Income Investing Secrets
How to Receive Ever-Growing Dividend and Interest Checks, Safeguard Your Portfolio and Retire Wealthy
by
Richard Stooker
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Copyright © 2007-2012 by Richard Stooker and Gold Egg Investing LLC.
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Dedication
To Paul Jacoby ("Grandpa"), for constructing the income investment portfolio that fed and clothed my sister and I after our father's early death.
DISCLAIMER
I am not a broker.
I am not a licensed securities dealer or representative of any kind.
I am no legal right to sell you securities and I'm not trying to do so.
Nothing in this book is to be construed as a solicitation or offer to sell you securities.
Nothing in this book is to be construed as personal financial advice.
I have no legal right to give you personal financial advice. Even if I were a registered financial advisor, I don't know you or your individual financial situation.
This book is the result of my research and is believed accurate. It consists of my opinions and suggestions.
I'm not making any representations as to how much money you will make if you invest according to the guidelines I set forth -- that will depend upon the payouts of dividends and interest of the precise securities you decide to invest in, and nobody can predict the future.
That is part of the problem with mainstream financial advice -- it assumes the future will repeat the past. It doesn't.
Past performance is not a guarantee of future results.
This book is for education and entertainment.
Nothing in this book is to be construed as professional advice. For that, you should consult your attorney, accountant or financial adviser.
I am not responsible for the results of your investment decisions.
I follow my own advice. The only financial investments I own, besides ordinary checking, savings and money market accounts, in my IRAs and my taxable brokerage account, are ones I recommend in this book.
I am not seeking to raise the price of those securities by making them more popular. I will not sell them unless driven by financial emergency.
You must read, think over what I say, make your own investment decisions and take responsibility for your own life, including the results of your investment decisions.
Continuing to read this book implies your acceptance of these terms.
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The Case Against Capital Gains
Objections to Investing for Income
Market Efficiency / Unpredictability
Real World -- NOT Academic – Risk
7 Foundation Principles of Income Investing Secrets
Principle 1 -- Income! Income! Income!
Principle 2 -- Reinvest Your Investment Earnings
Principle 3 -- Be Happy for Low Market Prices
Principle 4 -- Meet Basic Human Needs
Principle 5 -- Diversify for Safety
Principle 7 -- Reduce Expenses
Open-Ended, Actively-Traded Mutual Funds
Business Development Companies
Guaranteed Investment Contracts
Direct Access Notes or InterNotes or CoreNotes
Short-Term, Intermediate-Term and Long-Term
Matching Investment Types With Investment Vehicles
For Investors Getting Close to Retirement
Baby Boomer Retirement Age Wave
You're about to learn a revolutionary way to invest.
It's not magic, and it's not any more guaranteed than anything else in this crazy, mixed-up world.
It's not a short-term quick fix. The short term buying and selling of financial securities is more properly known as "trading," and is most akin to gambling. Even if you're a good guesser, the "house" -- your broker who gets paid commissions on every transaction-- is the only guaranteed winner. And sooner or later, you'll guess wrong more often than not.
But for long-term investing, as you'll soon see, it's the way that makes the most sense. It's building a foundation so that your investments can support you for the rest of your life.
And just so we're clear -- this method of investing is for the long term, especially for retirement.
It's not about saving up for a vacation, a house down-payment, or a child's college tuition (although if the child is still young it could be adapted to that). If you want to save up for a short-term goal, you should keep your funds in a money market account. In the short term you can always lose money in the stock and bond markets -- as they've proven so dramatically since the summer of 2008.
The younger you are, the better it'll work for you -- but we're all younger than we think.
We All Wish We Could Turn Back the Calendar
I do understand the people who could benefit most from it (young adults) are not likely to be reading this, because they tend to value what they can buy now more than saving money for the future.
Most of them will have to learn the hard way -- just as we did.
Those of us who are already old enough to understand someday we'll want to stop working, or at least stop being dependent on employment income, need this advice the most.
But frankly the sooner you start this program, the better.
If you want to help any young adults you know or in your family a favor, give them this book and make them follow the program.
But don't think you can't take advantage of these principles just because you're already 60 or 70 or 80. We're all living longer than before. Many of you who read this are going to live past 100. You may not think so now, but many of you will, thanks to advances in medical science.
And if you take advantage of advances in alternative medical science, you'll probably live even longer and enjoy it more . . . but that's not the subject of this book.
(I suggest reading THE FANTASTIC JOURNEY: Live Long Enough to Live Forever by Ray Kurzweil and Terry Grossman).
This Book is About Ordinary Investing and Investments -- Nothing that Requires Trading or a Lot of Work
Also, this book assumes you're investing in widely available, publicly traded financial vehicles. It's not about investing in real estate, tax lien certificates, penny stocks, art, stamps or coins, IPOs, commodities, diamonds, start-up companies or private placements. It’s not about foreign exchange trading. Nothing that requires special expertise, travel, inside contacts, extra time, or that you be an accredited investor.
If you're interested and you acquire the necessary information and put in the necessary sweat-labor and leg work, you might make money with any of those things. However, they are in effect businesses in their own right.
This book is about ordinary, passive investments you can profit from for the remainder of your life.
Much of what I write is not news, and so some of my advice overlaps with "conventional wisdom." Some of what I advise incorporates the findings of Modern Portfolio Theory and academic studies, but adapts it toward the point of view that income is what's important.
You Must Accept Principle 1
To truly understand this system and make it work well for you, you must grasp the First Principle and understand its implications. It's a "consciousness-bending" change from the conventional wisdom, so I ask you to keep an open mind.
One of my inspirations was the book RICH DAD, POOR DAD by Robert Kiyosaki. He upset a lot of readers by telling them their homes aren't assets, because they don't produce any income (assuming you're not renting out a room in your house or running some type of business out of it.)
Yes, he points out, when the value of your home rises, you can make a profit when you sell it -- but then you must still spend some money to live somewhere. Putting some type of roof over our heads is a necessary expense of living.
His point was to encourage his readers to invest in income-generating properties and businesses.
I maintain the same logic applies to financial investments. If they're not generating cash, what good are they? We still buy houses, because we need to live somewhere so we don’t get rained out. But growth stocks serve no practical purpose at all. Sooner or later, to realize that profit, you must sell them, and then you must either reinvest that money, or lose net worth by spending it.
The smart money of previous generations knew selling off capital was a financial sin. They put their wealth into stocks and bonds that paid an income, because that's all they allowed themselves to live on. To need to sell those stocks and bonds was a signal they were going financially downhill.
Just as smart farmers would rather starve through a winter than eat the "seed corn" they will need to sow in their fields come spring, sophisticated investors hang on to the stocks and bonds that produce income for them.
This program updates this once-common sense investing wisdom for the financial investments available in the 21st century, and combines it with the relevant findings of financial academics on reducing risk.
Put your money into the most sophisticated forms of income investments, and rely on businesses that meet the fundamental needs of human beings.
I wish all of you a prosperous, secure and comfortable life now and when you retire if you haven’t already.
The Case for Investing for Income (Dividends and Interest)
"The power of the basic principle of investor return is magnified when the stock pays a dividend."
-- Dr. Jeremy Siegel in THE FUTURE FOR INVESTORS
Income from your investments:
1. Cash in your pocket you can spend for things you need now, or reinvest to generate even more income in the future.
Newspaper listings of current stock prices AND checks in the mail are just writing on pieces of paper -- but only checks can be exchanged for the hard green (or whatever the color of your national currency) stuff that you can use to put food on your table . . . or buy a new table.
2. Dividends aren't guaranteed but, once shareholders are in the habit of receiving them, well-run companies hate to reduce or eliminate them, and do so only when absolutely necessary.
3. In absolute terms, dividends generally increase as time goes by.
(Yields as measured by current market stock prices have been going down for decades, but over time the amount of money paid per share usually goes up.)
4. Dividends from the best companies keep up with or even exceed the inflation rate.
Some companies have averaged 14% annual dividend increases.
5. Encourage you to hold on to your investments -- not sell when you have a profit or sell to prevent more losses.
A firm named Dalbar, Inc. has been studying investor behavior for over 20 years. They found most individual investors consistently buy when the market is high and sell when the market is low. Equity investors on average have earned only 2.57% per year even though the S&P 500 has gone up about 12% per year (on average) in recent decades. Bonds have gone up about 11% per year on average, but the average bond investor earned only 4.24% per year.
People investing for capital gains, whether in the stock or bond markets, woefully underperform the markets.
Investing for income encourages you to stop trying to time the market -- a futile and self-defeating effort, as documented by countless studies.
6. Allow you to enjoy cash from your investments without selling them.
7. Allow you to diversify by using the income you receive to buy different kinds of securities.
8. Using bonds, you can obtain the highest possible market interest based on the amount of risk you're willing to assume.
9. Indicate a company has a positive net cash flow.
10. Dividends indicate a company appreciates its owners, because it’s treating them as real partners in the business.
11. Dividends indicate a company's cash flow is well-managed, without fraudulent bookkeeping to enhance "earnings" through accounting tricks.
"Earnings" consist only of numbers required by government tax agencies and General Accounting Principles, but dividend checks have to be backed up by cold hard cash in the bank.
12. Can be received by you and your descendants into the far future.
Dividend-paying companies normally keep paying them for as long as the companies prosper.
Interest-paying securities can be reinvested when your principal is returned to you at maturity.
13. You must pay taxes on this income, but the IRS never forces you to have to touch the income-producing investments themselves.
14. TIPS and other inflation-indexed investments will increase their interest payments along with the cost of living.
15. Give peace of mind to the elderly, because once they have enough income investments to live on, they know they'll never run out of money.
16. Encourage you to never sell your investments at a profit or loss, thus saving on commissions and taxes.
This is a much bigger deal than you might think. Few investors realize how much their portfolio has been reduced by paying unnecessary expenses.
17. Allow you to sleep well at night, not knowing or caring what happened in the stock market that day.
18. Most investment income is, to a large degree, predictable -- though never 100%.
19. Makes it easier to evaluate different investments based on current hard numbers, not a stock tipster's subjective analysis or predictions of future market demand for a company's products.
Many companies, especially new ones, are sold by their "story." I love good stories. I've written some. If you like good stories too, I suggest you try out my novel VIRGIN BLOOD or one by any other author you enjoy reading.
But choose your investments based on numbers.
20. Allow you to compound your investments over time -- what Albert Einstein called the greatest miracle on Earth.
According to Roger G. Ibbotson in STOCKS, BONDS, BILLS AND INFLATION HISTORICAL RETURNS (1926-1987), if you invested $1 in the U.S. stock market in 1824 and did NOT reinvest dividends, by 2005 that $1 was worth $374.
If you DID reinvest dividends, by 2005 that $1 would have been worth $3,200,000.
Big difference.
21. You get paid bond interest so long as the issuer entity survives (or unless the government "bails them out," and stock dividends so long as the company is able to pay them. Capital gains depend 80-90% on the market's performance, and the remainder to the market believing the company is going to grow.
22. If you don't sell a bond, you get your principal back at maturity whether interest rates have risen or fallen (during the 20 year average lifetime of a bond, interest rates will probably do both).
23. If you start investing for income soon enough, you can retire early.
24. If you feel compelled to invest for the market price of your securities . . .
During bear markets, stocks that pay dividends don't go down as much as stocks that don't, because investors know they will receive some benefit from their investment.
During the bear market of 2000-2002, the S&P 500's dividend-paying stocks actually went up 10.4% -- nonpayers went down 33.19%.
Studies by Standard & Poors and the University of Georgia found the total return of dividend-paying stocks exceeds nonpayers in both bear and bull markets.
BOTTOM LINE:
You can't have your cake and eat it too, but so long as the "cake" sends you checks to buy other cakes with, you don't want to eat that cake.
The Case Against Capital Gains
"In contrast to skeptics who claim that high-dividend paying stocks lack 'growth opportunities,' the exact opposite is true."
-- Dr. Jeremy Siegel in THE FUTURE FOR INVESTORS
It just makes the most sense to increase your wealth by letting your "gold eggs" hatch into many more geese that lay more gold eggs that hatch into more geese that lay gold eggs . . .
Than to feed ONE goose until it's so fat you think it can't get any fatter, and then sell it.
The problems with capital gains are:
1. Capital gains are transitory
One day the stock or bond markets are up, the next day they're down.
We like to think the market price of the past few years is an established "floor," but in reality we just don't know.
On October 9, 2007 the Dow closed at 14,164.
By October 9, 2008 it was 8,579, down nearly 40% in one year, returning to its September 1998 level. The gains of almost 10 years -- up in smoke.
And the slide didn't stop there. As of March 9, 2009 the Dow hit 6,547, which it first hit in late 1996. The gains of almost 13 years, up in smoke.
It's rebounded since then, but far how long? Nobody knows.
Will it ever go down to 5,000 again?
We hope not, but who knows?
Nobody knows where the bottom of this current financial crisis is.
It would take a great disaster, but there are people in this world who are actively planning such a great disaster for the U.S. and all democratic countries.
Nor can we rule out natural disasters. People have forgotten a severe earthquake could put half of California into the ocean, but that ignorance doesn't affect the San Andreas Fault. Climate change, whether caused by humanity or natural events, will cost us.
Nor can we rule out economic cycles. We think the Great Depression could never happen again, but who knows?
Maybe baby boomer retirements will sink the market by 40-50% (as Dr. Jeremy Siegel says is possible), but nobody yet knows.
Maybe the EU and euro will implode.
2. Fluctuate in irregular, unreliable, unpredictable and uncontrollable amounts and directions
Nobody knows when the markets will go up (or by how much), or when they will go down (or by how much).
Yes, historically the stock market returns an average of 11% (which includes inflation and dividends as well as capital gains), but these returns are quite volatile. They can go up -- or down -- by as much as 40% in one year.
3. Useless until you sell the security
You can spend dividend/interest checks, and yet continue to own the underlying stocks/bonds.
4. Borrowed against, they are no longer yours
Yes, you can use securities as collateral for loans of cash. However, when you do so, there's a lien on them. You've lost control until you repay the loan. Plus, you must pay interest on the loan, so it's costing you money which you must have some source of income with which to pay. Instead of being an asset that provides you money, you've turned that security into an expense that's costing you money. You can default on the loan and keep the cash, but then you'll lose the security. You may just as well have sold it on the market.
5. Based on hope
You buy the latest "hot" stock based on its story of how it's going to take over a particular market. Maybe it succeeds, but many don't. Most glamorous company stories have unhappy endings, especially for investors.
6. Exist only on paper until you sell the security
I'm tired of hearing how owners of Berkshire Hathaway are millionaires. They don't get a dime in dividends.
Warren Buffett is a great investor, and so he buys up cash-rich businesses such as newspapers and insurance companies. Berkshire Hathaway has prospered because Buffett himself does not practice what he forces on Berkshire Hathaway investors. He buys businesses, such as Coca-Cola, pay dividends.
7. Cannot be reinvested by compounding
If I could go back in time to the 1970s, even knowing the tremendous gains Berkshire Hathaway was destined to make, I'd still put my money in stocks such as Philip Morris (now Altria) and Coca-Cola. If I reinvested the dividends from those companies I'd probably have a bigger portfolio -- as well as a much bigger dividend income -- than buyers of Berkshire Hathaway (whose dividend income is zero).
8. Are shared with the government when you do sell the security
True, income investors must pay taxes on the dividends/interest they receive, and this does reduce the number of "gold eggs" we can buy from reinvesting our income.
But the "geese" -- the securities we've bought -- are still ours. Tomorrow, and next week, and next year, those geese will lay new gold eggs for us to spend or reinvest.
When you sell the fatted goose of a stock/bond with capital gains, the government takes a big cut of your profit, reducing the cash you have left with which to produce new investing winners in the future.
9. Require research to discover your NEXT hot new growth stock after having realized capital gains through a sale of your most recent winner
You have a stock you bought for $10 and now it's selling for $110, so you sell it for a $100 profit. After sharing your profit with the government, you have $85 to reinvest. (Less, if the government raises taxes on capital gains or if you owned the security for less than a year.)
Assuming you are smart enough to want to keep those funds growing for your retirement and not blow it, you must now find a NEW hot growth stock you think will be a "ten-bagger."
10. May indicate fraudulent or questionable accounting by a company
All the infamous corporate frauds (Enron, Global Crossing, and so on) of the early 2000s paid no dividends (except one that once paid a one-time penny per share dividend). They used bookkeeping tricks to make their profits look higher than they were. This artificially boosted market demand for their stocks.
I can't say that all dividend-paying companies are 100% honest . . . but every quarter they must come up with enough real cash to pay their shareholders the promised dividends.
No smoke and mirrors accounting sleight of hand can cover up bounced dividend checks!
11. May hide poor management decisions on the use of cash
The conventional wisdom is that because dividends are paid out of a company's retained earnings (its net income after paying taxes), they reduce the company's ability to reinvest its profits and therefore to grow in the future.
In some businesses, this makes sense. In some industries, companies must spend all their cash on the latest, most modern and efficient equipment and factories, just to keep up with the competition.
I salute those businesses, but don't want to invest in them, and advise you not to also.
In many companies, management uses the cash available to buy up businesses it doesn't know how to run properly, makes other inefficient purchases, or otherwise wastes it.
Robert Arnott, editor of FINANCIAL ANALYSTS JOURNAL, and Clifford Nasness, president of AQR Capital Management, did a study that found that companies that began paying higher dividends actually had higher than average earnings in following years.
12. May reflect other factors affecting the market price, rather than efficient reinvestment of retained earnings by management
The conventional wisdom says when management efficiently and effectively uses retained earnings to grow the company, its stock market price rises proportionately, reflecting that growth.
This assumes there's a rational, clear-cut, direct cause-effect relationship between a company's financial standing and its stock price. So when a company's financial standing improves, its stock price rises proportionately.
Unfortunately, modern finance has found a stock's market price is only about 10-20% determined by the company's financial standing.
The other 80-90% is determined by the overall market or by the industry sector.
Let's say a nondividend-paying company's management avoids the flaws mentioned in reasons #10 and 11 above. They efficiently and effectively reinvest all retained earnings into growing the company's profits by 10% in a year.
Does that mean the company's stock price will rise by 10%?
Of course not. It may drop because the president of another company in the same industry is indicted for fraud. It may rise because the Federal Reserve announces a cut in the federal funds interest rate. It may drop because the United States' trade deficit goes up. It may go up because Congress cuts taxes.
In short, although you are foregoing current income with the expectation it will make you more money in the future through capital gains, that may or may not happen, based on many factors totally out of not only your control, but the company's.
13. Encourage you to sell too soon
If you invest for capital gains and your stock goes up a lot, there's always the temptation to sell it. No matter how many financial pundits tell you not to sell too soon, there's also that little voice inside you that says, "You can't go broke by making a profit."
You may also have a less rational little voice inside you that says, "You could buy a new car and take a trip to Hawaii and meet a hot babe/dude."
It's human nature to desire instant gratification. And in some ways that's rational -- we really don't know whether the good we see now will still be there in the future if we pass it up now.
Capital gains are transitory. Investors sitting on capital gains know that, and know that if they don't sell now, their profits may disappear next month.
Therefore, capital gains encourage you to fear losing money (and fear of loss is the most powerful human motivator), and therefore encourage you to want immediate pleasure from your profit.
Thus, many people sell profitable stocks, then watch as the market price continues to rise.
You know how people say, "Gee, I wish I'd bought Wal-Mart in 1980 . . ." or Intel or Microsoft or Dell Computer or Berkshire Hathaway, and so on?
Chances are, if you had, you'd have sold the stock decades ago, and you'd now be moaning about, "If only I hadn't sold that Wal-Mart/Microsoft/Dell/Berkshire Hathaway stock to buy that new motorcycle. I'd be rich by now."
Investing for income works with – not against -- the human need for immediate gratification. Regular checks are fun to receive, so they encourage you not to sell the security that's sending you those checks.
Capital gains encourage the fear/greed emotional seesaw that makes most investors buy too late and sell too soon.
14. Create an illusion of investing success
Years ago, in looking over the balances of my retirement funds on my job, I had a simple revelation.
I enjoyed seeing the balance of the account go up, but I figured out that so long as I was working and buying shares in that account, I'd be better off if the market stayed LOW throughout my entire working career. I was investing a fixed percentage of my paycheck, so the lower the share prices, the more I could buy out of my paycheck.
If I could manipulate the market price, I'd make it as low as possible while I was still buying shares out of my paycheck.
Then, right before my retirement, I'd shoot the market up 10 ten times!
Yet, so far as I know, only Warren Buffet and Dr. Jeremy Siegel have pointed out continuing to buy shares for a low price is more important to your long-run investing success than a high market price for the shares you've already bought.
It's human to look at a brokerage account balance and want it to go up every month . . . but it's the number of shares you own when you retire that will count -- not the current market value of what you've already bought. And you can buy more shares with the same number of dollars only if the share price is low.
15. May encourage you to lose money by buying high and selling low.
Most ordinary investors in common stocks lose money. They're scared of the market when stocks are low, and don't jump in until stocks have gone up a lot. Then they hold on, thinking stocks will go even higher and they're greedy for even more profits -- and then the stock crashes. Discouraged and afraid of losing even more money, ordinary investors then sell at a loss.
What happened to investors from 1995 to March-April 2000 is a good example.
But when an investor wants yield, they're happy to buy dividend-paying stocks at a low price. When those stocks go up with the market, they're not tempted to sell, because they want to continue to receive those quarterly checks.
When the stock market crashes, they don't sell, because they want to continue to receive those quarterly checks.
Income investing encourages you to buy low and buy high -- and never sell.
16. Worry elderly people who rely on them to finance their retirement. They are afraid a bear stock market will cause them to run out of money before they die.
This is a legitimate fear. What if you had retired in 1929, 1973 or 1999 or 2008? Some people did, and they suffered for it.
If you want to retire now and you've been depending on stock market gains . . . you're going to keep working for many years to come. If you retired in the past year or two, you're either an income investor already, rationing your Social Security check or looking for a job.
17. Cause you to waste too much time paying attention to every little up and down in the stock market.
I enjoy reading about investing, but consider the daily financial news a waste of good radio time. It's noise. I'd rather listen to a good song. I don't understand why people not employed in the industry pay any attention to the daily DJIA, S&P 500 or NASDAQ fluctuations.
18. Can encourage you to plan to retire early, but force you to cancel your plans when the stock market crashes.
Many people had to delay their retirements because of the 2000-2002 bear market. I suspect many people left retirement during that period because they had to return to work.
The same is happening now. Please, don't retire now unless you're wealthy enough to get through this crisis.
19. Contribute a lot less to the stock market's long term performance than you've been led to think.
Historically, the stock market has averaged a total return of 11%.
Here's what the big media financial writers fail to tell you:
According to Peter Arnott and Peter Bernstein in the Financial Analysts Journal, that includes over 3% from inflation and about 5% from dividends.
Only 3% of the market's long term historical, "real" total return has come from capital gains.
Dr. Jeremy Siegel, who came up with the famous graph comparing stock returns to gold, bonds, cash and the cost of living over nearly 200 years, which he published in his book STOCKS FOR THE LONG RUN, explained in his recent book THE FUTURE FOR INVESTORS that 97% of the stock market's rise -- which trounced every alternative by a long shot -- came from REINVESTING DIVIDENDS.
"From 1871 to 2003 97 percent of the total after-inflation accumulation from stocks comes from reinvesting dividends. Only 3 percent comes from capital gains."
20. Don't always exist.
That's the worst thing about capital gains -- sometimes they add insult to injury by not even being there at all!
Sometimes you have only capital losses.
If you happen to retire just before a drastic market downturn such as we saw from 2000-2002 and November 2007 to March 2009 . . . you could easily wind up selling far more of your stock than you'd expected, just to meet your expenses, and be faced with running out of stock to sell in your much later years.
Even though the Dow is now up dramatically since its March 2009 low, it's at a place it first reached many years ago.
If you have bought stock in the past ten years, you have not made money unless you're also receiving dividend checks.
The Dow Jones Industrial Average didn't break its September 3, 1929 pre-Black Tuesday record high until November 24, 1954. How would you like to have been a retiree relying on stock market capital gains during that period (which began before Social Security check)?
The Dow Jones reached 1000 for the first time in 1966 -- and didn't break that mark again until 1981 . . . after 15 years of the most extreme economic, social and political turbulence in American history since the Civil War. During those years we lived through several gas shortages, The Vietnam War, Watergate, skyrocketing meat, sugar and other food prices, street riots, and 20% interest rates.
Investors in certificates of deposit got double-digit returns. If you relied on capital gains from either stocks or bonds, you'd have fallen FAR BEHIND the cost of living.
Can't happen again?
Do you have a signed guarantee from God to that effect?
I don't pretend to have a 100% accurate crystal ball, but when I think about 82 million baby boomers selling off stock -- or even just failing to continue to buy as much stock as they are now -- to retire over the next 10 to 20 years . . .
. . . the rising costs of energy -- including where most of the world's accessible oil fields are located and how vulnerable they are to terrorists . . .
. . . and how many fanatical terrorist jihadist Muslims want to destroy the U.S., all democracies, and all countries not ruled by sharia . . .
. . . how China's current leaders seem bent on achieving the ancient dream of China -- ruling the world (China's emperors have traditionally always believed they ruled the world in spirit. But in ancient times they couldn't do much in practical terms, besides sometimes invading Tibet, Vietnam and Mongolia.) . . .
. . . how the EU and euro are falling apart . . .
. . . how much debt the United States owes . . .
I could go on, but I don't want to turn this book into a political rant. Let's just say too many Americans -- and Europeans, Canadians, Australians and Japanese too -- take their freedom and prosperity too much for granted.
Having your wealth in the form of capital gains means it's tied up in the shares of stock you own. You may as well as keep cash in a safe. Capital gains can't be stolen as cash can, but they can -- and often do -- simply vanish, when the market (or just the stocks you own) turns south.
You can lock and hide a safe, but no burglary alarm in the world can protect your capital gains from a bear market!
Just ask millions of people around the world who've been in the markets for the past four years.
BOTTOM LINE:
You can't continue to have capital gains and still enjoy, or reinvest, them.
You can't have your cake and it too.
Objections to Investing for Income
Here are the arguments against investing for income:
1. Stock dividends are double taxed.
This is absolutely true, and it's disgraceful class warfare political rhetoric in the U.S. is so powerful it's going to remain true for the foreseeable future.
Here's how it works. You own 100 shares of the XYZ Corporation. Let's say that's 1% of the total shares of the corporation. The XYZ Corporation figures out their 2007 net income is $1 million. Logically and technically, 1% of that -- $10,000 -- belongs to you.
However, the XYZ Corporation has to pay income taxes on that $1 million profit. For the purposes of illustrating this point, let's just say they have to pay 40%, which is $400,000. They write a check to the IRS and send it in with their tax return.
Therefore, they have $600,000 left.
Remember -- your 100 shares of XYZ stock makes you a 1% owner of the corporation. So you as 1% owner just paid $4,000 in taxes to the IRS. You as 1% owner now have a remaining $6,000 in XYZ Inc.
XYZ Corporation's Board of Directors votes a 50% payout dividend. Soon after, you get a check for $3,000. That's one-half of the remaining $6,000.
If the corporation didn't have to pay income taxes, you'd be getting $5,000 (One half of $1 million times 1%).
But now that you've gotten your $3,000 dividend check -- guess what?
The IRS wants some of that money too!
In effect, as a 1% owner of the XYZ Corporation, you have already paid $4,000 in taxes.
Yet now that you've gotten a $3,000 check with your name on it, the IRS wants a cut of that too.
So it's true that dividend investors get whacked twice by the IRS.
Yet just go to the floor of Congress and try to lobby for the end of this unfair situation. Mention "double taxation of dividends" and you'll immediately have a bunch of closet-socialist politicians spouting a lot of hot air about how fair it is "the rich" should pay more taxes. And they get away with it.
It's unfortunate most Americans don't understand this, but no matter what your politics, as an income investor you should understand it.
2. Interest is taxed at the recipient's normal tax rate. In most places and times, so is dividend income. The tax rate on capital gains is usually lower.
In the United States, the tax rate for dividends was reduced to 15% for most taxpayers for 2003-2012. (For low income taxpayers it was reduced to 5% through 2007 and 0 for 2008-2012. That’s something the people who claim these tax rates are only for the rich fail to point out.) At the last minute the end of 2011, these rates were extended through the end of 2013.
However, unless this reduction is made permanent, dividend interest received by U.S. taxpayers will again someday be taxed at nominal rates in 2013.
Therefore, some believe it's better for companies with excess cash to buy back their own stock. By reducing the number of shares of stock outstanding, they increase the value of each of those outstanding shares.
Stock repurchases began in 1983 due to a change in regulations. The total amount of repurchases was about $30 billion annually in the 1980s. By 1998, for the first time, the total money spent on stock buybacks exceeded the amount of dividends paid out by companies.
The September 10, 2007 BARRON'S reported on a study by Douglas J. Skinner, a professor of Accounting at the University of Chicago Graduate School of Business. The title: "The Evolving Relationship Between Earnings, Dividends and Stock Repurchases."
He concludes eventually companies will eliminate dividends.
His basic case is stock repurchases are more flexible for companies. If they pay out dividends this year, shareholders will want at least the same amount next year, if not more.
Unfortunately, the company's business next year may not be as profitable. If they repurchase stock this year but not next year, nobody complains.
Skinner says the number of companies doing repurchases but not paying dividends is increasing.
Eventually, he concludes, dividends may be eliminated.
I don't know whether the study examines the tendency of companies to buy back shares on the open market, but not to cancel them. These shares then remain in the company's treasury until needed for employees who're exercising their stock options.
Therefore, there's not always a net reduction in shares outstanding, so the apparent benefit to shareholders in capital gains is temporary and illusory.
A report published by the management consulting firm McKinsey & Co indicates some share repurchases may simply be for management's benefit, since their compensation packages are tied to the company's earnings per share.
If management is unable to increase the earnings, they'll decrease the numbers of shares outstanding.
Simple arithmetic, but bad business.
So stock buybacks can be a signal to shareholders management doesn't have any better ways to invest the company's capital.
There is a counter trend. In 2004 high-tech Microsoft began to pay dividends.
My own contention: I want money to reinvest or spend. I don't want to have to sell shares of stock to benefit from my investment in a company.
If all corporations stop paying dividends, I'll stop investing in the stock market. Unless the law is changed, Real Estate Investment Trusts and Master Limited Partnerships have to pay out 90% of income.
3. Companies that pay dividends are cutting their own growth rates, because they won't have the capital necessary to fund their growth. That will reduce their future potential income.
This is a nice academic argument, which seems to make sense.
If a company needs to build a new factory to expand its widget business, how dare its shareholders demand it pay them dividends instead?
So it's better for a company to build new factories than to pay dividends to stock holders.
Frankly, for some companies, it even makes sense in real life. Many industries are both capital-intensive and competitive. The leading companies in them need to constantly spend their profits by reinvesting in new factories or more modern equipment.
Or they fall behind, can't compete and therefore go out of business.
So they just can't afford to pay dividends to stock holders.
Avoid Companies Too Desperate for Your Money
My advice is -- don't invest in such companies.
Your responsibility is to provide for you and your family, not to fund a hyper-competitive industry.
Besides, many companies are able to both pay dividends and still keep growing their businesses.
Coca-Cola is one.
Would Coca-Cola grow any faster if it didn't pay dividends?
Coca-Cola Has Been Paying Dividends -- AND Growing -- for Over 90 Years
I don't know. Would Coca-Cola sell twice as much soda if it took out twice as many TV and magazine ads?
Could it sell more soda in more countries? I don't know, but I strongly suspect Coca-Cola is now in every country in the world that will allow its products to be sold there.
It could be many companies have just plain reached a point of diminishing returns. That means, they so dominate their markets they just can't sell any more, no matter how much money they spend.
How much more gum could Wrigley sell if it spent all its retained earnings on advertising?
I don't know. I do know that I'm not going to start chewing gun even if I see 300 Wrigley gum commercials every day for a year.
I'm not in their market, so they'd be wasting their time trying to make me buy their gum.
So it's better for them to send the rest of their money to their shareholders.
The Efficient Market Hypothesis and What It Means for Income Investors
"Anybody who tells you that they know the direction of the economy, interest rates or the stock market is either a) inexperienced or b) selling you something you don't want."
-- Dylan Jovine THE TYCOON REPORT
I'm not so sure markets are efficient -- at least as in all the connotations I associate with the word "efficient."
However, I am sure the markets -- however inefficient -- are the markets.
That is, you can't argue with them. You'll lose, because they're a lot bigger than you.
I spent years of my life studying how to trade. I've read about commodities, options, Japanese candlestick charts, and so on and on.
In the many chapters of Jack Schwager's MARKET WIZARDS books, each successful trader emphasized over and over their success came from following the market's direction, not arguing with it.
It's Easy to Know the Market's Direction -- When You Read the Charts in Books
Only trouble is, although you can look at a trend line and see in what direction the market's been going, you can't tell where it's going to go in the next five minutes, let alone tomorrow or the next day or the next month.
Sometimes what you think is a market peak is just the beginning of an upward trend.
Sometimes what you think is a slight pullback is the beginning of a downward trend.
You just don't know. I recall watching a video of options author David Caplan giving a lecture. He told about how during the 1980s he used to see a guy on TV telling investors to put on option spreads that profited so long as the stock market stayed within particular (and highly reasonable) limits.
Which they almost always did.
ALMOST always.
Caplan reported that after the 22% drop in the Dow during October 1987, he didn't see that guy on TV anymore.
Caplan taught a great system of making money from options by putting on a spread that profited so long as U.S. Treasury bonds stayed within certain wide, and historically reasonable, boundaries.
I went to a free seminar and got very excited as I watched the lecturer explain the system.
Putting My Money Into a 90% Successful Trade . . . A No-Brainer, Right?
Treasury bonds, I kept thinking. How boring boring boring -- how wonderfully boring. They didn't crash like the stock market could. They didn't shoot up like orange juice futures prices hit by a unseasonable Florida overnight freeze. They changed only due to interest rates and demand.
Controlled by the Federal Reserve, interest rates change slowly.
And demand -- how much could demand for U.S. Treasury bonds fluctuate?
According to Caplan, these option spreads were over 90% successful.
I dug up some money I couldn't afford to lose, and put on one of those trades -- an option spread that would remain in profit as long as U.S. Treasury bonds stayed within some wide limits for just 30 days.
How much could demand for U.S. Treasury bonds change in only 30 days?
In the chapter on hedge funds, I describe how, after Russia's stock market melted down, every wealthy person in Russia, Asia, Africa and South America sold everything they could put their hands on and sent it to the safest, most economically and politically stable country and currency in the world.
Like the infamous Long Term Capital Management LLC hedge fund, in the summer of 1998 I had a government-bond related trade going.
As the value of U.S. Treasuries shot off the charts, my 90% sure-thing position quickly turned into a negative $2000. I closed it out, thankful I'd followed Caplan's advice to hedge my trade so my loss was limited. Otherwise I'd have lost a LOT more money.
You just don't know what's going to happen -- even with such boring investments as U.S. Treasury bonds, let alone highly volatile stocks.
Buying Stocks for Capital Gains are a Crap Shoot Where You Pay Your Broker Instead of the Casino
Another time, following some system I've forgotten, I bought a cheap stock, and the very next day, its price shot up 60%.
Why? I didn't know then and I don't know now. I don't know what could happen to make one company worth 60% more in just one day.
I don't believe financial markets are "random" in the same sense a casino slot machine is random. People buy and sell stocks for reasons.
The markets are the sum totality of all those reasons, and I don't believe anybody can predict them.
In his 1900 dissertation, "The Theory of Finance," Louis Bachelier intensely analyzed the French capital markets. He concluded, "The mathematical expectation of the speculator is zero."
In 1931, having noticed few to zero stock forecasters had predicted the 1929 Crash, Alfred Cowles began analyzing the long term records of stock forecasters. He asked the question: "Can stock market forecasters forecast?"
After years of recording and analyzing stock market predictions, he concluded, "It is doubtful."
He founded the Cowles Commission and spent many years recording the forecasts of the forecasters (analysts and newsletter editors of many different types), and then comparing their forecasts to the actual performance of the individual stock or the stock market.
He never discovered anyone who in the long term could forecast the future of any individual stock or the market as a whole any better than randomly selected cards.
Some Stock-Pickers ARE Superior to Others
Understand the efficient market theory doesn't say it's impossible for anyone to get better than market results for a long period -- just extremely difficult.
I don't think the "if enough people flip coins somebody will flip many more heads than average" argument explains Warren Buffett's success.
To me, it's even more of a coincidence that the champion "coin flipper" (that is, stock picker) of the 20th century just happens to have taught himself how to do complex math in his head while still a child, just happens to have been a success raising money in his own businesses while still a child, has deeply studied accounting, finance and stock picking, and received the only "A" Benjamin Graham ever awarded to a college student in his stock picking class -- and that was just his early preparation.
In retrospect, it's easy to see Warren Buffett is an unusually gifted, stock picking genius.
Yet, because he's also honest, he'll also be the first to tell you he's not always accurate. In 2009 Berkshire Hathaway suffered its worst year since 1999 -- badly lagging the broad markets. The S&P 500 was up 23% -- Berkshire Hathaway was up a mere 2.7%.
Now -- find the "next" Warren Buffett. Are they managing YOUR mutual fund?
Maybe. You'll find out in 20 to 30 years. If not, though, it’ll be too late to avoid suboptimum results from their suboptimum money management.
And how will you know what fund manager really will beat the market without taking on excess risk?
If You're Investing for Capital Gains, Make Sure You Follow Wade Cook's Advice -- Don't Buy Stocks That Won't Go Up in Price
A lot of people like to quote Will Rogers: "It's easy to make money in the stock market. Just buy a stock and sell it when it goes up. If it doesn't go up, don't buy it."
Years ago I bought a tape set from Wade Cook before he became infamous (I never went to his $7,000 seminar, though!) I was astounded to hear him say something similar but, unlike Will Rogers, he wasn't joking.
He was describing one of his option strategies, the success of which depended on the underlying stock's price going up. It went like this: "Sometimes people tell me they lost money because the stock's price didn't go up. I ask them, 'What're you doing buying stocks that don't go up in price?'"
Advice like that may be why his stock market seminar business in now bankrupt.
So my conclusion is that although a few unusually talented and hard-working people can beat the market in the long run, you can't know who they are in advance, only in retrospect -- and then it's too late.
You can't predict the performance of a stock (or any security) picker any more than you can predict the markets.
Yes, I know that many of them boast of their records. Of course they can make successful picks. You can do that too, just by throwing darts at the stock listings. Their copywriters play up their successes and play down -- or totally ignore -- their losers.
To obtain a newsletter's real success rate, you should check with Mark Hulbert of The Hulbert Financial Digest. He tracks the real performance of over 180 stock and mutual fund advisory newsletters.
You Can't Rely on Finding "Inefficiencies" in the Market
In his book A RANDOM WALK DOWN WALL STREET Burton Malkiel tells the story of a student walking along with his finance professor. The student spots a $20 bill on the sidewalk and bends down to pick it up.
"Don't bother," says the professor. "If it were really a twenty dollar bill, it wouldn't be there."
Now, I actually once found a $20 bill on the sidewalk. And if it wasn't real, it was still accepted as currency by the store where I spent it.
So, opportunities do exist -- but not for long. For the $20 bill to stop being on the sidewalk, somebody has to pick it up. But after that, it's gone.
It's fine to take advantage of good luck when it happens, but you can't depend on it to finance your retirement.
I don't spend my days walking along all the sidewalks I can, looking for $20 bills.
The Markets Don't Seem Efficient At All -- But Don't Let That Fool You Into Thinking They're Predictable
To my way of thinking if the market were "efficient," that means rational, and stock prices would go up only as a company's earnings and other financial information improved. Stock market prices would closely track the performance of the overall economy. They would not zoom up as they did from 1995-2000, nor crash as they did in the summer of 2008.
Why Do Stock Prices Keep Changing?
We like to think a stock's price keeps changing because of its business prospects. We learn its main product is selling better than expected, so its price goes up. We learn a major lawsuit has been filed against it, so its price goes down. Analysts expect it to earn $10 per share this quarter.
And so on. In this model, investors and analysts are tempted to think, based on what they know of the business, its "true" price is really above or below its market price.
However, according to modern financial theory, these rational ways of analyzing a stock account for only 10 to 20% of its stock price. And this does not explain the daily fluctuations of stock prices when there is no news relevant to the company or, sometimes even, the economy.
I mean, it just doesn't make sense that on a given day ABC's stock can go from $30.10 to $29.50 to $31.80 and wind up at $30.20, based strictly on the company's business numbers. Except for exceptional events, a company's business does not change much on any given day. Its employees go to work. Sales people make sales. It pays some bills. It incurs some expenses. It manufactures some products. Everybody goes home.
Yes, on some days unusually big changes can happen: layoffs, restructurings, new product rollouts, ad campaign failures, buyouts, and so on. Those are major events that are new information that justify a re-evaluation on the part of stock analysts. But most days are just one more day on the calendar. If stock prices were rational, they wouldn't change much from day to day. But we know they change constantly.