March - a wonderful month to enjoy college basketball and avoid silly trademark infringement. How are all of your brackets doing? You’ll be fine as long as you picked Michigan as the national champion. Go Blue!
Spring is around the corner, which means it’s time to do taxes, clean up the messiness that’s piled up over the winter, and get some extra sunshine. After a somewhat rough season at work, it’s good to be back and writing. Cheers to jumping back on the train and back on the grind!
Fed Last Wednesday, the Fed announced that they would keep the Fed Funds Rate steady at 2.5%, with a target of one more hike either in 2020 or 2021. This represents a pretty substantial pivot from the previous stance in Oct 2018, when Fed Chair Jerome Powell said that the funds rate was still a “long way” from neutral. Those comments sent the stock market tumbling, as investors feared that Fed policy would ignore a weakening global economic condition. Think of it like the Spurs organization making Kawhi play before he felt fully recovered from his quad injury. We all know how that played out.
The Fed also announced it would end its balance sheet unwinding in September. (OK, now in plain English, please). During the 2008 Financial Crisis, the Fed took measures to try to save an economy that was quickly collapsing. By buying huge amounts of bonds and mortgage-backed securities (quantitative easing), the Fed took on the risk of default on this debt and provided some much-needed liquidity in the market. This massive Fed shopping spree is what led to a bloated balance sheet. As bonds reached maturity, the Fed would continue buying more bonds to replace the ones that rolled off. With less risk, more cash, and an extremely low interest rate, the economy got back on track. People and businesses went back to spending, because idle cash pretty much didn’t earn anything.
After a decade-long bull run, the Fed had been unwinding its balance sheet by letting bonds mature, but not buying back more to replace those. This then reduces market liquidity and has the opposite effect of quantitative easing. The Fed announcement to stopunwinding its balance sheet means that they will get back to buying more bonds as maturing bonds roll off. In other words, the macroeconomic outlook does not look good.
The market response was… …good, and then not-so-good. Kind of like the Lakers signing Lebron and then failing to make the playoffs this season (oops, too soon?) Usually, equities get a boost if the Fed Funds rate remains low. Raising rates makes bonds more attractive, so a stable forecast for the next two years on the Fed Funds rate would normally provide a boost to equities (as they would be comparatively more attractive). Following the announcement on Wednesday stocks soared on Thursday, and came crashing back down Friday.
So what happened? The treasury yield curve saw another major inversion, with the 3-month treasury yield outgaining the 10-year yield. That’s obviously concerning, because you should theoretically be rewarded more for keeping your money tied up for 10 years vs. 3 months. The inversion is also one of the more reliable indicators of a coming recession (in 12-18 months). In addition, global markets continued to show major weakness, with Germany’s bond yields dipping below zero, and Japanese bond yields inverting as well. Combined with the ongoing geopolitical risks - the global economy is slowing, people are starting to freak out a little, and it’s reflecting in this week’s market volatility.
All right, enough info for today. Just tell me - Should I continue investing in 2019 if recession is coming? Well, let me ask you first – are you retiring in the next 7-8 years? No? Then keep investing, buddy.
Like many people have mentioned, assuming you are earning the market average return, your investments should roughly double in value every 7-8 years. This market average return includes recessions, by the way. With time on your side, then the prudent thing to do would be to continue investing in some combination of total market ETFs, dividend ETFs, and bonds. There will always be downswings and pullbacks, but the key is to avoid the temptation to panic-sell and to stay the course. There are stories of people who panic-sold their investments in 2008 and 2009, and never jumped back into the market for fear of another sell-off. 10 years later, they’ve still never recovered from that loss, even though most could have recovered if they were well-diversified and just waited things out.
My personal outlook for 2019 is that we will continue to see economic expansion, albeit slower. Is recession on the horizon? Perhaps. But with the huge pullbacks we saw in 2018 (the market still has not climbed back to its previous all-time high), we probably won’t see recession in 2019. But you never know.
And even if we do, I’m not concerned. In fact, I might even be glad (from an investing standpoint), because it would mean I have the opportunity to buy investments on a much lower cost basis. However, as I’ve mentioned before, if the state of your investments give you great anxiety, then it would probably be better to keep it in a high yield savings account or money market fund.
Issawrap! I hope everyone’s been off to a great start to 2019. Let’s keep the momentum going into Q2.
Hard to believe that we are already nearing the end of January. Research shows that 80% of New Year’s resolutions fail by the second week of February. If one of your goals was to start investing, you’ve still got time to make good on your resolution.
But isn’t recession just around the corner? Why should I invest now?
There have been plenty of studies that suggest that trying to “time” the market over the long run does not work, and that a majority of actively managed funds do not outperform the general market. Basically, you’ll probably be worse off trying to time it than you would be simply investing incrementally over time, without too much consideration regarding whether the market is up or down. With that in mind, it is generally most prudent for individual investors to invest consistently and incrementally over the long haul (much in the same way that one would contribute to their 401k).
Current market conditions are pointing to a slowing global economy. For example, we see a Chinese economy slowing more quickly than anticipated, a slowing US housing market, and continued yield curve inversion. All of this points to what seems like the end of a decade-long bull run. The market may very well enter its first real bear market in a long time over the next 12-18 months. On the other hand, plenty of pundits have expressed their fears of recession for years now, meaning they have been wrong. For years.
So will the market continue to go up and to the right in the near term? It’s hard to say. But it’s certainly worth investing over the long haul, considering the total market tends to double every 7-8 years.
With all of this in mind, here are 5 ways to invest in the market in 2019:
1. Money market funds
The ultimate “safe” investment - most money market funds have very little fluctuation, and you can essentially be guaranteed that you won’t end up with a net loss (especially when taking into consideration a current yield of ~2.35% net of fees). Basically like “putting it in the bank”, but better. Money market funds and high yield savings accounts are both great options for those that are afraid of sustaining any losses. If you have any major upcoming expenses, it may be wise to keep a good amount of your cash parked here.
2. Treasuries & bonds
These debt instruments can range from guaranteed by the US government to junk rating. I am hesitant to allocate any investment to bonds due to the current level of corporate debt, continued interest rate risk with yield curve inversion, and confusion surrounding the Fed’s direction. For a yield between 2-3%, I would prefer a money market fund, because it is more liquid and not subject to the same interest rate risk as treasuries. High yield bond ETFs are certainly an option, but there is increased risk from potential corporate default (a certain utility company headquartered in California comes to mind).
3. P2P lending
Peer-to-peer lending gained a lot of traction over the past few years, but many have reported that they have seen a higher percentage defaults and lower overall yield, despite maintaining the same parameters and screening. Getting a higher yield requires loaning to individuals with a riskier credit profile. It’s like loaning a lot of money to that friend that never pays you back. If you get burned, you really can’t act too surprised. I cannot verify these claims from others’ experience with P2P lending, but a glance at other personal finance blogs indicates that the risk-to-reward ratio doesn’t justify investing through P2P lending vs. the other alternatives that are out there.
4. Dividend ETFs
Dividends will be a fantastic way to grow cash flow and overall portfolio, even in a relatively weak market. It’s a gift that keeps on giving. I’ve written before about the great benefits from dividend investing, and I will definitely look to increase my dividend positions this year.
5. Total market ETFs
The market is currently down over 11% from its all time high in September 2018. With a longer investing timeline, this is almost certainly the best way to go. Again, as mentioned many times prior, the market tends to double every 7-8 years, including recessions. With a longer timeline, investing in total market ETFs like ITOT, SPTM, VTI, and SCHB are all great long term bets, because the US economy continues to grow. At current levels, I still think these ETFs are wise investments - even more so if the market drops. However, I will decrease my allocation of new funds to these ETFs moving forward, as I have some large cash needs in the pipeline. Because I know for a fact that I will need the cash, it’s a bit more prudent to keep it in MMFs than to have significant exposure to the total market.
We may still be in for a rocky ride in 2019, but don’t let that deter you from getting your feet wet in investing. Leave a comment about your own investing strategy for 2019 - would love to hear your thoughts as well. -Ezekiel Emunah
Looking back on 2018, I can’t help but to thank God for such an amazing year. So many incredible memories, travels, relationships, changes and experiences packed into the past 365 days. While I am certainly grateful for financial blessing, God has blessed me in so many greater ways. Psalm 69:30 - “I will praise the name of God with a song; I will magnify him with thanksgiving.” Thank You, Jesus :)
Now onto the 2018 stats:
Net investment loss: $154
After-tax savings rate: 47.4%
401(k) contribution: $18,500
I began the year still thinking that I could outperform the market using some of my own investing strategy. Welp, I was mostly wrong. I may still look to opportunistically enter certain positions, but being overweight the technology sector hurt my portfolio considerably. During the second half of 2018, I focused primarily on just earning a market neutral rate through total market ETFs and dividend ETFs, which also saw some significant losses. Despite eating some losses and exiting some losing tech positions, I’m actually pretty happy with my portfolio rebalancing. Total market ETFs and dividend ETFs now represent 75% of my portfolio, and I’m looking to continue pushing forward to maybe 90% (with the remaining 10% in either cash or bond positions that can be used opportunistically). Overall, my total portfolio has done surprisingly well, with a net loss of only $154, considering I entered many positions during the peak (summer) and have been mostly dollar cost averaging my way down since then. In actuality, the total investment losses would be several thousand dollars worse, but I have the added benefit of restricted stock units (RSUs) that vested net of tax, and employer 401(k) match. More on that later.
Looking forward to 2019, I will be in a stronger position by having more shares of mostly ITOT, PGX, and PFF, and continuing to earn dividends on those shares. Some people might be tentative or nervous about investing moving forward, given fears of an upcoming recession. However, I intend to continue buying using the same strategy as now, especially with the market as depressed as it has been in recent months. I have no real fear of “losing everything”, because the ETFs are well diversified and largely represent the entire US economy. Even in the event of full blown recession, I am fairly confident that the market will rebound and reach new highs in a matter of time. So I intend to remain mostly invested in equities, and will continue buying investments into 2019. However, for those who are further along in their careers or have intentions to retire in the relatively near future, it may be wise to have a more defensive stance with larger bond positions.
In my overall financial performance, I am proudest of my savings results. I certainly could have been a bit more frugal or wiser in some of my spending (especially on eating out and drinking boba/coffee), but I still managed an after-tax savings rate of 47.4% (which doesn’t include 401(k) contribution). This was possible for a few reasons:
1. Living below my means
I am not a true minimalist, but I do value a rather simple lifestyle. I don’t have much, and could comfortably fit everything I own in my $6,000 used car that I bought in 2016 with cash. I live with roommates even though I can afford to live on my own. My personal laptop is a late 2010 Macbook Air (still works!). This honestly isn’t meant as a boast, but simply to say that we really don’t need much. There are undoubtedly much more extreme examples of minimalism than this. Most people in the world don’t even have the option to live in the kind of extravagance that most of us do in the US, and I am grateful for the comforts that I have. Choosing to be a little more “uncomfortable” isn’t much of a sacrifice in my eyes, and the tradeoff in savings is worth it for me.
2. Setting goals
We often need some inspiration in order to accomplish anything. With saving, it’s not always enough to simply know that it’s a wise and prudent thing to do. There needs to be a greater purpose to strive for. Having specific goals has helped to motivate me and keep me on track in investing, especially as I prepare the funds necessary to potentially buy a house in late 2019 or 2020.
3. Not buying useless stuff
While this is strongly correlated to the first point, it’s still worth mentioning on its own: Do not buy stuff you don’t need. Do you need to upgrade your laptop or phone each time a new one comes out? Do you need to buy those new clothes when the stuff you currently have is just fine? Of course, don’t skimp out on things that are important to you. Even though some coffee and boba are ridiculously priced, I’ll buy it regardless. But do exercise self-control and prudence, particularly with the bigger ticket items.
First of all, employer match is a wonderful thing. If your employer offers to match a certain percentage or dollar limit, you should take advantage of it. Before any other investments, it would probably be best to take advantage of the full employer match if possible. It’s literally free money.
Next, if financially feasible, it’s good to contribute the maximum amount possible. It’s essentially an automatic savings plan. Even if you think Jesus will return before you retire, it’s good to contribute to your 401(k), especially since you can still use the money in case of emergency, or take out a loan against it. Plus, there are tax advantages. For tax purposes, I am a single adult working in California. By contributing the maximum amount, I am saving nearly $6,300 in tax. I will be taxed on it in retirement, but I highly doubt I’ll be taxed nearly 34% as I am now.
As for my 401(k) performance, I’ve opted to invest entirely in an S&P500 index fund. Again, this is based on my current timeline. I am still in my 20s, so I plan to continue investing primarily in equities for the foreseeable future.
Finally, remember that the maximum contribution is increasing by $500 to a total of $19,000 in 2019. Happy saving!
All things said, I’m thankful for how this year panned out. Not an easy year for investing, but the key is to remain disciplined and to stick with a strategy that will work in the long run. I’m excited for 2019, and anticipating a lot more changes both personally and in the market. Onward to 2019!
I remember my hands shaking the first time I placed a trade. I have no idea what I’m doing, I thought to myself. Beginning my journey in investing seemed like such a steep learning curve, and the amount of information online actually made it more confusing at times. Many sources can either oversimplify or over complicate the process. It was that initial fear that stopped me from dipping my toes into investing until many years later. This article is meant to dispel at least a small part of that fear, and to equip you to read and understand the basics of a stock ticker. Don’t worry, it’s not rocket science, but you’ll still need to focus.
Let’s take ITOT, my favorite ETF, as an example:
You can easily Google search all of your favorite companies’ tickers online to see their respective charts, which will look like the above (but specific to the company that you’re searching, of course). Ultimately, these charts give you some perspective on the performance of a company’s stock. However, it’s important to note that stock performance is not the same as a company’s business performance. More on this later. Onto the definitions!
Symbol: First, every stock (or ETF) will have its own ticker or symbol. In this case, it is ITOT, which is the iShares S&P 1500 Index Fund. This fund basically represents the entire US stock market. Abbreviations are great - Who has time to always write out full names anyway?
Price: The price indicates the current market value of a given security. If you’re looking at this chart during typical market hours between 9AM and 4PM EST, then this will constantly be changing. The price of ITOT at the market close of Dec 21, 2018 was $54.62. Sigh.
Change: In the above example, ITOT dropped $1.17 from its previous close of $55.79 (or 2.10%). These changes can swing wildly on some days, given different market events and news.
Date range: This could differ by website or app, but most stock symbols will have charts for 1 day, 1 week, 1 month, year-to-date, 1 yr, and Max. They represent exactly what you’d expect - stock performance over those specified time periods.
Take a look at the 1-yr example of ITOT. You can see that we are indeed in a “bear” (ie down) market.
However, the “Max” time frame shows that it’s clearly a great investment over the long haul. I’m sure most people at this point would still say that the US market is the strongest and most reliable.
These charts can reveal underlying stories and narratives of a company. Take a look at Facebook over the past year:
Facebook has definitely encountered some tough times over the past year. News broke that Facebook had leaked a millions of users’ data to the political consulting firm, Cambridge Analytica. Then, FB reported slowing growth for the first time, sending its stock tumbling once more. The only reprieve came in early January with the announcement of a more aggressive stock repurchase program, but the slight gains have been crushed once more by overall market pessimism following the Fed’s rate hike and uncompromising attitude toward rate hikes moving forward. As mentioned before, stock performance is not the same thing as business performance. From a standpoint of earnings per share, FB has actually been doing incredibly well. Through all of its precipitous drop from almost $220/share down to $125/share, FB has posted great numbers in terms of earnings. However, investors are spooked by the slowing growth, as well as the uncovering of many different scandals involving the liberal sharing of user data.
Finally, you can also see some patterns from the charts, such as when a company has seasonality or is part of a cyclical industry. For example, Amazon has seasons where people are more aggressively shopping (holidays) than other times. Below is an example of AVGO (Broadcom):
Certainly not all of its ups and downs are a result of seasonality, but it does play a significant role.
Open: The price of the stock at market open (9AM EST).
High: The highest price of a stock during a particular trading day. Again, because prices always fluctuate, the “High” simply records the highest price reached during market hours.
Low: The lowest price of a stock during a particular trading day.
Mkt cap: Market cap refers to the total market value of a particular fund or company. Basically multiply stock price by all outstanding shares. Taking the FB example again, its current market cap sits at $359B (quite the drop from its all-time high market cap of $601B+).
P/E ratio: Price to earnings ratio. Per Investopedia, “In essence, the price-earnings ratio indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company’s earnings.” Taking the above example, ITOT has a P/E of 6.93 vs. FB’s P/E of 18.81.
Now, you might be wondering, “Why wouldn’t I just invest in companies with the lowest P/E ratio? Wouldn’t that mean I would be getting the most for my investment?”
While there is some logic to that, it’s not quite so straightforward. Stock prices represent expected future value, whereas earnings represent the most recent earnings per share. Basically stock prices are more forward-looking, whereas earnings are more backward-looking. When Amazon stock first hit the market, it had negative earnings per share (ie it was losing money). However, as we all know now, the company would later become a behemoth and peaked at >$2,000 / share. It still has a relatively high P/E, because most people still believe in the future growth of the company. In general, high P/E usually represents stocks of companies that are expected to continue growing impressively, whereas low P/E tend to represent very mature companies like CVS or Bank of America. P/E gives you a snapshot, but certainly should not be the only thing you look at when considering an investment.
Div yield: Percentage “interest” received from holding a stock. Investing in high-growth companies can certainly pay off - as prices climb higher, you eventually sell and take the difference as profit. But what happens if the company is already mature? They keep you onboard by issuing quarterly or monthly dividends. You can find out more about dividend investing here. I’m personally a fan of dividend investing, because it is an easy way to build up passive income with little to no maintenance.
Prev close: The closing price from the previous trading day.
52-wk high: Highest price over the past year.
52-wk low: Lowest price over the past year.
Volume: Number of shares changing hands. A higher volume generally means higher liquidity (ie you can buy a share, because there’s definitely someone also selling or vice versa).
Expense ratio: Management fees - This only applies to mutual funds and ETFs. In essence, it is the fee you pay in order for someone else to manage the fund. When I buy ITOT, it is mostly a computer automatically rebalancing a $14B portfolio to make sure its portfolio continues to represent the S&P 1500 index. Having a company provide this service is not free, hence the expense ratio. But with ITOT, it’s only 0.03%, which amounts to very little, even over the long haul.
And there you have it! Take some time to familiarize yourself with the charts and terms, and be better prepared if and when you decide to take the plunge into the world of investing.
Today marked another day of pretty shocking volatility. The market seemed like it was finally rallying after a brutal first half of December, but those hopes were rather unexpectedly crushed. Kind of like getting a wrapped Christmas present only to later find out that all you got were socks. And not even the comfy kind. The overall volatility on the day was likely caused by a combination of Wall Street’s reaction to the budget bill, institutional investors covering short positions, and alternating optimism / pessimism about the close of tomorrow’s Fed meeting.
Tomorrow might be the last chance to see any rally in 2018 when the Fed posts its minutes (commentary) at around 11AM PST. (The only other event that could turn this market around is some sort of resolution to the US / China trade tensions, but don’t expect to see that in 2018). The current sentiment is that the Fed will follow through with its previously broadcasted intentions to hike rates in December, but soften the 2019 approach (from three hikes to two hikes). If this is the case, expect to see a rally. But we won’t know until we know, so get ready for perhaps another wild ride. I will continue buying total market ETFs, especially while they remain at a “discount”, but no one can say for sure what kinds of gains or losses we might expect in the coming weeks or months. Stay disciplined, and invest wisely.
This morning, I received a notification from my Robinhood account that they are introducing checking and savings accounts on their platform at 3% interest, with no minimums or fees. I immediately signed up for early access (and I’m not being paid a single penny to promote this, it’s simply awesome). You can read more about the features here.
What’s incredible about this is the fact that the next best rate for a savings account is maybe 2.10%? And even then, there are usually $10K minimum balances and withdrawal limitations. A 3% interest rate with no restrictions or fees is pretty much unheard of. For context, as of the time of this writing, the 10 yr US treasury yield is 2.91%, and the 20 yr treasury is 3.05%. Instead of investing in a treasury and being subject to interest rate & inflation risk, you can simply park your cash in a checking account, which basically eliminates those risks and is insured up to $250K by the FDIC (in other words, insured by the US government). Even if you don’t invest or trade, taking advantage of Robinhood’s new banking seems like a no-brainer.
Also, shoutout to Feedspot for featuring Five Talents Capital on their Top Personal Finance Blogs post. Thanks for acknowledging us, and we will strive to continue bringing the best content for our readers!
Market volatility is back! Maybe some day traders are rejoicing, but for most of the population, it can feel like a cause for concern.
Before you decide to make some yolo trades or liquidate your portfolio and quit, read this article first.
What is volatility?
A simple way to understand market volatility is to see how much a stock’s price fluctuates. If you see the chart for ITOT (which tracks to the S&P1500 index), you can clearly see the big ups and downs in price over the past few months. High volatility environments lead to large up- and downswings over fairly short periods of time (there is a more comprehensive definition here from Investopedia in case you’re interested). Put another way, high volatility is like Detroit’s weather (snow storm one day, sunny and warm the next day). Low volatility is like the weather in Los Angeles (sunny and warm basically year-round).
What causes volatility?
There are plenty of great academic papers detailing the different models and factors that contribute to volatility, which in turn affect asset prices. For simplicity’s sake, we can think of it in terms of the market’s sense of uncertainty. The greater the sense of uncertainty, the greater the volatility. Because equity prices are forward-looking, current prices reflect the market’s best understanding of what will happen in the future.
Taking the above example of ITOT over the past few months, we can clearly see huge variance in stock price. While a few percentage points up or down may not seem like a lot, this chart represents the entire US market. Investors have been primarily concerned over two issues: Fed interest rate hikes and US-China trade war.
First, the Fed has been inconsistent in its commentary on rate hikes in 2019. Future interest rates play a big part in the market. With a higher future interest:
Bonds become more attractive vs. equities
Corporate debt becomes more expensive, and discourages companies from using too much leverage
Loans generally become more expensive (especially for those that have floating rate loans, whether for student loans, car loans or mortgages)
In short, raising interest rates reduces both consumer and corporate spending, which generally slows the economy. Then why does the Fed raise rates in the first place? Because there is a need to keep inflation in check. If inflation starts to grow out of control, prices can grow at an unsustainable pace. With serious inflation, your morning Starbucks might jump from $4/cup to $6/cup in just a year. (And people would still buy it each morning anyway. Sigh.)
Second, there continues to be confusion regarding the state of affairs between the US and China regarding tariffs and trade. Months ago, Trump proposed tariffs on Chinese goods in retaliation to China’s refusal to change its policy on taking intellectual property and technology as a means of entry. The two sides have traded tariffs, and continued to escalate when the other has refused to back down. Little bits of news have significantly impacted the market as investors wait with bated breath for any signs of a resolution to the conflict.
Both issues have a major impact on the 2019 economic outlook. Unfortunately, both issues also remain very unclear. No one is entirely sure what to expect, contributing to the sustained volatility over the past two months in particular.
So what should I do in this volatile market environment?
Truthfully, it’s probably best to simply stay the course. As I’ve already mentioned in this article about the golden principles of investing, know your timeline. If you need a large amount of cash soon, it’s best not to invest any additional funds. Do not place all of your eggs in one stock - stick with ETFs. Buy low and hold. Do not try to “flip” investments for short-term profit unless you are committed to becoming a trader. It requires an appropriate amount of research, practice, and diligence to succeed this way.
There’s just one thing I would change given a volatile environment - an extra focus on dollar cost averaging. Because prices continue to fluctuate significantly, I have been more intentional in buying a bit more aggressively on the dips. I have a long term timeline, and the total market tends to double every seven years.
For those who end up feeling very anxious looking at the prices of equities swing up and down dramatically, it’s important to exercise extra self-control. It will always be tempting to follow the crowd (panic selling, panic buying), but this is often what results in the greatest losses. Riding roller coasters is meant to be fun. If you’re vomiting instead of having fun, maybe you should reconsider jumping on the next ride. If you don’t trust yourself, then keep dollar cost averaging on a flat schedule (rather than buying more or less in response to market movements).
As a final note, remind yourself to stay grounded. The type of investing I am promoting is a long-term, passive strategy that is meant to provide a person greater financial freedom or flexibility in the future. If you find yourself becoming enslaved to the market (constantly checking prices, making rash decisions with trades, or otherwise having your thoughts consumed by the market), then it may be best to take a step back. You cannot serve both God and money. Keep your priorities straight, regardless of what the market is doing.
In addition to investing in total market ETFs, the only other investing strategy I strongly adhere to is dividend investing. Of the many potential passive income streams that one could build, dividend investing is among the most effective because of its consistent, predictable gains and the minimal effort required to maintain it.
To understand dividend investing, let’s first take some time to understand terminology. (If you’re already familiar with the terms, skip to the next section).
Interest: money paid regularly at a particular rate for the use of money lent, or for delaying the repayment of a debt. (Source: Google)
For example, when you leave money in the bank, you earn interest on it (but the current interest rate on a standard checking account is nearly zero). Also, if you take out a loan, you need to pay it back with interest, which serves as their compensation for giving you money for a period of time.
Compound interest: interest on interest.
Imagine you plant an orange tree. Instead of eating the oranges and tossing the seeds in the trash, you decide to replant the seeds in order to grow more orange trees. After many years, you end up with an acre full of orange trees. Compound interest works in much the same way, using the interest earned to earn more interest.
Dividends: the “interest” earned on certain stocks.
Many companies (particularly large, mature companies) incentivize investors by paying monthly or quarterly dividends. These companies pay out cash from their profits to their shareholders to reward them for continuing to hold onto their stock. Some examples include JPMorgan, Coca Cola, and McDonald’s. By contrast, most growth companies do not pay dividends, because they are still experiencing strong growth, and are better off reinvesting their profits into the business.
Dividend Terms: Here is a useful article summarizing the timing of dividend payments and how to receive a dividend. Basically, in order to receive your dividend, buy the stock before the Ex-Dividend date, hold it until after the Record Date, and then receive the dividend on the Payment Date.
Dividend investing is a great tool for a few reasons:
1. Dividend payments are very consistent and predictable.
It’s about as plain vanilla as investments get. Most dividends payments are monthly or quarterly, and the amount and date they will be paid are typically largely the same.
Look at the following chart for PGX:
There is clearly minimal variance in the amount or timing of the dividend payments. Just like a paycheck, it’s nice to know when and how much to expect in your next payment.
2. It’s a purely passive source of income.
Literally all you have to do is buy the shares, and they will pay you for being a shareholder. If you are invested in a dividend ETF (again, it is good principle to be invested in a basket of stocks rather than individual stocks), you don’t need to worry about a company discontinuing dividend payments or going out of business.
3. Dividends are paid in cash.
Admittedly, this is both an advantage and a disadvantage. The plus side here is that you do not have to sell principal (your shares) in order to receive the benefits. On the other hand, if you own a stock like Google, and it appreciated in value from $1,100 to $1,200, you would have to sell the share to gain $100. If you choose to keep holding, you may benefit more from continued rise in share price, or the shares might drop from any market factor (overall recession, changing marketplace, major litigation, etc). Either way, you have to eventually make a choice.
While the earning potential on dividends is generally less than that of growth stocks, you know exactly what you’re getting. Think about it like this: You’re going out for dinner, and you’re picking a place to eat. On the one hand, you could go with something familiar, like In-N-Out. With In-N-Out, you know exactly what you’re getting (cheeseburger with no onions, fries well-done, and a Coke). While it’s not fine French dining, it’s undoubtedly delicious. On the other hand, you could check out the new Korean-Mexican fusion restaurant that everyone’s been talking about. You might be mindblown by their bulgogi tacos, or you might walk away shaking your head in disappointment because the hype wasn’t real. This is basically dividend investing vs. growth stocks in a nutshell.
The other downside is taxation (when are taxes ever a positive? Hah). Dividends are realized gains, therefore they need to be recorded as taxable income.
Let’s throw some realistic numbers in the mix:
First, it’s pretty evident that just throwing your money in the bank is not the best use of your cash, assuming that you don’t need it immediately. There are some savings accounts that pay nearly 2% in annual interest, but there are usually conditions attached like a $10K minimum balance, limited number of withdrawals, and fees for going under the minimum balance.
Next, you can opt to just use the cash earned from dividends for your daily life. An extra couple of dollars each month can help with your expenses. You can smugly tell friends that your dividends paid for your Netflix subscription.
However, the best option, especially for young people that still have a long time to invest, is to reinvest the dividends to take advantage of compounding. In the example above, $10K invested over 10 years results in a $7,835 gain (excluding taxes) from doing essentially nothing. The key to dividend investing is ultimately time and patience. The initial amounts received are admittedly tiny, especially with balances under $10K. But let’s say you’re 25, and you’re able to aggressively build up a balance of $100K in dividend ETFs over the next five years. At that point, you would be receiving about $500 in monthly dividends. While it’s not enough to be able to quit your day job, it absolutely can go a long way in helping your financial position. End up quitting or losing your job? You can still rely on your dividends to help you instead of having to pay purely from your savings. But to get to this point, you must be disciplined in saving up and resist the temptation to sell off shares when different circumstances come up.
Okay, you’ve convinced me. But how do I choose what to invest in?
As I’ve mentioned before, a passive investor should almost always invest in an ETF rather than an individual stock. There are quite a few dividend ETFs to choose from, and it can feel a bit overwhelming with the options. There are a few factors to consider:
Size People can run into problems if the fund is small (in my definition, less than $1B). Small funds may cause problems with liquidity (ie you can’t find a decent price to sell your shares because there aren’t enough traders). Small funds may also not be as well diversified, which leads me to my second point.
Portfolio composition If the portfolio is comprised of just a few companies, or “overweight” one company (high % is in just one company) then one company finding itself in troubled waters could drag down the entire ETF. Any portfolio with large positions in GE, FB, or PCG probably got demolished this year. Also, if you discover that you don’t recognize any of the names in the top holdings of the portfolio, that’s probably an issue. It’s like eating a “mystery meat” chicken nugget. You know from the ingredients list that the meat definitely isn’t just chicken breast. Still tastes good, but questionable enough to make you second guess whether or not you should be eating it.
Risk Just because an ETF has a very high dividend yield does not mean it’s “better”. Markets are fairly efficient, so a higher yield almost always means higher risk as well. That ETF with 8% dividend yield might look very attractive, but it could be a trap.
Expense ratio It’s always good to check the expense ratio, which is the percentage of your investment that will be taken out as part of the admin fees associated with the fund. Two funds may look largely similar, but one may have a higher expense ratio than the other, making it less profitable.
My personal preference is for PFF and PGX because they are large, well-diversified portfolios of preferred stock. I recognize all of the top holdings (mostly banks and energy companies). There are many other options out there, including DIV, SDIV, SRET, VIG, VYM, etc. These all have different focus (US, non-US, real estate, etc), and track to different indices.
When investing, check to see whether your brokerage allows a dividend reinvest plan (DRIP). If so, you will be allowed to automatically reinvest your dividends to purchase more shares (including partial shares). I personally use Vanguard, which has the option to enroll in DRIP.
Conclusion Ultimately, dividend investing is an excellent way to build up passive income. It’s not the most lucrative or the flashiest option in terms of investing, but there is a lot to benefit from the consistent approach found in dividend investing.
You've decided to take the plunge. After reading many articles, you've finally been convinced that you're missing out by not investing. With great trepidation, you're now just a few clicks away from making your first investment in the stock market.
Boom. 5 shares of Facebook stock.
The rush. The relief. And then...the growing sense of dread. What's going on? The stock price takes a plunge, and continues to plunge day after day. You've already lost $100 in less than a week. Oh man, I could lose everything. In a panic, the "sell" button is simply too tempting. You sell out, and now you're down $114 including commissions to finish off the week.
Hopefully the above story doesn't sound too familiar. But like most novice investors, I've also experienced some significant losses. There will always be gains and losses when investing in the market, but losses like the one mentioned above can certainly be avoided. Contrary to common belief, being a successful investor does not require some astounding intellect or deep knowledge of the markets. For the typical investor, his or her greatest advantages will be time and discipline. By applying the following principles, an average person can outperform an average hedge fund manager:
1) Know your timeline First, you must know your timeline. Are you investing for the long haul? Or do you need cash for a down payment in the next 2 months? With a longer timeline, it makes sense to be invested in equities. On a shorter timeline, a certificate of deposit, treasury ETF, or high yield savings account would be the better choice. If you invest in the stock market with a very short horizon, you run the risk of loss that cannot be recovered by the time you need the cash.
2) Diversify In my first year of investing, I had over 20% returns from investing in just 3 high-growth tech companies. After a tech downturn, I found myself lagging the market, and barely breaking even. Since then, I’ve realized the importance of diversification. It’s easy to get an inflated sense of confidence after outperforming the market for some stretch of time, but it is oftentimes not replicable over the long haul. It’s by no surprise that one of the most famous and successful investors in history, Warren Buffett, advises people to "consistently buy an S&P 500 low-cost index fund.” In brief, buying index funds or index ETFs allows you to be invested in hundreds of companies instead of just one. In general, a person who invests $10,000 in an index of 500+ companies will easily outperform a person who invests the same amount in one stock only over the long haul. Even great (or seemingly great) companies can implode or fail to adapt to new market conditions (Sears, Blockbuster, Yahoo, GE just to name a few). Being invested in an index like the S&P 500 provides diversification that mitigates the risk of any one company’s struggles destroying your entire portfolio.
3) Apply Dollar-Cost Averaging It’s impossible to perfectly time the market. It is generally unwise to suddenly invest a very large sum all at once, thinking that you may have caught the bottom. Even general trends in the market can suddenly change based on different events or circumstance. As a recent example, the Fed’s commentary on interest rates being far from neutral sent the market crashing for the entire past month. Instead of trying to perfectly time a downswing to buy everything, or an upswing to sell everything, it’s better to simply buy consistently over time (your 401K plan basically already does this for you). Buy a little more when the market is tanking, and a little less when the market reaches new all-time highs.
Imagine that you need to buy jugs of water for drinking and cooking (this is actually a reality in some places in the world. Hah, I digress). Say that these jugs of water occasionally jump in price, but also occasionally go on sale. They also continually grow in price due to inflation. That being said, you always need at least some water to survive, so you buy it consistently. During times the price jumps up, you hold off a little and buy less. During times it’s on sale, you pick up a bit more. Dollar-cost averaging in purchasing index ETFs follows the same principle.
Again, this follows the old adage of “buy low, sell high”, with the added caveat that you cannot truly predict market movements. So determine a plan and stick to it, whether that means buying once a week or once every other week in some fixed dollar amount (unless there are large rallies or selloffs in the interim). In doing so, your dollar-cost average will be lower, and your return will potentially be a bit higher than the market.
As a real world example, here is the YTD chart for ITOT, which follows the S&P 1500 index.
Person A and Person B both apply dollar-cost averaging. However, Person B is a bit more opportunistic, and buys more shares during market panic, and buys fewer shares when the market seems to border on all-time highs.
In this example, Person A, after seeing a two day drop at the end of January, decides to go all-in. He bets on a market rally to bring the total market to new heights. Person B applies dollar-cost averaging in a purely flat-line manner. Person C pays a little closer attention to the market, and decides to buy a little more aggressively on the downswings, and a little less on the upswings.
Over time, Person C will almost always end up with the lowest average cost. Person A may look a little foolish in hindsight, but many people do fall into this kind of mentality.
4) Remain disciplined The market is a fickle beast that often does not move according to our expectations. It will undoubtedly be tempting to sell and just get out when people are panicking and the market is crashing. At the same time, when the market is reaching new highs, it may be tempting to think that you have to get in now and not miss out. However, do not be fooled into taking any drastic measures, or succumbing to these temptations. Even brilliant people have lost an incredible amount from their investments due to falling for these temptations. In general, any strategy that likens to “get rich quick” is likely to set you up for huge loss. Stick with the plan.
Disclosure: I am/we are long ITOT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.