a $100k investment, we would have at one point had $4.5 million, but eventually only $74k left of our original investment.

With the no lose strategy we could have made about 23 times our money over the last 20 years. So we start with $100k and end up with $2.3 million. That’s actually quite good, better even than the JNJ buy and hold above. That’s the equivalent of a return of about 16% per year.

Summary

The thing to realize here is that both JNJ and FNM, and all stocks, are highly affected by randomness, and are vulnerable to situations and circumstances that we can’t know about beforehand. Even something that looks really good today (like JNJ now, or FNM about 6 years ago), could eventually turn sour, and do so very quickly. And it is nearly impossible to tell when a stock is turning permanently sour, or just “correcting” before moving higher.

The idea then is to choose the strategy where the possible paths lead to a comfortable outcome the most often, even if that outcome is not the highest success conceivable. So we give up a shot at the best-case result, in exchange for avoiding the worst-case result, and getting a high likelihood of hitting a comfortable-case result.

What about IRA penalties?

2008-09-07T16:16:00.001-05:00

Putting money in a traditional 401k or IRA is a good idea if only for the tax benefits. In the last article on how to invest a 401k I noted that someone in the 25% tax bracket gets an instant 33% gain on their money just by depositing that money in the 401k or IRA.

But 401ks and IRAs have restrictions on when we can make withdrawals. Namely, if we withdraw the money before age 59 ½, then we are required to pay a 10% penalty fee.

This seemingly puts a cramp in the plans of someone who is planning to retire early and wants to take advantage of the tax advantages of IRAs and 401ks. If a person started working at 22 and saved 50% of their income in order to retire in 20 years at 44, then it would seem they’ve still got 15 ½ years left before the money will be penalty free.

While there are a few well-known ways to make IRA withdrawals without the penalty like for buying a first house or for education expenses, there’s also one that’s not so well known called Substantially Equal Periodic Payments (SEPP).

SEPP says that if we agree to take money out of our IRA on a pre-defined schedule, then we can avoid the 10% penalty. This actually turns out to be kind of convenient. We’ll basically be replacing a regular paycheck from our job with a regular paycheck from our IRA.

This article on SEPP is a good primer on the subject.

SEPP can be a little complicated and situation specific, so you’ll want to research it more than just reading that article, but just knowing that the option for penalty-free withdrawal exists opens the way to using them in our financial planning.

No Lose Stocks addition

I added a small but interesting feature to No Lose Stocks this past weekend. I noticed in some cases that instead of buying the put and stock, it’s a better investment to take the money I would have invested in the put and stock, and instead to put that in a money market account, and then use the interest to buy a call option at the same strike price.

The new column shows an interest rate. This is the interest rate you would need to earn to make the call a better investment than the put and stock combo. That way you can decide for your own situation if the call option is better for you depending on where you park your cash.

Here’s a recent example to illustrate.

The data from Friday, September 5, 2008, says that JNJ could be purchased for $70.67 per share, and that a put option expiring on January 15, 2010 with a strike price of $80.00 could be purchased for $11.50. The total amount invested then to put on this trade would be ($70.67 + $11.50) $82.17 per share. Assuming you get the expected $2.30 in dividends by the expiration date, this trade can only go up. So you won’t lose money, but on the flip side you only profit if the price of JNJ goes over $80.00 before January 15, 2010.

Let’s say you consider buying 100 shares of this trade, which would be an investment of (100 * $82.17) $8,217.00. Then let’s say you look at your money market and notice that it’s paying 3.5% interest.

If you deposited that $8,217.00 in the money market for 496 days (the time to expiration), you would make roughly $390.00 in interest.

Another way to make money if the price of JNJ goes over $80.00 by January 15, 2010 is to buy the call option with that strike and expiration. That call option costs $2.60 per share. The $390 in interest divided by $2.60 means you could buy 150 shares of the call option and be in a similar situation to buying 100 shares of the put and stock combination. That means that if you get lucky and JNJ does go up, then you make more money owning the call option than you do owning the stock and put option.

Tracking results

It was suggested that I start showing some results for the Inflatable Dividends and No Lose Stocks Premium Services in order to market the services better. I have a bit of a moral dilemma on this though.

Here’s my dilemma. I don’t use the Inflatable Dividends service. I did initially, but that investing strategy doesn’t fit my goals any more. It exposes me to more risk than I’m willing to take and it doesn’t guarantee that I won’t suffer large negative changes in my account balances.

I’m only willing to be exposed to a very small fixed amount of risk (like the possibility of a dividend being cut). With Inflatable Dividends, since I first have to buy back the call option before I can sell the stock, it’s possible that the stock price could fall fairly far before I could sell the stock. So Inflatable Dividends doesn’t meet my requirements.

But I also recognize that I shouldn’t make decisions for other people because what I want may not be what they want. So I will continue to provide the Inflatable Dividends service as long as people want to subscribe to it.

However because of my behavioral finance research I’m also aware of people’s confirmation bias. This bias means that we look for information that agrees with our current opinion. The information doesn’t prove we are any more right, but we feel much more right. This is like the black swan problem. No matter how many white swans you see, you can’t prove there are no black swans. But the more white swans that you see, the more you will think that you are right that there are no black swans.

So if I posted trade results for the Inflatable Dividends service, it’s possible that they will be good for a long while, and would lull potential subscribers into a sense of safety and consistency. But it could be a false sense of security. If one bad trade can wipe out all the gains made on the previous good trades, then all those good trades are meaningless.

I have the opposite problem with No Lose Stocks.

I do use this service and it does fit my goals of a specifically limited amount of risk. But it suffers from the opposite problem that Inflatable Dividends has. The No Lose Stocks strategy can look wrong for a long time. It can look like you aren’t making any money because a lot of the time you are just breaking even. Then suddenly one of the stocks you own will pop up on good news and you’ll have a gain. The whole idea of the strategy is to make one-way bets and then wait for luck to strike.

A history of these trades looks like a lot of non-winning trades and then suddenly a win. So a history of the trades would scare off or discourage someone who didn’t understand the strategy because it doesn’t have the flash of lots of winning trades.

Either way I don’t think it would be a net gain to post a history for either service.

How should you invest your 401k?

2008-08-29T21:49:00.001-05:00

Last time I wrote about my dislike of mutual funds as investment vehicles. The problem is that mutual funds are usually the only investment in 401k plans. So should you just avoid investing in a 401k then?

No. The tax benefits of using a 401k are way too good to pass up. The maximum 401k contribution for 2008 is $15,500. If you saved that $15,500 in a savings account instead, and you were in the 25% tax bracket, you’d pay $3875 in taxes, leaving you with just $11,625 in savings. So by depositing that $15,500 into a 401k, thus getting to keep it all, you get an instant, risk-free gain of 33% over what you would have had. If your tax bracket is higher, your risk-free gain is even higher.

That tax gain is over and above any matching your employer gives you, which would just be icing on the cake.

So now the money is in the 401k, but I’ve still said mutual funds are bad, and since that’s the only investment option, what should you do?

An ignored investment option

Mutual funds aren’t exactly the only investment. There’s another one that most financial advisors will frown at and call a “bad idea”. But just like electricity, kitchen knives, and options investing, dangerous tools can still be used safely and profitably if you use them right.

The investment I’m referring to is 401k loans. Most 401k plans allow you to take a loan against your balance. In many cases they allow you to borrow up to 50% of your balance.

You pay interest on the loan at a rate set according to the current interest rates, and you make payments on the loan generally straight out of your paycheck.

Benefits

The foremost benefit is that you can now invest the money that you borrowed in whatever you want.

The second is that you are now paying your 401k interest, so you’re depositing more money than you would have otherwise been able to and that money can grow tax-deferred. Also, you’re usually getting a pretty good interest rate. And because you know the borrower better than anyone, there’s a good deal less risk involved in making the loan (as opposed to loaning money to a company through a bond).

The third benefit would be that if or when you leave your job, you’d be able to roll the 401k into an IRA. IRAs allow you to invest the funds pretty much any way you want (there are a few restrictions), so putting more money into a 401k now in the form of loan interest will give you more money to freely invest later.

Dangers

The one that you should be most aware of is if you leave or lose your job, you usually only have about 30 days to pay the money back to your 401k or you will owe taxes on all of the money. So that means you shouldn’t invest the money in anything where it will be tied up for a long time, or that might fall in value.

Another danger is that you might be required to pay back money faster if the value of your account drops. Remember you are only allowed to borrow 50%, so if you have $20k, and you borrow $10k, leaving the other $10k in your 401k in a mutual fund, and that mutual fund takes a nose dive dropping your account to $5k, you’ll now be borrowing 66%. But since I don’t like mutual funds anyway, that’s not really a problem. Just stick the funds that are still in the 401k into the money market fund in your account. Those funds will earn about 2-3%, which isn’t very high, but there’s no chance they’ll go down in value.

The remaining danger that comes to mind is a willpower weakness. Don’t borrow from your 401k if you are planning to spend the money or you think you might be tempted to spend it. This money is for investing only. Spending the money would be like sticking your tongue in a light socket, or juggling the kitchen knives. It’s not the safe way to use this tool.

Other

Borrowing money from your 401k only really makes sense if you are maxing out your 401k contributions and want to get more money in there to grow tax-deferred, or if you already have a large 401k balance (more than the maximum contribution), and don’t want to invest in mutual funds.

In the last article I asked the question, “If you’re going to dull both [gains and losses by diversifying], why not just avoid investing altogether and just save your way to retirement?”. I was being half serious about just saving. Sometimes just saving and not investing is a good move to make. If you don’t have enough in the 401k for it to make sense to borrow, then I would suggest just leaving all the money in the money market in the 401k. You already received a 33% gain just by making the deposit, so be happy with that and keep feeding the nest egg until it grows big enough to make borrowing make sense.

Something else to note is that the interest you pay on the 401k loan is generally paid with after tax money. This means that you might pay taxes twice on the interest you pay to your 401k. You’ll pay once when you take it out in retirement, and possibly once when you pay it in as interest.

Personally, I have taken a 401k loan and invested the money and then claimed the interest as investment interest on my taxes. I was following the spirit of the law, the interest was an investment expense, but I’m not certain that the IRS will see it the same way. So you may or may not be able claim the interest as a tax deduction. If you’re willing to gamble on paying the fines or your tax advisor says its copasetic, then give it a whirl. But just to be clear, I’m not advising you to claim it on your taxes, just pointing it out as an option.

Perfect investment for a 401k loan

Last weekend, the No Lose Stocks service started taking subscribers. That link explains the service and has the link to subscribe via PayPal.

Since a 401k loan investment needs to be something that doesn’t tie your money up for a long time and that doesn’t have a possibility of falling in value, No Lose Stocks fits the bill perfectly. The put option protects the invested money so that it can’t be worth less than the initial investment, and since the put option can be exercised at any time, it allows you to close out the position at any time and get the money back if you need to quit your job or get fired.

In case you’re interested, here’s the link to the No Lose Stocks spreadsheet for today (Friday, August 29, 2008).

Personally, I like to sort the list by "Percent To Profit" from smallest to largest. "Percent To Profit" is how much the stock has to gain to be above the strike price of the put option. After the list is sorted, I start looking down the list for stocks that are 3-6 months out in their put option expirations, and that aren't in some kind of possible buy out situation. It seems that a stock that is about to be bought out usually has a very low "Percent To Profit" because people don't think it will go higher than the buy out price.

If the service interests you, sign up and try it out. There’s a 6 month free-trial for all subscribers, and if you don’t like it, you can cancel from your PayPal account and don’t even have to contact me.

Why NOT Mutual Funds?

2008-08-24T11:02:00.001-05:00

The conventional wisdom is that mutual funds are the perfect investment for the small investor. The idea being that a small investor can easily buy them, have instant diversification, and have a professional managing their portfolio.

Since I advocate investing in individual stocks and not mutual funds, I figured it would be a good idea for me to lay out my grievances, so you can decide for yourself if you agree with me or not.

Easy to buy

On the first point, I would agree, mutual funds are easy to buy. But that’s not really sufficient for me to endorse them as a good. Lots of things are easy to buy, including individual stocks.

Instant diversification

On the second point, I would tentatively agree, some mutual funds do provide some diversification. But the root assumption is that diversification is good. It does cushion the blow of large losses, but it also lessens the impact of big wins.

For example, let’s say you had $10,000 to invest a year ago, and you decided to ignore diversification and put it all in Fannie Mae. At this point you would have only about $700 left (7%), and would have lost the other $9,300. That’s pretty painful. If you had diversified, and only put 2% of your portfolio ($200) in Fannie Mae, then you would only have lost $186.

On the flip side, if you had invested that 2% in Wal-Mart, which went up about 36% over the last year, you would have a profit of $72 dollars. Not too exciting. But, if you had invested the whole $10,000, then you have $3600 dollars. Way more exciting.

So diversification is really just a way to dull both the gains and the losses. If you’re going to dull both, why not just avoid investing altogether and just save your way to retirement?

Professional management

This is where my biggest objections are.

It’s all luck

An extremely high amount of the results from the markets can be attributed just to luck. I would highly suggest reading Taleb’s “Fooled By Randomness” to get a more in depth description of this, but I’ll give it a shot here.

If a manager has 5 years of good returns, it doesn’t mean he’s actually a good investor. It’s actually more likely that he just happened to be lucky. There’s so many mutual fund managers out there that many of them are likely to have long winning streaks even if they just flipped a coin to decide what stocks to buy.

Let’s say we start with 10,000 mutual fund managers who use each use a coin toss to decide their purchases. Each year there’s a 50% chance they pick a winner and a 50% chance they pick a loser. So the first year, 5,000 pick a winner, and 5,000 pick a loser. The second year, the 2,500 of those who picked a winner pick another winner, and 2,500 pick a loser. The third year, 1,250 pick winners, then the fourth year 625, and finally the fifth year 312 mutual fund managers have managed to pick winners 5 years in a row, just by chance.

That doesn’t mean that none of the managers have any talent at picking stocks, but it does mean that it’s extremely difficult to tell which ones do have talent and which ones are just on a lucky streak. And it also means that even the ones that do have talent could hit an unlucky streak and not have a good record.

So it’s almost impossible to tell who is a good manager and who is not, and given how much luck affects their performance, it may not even matter.

Conflicting incentives

Mutual funds make money by taking a small percentage of the money that they have under management. These are the fund fees. If a mutual fund does well one year, more investors will give them money because those investors think that means the mutual fund manager knows something (rather than that the mutual fund manager was just lucky).

The more money that a fund manager has to manage the harder it is for him to find good places to invest it. So if a manager only has a few really good ideas, but 10 times the amount of money that he can invest in those ideas, then the other 90% of the money is going to be invested in something less well performing.

So we’ll get the same effect that we saw above with diversification. Even if the manager can make a 50% profit on those good ideas, that’s still only a 5% benefit to each of the investors since that 50% profit is spread over 10 times the money.

So if the manager thinks he can make a 50% profit on only one tenth of the money, then why doesn’t he only take one tenth of the money and reject the other 90%?

The reason is that it doesn’t make sense for him. Since the manager gets paid a percentage of the money he manages, he can get a 900% raise by taking 10 times the money that he can invest well. So there’s no incentive for the manager to stop taking money when he has more than he can profitably manage.

No control

Another objection I have is the lack of control. You can’t control when stocks are bought or sold, and so the tax bills for those buys and sells are going to come whether you wanted them or not. The same for the transaction costs. You’re going to pay the transaction costs whether you think the buying and selling was a good idea or not.

Secrecy

It would be a bad idea for mutual funds to tell everyone what they were buying. If they told everyone they thought a stock was a good buy, then everyone would buy it in anticipation of the mutual fund buying the stock and push the price up.

But since they can’t tell everyone what stocks they are buying, you as the investor in the mutual fund don’t know what is being bought. This actually leads to at least two problems.

The first is that you could be more exposed to a particular stock than you wanted to be. Let’s say you own two mutual funds and both of them think that Google would be a good investment. If they both buy Google, and Google goes down, then you just took twice the damage you were expecting to take from exposure to Google. This is actually one of the dangers of expecting mutual funds to give you instant diversification. In some cases they can hide how not diversified you are.

The second problem is that mutual funds can try to cover their mistakes. Mutual funds do report their holdings, but not frequently. So if a mutual fund knows they have to report their holdings, they can sell any stocks they own that performed badly, and buy the ones that did well. This makes it look like they may have been holding the good stocks all along. However it also means that you the investor had to pay the transaction costs, and now you’re invested in what was the hot stock over the last year. Which means you’ve probably missed all of the upside and now you might be in for a downside slide.

This article on mutual fund window dressing goes into a little more detail.

Paying for what you already have

Since there is so much luck involved in investing, you pretty much already have an equal or better chance to do what the mutual fund manager is doing. And since you likely have a lot less money to manage, you can look for much smaller opportunities to invest in than the large funds could. And of course by investing for yourself, you avoid the fees that the mutual fund would have charged you in the first place.

Doing nothing would be better

I’ve read it quoted in many places that 9 out of 10 mutual fund managers don’t beat the benchmark they are measured against. The benchmark is usually an index fund of some kind. This means that you can beat 90% of the mutual fund managers just by buying an index fund instead of an actively managed fund. And since the index fund doesn’t need a manager, it usually has much lower fees too. Given how much luck can affect a manager’s performance, what are the chances that you could pick the 1 in 10 that is going to do better than the index fund?

My only real objection to index funds is that I don’t like riding down with the rest of the market. I don’t like exposing that much of my portfolio to downside risk because of how painful losses are and how much effort it takes to get back to zero. That’s my main reason for looking at strategies like the No Lose Strategy.

Conclusion

Managed mutual funds are about the worst investment you could make because the incentives are wrong, and there’s way too much luck involved to know what’s really going on. Index funds are definitely better than managed mutual funds, but that doesn’t make them good enough. In the end, I’d avoid funds altogether and stick with individual stocks and options, and make the effort to avoid taking losses as well.

What is a put option?

2008-08-17T20:57:00.002-05:00

A couple of weeks ago, I wrote about a strategy for investing with no losses. Part of the strategy requires buying a put option. When it came to the part of the article where I might have explained what a put option is, I said:

“If you’re not familiar with put options, I encourage you to invest some time in understanding them. I promise that investment of time will be a no loss investment as well.”

That was mainly an attempt at keeping the article short, and an attempt at leveraging the rest of the Internet where other people have already explained put options. However, I’ve had many people tell me that options are just too complicated for them.

What that means to me is that the explanations these people have received so far are just not good enough. So I’ll see if I can do any better. (And if I don’t, let me know. If you do not understand the explanation, I’m just not explaining it well enough because options are not that difficult.)

I’m going to explain put options from the perspective of the No Loss Strategy. [1]

Purpose

Sometimes it’s easier to describe something by what its purpose is, rather than by describing it directly. If I told you something has 4 wheels, a steering wheel, and a gas tank, you might guess that I was describing a car. But if I instead told you its purpose is to cut grass, you’d be pretty sure I was talking about a lawnmower.

So the purpose of buying a put option is to protect your investment. If the price of your stock on the market goes down but you own a put option on the stock, the put option is a guarantee that there is someone that will buy that stock from you for a higher price. This means that even if the stock goes down, you don’t lose money. Keep that purpose in mind as we go through the definition.

Definition

Investopedia’s definition of a put option is:

“An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time.”

This definition can be found in most textbooks, which doesn’t say anything about its helpfulness. I understand it now, but if I didn’t already know what a put option was, I don’t think I would. So let’s break it down and see if we can make some sense out of it.

“…option contract…”

So when you buy an option, you are making a contract with someone else. A contract is just an agreement. So you’re making an agreement with someone else.

This is not that unusual. When you buy something you are making an agreement that you will give the seller the money, and the seller will give you the thing. Another contract might be when you pay for insurance and the insurance company agrees to cover you for the next month. Or when you buy an extended warranty and the warranty company agrees to repair or replace your item for the next year.

“…the right, but not the obligation…”

This is a convoluted way of saying that the person who pays the money gets to decide if they want to use the service they paid for. If you bought a ticket to a baseball game, but then weren’t feeling well on the night of the game, it’s your choice if you go or don’t go. The ticket seller can’t force you to go. So when you buy an option, the person you buy it from is waiting for you to decide if you want to use what you bought or not.

If you do decide to use it, that’s called exercising the option, exactly the same idea as exercising a right, like exercising your 1st Amendment rights.

“…to sell…”

So buying a put option gives you the choice of whether or not to sell your stock. But you always have that choice. The difference here is that the person that sold the put option in the first place is required to buy your stock when you want to sell.

“…to sell a specified amount of an underlying security…”

Underlying security just means a stock. So it means, “to sell a specified amount of stock”. The specified amount is how many contracts you bought.

Options come in contracts, like eggs come in dozens. A contract is a fancy way of saying a “block of 100 shares”. So if you buy one put option contract, then you have bought a warranty on 100 shares of stock. If you buy two contracts, then it’s 200 shares of stock. [2]

“…to sell…at a specified price…”

So the other side is agreeing to buy your stock for a specific price, which you decide at the time that you buy the put option. This specified price is called the strike price.

“…to sell…within a specified time”

So the other side is agreeing to buy your stock for a specific amount of time, which again, you decide at the time that you buy the put option. This specified time is the time until the expiration date. The expiration date is the same day of each month for all options.

Example

Now let’s put that all together in an example and see if it makes sense.

Let’s say you buy 200 shares of Johnson and Johnson (JNJ) for $71.33 per share. But you realize that there is always a possibility that a stock will fall in price. So you want to protect against your investment falling in value. So you buy a put option.

You decide to buy 2 contracts, since you want to protect all 200 shares. If you bought only 1 contract, then you’d only be protecting 100 shares of your stock and the other 100 shares have the potential to fall all the way to zero.

You decide that you want to protect the stock for at least the rest of the year. So you go take a look at the options for sale. There are contracts for sale on JNJ that expire in September 2008, October 2008, January 2009, and January 2010. The best fit for the time frame you want is the January 2009 options.

Now you need to pick a strike price. The price that you want to be able to sell the stock at no matter what it’s worth on the market. The amount of insurance you want. The available strike prices for sale are $40, $50, $55, $60, $65, $70, $75, $80, $85, $90, $95, and $100.

If you pick a strike price of $40, you’ll only be protecting $40 of the $71.33. If you pick a strike price of $100, you’ll be paying for way more protection than you need. So ideally for this strategy you want to pick something closer to the price you paid, but still high enough to protect your entire investment.

The strike price of $75 costs $5.30. So if the stock drops in price, and you exercised the option, you get paid the $75 for the stock, and paid out $5.30 for the option and $71.33 for the stock originally. You would have a net loss of ($75 - $5.30 - $71.33 =) -$1.63 per share. That’s still not a complete protection from losses.

So let’s move up one strike price to $80. The cost of this option is $9.30. So if you own this put option and the stock drops in price, then you would have a net loss of ($80 - $9.30 - $71.33 =) -$0.63 per share.

But we’re forgetting the two dividends that JNJ will likely pay out between now and January 2008. One is expect on 8/22/2008 and if history repeats, then the other is expected around 11/24/2008. And the dividend amounts will probably be about $0.46 per share. So if you add the two dividends to the expected net loss, you get a net gain of (-$0.63 + $0.46 + $0.46 =) $0.29 per share.

So the worst-case scenario is you make a gain of $0.29 per share.

Summing up

So that’s it.

- You choose the stock you want to protect.
- You choose how many shares you want to protect.
- You choose the expiration date.
- And you choose the strike price.

If you’re interested in the No Loss Strategy or you have any questions about it, feel free to send me an email at contact@dividendium.com.

[1] There are other ways to use put options for investing or speculation, and I may come back and explain those in the future if it seems like there’s some interest.

[2] There are some option contracts that are “non-standard” and are not 100 shares. You should check with your broker if you aren’t sure if the contract you want to buy is standard.

Book Review: "Happiness: The Science behind your smile"

2008-08-10T10:23:00.002-05:00

I just finished what will probably be the last book I read on the subject of happiness. It was a thorough treatment of the subject and wrapped all the ideas in to a package that made sense to me. The book was “Happiness: The Science behind your smile”, by Daniel Nettle. However I’m not necessarily recommending you read the book because I recommended it to my wife and she found it agonizingly boring and “happily” decided not to finish it.

So here’s my disclaimer, if you don’t care about the results of studies, don’t want to see graphs or charts, and just want to know the conclusions, then this review should be perfect. Otherwise grab a copy from the library and dig in.

The book focuses on the topic of happiness from the perspective of feeling good, contented, and satisfied. The bases of the observations and arguments are scientific. There was a head nod to the idea of happiness as fulfilling one’s potential, but not much more since that is more of a philosophical or moral judgment.

Evolutionary psychology

The touchstone for the book is evolutionary psychology. Most of the findings and results of the studies discussed are checked against this theme to see if they make sense in the larger picture.

Evolutionary psychology looks at the brain in light of the problems it was formed to solve. The brain hasn’t changed that much from the brain of our ancestors, and the main problem it evolved to solve was how to avoid being eaten long enough to mate and produce offspring.

A crucial point of the book that flows from this is that if our brains evolved to primarily keep us alive, and not specifically to keep us as happy as possible, we may need to manage them some to be happy rather than to just stay alive. Our brains may actually try to trick us at points to try to help keep us alive, assuming that “miserable and mating” is better than “happy but dead”. [1]

Long-term vs. short-term

The brain has to balance the long-term goals against the short-term goals. In doing so the short-term goals of staying alive and avoiding danger are given preference. So he explains that negative feelings, such as fear and worry, don’t die off and can actually trigger more feelings of fear and worry.

If you’re worried about a specific social faux pas you made, you might lay awake that night and turn that into a worry that no one likes you. I think the idea here is that the brain wants to keep you alive to mate, and so from it’s perspective, better safe than sorry. If you have to worry a little more than needed, but that keeps you out of danger, the brain has done its job even if that keeps you from being happy.

The opposite side of this is the positive or good feelings like pleasure from getting a raise, eating, sex, and so on. These feelings tend to wear off a short while after the appetite has been satisfied. This is so that we will go on to do the other things we need to do. If sex felt so good that you never wanted to do anything else, eventually you would starve to death.

So in the battle of joy versus fear, joy will die off to let us do other things, but fear will hang around to make sure we keep running just in case something is still chasing us.

Tricky brain

So if our brain is willing to let us be tricked into being more fearful than we need to be. How else is it willing to trick us?

One of the most interesting parts of the book for me was the discussion of wanting versus liking. Our brain tells us that we want something like a raise, or an increase in living standards, and that thing does make us happier when we get it. But the happiness is extremely short-lived, like on the order of a few weeks to a few months. So you strive to get a raise all year long, and then when you do get it, you are only happier for a few weeks.

He goes into great detail about how we would have evolved brain mechanisms that would continually trick us into striving to do better because our ancestors that did better were the ones that survived to mate and produce us. Which means that we are programmed to want more and more stuff, even if we don't need that stuff. And no matter how much we get, we always want just a little more because if we were ever satisfied for too long we would stop striving.

So he spends a lot of time talking about adaptation. The idea that we are happy that we got something (new toy, new raise, etc.), but only for a very short time before we start wanting a new thing or more of that thing than we have. This is the same idea above with wanting versus liking. You keep wanting these things, but you won't actually like them when you get them. But you'll still want more even though you don't really like it.

He also mentions a few other ways that our brains trick us.

Framing is the idea that our most recent thoughts are going to color how we feel about our entire life. So if we are asked about how happy our entire lives have been on a gloomy day then we would be more likely to give a lower happiness rating. But the thought is really used as a comparison point. So if you were asked to think of a time in the distant past when something bad happened to you, and then asked how happy your life is, you would rate it higher because life has gotten better than that bad thing way in the past.

Relative fitness is the idea that the best way for our ancestors to tell if they were doing well was to be better than the people around them. At the time we lived in small tribes and were not exposed to the best of everything like we are now through the news. So it was a good solution to the problem. Now however we always feel like we need to push harder to get more to “keep up with the Joneses” to maintain our relative fitness.

The endowment effect is the idea that we think it would be hard to get along without something, but we don’t remember that we did just fine without it before. Because of this effect, losing something you had can be worse than never having had that thing at all.

Another was how we remember and compare experiences. When judging if an experience in the past was good we mainly consider two factors. How good or bad the peak was, and how good or bad the end was. One experiment that demonstrated this was one where in the first trial participants were asked to hold their hand in 14 degree water for 60 seconds. Then in the second trial they were asked to hold their hand in 14 degree water for 60 seconds, and then the water was warmed up to 15 degrees for an additional 30 seconds. When asked which one they preferred to repeat, the majority chose the second trial, the one that lasted 90 seconds instead of 60 seconds because they said it didn’t hurt as much, even though they had the same 60 seconds of 14 degree water exposure. So duration doesn’t actually matter, only the peak and the end.

Happiness Set Point

According to the studies cited if you want to find out how happy someone will be in the future, the best predictor is how happy that person is today. This implies that we have a genetically set default level of happiness. However our current happiness level can be skewed above or below that default level.

So the first goal would be to get back to that default level.

Getting back to neutral

There are a few things that if we lack, we will be less happy than we otherwise could be. According to this book those are:
- health
- autonomy
- social embededness
- quality of environment

Health is an obvious one. If you don’t feel well, you likely aren’t going to be very happy.

Autonomy is something that I’ve talked about before in the article on maintaining control of your life. Evidently people don’t like being told what to do.

Social embededness is the idea that we like being part of a community. We were originally part of small tribes so not being part of those communities can be stressful. We need friends and communities to ease that stress.

Quality of environment refers to external stimuli that might be threatening. Noise, chronic cold, and food shortages for example are all things that we don’t adapt to. Our brains continually tell us that these mean danger and that we need to correct the problem or run away. So again we are looking at stress.

Another one to note here would be that bad feelings like fear and worry create more bad feelings. One way he discussed of breaking that downward spiraling snowball effect is to practice Cognitive Behavioral Therapy. This is basically the practice of using logic to refute the irrational and exaggerated thoughts that lead from “I shouldn’t have said that” to “Everyone is going hate me forever”.

Once you’ve removed all the hindrances to your default happiness level, it might make sense to try to keep from falling back below it.

Building defenses

There are a number of things that you can do to help protect against those downward mental spirals and keep your level of happiness resilient.

One is to have more social definitions or roles for yourself. Most people have a definition of themselves as an employee. But if you have a setback at work, then your only definition is threatened and you have no other definitions to fall back on to support your confidence. So it was suggested that you have many different definitions for yourself by doing more things like hobbies or community organizations. Some of these roles might be employee, coach, writer, husband, father, volunteer, mentor, cook, surfer, softball player, a religion member, and so on. The idea is to provide a broader context to refute the bad thoughts your mind starts generating from that one setback in that one area..

Another defense is to connect to things. Some examples were communing with nature, connecting through religion, belonging to community organizations, doing volunteer work, and having rich/deep social connections. The idea here is to give yourself again another role, but also to give you a connection to the world and make you less likely to want to voluntarily leave it. The stat he quoted was that 1 in 10 people contemplate suicide at one time or another.

Another suggested defense is mindfulness meditation. The idea here is to detach you from the bad thoughts and help you realize bad thoughts are transient and will pass. This keeps you from spiraling down until the thoughts go away or the external stimulus causing the thoughts goes away.

An alternative to meditation would be writing like journaling or keeping a diary. The idea here is to put distance between the feelings and you, which allows you to reflect on them and again realize that they are not as big as your brain makes them out to be.

Reaching a little further

So now that we are at neutral and relatively stable there, we can start thinking about how to push just a little higher.

I’ve already mentioned that good feelings will wear off after a while even if you keep doing whatever it was that brought the good feeling. And I’ve mentioned framing, which is the idea that we compare our lives against our most recent memories. So keeping those two things in mind, one strategy is to do things that bring us joy more often. The joy will wear off but if we do the things often, then on average we can raise our happiness level. And in doing them often, we will always have a recent example to frame against so we will feel like our life is happier too.

You can keep a journal and try to figure out those things that make you happy and do them more often, but he suggests that the things that most people find joyful include, interactions with friends, food, drink, sex, success in some domain, sports, cultural activities, going out, and visiting new places.

He points out that some people don’t realize they would like these things and actually need to make themselves do them. Ideally forming habits around them to make it more likely that you would do the act and bump your happiness level up.

He also points out that you should distract yourself from trying to seek happiness. It's something that will creep up on you when you aren't pursuing it directly. Constantly worrying about if you are happy or not will actually take away from being happy.

And lastly, I mention this just because it was mentioned in the book; he notes that studies show there does seem to be a lasting increase in satisfaction from breast surgery. I have a hard time believing this, as it seems to me that a person would just find something else to obsess about. Similar to how we always want just a little bit more income than we currently have.

Correlations with happiness

There were a few things that were correlated to happiness, but he didn’t argue causation. Meaning that the two things seemed to be related, but it wasn’t clear if one caused the other or if there was a third thing that affected them both.

Health and longevity were correlated with happiness. He hints that there might be a causation in that higher happiness leads to a longer life, but above he noted that poor health leads to lower happiness, so there may be more interrelation there than just one causing the other.

Higher social class, but not income, was correlated with happiness. And when you control for higher social class, personal control is highly correlated with happiness. So evidently if you want to be happier just maintain more control over your life.

Conclusions

According to the findings discussed in this book, to reach their potential happiness, people should work part-time, take on hobbies, control their own lives, join community organizations, and get involved in active leisure like sports.

The working part-time comes from the idea that you won’t actually like the amount of stuff that you want, and that the stuff will not make you any happier for an extended period. So if you don’t need the stuff, you don’t need the income to get the stuff, and can work less time. Which is important because you need that extra time to concentrate on spending time with friends, your hobbies, community organizations, and active leisure commitments, all of which do affect your happiness.

As far as vacations go, since we only consider the peak and the end, and not the duration, you might shoot for short, intensely enjoyable vacations that end with a bang. They’ll be cheaper since they are shorter, and you’ll have just as fond memories of them afterward.

In light of our tendency to continually try to out do our neighbors; it might make sense to move to an area where you are already better off than the neighbors. So instead of stretching to barely afford the swanky house in the up scale neighborhood, you save the difference and buy the nicest house in the blue-collar neighborhood.

Another implication is that we should avoid the news. The news exposes us to the best of everything, the prettiest people, the most talented, and the richest, so we are continually being reminded that we are not the top dogs, which is a stressor because of the effect of relative fitness. Better to avoid this and spend the time on things we do enjoy. A further point about the news is that it also serves to exaggerate our fears of the world since the worst things are also thrown in our faces.

So the idea is to live more simply and to voluntarily take ourselves out of the competition. We should realize that we already have more things than we need and stop pursuing more stuff. The extra stuff is actually dragging us down in terms of money costs and psychological costs. Think about how much maintenance you have to do on the stuff you already own, like cleaning a large house, paying insurance on it, paying electricity, etc. This introduces more stressors, which will push us below our happiness set point.

Finally, we will always think we can be happier than we are now because this is how evolution keeps us striving. But above neutral and below max is probably as good as it gets. So if we’re already above neutral, we should stop worrying about being happy, and just sit back and enjoy being happy.

[1] That our brains may intentionally try to trick us was a key theme in the book “Stumbling on Happiness” from a previous article.

How can we invest while avoiding losses?

2008-08-03T01:15:00.000-05:00

The short answer is we get someone else to take the risk, while we keep most of the gain.

The long answer

We want to expose ourselves to the positive side of luck, and shun the negative side. If a stock goes up, we want to be right there riding it up, but if it goes down, we’ll get off and let someone else take that part of the trip. But we need someone to agree to take our place before the stock starts going down, because no one is going to agree after it goes down.

The way to do this is with put options. If you’re not familiar with put options, I encourage you to invest some time in understanding them. I promise that investment of time will be a no loss investment as well.

The no loss strategy

In a nutshell, the strategy is to buy a stock, and a put on that stock with a strike price near the current price. The put will protect our investment value from going down, and we’ll be able to wait until the expiration date to see if luck happens to take our stock up and hand us a profit.

Since we had to pay for the put, this strategy will often end up in a net loss if the stock does go down. But we don’t want to take any losses. So lets switch out the stock for a dividend stock, and have the dividends on the stock pay for the put and cover any gap between the strike price and the current price.

A stock that can pay for its own put with its dividend isn’t too easy to find. It’s kind of like looking for a needle in a haystack. But assuming we could find these stocks, let’s look at the benefits of this strategy.

Benefits of put protected stocks

So assuming we can find one of these dividend stocks that can pay for it’s own puts, we now have a one way position. We are fully exposed to positive surprises like new products, high priced buyout offers, good earnings surprises, etc. And protected from negative surprises like scandals, lawsuits, bad earnings surprises, etc.

We’re also protected from inflation in a way. If prices in general are rising because of inflation, then the price of the stock that we own will also increase. So inflation is actually working for us in this case.

Lastly if an investor is willing to sell a cheap put on a stock, one that can be covered by that stock’s dividend, then that investor is indicating that they think the stock will not go down. And since no one else is buying that put at this cheap price, they don’t think it will go down either. So we get a nice little boost in that the market seems to think that the stock we are buying is not going to go down. And as the market turns around and investors gain confidence, more and more of these opportunities will become available.

Risks

It’s always good to know the risks of an investing strategy, no matter how remote they are. So let’s go through those and see what we can do to hedge against them.

One risk is that the dividend could be reduced after we buy. If the dividend were reduced before the expiration date of the put, then we would end up paying for the put protection out of pocket rather than with the dividend.

To hedge against this risk we can concentrate on stocks with long histories of paying dividends and generally stay away from high dividends that look like they are about to be cut.

Another hedge would be to look for put options with shorter expiration dates, as those put options will be cheaper and not so painful to pay for out of pocket. But we don’t want to go too short on the expiration or we’ll be paying too much in transaction fees.

Another risk is time risk. Consider the situation where we buy a stock and put combo that has an expiration date a year in the future, and then the stock drops 50% the next day because of some scandal, and it’s pretty clear the stock is not coming back any time soon. We would still have to hold on to the stock for the rest of the year to collect the dividends to pay us back for the put. That means that all the money in that stock is basically tied up for a year and not earning anything. Again the solution here is to go for the shorter-term expiration dates.

Another risk is not being diversified enough. We are basically fishing for luck here. We have a nearly zero risk of losing money, but most of the upside. So if we put all our money in one stock, and that’s the one stock that doesn’t go up, then we’ve missed out on the opportunity to make some gains. So we want to try to spread our bets on multiple different stocks. Since put options can only be bought in contracts of 100, you’re probably going to be buying stock and options in groups of 100 shares. So that’s probably a good amount to stick on each stock. Although if you just happen to have a feeling that a particular stock is going to rocket up, there’s nothing to keep you from putting all your money on that one and protecting the downside with this strategy.

Lastly there is the systemic risk. It’s extremely unlikely, but possible that the whole financial system could crash and that the exchange that guarantees the options would not be able to cover the options in the event that the original seller is bankrupt. If this really happened, we’ve all got much bigger problems, so it’s not really something to worry about, but it is there so I mentioned it to be thorough.

Get a magnet

So we’ve got the strategy, we know the benefits, and we know the dangers. The only thing left is to figure out a way to pull those needles out of the haystack. Best way I can think of is to use a magnet. Turns out I just happen to have written one.

I recently finished writing some code to sift through the haystack of stocks and pluck out those specific needles that match this strategy. However right now the output is just a spreadsheet. And it takes a fair amount of work to go from just a spreadsheet to a full-blown subscription service. Before I go through all that work, I’d like to know if anyone is actually interested in this service (other than me).

If you are interested please let me know by emailing me at contact@dividendium.com. And if you could, please specify answers to the following questions:

1) Does it matter if the service is displayed in a web page, or is a downloadable spreadsheet just fine?
2) What would you expect to pay for this subscription service?
3) How often would you want the spreadsheet updated? Nightly, weekly, monthly?
4) Do you want to be notified via this email address when the service starts taking subscribers?

I’m also looking for a few readers that are willing to help me refine this service. These readers would need to understand the intent of the strategy and be able to make suggestions for improvements. For example, if there is a specific piece of data that would be helpful, but is not currently being captured, you would send me an email request to add that data. If that sounds interesting to you, please mention it when you email the answers to the above questions.

Lastly, here’s an example from the most recent output.

Example

Stock: SO
Stock Price: $34.59
Annual Dividend Yield: 4.86%

Option: SOWH
Option Ask: $5.80
Option Strike: $40.00
Option Expiration: 11/21/2008

Dividends Expected By Expiration: $0.42
Minimum Profit: ($40.00 + $0.42 - $34.59 - $5.80) $0.03
Max Loss Without Dividend: ($40.00 -$34.59 - $5.80) $-0.39
Percent Gain Needed For Profit: ($40.00 / $34.59 - 1) 15.6%

How long until you don't have to work?

2008-07-26T10:26:00.001-05:00

Usually the answer to this question is stated as "until your investment income exceeds your expenses". That form of the answer makes me a little uncomfortable. It doesn't really highlight the most lucrative place to make changes if not needing to work is your goal. I much prefer the answer "until your expenses are less than your investment income" because it highlights the fact that it’s your expenses that are keeping you from being financially independent. If you had zero expenses, then you wouldn’t need any income at all to maintain your standard of living and you’d already be financially independent.

Not needing to work to maintain your current standard of living is what I mean by the phrase financially independent.

Lately, I've been talking about happiness and how money is not really the answer. True, money can alleviate some unhappiness, but that really only happens up to the point where you have food and safety. Beyond that point money only provides increases in our standards of living, which we quickly get used to and soon return to our set point of happiness (although now dependent on and expecting the new standard of living). So as I suggested in the last article on maintaining control of your life, one very effective method to maintain control and happiness is to reduce your expenses.

But words only go so far and without numbers, they are only opinions. So lets get into some examples and see what we can find out.

Running the numbers

First let's look at how long it would take a minimum wage earner (MWE) to become financially independent. In the article on who should be saving and investing, I laid out some expenses and income numbers for the MWE. Recapping the pertinent numbers, the MWE has $10,300 in gross annual income, $5,784 in annual expenses, and $9,012.50 in after tax income. So each year, after paying expenses, the MWE has the remaining $3,228.50 left as savings [1]. That's a savings rate of 31.3%.

If we assume that the MWE can match the market, and generate 6% returns, and that inflation is 2%, then we can plot out a spreadsheet to show how long until the MWE makes it to financial independence. It turns out the MWE has to work 36 years to meet his current level of living standards. So if the MWE starts working at 18 right out of high school and never increases in skill to make any more money than the minimum wage at the time of that original article ($5.15), the MWE can stop working at 54 [2].

If you play with the numbers some more, it turns out that the amount of time it takes to get to where you can maintain a given living standard without working is a function of the savings rate. Someone who makes $100k per year and saves 50% of their income is going to be able to cover their expenses with their investments in the same amount of time as someone with $50k that saves 50% of their income. The $100k earner will be able to spend $50k (of today's dollars), and the $50k earner will be able to spend $25k (of today's dollars), but both will be used to living on that and will not need to have a job to cover their expenses.

Incidentally, the number of years to cover your expenses at a 50% savings rate is 20. So start working at 22 right out of college, save 50% of your income every year, and you'll be able to stop working at 42 and maintain the same relative standard of living the entire time.

To calculate the savings rate, I’m taking the amount deposited into savings for the year divided by the gross income for the year. Gross income is the amount you get paid over the entire year before any taxes are taken out.

I’m assuming that anything that didn’t go into savings was spent on some kind of consumption and is in some way supporting your standard of living. So this is a conservative estimate, meaning that you might get there faster. For example, in retirement, you might have lower taxes on your income since currently investment income is taxed at a lower rate than earned income, and you wouldn’t be paying employment taxes like FICA on that income.

Here's a rundown of the savings rates and the years to be financially independent:

So what is cable really costing you?

Now that we have that continuous graph, we can find our own savings rate and get a conservative estimate of how many years it will take us at that rate to be financially independent. We can also look at what changes in our spending can do to shorten the time to when we are financially independent.

So let’s say you look at your cable bill and figure out that you pay $100/month for cable. That's $1200/year. Let’s also say that your income is $50k/year, and you're currently saving 10% of your income, or $5k/year. Remember at 10% you have to work and save 61 years to match your relative standard of living.

So if you stopped paying for cable and started saving that $1200/year, you'd now be saving ($5000 + $1200) $6.2k/year total. So your savings rate is now 12.4%. The number of years to match your spending at 12.4% from the graph is 56. So if you're only saving 10% now, and you can drop cable and save that money instead, it's going to save you 5 years of working.

It’s important to note that only the person saving only 10% per year is going to see a 5-year benefit from dropping cable. And the reason is because that person is already saving so little. Even small changes in savings will make large differences to this person. But if you're making $50k and saving 50%, or $25k/year, then an extra $1200/year is only going to shave 2 years of working, 18 years instead of 20 years. Maybe you're willing to work a couple more years to watch The Daily Show? Maybe you’re not. But the point is you can now figure out how many years a monthly expense is really costing you and determine if it’s really worth those extra years of work.

Does it make sense to work harder?

So you can see that someone who's a diligent saver gains less from cutting expenses than someone who is less diligent of a saver. But let’s take a look at what the diligent saver might get from working harder and adding some extra income. If you're the 50% guy, and you add an extra $10k of income (without adding any new expenditures), your new savings rate would be 58.3%. So instead of the 20 years, you'll be able to quit working after 16 years, or 4 years earlier. Assuming you started at 22, that’d be financial independence by 38. Again, maybe that’s worth the extra work, and maybe it’s not. That’s a decision for you to make, but consider taking a dry run at it to make sure it’s worth the extra work.

Forward looking statements

Now there are lots of caveats here and we can only make guesses about the future, so all of this is subject to those limitations.

For example, the above assumes that when you do quit working that you will have the same level of expenses as when you were working. That may not be the case for you. Maybe you expect your kids to be living on their own at that point. Maybe you will have paid off your mortgage and only owe taxes and insurance each year. Maybe you don't have to maintain a work wardrobe and can wear Bermuda shorts, sandals, and Hawaiian shirts all the time. Maybe you don't buy lunches out any more. But consider that you'll also have extra expenses, like needing to maintain your own health insurance.

Or you may plan to move to somewhere much less expensive than your working environment. If that's the case, again I encourage you to do a dry run now. You don't want to save less now assuming you'll be happy living some where cheaper, and then find out you were wrong, but don't have the money to live where you wanted to.

A few times in this article I referred to maintaining your “relative” standard of living. What I mean by this is your standard of living relative to the rest of society. The benefits and opportunities that a middle class family has now were not even available to the richest families even 50 years ago. And it can be inferred that as time passes more advances will be made.

But if the benefits and opportunities currently available are good enough and you don’t feel a need to increase with the times, you might be able to be financially independent even faster. You would be trying to maintain an “absolute” standard of living, rather than a “relative” one. So you could probably ignore the affects of inflation on the amount that you needed to spend to maintain your standard of living, but still benefit from the affects of inflation on your income [2].

Consider though that you will be like the older person now that doesn’t have or want a microwave, a computer, a cell phone, cable, Internet access, or any of the other advances that have been made in the last 50 years. It’s certainly possible to live without these things, but you need to know yourself and whether or not you can handle seeing other people having these things and you not being able to afford them. If medical science comes up with a procedure to reverse the aging process are you going to be happy continuing to age while everyone else stops aging?

Also when playing with the numbers, don't get fancy with the earnings percentage. 6% is about the most that you should expect to make long-term. You don't want to be stretching to make more gains on your money when investment income is the only income you have. That will just lead to taking risks that are less likely to pan out and more like to end up with you poorer, and possibly having to go back to work.

And lastly, the calculations above assume that you have zero savings to start with. If you have more than zero, then you'll want to add that in to your own spreadsheet to see where you stand.

Summing up

So if you're considering adding a new monthly expense, like a mortgage payment, car payment, or some other loan or service payment, take a few minutes to figure out how many more years of work you'll have to endure to fund that new expense. Is it really worth it?

[1] The MWE would have about 10% more savings if they were saving the money in an IRA, but I'm going to ignore that option to keep it simple.

[2] In the calculations above I'm assuming you'll get regular cost of living (inflation) increases in your income and will continue to save the same percentage of that new pay level.

Are you smarter than a raccoon?

2008-07-18T22:04:00.001-05:00

A book I read in the third grade had an interesting description of a raccoon trap [1]. It consisted of a hole just large enough for a raccoon to pass an empty paw through, and something shiny at the bottom of the hole. When the raccoon sticks its paw in and grabs the shiny object, its paw is now too large to fit back out through the hole. But the raccoon doesn’t want to let the shiny object go, and so the raccoon is stuck, trapped by its own desires.

If you’re feeling sorry for the little critter at this point, consider that you might be in a frighteningly similar situation. In the last article on happiness, I suggested looking at creating a happiness plan and trying it out for a year to see if it’s actually something you want to do. The idea being that you’re spending all this time and effort trying to attain the dream of early retirement or a bigger house or more stuff, but you don’t really know if any of that will actually make you happier.

If you balked at the idea of taking a year off or thought it ridiculous, take a step back and think about why you had that reaction. Is it because you fear leaving your current job would mean a painful reduction in your standard of living? If that’s the case, consider that this fear is an indicator that your current level of happiness might already be in danger.

Jealously guard control

Maintaining control over our own lives is one of the ways we can protect our happiness. When we feel out of control we suffer helplessness. Helplessness is one of the least bearable feelings and causes physical and mental distress. And if we feel helpless for long enough, we simply give up and stop trying. We become depressed, and stop even looking for ways to make it better. So if we want to maintain and increase our happiness level, we must maintain control over our lives.

Reduce your “standard of living risk” and be happier

Two of the most important places to maintain control are in our standard of living and our job. Interestingly the two are closely related, and gaining control over one, will provide greater control over the other.

“Standard of living risk” is the likelihood that we won’t be able to maintain control over our standard of living. Since our standard of living is funded by our income, and higher incomes are harder to get, more expensive living standards have a higher standard of living risk. That is, we are more likely to suffer an involuntary lowering of our standard of living if our standard of living is expensive.

So in order to avoid suffering an involuntary lowering of our standard of living we can voluntarily reduce our standard of living risk by choosing to have a less expensive standard of living. Even if we can currently afford a more expensive standard of living we would choose to maintain a more modest one.

So instead of buying a huge new house in a new neighborhood with a massive mortgage payment, we would choose one in a less swanky neighborhood, or we skip the house altogether and go for an apartment. And instead of buying a new car, and maintaining a car payment, we buy an older car for cash. And we make do with one TV and no cable. And the kids share a bedroom. And so on.

The idea here is lower our standard of living to the point where we know we can keep it constant at that level, and in that manner to keep control over our life.

It may seem counterintuitive to try to be happier by lowering our living standards, but consider that studies show that we feel a loss more than twice as keenly as we feel a gain. So in order to preserve our happiness, we should be more mindful of preventing losses than seeking gains.

Also consider that we adapt to a new level of living standards and return to our set point happiness, but it does take a little time before that happens. So if our living standards are constantly being taken up and then brought back down, we don’t have a chance to get used to them and our happiness level is always less than it could be if our living standards were constant.

And finally, with a lower living standard there is less financial worry. If we don’t have bills to pay, or we can easily afford to pay them all, then we won’t have worry. And avoiding worry will increase most people’s happiness all on it’s own.

So as odd as it may sound, we would actually be happier at a lower standard of living if that standard of living was constant.

Hold the line with slack

So how do we provide a constant standard of living? We make sure that we can maintain an income that easily supports that standard of living. And just as importantly provides some extra room for when things go wrong like car repair costs, and other financial surprises.

We want to match our standard of living to an income that we are relatively sure we can maintain. This would be the lowest income we are certain we could get if we went out in a poor to middling economy and took the first job offered. This income doesn’t include raises, bonuses, performance pay, overtime, time and a half, unusually high salaries due to a boom in our industry, or unusually high salaries because we are extremely valuable to our current employer. We want to remove all those variable income components and only consider the part that we can really count on. That’s what we will match our standard of living to.

I imagine that is quite a bit less than most of us are used to living on. But if we base our standard of living on that amount, we can be relatively assured that it will be constant and that our happiness level will not be affected by a reduction in living standards.

A side benefit is that all those raises, bonuses, and other income goes right into savings. This builds a nice cushion to handle any big financial emergencies. And another benefit is that the lower our expenses, the easier it is for us to be financially independent. So not only are we increasing our savings faster, we’re also reducing the total amount we need to save to support ourselves indefinitely. That’s like burning the candle at both ends. We’ll be there in no time.

Control at work

So now that we have our living standards under our control and we can fund that standard of living with a job we can pretty much go out and get tomorrow, how important is our current job? Right, not at all. It’s no longer a trap for us. We can leave whenever we want to.

Before, when our living standards were dependent on our exact current job, our employer had complete control over us and we were at their mercy. They could ask us to work longer. They could ask us to work harder. They could reduce our benefits or take away our perks. They could even ask us to violate our morals. And until now, if we didn’t take it quietly and do what they asked, we were afraid that they would take our job and hurt our standard of living.

But now, we have the control and are on equal or higher footing than our employer. Now the situation has flipped and they need our knowledge of their business, our skills, and our time, but we don’t need them. Any job will do for us now. So we no longer fear losing our current job because it can be replaced without a problem. We don’t have to suffer any insults or indignities and can walk out at any point that we desire without any pangs of worry.

In fact, we now have the confidence and control to take risks that our coworkers won’t be willing to take. We can boldly ask for a raise or other perks. We can speak our minds and say what needs to be said. It might even make us better employees, as we won’t be scared into being “yes men”.

We can even ask for a year off with benefits to go pursue our happiness plan. And we can confidently threaten to quit if we don’t get what we ask for, which again, counter intuitively might mean we’ll get an even higher salary than we would have if we just stayed quiet and kept our heads down. The squeaky wheel really does get the grease.

Voluntarily let go of the shiny object

Free yourself from the high living standards trap. Voluntarily choose to lower your living standards to where you can maintain them at a constant level. And take back control over your life and your happiness.

[1] The book was “Where the Red Fern Grows” and the real trap was a little more gruesome, but the point gets across well enough without that part.

What does happiness have to do with investing?

2008-07-14T22:53:00.001-05:00

Happiness is the ultimate goal of almost any action we take. We want to invest to make more money. We want more money to buy more things or to be free from work. And we want to buy more things or be free from work because we think this will make us happier. So at it’s most basic level we invest because we think investing has the potential to make us happier.

But can we really be certain that more money will make us happier? In a post on behavioral finance, I talked about how we are poor at predicting what will make us happy. So it seems important to question the implicit assumption that more money will make us happier.

Will more money really make you happier?

There’s some evidence to say that more money will not make us happier, or at least not substantially. Some studies have shown that about 50 percent of your happiness can be attributed to your genetics. So regardless of your wealth, half of your happiness level is already determined.

We also have a tendency to quickly adapt to changes in our environment. So even if you gained more money, you would quickly get used to this new level of wealth, and probably decide that you needed just a little more to be at the level of happiness that you wanted. Think about the last time you got a raise, or bought a dream house. The euphoric feeling wears off much faster than we think it will. We are definitely happier in the short-run, but not for very long, and it will take an even larger amount of money to make us happier next time. Given these symptoms, the pursuit of more and more money kind of has the profile of an addiction.

Even after noting this though I still think not having to work every day of the week would be a huge gain in happiness. But one of the surer ways to tell if a particular thing will make you happier is to ask someone who is already doing that thing. And surprisingly, according to this article by someone who did retire early, whether or not you are happier depends a great deal on what you plan to do with the newly found freedom. (Take a look at the comments at the end of that article for some more examples of people with the same problem.)

But what if you have a plan that you think will keep you happy?

If you already have a plan for what you would do if you didn’t have to work, consider dipping into your retirement savings, and taking a year off and implementing that plan now. If you are right, then you get to spend a year doing something you really enjoy and now have some motivation to get there faster by cutting your current and future expenses. If you are wrong, you probably won’t even take the entire year. You’ll probably know within 30 days if your plan is something you won’t enjoy doing for the long-term.

I’m sure your financial advisor will howl in pain if you tell him this plan, so let me address the objections he’ll throw at you.

One tactic he might take is to point to a graph of two people who start saving at different times and how the earlier saver made more in the end, even after stopping saving at a certain point.

The graph is true, but if money doesn’t matter as much for happiness, then why would that graph matter? Well it matters to the financial advisor because his income is a percentage of your savings, so the lower your savings, the less money he makes. So in this case, his interests might not be completely aligned with your own.

Another objection might be that you need to raise as much money as possible (and pay the higher fees that it brings), so that you’ll be able to afford surprise medical expenses.

You should have catastrophic medical insurance to guard against this kind of thing. And even further if there was a large expense, you should be able to take the sum out of your principal and only lower the income that you make off of that principal each month by a small amount.

Another objection might be that you’ll need as much money as possible to outrun inflation. I would suggest you consider Buffett’s advice about buying stocks in companies that have strong brand names, or what he calls goodwill.

The strong brand name allows the company to sell their product for more than their competitors can, so the company can make higher profits using less capital. And when inflation pushes prices up, the company now makes an even higher profit than before and the value of the company increases even more relative to other companies because they gain the benefit of selling at higher prices, but not as much of the hindrance of having to purchase supplies at inflated prices.

Gaining perspective

Finally, consider that by taking a year off now, you are exchanging a year of youth for a year of age. If after taking the year off, you make no other changes and go right back to saving as usual, you will only have to tack one more year to the end of your retirement schedule to be at the same place as before. Is there really a valid difference in retiring at 65 versus 66?

But if it turns out after trying out your plan that it does make you happier, you’ll now be in a position to compare the benefit of a current expense against pushing your plan further out. You’ll be able to make an informed decision on whether or not cable is really worth what you are paying for it in terms of how many more years out it pushes your plan. The same goes for a large house, or new car, or any of the many things that we spend money on now in an often-failed attempt to increase our happiness.

Or you might be able to figure out a way to implement part of your plan now. Perhaps you work fewer days a week, or only part of the year. Or if someone else might like to do what you want to do, you teach lessons and get paid to do what you like, in more ways than one since helping is a way to gain happiness as well.

Once you start thinking about the things that really make up what it is you want to do and what parts of it really make you happy, you might find that it’s not so expensive as you thought and that you can do it much earlier than you originally thought.

Where Can You Learn More About Dividend Investing?

2008-07-04T16:41:00.003-05:00

I recently left a company that was having some personnel problems. Shortly after my leaving I heard that they made everyone who remained sign a document stating that they would not solicit any of their current coworkers to go work somewhere else. This includes passing on an email about a job opportunity that a current coworker might find more fulfilling.

I worked there for quite a while and still would like to see them do well, but this makes me a little concerned about that company’s future. Consider which company you would work harder for and would feel more loyalty toward:

A) A company that tries to hide opportunities from you and threatens legal action if you tell a work friend about an opportunity the friend might find really fulfilling, or

B) A company that is so confident that they are providing a superior work environment that they are not afraid of you looking around to see what else is out there.

Something else to consider is that a company that artificially restricts the competition for their workers is sort of sticking its head in the sand. Attrition is an important indicator of problems within a company. By artificially restricting that indicator it’s kind of like ignoring the pain in your side that might be cancer. The longer you wait to deal with it, the worse things are probably getting.

It may seem a little backwards given that the tendency is to try to stop people from leaving, but companies might consider encouraging people to leave on a regular basis with “leaving bonuses” to find out how good of a workplace they are providing.

If a particular person takes the offer, then you probably didn’t want them hanging around dragging down your productivity with a bad attitude anyway. If many people take the offer, then you know you’ve got some work to do in making the workplace better.

But if people aren’t taking the offer, then you know you’re providing a better working environment than anyone else around. Which means you probably have happy productive workers, and consequently happy satisfied customers.

There’s actually at least one company that’s currently doing this, the shoe-seller Zappos.

So what does this have to do with dividend investing?

I often find that when an idea occurs to me, it seems to be a congealing of many things that I’m thinking about at the time. The independent topics and questions all click together and shine light on an idea that I hadn’t seen before.

First, in this case I was considering that a lack of open competition leads a company like my former employer to stop improving and get sick, fat, and slow. So I started thinking about how I could make sure that I was openly competing so that my business, Dividendium, would keep growing and stay healthy, lean, and quick.

Second, I’ve been reading about startups (Paul Graham and Founders at Work), since that’s kind of what Dividendium is. One of the things I’ve read is that if you want to open a shoe store, don’t do it in a town that has no shoe stores. You’re better off choosing one with lots of shoe stores. Why? The cost of educating the consumer has been spread across all of the shoe stores. So your consumer already knows what they want, and in some cases they can even tell you what you should be selling and what you shouldn’t. So I was also thinking about how I can better educate my website users and whom else I can get to help with that.

Third, I’ve been reading about happiness research. There’re lots of interesting implications for investing and finance there, which I’ll get to in another post, but the one that tugged at my thoughts here is that we get lasting happiness from friendships and from helping other people. I’ve noticed this good feeling myself when I get feedback that an article was helpful or some specific advice turned out to be just what a person needed. And it makes me want to work on the site even more. So I was now “selfishly” thinking about how I could be even more helpful to other people, so I can get that good feeling and the extra boost in drive to work on the website.

Fourth, I’ve been looking at how to improve Dividendium as a business. For a website this means increasing traffic to the site. But I wasn’t sure how much more I could grow the traffic. It seems to me that the best indicator for how high traffic can go is what kind of traffic your competitors are getting. So I looked them up. Wow, Dividendium is by far the underdog.

Looking at that from a “glass is half-full” perspective that means it has lots of room to grow. And from my own experience people who consume investing information will generally read as much as they can get. So all those users at the other sites are likely going to be interested in Dividendium as well. They just don’t know about it yet. So now I was thinking about how I could get those other people to know about Dividendium so they can try it out too.

So my goals are to encourage competition, educate users, help more people, and reach the same or higher levels of traffic as my competition.

It seems the best way to accomplish the first and second goals of encouraging competition and educating users is to openly acknowledge the competition and tell you what I see helpful that you can find there. Then if you see something on those sites that you would like to see done slightly differently, like perhaps at a lower price, such as free, let me know at contact us. And I’ll get to work implementing them on Dividendium and hopefully making it a better resource.

And if you agree that it’s a better resource then you can help me out with the third and fourth goals of helping more people and increasing traffic by letting more people know about the site. Evidently one of the bigger factors in search engine rankings and traffic generation is having your site linked on other sites. So for example, if you like this article, use the share links at the bottom to post it to Digg or whatever news aggregation sites you prefer. Or if you like the whole site, suggest it to other people by posting the address (www.dividendium.com) in forums or in the comments sections of blogs or articles that you read. The more external links the site gets, the more traffic it will get and thus the more people it’ll help.

So Who’s the Competition?

The obvious first one is Ex-Dividend.com. They’re actually the reason I created Dividendium in the first place. I didn’t want to pay for their service and figured I could do it just as well or better. I’ve never used their service, but as of this writing it looks like they charge $29.90 for basically the ability to see ex dividend dates, which you can see right here on Dividendium’s ex dividend calendar. If there are other benefits that readers know of, please post them. I also see in their free data that they provide a list of dividends increased and dividends reduced. Since increasing dividends generally points to a healthy company and decreasing dividends generally leads to a lower stock price, these might be good services to watch.

The next one would be Dividend Detective. Harry Domash is a long-time columnist and author and so there’s lots of info on this site including explanations of some of the more specific types of dividend paying companies, like REITs, MLPs, Canadian Royalty Trusts, and Closed End Funds. The site also has a “Big Dividend Stock List”, which is just an alphabetical list of stocks paying between 2.4% and 20%. There is also a “premium feature” that’s a list of the 50 highest yielding stocks on that list, but you can find that here for free on Dividendium’s highest paying dividend stocks. Just move through the list until you get to the 20% area and count off the top 50. Then, there is a premium service of $15 per month that appears to be access to 3 sample portfolios of minimizing risk, fastest growing stocks, and highest yield where they have done their own research and analysis and picked out what they think are good stocks. I don’t know anything about the results of these portfolios, so I can’t comment on the worth of the service.

Another dividend related site is Dividend Investor. The site is nice looking, but just about everything on it is hindered in some way unless you are a paying customer. The cost is $24.99 per month. The offerings I see that they have that aren’t here at Dividendium (yet…) are the stocks that pay monthly dividends, the stocks that have 5, 10, 20 year increasing dividends, and a specific screener that looks for preset criteria. If you think the monthly dividends list sounds interesting, let me know at contact us as I know I can implement that and post it for free if people will find it useful. The remaining two from that list can be done at Kiplinger. They have a sample screen called “Dividend growers” up in the right hand corner, or you can enter your own screening criteria. The “consecutive yrs dividend growth (max 20 yrs)” criterion is the one that is probably most important about that screen. It doesn’t look like it can search on the payout ratio, but it seems like after you narrow the list down you can check the payout ratios on Yahoo fairly easily.

The last one that I’ve been looking at is The Dividend Guy Blog. He’s been writing very consistently for a long while and has lots of excellent information, although it looks like there’s a little bit of confusion between “advertisements” and “sites of interest” on the right side bar, so watch out if you’re clicking around there. The archives are on the bottom of the page. His focus seems to be long-term value investing. In terms of fundamental investing information and sheer content mass, he’s definitely got Dividendium beat. It seems one way you get lots of interest from search engines (and thus traffic) is to post very frequently like every day or multiple times a day. But as I’ve pointed out before, that isn’t always good for the readers. And in this case it also tends to hide some of the better articles, so I find I have to wade through the fluff to get to the meat in some cases. (But maybe you feel that way about my writing. If so, let me know in the comments or at contact us.)

If you know of other sites that you find useful for investing (of any kind, dividend or otherwise, pay or free), please feel free to post them in the comments of this article or any other article if you find them later, even if it’s a site that you run.

And as I said previously let me know if you see a feature that you’d like to see here at Dividendium for free or done a little differently than the site that currently does it. And if you find Dividendium useful, it would really help me out if you could let some people know about it by posting the link at various places on the web. And if you really do find it useful, then you’ll be helping them out as well by telling them about a good tool, and it turns out that can make you feel pretty good, too.

Thanks,
Aleks