New Financial Plan

Warren Buffet is trying to make a quick buck again.  He’s timing his investments again.  When will he learn?  Never-mind.  I know my place.  Buffet is someone I learn from, not lecture.  He believes in timing investments.  He believes in buying cheap.  He’s made billions doing just that.  Buffet knows how to do that and has the resources to do it well.

It’s funny, headlines yesterday pointed to Buffet’s move as great for the markets.  The first thing I thought was that it has to be great for Buffet, but that means it’s not so good for someone else.  Apparently he wants to re-insure municipal bonds for several companies who are possibly in trouble.  Due to financial policies and credit rating systems these companies need to have a certain amount of cash available according to the risk of their portfolio.  I guess Buffet believes that they are in a bad enough position that he can take the best big chunk of bonds from them.  They have to decide if giving up the fees he wants, and the bonds he wants, leaves them in a much stronger position.  One company came out very soon after I saw the news and rejected it.

What can we learn from this?  The biggest lesson is understand your position.  I believe timing investments is smart if you can handle it.  Buffet, Microsoft, and Blackstone Group are all trying to do it again.  But they are in great positions.  Billions in cash.  Finance, accounting, legal, and management teams working with them.  They will not only make investments, but take control.  It’s a lot easier to make money when you have a lot of money already.  Fees take a percentage off your investments.  That fee percentage will be a lot smaller on $1M than it will on $1k, so a larger investment can make a profit after fees quicker than a small investment.

If you had a billion dollars and real time access to Buffet’s financial moves what would you do?  Would you make the same moves as him, invest in Berkshire, stick with index investing, or be happy to preserve it and go more conservative?

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To all of you indexers out there, it’s good to stick with your indexing plans, but notice that these types of changes happen.  Do you know how your index investments work?

This article describes changes coming to the Dow index. The index will drop Honeywell and Altria to pick up Bank Of America and Chevron.  The changes will be in effect next week.  The index isn’t actively managed, does not have a lot of turnover, but at this point in time there is an impact in changing a large portion of investments.  This is what happens with smaller or targeted indexes.  To truly track the broad market there are larger indexes such as Vanguard’s Total Stock Market Index.

Here’s a quick highlight of the companies involved in this change.

Altria was formerly Philip Morris.  It is primarily a vice stock, tobacco, but still owns other operations.  It has a market cap of $154B, a PE ratio of 16.59, and dividend yield of 4.13%.

Honeywell is a technology and manufacturing company with worldwide sales and diverse product lines.  It has a market cap of $42.6B, a PE ratio of 18.08, and a dividend yield of 1.75%.

Bank of America is one of the big financial and bank stocks.  BoA recently completed a deal to buy Countrywide Financial, the top, but troubled, mortgage lender.  It has a market cap of $186.6B, a PE ratio of 12.74, and a dividend yield of 6.09%.

Chevron is an oil, chemical, mining, and energy company.  It has a market cap of $166.4B, a PE ratio of 8.99, and a dividend yield of 2.94%.

All of these companies are large, and all have global operations.  Honeywell is the smallest of the four and also has the lowest dividend yield.  So this change will increase the market cap and the dividend yield of the Dow index.  It will lower the index PE ratio.  It will also shift the sector balance of the Dow, since some tobacco, manufacturing, and technology are being dropped.  More financials and oil are coming in.  The financials and oil seem to be more cyclical than the others, and especially now with the credit problems and high oil prices this shifts the Dow’s position in the current market environment.

Another thing this changes is the risk faced by Dow components.  Altria has recently dealt with lawsuits and government regulations, but seems to be through most of it.  Large portions of the lawsuits against tobacco were resolved in recent years, and global tobacco sales and prices have been strong.  On the other hand, financials and oil companies have been under scrutiny for their practices and pricing.  Bank of America will have it’s mortgage and credit card operations watched and possibly regulated.  Chevron will be watching for regulations aimed at high profits from high oil and gas prices.  On the positive side Chevron will be profiting from those high prices.  And BoA will hopefully come through the credit problems and maintain both it’s high dividend and it’s credit rating.

So, what is important here?  The Dow is a popular index, and popular indexes highlight the market’s performance.  But you can see that this highlights part of the market, and next week that part will be different than this week.  I don’t have any investments based on the Dow, but I do have investments based on other indexes.  The highlight of this news to me is make sure you understand what your index is supposed to do.

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The Giants surprised a lot of people in beating the Patriots.  Who would have thought that so many experts could be wrong?  As far as picking the winner I’d guess that more people picked the Patriots than picked the Giants.  Of course bets and odds are made based on perception.  Everyone thought the Patriots were very likely to win big, enough so that the spread was 13 points.  I don’t know how well that spread evened out the money bet against it, but the people who make that number are good at it, so I’d guess it balanced things out quite a bit.  So the spread is a handicap that brings more money to bet for the Giants when betting against it, but probably more money betting for the patriots straight up.  After all, if the experts are saying the game will go one way by 13 or more points it is a pretty strong prediction.

What about the markets?  Many experts have made their picks for the year and have predicted market returns.  There are all kinds of forecasts.  There are also predictions for inflation, current measures of inflation, and the opportunity to lock in yields through bonds.  That brings me to my question for you.  What spread are you looking for to invest more in stocks now?  Some people saw the recent declines as enough of a discount to jump in.

The reason for investing in stocks is believing that they will return more than other investments over the time frame you want to invest.  Investing in indexes is supposed to lower the risk involved.  So stock indexes will hopefully return more than bonds.  If your index has decent dividend yields it makes it feel even safer, since that yield makes the spread between stocks and bonds smaller.  In theory that means stocks only have to go up by that spread percentage to break even.  Any returns above that should mean stocks were the better investment.  Then Citigroup slashes it’s dividends.  What is the new yield on the index?  What is the new risk picture on the index?  How much weight does Citigroup have in either of those considerations?  This all goes back to what extra return you expect from stocks for the extra risk you are taking on.

Experts look back over the history they have recorded and pull out averages.  Those numbers influence expectations.  Stocks historically yield 10% over time.  Over longer periods stocks are several percentage points favorites over current bond offerings.  How will you bet on that spread?

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With the market already down a good chunk for the year, and a big drop on Tuesday, it looked like a great buying opportunity.  A common feeling is that when things are cheap it is time to buy more of them.  That is why stores have sales.  It is the reason people suggest buying stocks when everyone else is selling.  There is a bit more to it than that.  Everyone believes the market will go up over the long term, and most people feel the market will move up relatively soon, as several quarters of back to back declines are considered unlikely.

I also assume those are true.  I agree that indexes are the way to go, that over time they will go up, and that large dips are buying opportunities.  If I had enough free money to play with I would trade on big market moves.  The trick is having enough money with enough flexibility to make up for transaction and account fees while keeping the right risk strategy.  Unfortunately I am not in position yet to have money for that type of investment.

I believe that you should time financial moves when you can.  If you itemize taxes it can make sense to pay taxes early, or to delay income.  It can pay to sell losing investments to offset gains.  When buying or selling a house you hope to find a relative bargain when buying, to get a high price when selling, and to meet the criteria for tax exemption of profits.  When buying and selling investments you also have to look at the prices when buying and selling, along with distributions, gains, and taxes.  Those are all types of timing, although for slightly different reasons.  With investments you have to invest according to your goals.  My goal is aggressive allocation, timed deposits, and frequent evaluation with adjustments as needed.

My investment strategy is all about retirement.  The retirement funds I hold use a two day delay to discourage timing.  They also have restrictions on moving back into a fund within so many days of selling it, and many funds now charge fees for selling within so many days of purchasing.  I know the limits and fees I have to work with.  For those reasons this week was not a buying opportunity for me.  Without those restrictions, if I had free money to invest, I would have looked at buying some index ETFs on Tuesday morning and been watching for a bounce back.  Even yesterday, if you had money to invest in the morning, could have been a very quick gain of a couple percent.

Since I know the limits and delays in my retirement accounts I put my investments in last week.  You could say I missed this bottom by a day or two, but I wasn’t trying to find the bottom.  I am investing according to my plans.  Being relatively early in my investing plan I am able to be aggressive.  I invest throughout the year and fully fund IRA accounts.  But I do not simply throw money in as it becomes available, or at set points each month.  Instead I buy when the price seems right.  I thought about investing throughout October, November, and December.  I decided to wait then.  With the nice discount January had already brought it was good enough for me.  Very soon the market could move down again and go for a full correction.  In that case I will do everything I can to come up with money to invest more while it’s down.

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Wow.  Global stocks plunging.  More bad news in the financial sector.  And the Federal Reserve with a surprise 3/4 point cut to hold off some of the pain.  There is some other news mixed in too, with oil backing down a bit and a stimulus plan creeping closer to reality.  If only the stimulus plan was a reasonable one and truly quick, like now, instead of another political game that waits through more pain.

Assuming some tax rebate comes in soon I have different plans for it now.  We were waiting for the market to show it’s real direction before finishing off our 2007 Roth contributions.  It looks like it’s about time to buy on another big dip in the market.  The money we have for our 2008 contributions might be put to use too.  This is a decent size pullback, I believe 10% YTD.  We will still be dollar cost averaging our contributions by not dumping it all in now, but will also be timing them to invest on the dips in the market.  Even with the volatility of the past several years this month has been a harsh one.

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It seems like timing the market, if you could really do it consistently, would be the single best way to grow rich.  If you follow most mainstream personal finance resources you hear that it is virtually impossible to make that work.  If you dabble in it and test your luck you most likely will find that they are right.  Many things I have done, however, have involved a bit of timing.  It hasn’t always worked perfectly.  It hasn’t made me rich (yet).  But I do believe it has worked in my favor.  Below are a few of my financial timing experiences.

Real estate and mortgage loans.  We bought our house early on.  Housing was moving up quickly in the area and we wanted to own.  It was a stretch for us at the time that we considered worth the small risk.  Within a few years of buying we had earned a few promotions at work and the housing market had kept rising.  Then mortgage rates moved lower, bounced a bit, and moved lower again.  We refinanced and cut our rate by 2%.  Now we have a decent house with a very affordable payment.  Our timing in both buying and refinancing worked out very well.

Timing the market.  Stocks have been volatile, hitting all kinds of highs and lows over the past several years.  I remember when I starting investing in IRAs.  People told me not to put any money in stocks because they were too risky.  That was short term thinking.  Down stocks have been good to me, and I have enough time ahead that they are very likely to do well.  We try to max out our contributions by the deadline, to dollar cost average by spreading contributions out.  I also try to beat the market by buying lower.

Not to say all of our moves worked out, for example the money in a real estate fund we own, I believe is about even with where I started while the stock market is up since then.  At the same time the emerging markets we picked up a few years ago have beat the market index.  By putting more money there we missed out on having a larger portion of our investments in that winning fund.

I guess In my mind this version of market timing is really just reallocation taken a little further.  Instead of picking an allocation and sticking to it, I adjust the allocation too.  Maybe it’s along the lines of shifting the allocation of stocks vs bonds as you approach retirement.  Maybe it’s like moving to fixed income investments after you have a sum that you want to live off and protect.  Do you think in either of those cases your situation determines what the market will do?  It doesn’t.  Is it the market determining what you will do?  Then you are timing the market.  No, in either case it is risk as the deciding factor.  Those moves are simply to reduce exposure to risky investments while protecting principal or cash flow.

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