Author: OnceUSave

Say you decide to play blackjack with a friend, and you play to a point where one of you wins everything from the other.

And say the game starts with $100 from you and another $100 from your friend and ends when either of you goes home with $200. The net wealth in the system (the game) started at $200 and ended at $200. The only thing that changed is how that money got divvied up.

A concept from game theory, this is an example of a zero-sum game. For you to win, your friend must lose. For you to lose, your friend must win. The net wealth in the game though, remains unchanged.

Each game of blackjack you play with your friend is a zero-sum game and say you play that game every day for five years. And assume each of you are equally skilled at that game. Some days you win, other days your friend wins but in the end, each of you will end up with the same amount of money you started with.

And just like before, the net wealth in the system remains unchanged. This is a longer-term view of a zero-sum game.

Playing blackjack at a casino is worse than a zero-sum game because now the casino wants its cut, and that cut is coming from you. So, what started as a zero-sum game is now a negative-sum game for you and a positive-sum game for the casino. It must be that way, or the casino won’t stay in business.

So, if you win playing the casino, consider yourself lucky. But never mistake luck for skill because play there long enough and you’ll lose. That is by design.

Playing the lotto is a big negative-sum game for you and a hugely positive-sum game for the state sponsoring that lotto.

Trading in commodity futures, if you have no business trading in them, is another example of a zero-sum game. For someone to gain on a contract, another someone at the other end must lose. Take taxes and transaction costs into account and that seemingly zero-sum game quickly turns into a bigly negative-sum game.

And if you don’t know what commodity futures are, you don’t ever need to know unless you are in the business of dealing with stuff that you’ll use in your business, and you need some certainty around that stuff’s future prices.

For example, if you are running an airline, you might want to lock the price of oil say six months out by buying an oil futures contract. If you are not running an airline and you are trading in oil futures, don’t.

What other negative-sum games do we play knowing full well that we are going to lose but this time around, we don’t mind? Life insurance.

You buy a policy and pay premiums all along, but the worst-case scenario never happens. And you are glad it never happened. The insurance company facilitating this whole thing will take its cut but that is a good thing because when you buy life insurance, you are buying peace of mind. You are insuring your income for your family against you prematurely dying.

Day trading stocks is another example of a zero-sum game before taxes and transaction costs and a big negative sum game after accounting for those costs.

Then there is options trading on stocks and there are reasons for it to exist, but retail investors should never be allowed near that. It is a hugely negative-sum game after taxes and transaction costs with oftentimes tragic life changing consequences…

Krurd, as it turns out, is a 35-year-old unmarried Chicago psychiatrist who had invested, and subsequently lost, nearly $1 million — all of his savings — in call options on Bill Ackman’s special-purpose acquisition company, Pershing Square Tontine Holdings, before it found a merger partner and inked a definitive agreement, or DA.

How Millennial Investors Lost Millions on Bill Ackman’s SPAC
Michelle Celarier, Institutional Investor, August 11, 2021

$1 million at age 35 is all you need to be set for a fantastic retirement life. But now all gone in the blink of an eye.

These men — and they all happen to be men — are immigrants, first-generation Americans, and children of the blue-collar working class who have excelled in their professions. They are now engineers, small-business owners, doctors, consultants. Some went to Harvard, Princeton, UCLA. Many were the first in their families to attend college; a few are still students.

They are millennials — ranging in age from 24 to 39 — who live in New York, California, Illinois, Maine, Utah, and Texas, as well as Germany and Canada. They all lost money in Tontine — in at least one case more than $2 million — as SPAC mania swept through the stock market like wildfire over the past year.

How Millennial Investors Lost Millions on Bill Ackman’s SPAC
Michelle Celarier, Institutional Investor, August 11, 2021

The write-up also talks about a 39-year-old software engineer who scrimped and saved $1.6 million over twenty long years and rightly afraid of losing any of it, kept it all in a bank account. Not the best of deals but worked for him because he did not know any better.

And then lost it all on call options that expired worthless in a matter of days.

But back to stocks, day trading them is the dumbest thing you could do with your money. Because stocks are not just little digits on your screen. They represent partial ownership in real businesses that make real products.

I consider day trading as any activity that is short of perpetual ownership of businesses while you wait for the cash flows in the form of dividends to flow to you until that business has run its course.

But owning one or two businesses entails the risk of those cash flows from ever materializing so you own a bunch of them. And then you sit tight and wait.

The only positive-sum game hence, in the world of investing is long-term, perpetual ownership of businesses; businesses that power and feed our ever-growing economic pie; businesses that are run by some of the brightest of folks around; businesses with all their buildings and machines and processes working in unison to create the magic we see all around us. You’d want to forever own a piece of that magic.

Thank you for your time.

Cover image credit – Gladson Xavier, Pexels

You think you’ll spend like this…

But instead, you spend like this…

Retirement experts who’ve studied this say that we spend in three phases…

• the go-go years,

• the slow-go years,

• and the no-go-years.

The go-go years are your first set of years in retirement. You play, you travel, you spend.

Then you start to slow down. Your spending naturally declines.

And then you really slow down. But your spending rises as you start to spend more on healthcare.

So, if you planned to spend like you thought you’ll spend, you should allow yourself to spend more.

Because the money you don’t spend in the early years compounds and it can compound for decades into an enormous sum. Not the worst of things but then you can’t take it with you.

But then who likes the word retirement? Financial independence sounds better – independence to do the best work of your life while you keep yourself engaged, active and relevant.

I mean don’t quit working but quit the work that looks like work. And then mix in those interim all-deserving breaks. Travel, explore and continue discovering.

Thank you for your time.

Cover image credit – Kat Smith, Pexels

Cockroaches are the ultimate survivors¹. They can live without air for an hour, without food and water for months. They can survive the Arctic cold. Ice ages and continent shifts mean nothing to them. It is no surprise then that the cockroach as a species has been around for 300 million years and it is not going anywhere soon.

Your plan should have the same survivalist foundations as that of a cockroach. No matter what the world throws at it, your plan must survive.

So never set yourself up for a disaster like this…

And disasters like these happen all the time. Leverage, which is when you borrow money to invest, is oftentimes to blame.

Tying up a big chunk of your net worth in one or two stocks is another very common cause. That is taking on unsystematic risk at its core and the outcomes could be life-altering…

Former Enron Corp. employee George Maddox, who lost his retirement savings when the energy giant collapsed, says he has been forced to spend his golden years making ends meet by mowing pastures and living in a run-down East Texas farmhouse. Maddox, who served 30 years as a plant manager with the company, was long retired as Enron began spiraling out of control in the months leading up to its bankruptcy on Dec. 2, 2001. With all his retirement savings tied up in 14,000 shares of company stock, then worth more than $1.3 million, Maddox says he never saw the crash coming.

10 YEARS LATER: What Happened To The Former Employees Of Enron? Business Insider, December 1, 2011

I know of someone who went from $4 million in their employer stock to zero in six months. If you have seen some of the headlines around recent bank failures, you’ll know which one did it. That is literally all the money they had so life-altering is the least bad way I can describe it.

Unsystematic risk, in plain English, means you cannot predict the good (or the bad) about a stock for long into the future. You can do that with a basket of stocks (businesses) but with one or two stocks, in this day and age of hyper-rapid disruptions, it is a near impossibility.

And most of the concentrated stock risk unknowingly creeps up on you if you get paid in employer stock. You must then diversify out of it because for every story that pans out, there are multitudes more that fizzle away.

And when your employer’s story fizzles away, you lose the money that you invested in that stock, you lose your paycheck, your health insurance and the rest.

And regardless of how much you believe in the business you work for, it won’t be around forever. Things change, key employees leave, and competition is always waiting at the heels to eat into whatever moat your business currently enjoys.

And drawdowns (declines) are deeper with concentrated portfolios with no guarantee of a recovery. That reversion to the mean (more on this later) that is ingrained in the design of most broad-based portfolios could never happen to you.

Talk about drawdowns, you know that had you invested in Apple stock 20 years ago, you’d now be rich. But go back another 20 years and say you bought $10,000 worth of Apple stock in April of 1983, guess how much money you’d have 20 years later?

$8,400.

Are you telling the world that you would have the fortitude to hold on to a “loser” for 20 long years while the rest of the world gets rich? Not a chance.

Plus imagine the lifelong guilt and literal trauma you’d be living with had you waited for 20 long years only to eventually bail on that “loser” and then watch it soar to become the most valuable business in the world.

So do individual stocks ultra-sparingly and if you do decide to do it, do it with a tiny portion (under 5%) of your money with the intent of holding forever. If those stocks go nowhere, no big deal. You still have the bulk of your savings intact to take you to your goals.

And when I say do individual stocks, do it with stocks that can matter. Because you are looking for that lottery-type outcome to get compensated for taking on lottery-type risk.

So, you can’t be holding a trillion-dollar stock because for that stock to double, it needs to become a 2-trillion-dollar stock. How many 2-trillion-dollar stocks do you see around?

Plus, you likely own that trillion-dollar stock by the boatload anyway if you own a half-decent portfolio so if it were me, I’d own small, obscure stocks that have a shot, regardless of how faint, to do 10 times your money in 10 years.

Reversion to the mean…

I passingly mentioned reversion to the mean but I feel it needs more explaining. Reversion to the mean assumes that the value of an investment, even if it were to decline, will eventually revert to its long-term trajectory of perpetual growth.

You cannot assume that with individual stocks because stocks go down all the time, never to recover.

But with a diversified basket of stocks that are at the top of our ever-evolving economic value chain, with that basket getting refreshed with new businesses as the economy changes, sort of like auto self-cleansing, the price of that basket can go down, but it will eventually recover. It must recover unless we are talking the end of the world kind of scenario.

This reversion to the mean backdrop is what then allows you to confidently dollar cost average into your plan, knowing full well that in the long run, the collective prices of the investments you own will recover. They must recover.

Thank you for your time.

Cover image credit – Erik Karits, Pexels

¹ Loren Grush. “The Verge review of animals: the cockroach“, The Verge. January 17, 2016.

Buying businesses (stocks) is not about winning popularity contests. In fact, the more popular a stock or a category of stocks gets, the less likely its price matches its value. Pay too rich a price for a popular stock du jour and you could be sitting on that stock forever, never to be made whole.

A great business, hence, does not a great stock make. Take Cisco Systems for example. Cisco Systems, as we know, supplies infrastructure that powers the internet economy. They are of course not the only ones. They have competition but by far they are the biggest of them all.

And you don’t just wake up one day and decide to compete with Cisco Systems. You need engineering. You need services. And above all, customers need to trust you to provide them with reliable products that won’t bring down their networks. If you want all of that, Cisco Systems is your place to go. It is as predictably profitable and as moat-infused a business as any business can get.

At the peak of the Dot-com boom in the year 2000, Cisco stock was selling at triple-digit multiple of profits with its total market capitalization eclipsing $600 billion. Market capitalization is the price quoted for a business on the stock exchange on any given day so if you wanted to buy Cisco Systems as a business in its entirety, you would have needed six-hundred billion dollars.

That was the quoted price but was that the right price? In hindsight, clearly not. Cisco trades today¹ at less than a third of its market price of almost a quarter century ago. Will it ever see the old highs again? Never.

And there was never much wrong with the underlying business. It made billions in profits and still makes billions in profits. It is just that the market at the time priced the business far, far away from its true intrinsic value. The market was clearly wrong then and possibly right today, but we can only know that in hindsight because predicting profits years and decades out is a near impossible feat.

But could you have bypassed that train wreck had you done some basic back of the envelope math? Maybe.

I say maybe because we can do Monday-morning quarterbacking all day long but when we are in the heat of a stock market mania, who knows what we’d really do and what theories we might concoct to justify any valuation. And the heat at the peak of that mania was intense.

So, here is how you could do a first-cut analysis on any stock you are considering buying. The first thing is to always evaluate your buying decision as if you are buying the entire business. That is regardless of how small or big of a stake you plan to buy in that business.

Then consider your payout timeframe. I have talked about this before but say you are in the market to buy a corner gas station and it costs a million dollars.

Now if you invest a million dollars, you want that gas station to get you back your million as soon as possible.

So, say it takes ten years for that gas station to generate enough profits that equals your initial investment. That is your payout timeframe.

Once your initial investment comes back to you in the form of profits, only then do you really start making a net return on your investment. This math of course ignores opportunity cost and the hassles of running a business so if you were to factor that in, you would need that payout timeframe to be a lot quicker but let us ignore that to keep the math simple.

So back to buying Cisco at the then quoted price of $600 billion and if you were looking for a ten-year payout, you were expecting that business to return $60 billion a year in profit for ten straight years. Only then, you’d start making a return on your original investment.

Cisco’s profits in the year 2000 were about $3 billion, a far cry from the multiple tens of billions of dollars you should have expected in theory. And $60 billion a year in profit was and is a gigantic number for any business to sustainably deliver for that long a timeframe.

So of course, it was an insane valuation from a payout perspective and that is the only perspective that eventually counts.

That was the Dot-com bubble, and you’d think we would have learnt our lessons but here we are. In fact, the insanity of the last few years is at another level. I don’t recall ever a time in history with so many businesses priced at tens of billions of dollars but with a nary a sight towards making a profit.

And when the market eventually comes back to its senses, the consequences can be brutal. The list below highlights some of the names that were insanely priced and the after-effects of what happens when the market resets its expectations.

And it is by no means a comprehensive list. 

This is not to say that all these businesses are hurting. The businesses can continue to otherwise thrive. It is just that their stock prices ran way ahead of their true fundamental value and now prices are reverting to meet that value.

Often though, a stock price faltering can falter a business. With a big chunk of key employee compensation especially in the growth, tech space, tied to employer stock, when the stock price falters, they leave. That in turn creates a self-destructive downward spiral towards mediocrity. And eventually, insolvency.

Bubble stocks, once they collapse, seldom recover. So, if you are holding on to them thinking that you’d be made whole someday, you could be holding forever. That while the rest of the economy continues chugging along.

Thank you for your time.

Cover image credit – Mary Taylor, Pexels

¹ March 31, 2023

Cookie-cutting the investing process seldom works. Take for example someone who is a federal government employee, and we know what that entails: a rock-solid job security with access to an equally rock-solid pension plan.

So, assuming she continues to work there till she retires, should she ever own bonds?

And we know the deal with bonds; stable prices with near-guaranteed income but with long-term returns far lower than what we can expect from stocks.

And why should we expect anything else? Why should we get paid more for stuffing our savings under the proverbial mattress? We should not because capital preservation and growth doesn’t exist. And it shouldn’t exist.

Stocks will test your will from time to time, but they are what you need by the boatload if you want to retire well.

And even with stocks, there is a range of outcomes we can expect. Small company stocks should earn us more than large company stocks because they are riskier. So should emerging market stocks over say developed market ones because again, they are riskier.

But there are no guarantees. Because if there were any guarantees, they wouldn’t be riskier.

So, going back to that federal employee, should she ever own bonds? Almost never.

She does not need to own bonds because her pension is the best bond replacement. Not only that, that pension is inflation-linked so an even better deal than plain old bonds.

At the other extreme, say instead of working for the federal government, she worked for a startup. Or say she worked in sales or on Wall Street as an investment banker.

She is now exposed to all the vicissitudes of the economic cycle; both on the upside and on the downside.

Her livelihood is now near-perfectly correlated to the stock market. She is more like a stock whereas her alter-image, the federal employee is more like an inflation-indexed bond. A big decline in the stock market would likely cause the Wall-Streeter to lose her job whereas the federal employee will remain unscathed.

So now that we have the context, clearly these two sets of employees cannot own the same portfolios. They could but that would be sub-optimal.

And that is the problem with cookie-cutter investments like the age-based portfolios that happen to be the default choice in many of our workplace retirement plans. These funds start out aggressive with an heavy allocation to stocks and steadily get conservative with a greater allocation to bonds as you near your goals.

And they (the funds) do all this mechanistically without knowing what else is going on in your life because they cannot know about your life. All they do know is that you have this one account in which you have picked this one investment and that is all.

Take another scenario where say you have $5 million socked away in an age-based portfolio after a lifetime of aggressive saving. And even if you needed a ‘mere’ $100,000 a year to live on, these portfolios would still move a big chunk of your savings into bonds. You’ll certainly own a less volatile portfolio but is that optimal?

Not really because $100,000 a year off a $5 million portfolio is a 2% withdrawal rate, a rate that could easily be achieved with an all-stock portfolio.

Plus imagine giving up on all that growth that an all-stock portfolio is likely to deliver with time. You might not need the money but your heirs or the charity you wish to bequeath your savings to would be glad you didn’t make a sub-optimal choice.

One size does not fit all. Every situation is different and hence every allocation, every plan should be different.

No problem sticking with these pre-packaged portfolios early in your savings journey assuming you are aware of some of their eventual flaws. But as you get up in assets with time, you’d certainly want to revisit these choices to reformulate a plan that is yours.

Thank you for your time.

Cover image credit – Jéshoots, Pexels

San Luis Obispo has one of the cutest downtowns in California. A must try there if you are ever around is a Turkish pastry shop called Lokum. So, so good.

On a stroll to one of the many beaches there, I happened to come across a long-retired couple, likely in their seventies, voluntarily cleaning up the trash people left behind. Good on them.

So, I started chatting with them to find out more about their life and how retirement is going for them. They said they have never been busier. They restore 100-year-old musical instruments which started out as a hobby but has now become a full-on money-making gig. Folks from all over the world reach out to them for business.

And it is not like they retired and then they went looking for a hobby to fill their time. The husband, a mechanical engineer by training, was already tinkering with it while he was working, and he carried that into his retirement.

That is the way to do it. I know what I just described and what I am about to expand on is a first-world problem but now that we are here, I can see our lives segmented into three distinct phases. The first phase is mostly about play and school and eventually blossoming into a functioning adult.

Then we enter the workforce, oftentimes followed by marriage and possibly kids. This stretch by far is likely to be an intensely busy phase of our lives. We cannot ever wait to retire.

So, we do the requisite amount of planning to make retirement a reality and we retire.

But retire to what? There is only so much Netflix we can watch. There is only so much golf we can play. We’d eventually tire of all that we consider fun until we are in the thick of it.

And we don’t realize it yet, but work is not just about fulfilling our financial obligations. It becomes our identity. It is the first thing we get asked when we meet someone new. It provides us with a sense of meaning. It gives us a reason to wake up and fill our time with all the good that we are about to do in this world.

So, transitioning from a life with our calendars filled to the brim into a life of literal nothingness is not going to be fun. It is best we plan for that transition before we are already there.

Plus, with the continual rise in life expectancies, we could be retired more number of years than we spent working. And it is not just about money because with adequate planning, most folks reading this will be able to afford a life of nothingness, but would you really want that for decades on?

For the lucky few who have found their calling in the work they are already doing, life is great. They have no reason to look for an alternative. Granted, the workplaces of today are not as accommodative to older employees but that will change. Imagine letting all this experience and expertise go to waste.

But if you are in the camp where you want to try something new, there is this sweet little phase that’ll likely come in your fifties where the kids are off on their own and you have some breathing room to explore. That is your figuring out time but figure something out you must.

Because one of the surest ways to prevent and delay cognitive decline as we age is by keeping our brains active. And there is nothing better than work that gives us a shot at that.

Again, it doesn’t have to be work, work. It could be anything but sitting in front of the TV to kill time is not it.

Remain useful, feel youthful.

Thank you for your time.

Cover image credit – Greta Hoffman, Pexels

Google was busy relishing its unrelenting grip on the search business and along comes ChatGPT, a supposed Google-killer that helped lop several hundred billion dollars off its market value. Whether ChatGPT does any lasting damage to the core of Google’s business is to be seen but the stock market thinks there will be some damage.

And this revaluation, which gets instantly reflected in a stock’s price, is all about changes in expected future profits. The stock market thinks that Google’s long-range profits are going to decline.

The market is not always right but it is more right than wrong. Predicting changes in future profits is hard.

But long-range profits are all that count. If profits do not come, a business ceases to exist.

But even if the market is not always right, assuming that it is right will save you from the poorhouse. Because who makes up the market? The best and the brightest from around the globe. These folks live and breathe these things. They are constantly on the hunt with super-computers running in the background, to drive out any pricing inefficiencies that exist.

So, if you got some news about a public business that you think only you know, rest assured the world knows. And it is already priced in.

Human beings do go crazy from time to time that cause bubbles, but bubbles eventually burst. The price and the value of a business will converge and that is all that matters for long-term investors like us.

But back to ChatGPT, guess who owns a big chunk of the underlying technology that could damage Google’s core business? Microsoft.

Microsoft will reap some of the profits that would have flowed to Google. And if you owned shares in both Microsoft and Google, you’d get a piece of the action regardless of who wins.

That is competitive disruption. It forms the heart of an efficient capitalist system. The more profitable a business and the lower the barriers to entry to that business, the more competition it is going to invite. Most good businesses have moats around them to defend against competition. The stronger that moat, the greater the profits a business derives and the higher its eventual stock price.

But the moment that moat weakens, the market reprices that business and almost uniquely to the downside.

And gone are the days where you can own a few blue-chip businesses and sleep on them. Change happens so quickly these days that one moment you have a business and the next moment it is gone. Even for businesses that you thought you could own for life.

Take Procter & Gamble (P&G) for example. What can change with toothpaste and detergent but then P&G must meet their customers through a retailer.

That is where Costco Wholesale comes in. They own the distribution. Without distribution, Procter & Gamble can’t sell nothing.

And Costco knows how profitable some of P&G’s brands are.

So, what do they do? They make a near-perfect copy of that brand and sell it under their own Kirkland Signature label at a cheap enough price point and poof go P&G’s profits.

The underlying demand is still there. Who gets to fulfill that demand changed. That is again, capitalism at its best.

And if you really want to know how risky individual stocks can get, let me take you back to the good ol’ days of 1999. Nasdaq was on fire. Anything Dot-com was an instant hit.

The stock of the day was Cisco Systems. And Yahoo. And AOL. And InfoSpace. And Inktomi. And Sun Microsystems. And Lucent, Qualcomm, Juniper Networks, Global Crossing, Nortel, WorldCom, JDS Uniphase, Palm, BlackBerry and on and on. If you did not own any of these, you were a loser.

Where are they now? Many don’t exist. Those that do, their stock prices have yet to recover 25 years later. All that while, the world stock markets continue to climb, delivering that expected equity risk premium that we rely on to meet our many life goals.

That equity risk premium does not come for free. You’ll have to live through stomach-churning volatility from time to time. People call that risk but that’s not true risk. That is the fee you pay to participate.

But you must own stocks. When you own stocks, you own businesses. And owning businesses is how you fight inflation. You must invite all and every opportunity to own more of those businesses.

But single stock risk is real. Hendrik Bessembinder, a finance professor at Arizona State University’s W. P. Carey School of Business writes that out of the 26,000 businesses that went public between 1926 and 2019…

• Only 42 percent of them created net wealth for their shareholders. The remaining 58 percent (15,000 businesses) destroyed wealth in all their existence.

• Five firms accounted for 12 percent of all the wealth created in the stock market.

• Eighty-three firms (0.3 percent of the total) accounted for 50 percent of all wealth created.

• And 1,000 stocks (4 percent of the total) created all the net wealth above what Treasury bills would have paid you.

Feel lucky yet?

There is of course a difference between owning stocks and renting them. Owning stocks is how you get rich but only if you own them for the long run. You must give time to let capitalism work its magic.

But you don’t own a stock here and a stock there. You own a whole bunch of them, spanning all sectors, sizes and continents.

Thank you for your time.

Cover image credit – Raka Miftah, Pexels

We’ll start with the simplest of all possible investments and that is buying Treasury bonds. When we buy a bond, we become a lender. And with Treasury bonds, we become a lender to the U.S. government.

So, say the yield (interest rate) on a Treasury bond that matures in 10 years is 5 percent. For every $1,000 invested in that bond hence, the U.S. government pays you $50 each year as interest payment. And they do that for 10 straight years. That is the U.S. government compensating you for borrowing from you.

When that bond matures (when the loan term ends in 10 years), you get your original principal amount ($1,000) back along with the final year’s interest.

Treasury bonds are the safest of all investments so your chances of losing money investing in them are virtually nil.

With that as a backdrop, we now turn to the most widely held of all investments, an investment you can touch and feel and live in and that is, your home. Estimating return on that investment gets a bit murky but fundamentally, it is the market rent on that home. If your all-in costs are higher than what you can make if you were to rent your home out, you are losing money on that investment.

But your home is not just an investment. It is your home. You derive a surplus psychic income from owning it. Schools, community, some aspect of forced savings, a sense of permanence and stability, pride of ownership – these are all pieces of that psychic income.

It is hard to put a price tag on that surplus psychic income but that plus market rent is the return on investment on your home. If home prices rise, the market rents on those homes must rise as well. There will be lags but those lags eventually heal. If they won’t, you’ll be losing more money owning a home.

Where it is more black and white is with owning rental real estate. Your return on that investment is the rent you collect minus your expenses. There is no psychic income there. The market decides the rent you can charge and that minus expenses becomes your return on investment in any given year.

We now turn to investing in businesses. Businesses create wealth so you’d want to own a piece of the machine that creates that wealth. Without businesses, there is no economy. Businesses in aggregate must do well for all other pieces in the investment ecosphere (bonds and real estate) to do well. Businesses sit at the top of our economic value chain.

You can run your own business but that requires super-human abilities. Lucky for us though, the stock market offers us a chance to own world-dominating businesses with a click of a button. You won’t ever have to get into the weeds of running them, ever. The superhumans hired to run these businesses on your behalf do all the heavy lifting.

So, say you own a piece of a business that trades at a price to earnings (PE) ratio of 20. Earnings is another word for profits. So, the market is pricing each dollar that a business earns in a given year at 20 times that. The earnings yield hence on that business is $1/$20 = 0.05 or 5 percent.

That is your first-cut return on investment as an owner of that business. And you being an owner (shareholder) have claims on those profits.

But then those superhumans running these businesses on your behalf decide that they have a better use for some or all of those profits. They want to expand into new lines of businesses. They want to grow the existing lines of businesses. They want to do all of that and more to make even more profits.

And as a profit-maximizing owner, that is what you’d want. Only the piece of profit a business cannot justifiably invest should flow to you.

And dividends, which are cash payments into your brokerage accounts, is one way that profit gets returned to you.

Many businesses don’t pay cash dividends and instead, decide to do share buybacks with their surplus profits. Buying back and then retiring those shares increases your ownership stake in a business so they are an indirect form of dividend payment. You won’t see the cash coming into your accounts, but you should see the share price of the business you own rise over time.

And many businesses like the Warren Buffett run Berkshire Hathaway exclusively prefer doing share buybacks with their gushing of surplus profits instead of paying cash dividends. Why? Because cash dividends into your accounts mean direct income to you whether you want it or not. And income coming into your accounts means paying taxes on that income.

But with share buybacks, there is no direct payment to you. You decide when you want to take dividends by selling the appreciated shares. Share buybacks, hence, if done right by the businesses you own, are more flexible (to you) tax-wise than being forced into accepting cash dividends.

Many businesses in the hyper-growth phase do not do either because they, in theory, should have a much better use of profits than to give them back as dividends. They need all that capital and more to expand and grow.

But not every business deploys capital as efficiently as initially planned because projects sometimes fail. That is the nature of the game but if you own a bunch of them, more will succeed than fail. 

But every business will eventually pay out the accrued profits back to its owners (shareholders) in the form of dividends. Those that ever won’t, fizzle out. Apple for a long time, did not pay a dividend. Now they are a dividend stalwart. And they do billions of dollars’ worth of share buybacks each year so even more indirect dividends.

There is another big driver to your long-range returns with stocks and that is changes in valuation. That is what John Bogle, the founder of Vanguard, calls the speculative aspect of your total return. Speculative because it has nothing to do with the goings in a business and everything to do with what investors will pay for each dollar of earnings that business earns today versus in the future.

So that business we alluded to that trades at a price to earnings ratio of 20 today, say ten years from now, the market bids up its price to earnings ratio to 30. That is a big deal because that change in what investors are willing to pay for that same dollar of earnings adds an extra 4 percent each year to your total return.

But now your earnings yield as an owner of that business that started off at 5% when the PE ratio was 20 dropped to 3.33% at the new PE ratio of 30. Any new shares you buy from now on are not as great of a deal because your investment dollars are buying less business profits than before.

So, if you are retired and living off your portfolio, upward changes in valuation is great. But if you are still working and contributing to your investment plan, it is not quite a disaster but close.

What you want is downward changes in valuation in your accumulation years and not upward changes so that you continue buying a bigger and bigger slice of business profits with each contribution you make.

But no one likes that because most don’t know how this game works, but we do.

To summarize…

Dividend yield on global stocks is roughly 2% today¹. Add in dividend growth rate of 5 to 12% in any given year and that is your baseline expected return from stocks. Tag along changes in valuation and you get the total return. Anything more means uncompensated risk. No problem doing it with a tiny slice of your savings but overdoing it could eventually kill.

And anything that is deemed an investment must have associated cash flows. With bonds, we have interest income. With real estate, we’ve got rents. And with stocks, we have dividends.

Anything that does not generate cash flows is not an investment. Gold is not an investment. Commodities are not investments. Currencies are not investments. Crypto is a scam.

So, having a rough idea about where the return on your investment comes from and how much of it should you reasonably expect is critical to preventing you from getting bamboozled out of your hard-earned savings.

Thank you for your time.

Cover image credit – Marlene Leppanen, Pexels

¹ December 31, 2022

The truth about the Warren Buffett class of wealth is that if somehow a Buffett were to be stripped of all his wealth, his life wouldn’t change.

The Gates and the Zuckerbergs of the world fall into the same league. Some do indeed live larger than you and me, but you can tell that they are not into it.

They don’t seem to care.

They don’t seem to care because they own a different kind of wealth, the kind of wealth that is difficult to strip away. So, let me let you in on the secret to that kind of wealth.

And it is this…

Designing your version of a happy life that allows you to live far below your means in a perfectly contented, Zen-like state is that wealth. No rigid adherence to societal norms, no worrying about what someone thinks about the kind of car you drive or the home you live in. It works for you is all that matters.

You practice that over time, systematically investing the difference and you’ll be set. And you won’t believe how fast you’ll be set.

And there is a certain kind of inner peace you attain when you know you don’t have to worry about what other people think about how you choose to live. You can act poor with never a qualm. The Buffetts and the Gates of the world know this. You should too.

And those intermittent spurts you see in the plot above are spurts of discretionary spending that you indulge in every now and then to buy experiences.

We (my family) are not big spenders. We don’t spend much on stuff but spending on experiences is where we don’t scrimp. We have an experience budget we have earmarked for each year, and we make sure we exhaust it and then some.

That was a hard thing for us to get around to but get around to we did. And we are glad for it. The bonds we build as a family, being in unfamiliar settings on these one-off trips, is something that is not possible in our daily grind of an existence.

And the more we do it, the more we want to do it.

Why spend more on experiences than stuff? Because owning stuff takes work. You have to store it, maintain it and eventually dispose of it. The more you own, the more the work.

Experiences deliver fond memories. Possessions deliver repair bills.

Jonathan Clements

But back to us, we go out of our way to make these experiences of a pseudo-luxury kind in an otherwise mundane existence and there is a reason for that. Because if we had permanently designed our lives to be of the ‘good’ kind, we wouldn’t be able to relish these occasional hits. Because we as humans get used to the good life fairly quickly and then we are back on to that proverbial treadmill, always looking for more.

But when you design your life to be way below what you can afford and then you take these occasional hits, you’ll savor those experiences forever.

Start life in first class, and you’ll take it for granted. Occasionally get upgraded, and it’ll be a real treat.

Jonathan Clements

All this of course assumes a certain level of baseline income. But then we also know stories of people working menial jobs who are literal millionaires while many others making bank but do not own two nickels to rub together.

So it is never about the quantity of wealth because even billionaires go broke. It is about how you never let that wealth take over your ego from the many important things that matter in life.

So, lift weights, do yoga, dote on your family but keep that burn rate in check. Because any money you spend that does not uplift your family’s well-being is money wasted. You can’t optimize for everything but try you must.

Thank you for coming to my Ted Talk 🙂 .

Cover image credit – Sound On, Pexels

Joel Greenblatt, founder of Gotham Funds, says that the secret to investing is figuring out the value of something and then paying a lot less to buy it. Obvious but wish it were that easy.

Price is not the problem. We see it quoted every day for the businesses that are publicly traded. Getting the price for a private business requires more work, but we could get it if we wanted to from a willing seller.

Determining value on the other hand is hard and that is not because it is complicated. The math is the easy part but there is so much of the present and the future that goes into that math that it then becomes a guessing game.

And guessing game it is for the most part.

The quoted price for a business on any given day is almost always wrong. Wrong in the sense that it does not reflect the true value of a business at any given time. Eventually though, the price and the value of a business converge.

To give some intuition around how to think about valuation or how I think about valuation, assume for example that the year is 1990 and a corner gas station is on sale.

And say it costs a million dollars to own it with no business extinction risk on the horizon. Business extinction risk for a gas station these days is real with the rapid electrification of our auto fleet plus with the eventual densification of our communities that could make owning cars less of a necessity.

But not many thought that to be possible in 1990. This just shows how hard it is to predict the future but predicting the future is how you get to the true value before the market does.

But I digress.

So, without knowing much about how to value a business, here you are in the year 1990 trying to make a call on whether to buy that gas station or not. How would you make that call?

You intuitively know it already. You would want to know how fast you can recoup your original investment of the million dollars spent buying that business. Only then, you can think of profits.

So, return of your initial investment comes first. And then comes return on your investment.

But there of course is more to the return of investment math. There is opportunity cost in terms of the stress and the time you’d incur running that business so that needs to be factored in.

Then there is inflation and what that does to the value of future profits that business will generate.

Buying a business also entails risks that you’ll want compensation for. Future profits, as we know, are not guaranteed.

Plus, what else could you have done with that million dollar? You could have bought Treasury bonds that were yielding 10 percent at the time (1990). That is like doubling your money every seven years with zero risk, with no effort and with zero stress. The gas station business, hence, better be making much more than that or else why bother.

So, you’d demand your money back in a much shorter time than seven years. I’d say with all the hassles of running that gas station, it better double my money in five years, or I am buying Treasury bonds instead.

The same logic applies to a $100 billion business that you could be considering owning a tiny piece of through the stock market. $100 billion is the market value which in the stock market parlance means market capitalization.

So regardless of the market value of a business, you must still think like that owner about to buy a gas station. How long would it take for that business that you want to own a piece of to earn back $100 billion in profits?

But how does a publicly traded business return profits back to its owners? The same way a private business does and that is through cash payments. In the stock market world, that is equivalent to a business issuing cash dividends.

This line of thinking sometimes gets lost in all the hysteria around the day to day moves in the stock market but this is how you should think about making any long-term investment.

I am not picking on DoorDash, but I’ll use it as an example. At its recent¹ peak, it traded at a $100 billion valuation.

It trades today² at $22 billion so about an eighty percent decline from the peak just a year back.

But there is someone out there who paid $100 billion for that business. They better be playing a different game than what a long-term business owner would play because that was an outlandish price to pay for that business.

And we intuitively know why it was an outlandish price. It is hard to contemplate that DoorDash in its current form could ever make $100 billion in profits in the entirety of its existence, forget a decade.

Now let us compare that to say Microsoft. You can buy that business outright today² if you have $1.8 trillion lying around.

Is that a good deal? Microsoft made $18 billion in profits last quarter. That is roughly $60 billion in a year.

How many years would it take Microsoft to earn back your investment if you were to buy that stock (business) today?

$1.8 trillion divided by $60 billion gets us 30 years. That is in today’s dollars. Factor in inflation and it will take much longer.

Plus, there is a non-zero business extinction risk. Would Microsoft be around in 30 years? The market, a collective opinion of millions of participants, thinks it will be.

The expectation also is that the profits Microsoft generates would grow over time, which in turn will shorten that return of investment timeframe.

And hence the richer price.

But whatever the business, what eventually counts is how soon is that business going to make back your initial outlay and then and only then come your profits. Return of investment comes first and only then you can think of return on investment.

A perfect example of how that plays out is Warren Buffett‘s 2009 purchase of Burlington Northern Santa Fe (BNSF). BNSF is in the business of transporting stuff by rail through one of the largest rail networks in North America. As plain of a business as plain can get.

Buffett paid $34 billion to buy that business as part of the Berkshire Hathaway portfolio. Since that purchase, BNSF has paid out $45 billion in dividends².

The business, hence, has paid more in dividends in the first 10 years than what Buffett paid to buy that business. Everything from now on and into perpetuity is all profits.

That should be the expectation from every investment you make. New businesses and ventures can take longer but not an infinite amount of time.

And this simple, back of the envelope hack is sometimes all we need to keep us out of harm’s way.

Buying stocks of prosperous concerns may be good business – but only at a certain price. But if you will make sure you know what you are getting for your money, you will be doing what nobody does in a bull market.

by Edwin Lefevre in Reminiscences of a Stock Operator.

Thank you for your time.

Cover image credit – Pixabay

¹ March 12, 2021

² December 31, 2022