I had some great conversations over a week long vacation with a few buddies about investing. I realized the commonality among a lot of these conversations wasn’t so much stock picking, but how to have a sane personal finance strategy. I’m using “personal finance” and not “investing” because, as this post will get into, growth of capital involves more than buy / sell.
I want to record some of them here for myself and as a reference for future conversations. The goal of this post is to provide some actionable bullet points. Implementation should be easy and everything except the stock picking section below aims to be “set it and forget it”. Check out Very Corporate Slide Overview on the bottom for the highlights or read on for the full details.
First off – in no way am I even close to a finance professional. All of what I know I’ve read or someone has taught me over the years. For 50,000 foot view of the land, I’ve found the following super useful:
– Dave Ramsey’s Total Money Makeover – some readers may find the tone in this book a little harsh, but I like it. Ramsey’s advice in this book is no-nonsense and easy to understand – eliminate debt, build an emergency fund, invest early and often once the prior steps are complete.
– Mr. Money Mustache’s blog and interview with Tim Ferriss – you don’t have to agree with living on <40K to get valuable insights on from this blog and interview – the value I mainly got from here is creating simple-to-understand targets (savings measured as multiple of annual living expenses), not complicating asset allocation too much (use Betterment-like vehicle or simple index funds whenever possible) and expenses (take a no-mercy approach to cutting)
– Ben Carlson’s A Wealth of Common Sense – this book is all about simplicity in financial planning, taking actions that are maintainable for the long term and having the guts to put money in during a crisis because the data supports it.
What these resources really taught me is that before even thinking about investing, it’s important to think about things you can control that aren’t market related – taxes, available cash and expenses being the big ones.
Taxes and maxing out retirement accounts – (this section may be obvious to a ton of readers here so please skip if so) on the tax front, I can’t stress enough that taxes matter a ton. Retirement accounts like 401Ks and IRAs (traditional, Roth or SEP – all of these are different and worth reading up on, what works for you will be based on income, if you own your own business, etc.) get you the dual benefit of tax savings and compounding on those savings.
There’s no free lunch in that 1) withdrawing before a certain age has penalties and 2) in most cases you can’t pick stocks and are limited to employer plan options, but the liquidity / market return tradeoff in my opinion is always worth it. An example is pretty illustrative with the 401K. On a 401K, you don’t pay income taxes when you contribute; on normal income going to a normal brokerage account, you do. If your income tax rate is 30%, that means $100 in a 401K is $70 in a normal investment account. That $30 compounds over time and creates a ton of separation assuming the same return on both. The below shows a maxed out 2020 401K ($19.5K) held for 30 years at a 10% market return with no match:
The diff at the end of 30 years for one years savings is 102K. Let me rephrase that for emphasis – not allocating to your 401K – even without match – IN A SINGLE YEAR CAN COST YOU 100K+. I’m not even talking about over 5 or 10 years, in which case we’re getting into the millions of dollars range. Yes, over ten years, compounded over 30 years each, the diff grows to over a million (assuming 10% market return). Here’s the math for one year:
I didn’t even include match in the example above. Via Investopedia, the mean employer match is 3.5%, so the compounding diff increases – here, it’s 114K:
The biggest lesson in this post is to max out these retirement accounts. It IMO easily makes the biggest delta – no taxes (yourIncomeTaxRate%+) and an instant 3.5%+ return right off the bat through match if your employer offers it.
Emergency fund and Bazooka fund – This section is on cash funds that have no correlation to the market. The emergency fund is the first one to contribute to if it’s not fully topped out and the first one to draw down on in an emergency. Bazooka is for special investing situations – once every decade financial crises.
Emergency fund – Exactly as it sounds like – a fund for emergencies (ex. car crash, basement floods, etc.). Ramsey recommends 3-6 months of living expenses in an interest bearing savings account for unexpected problems. The point here isn’t the interest (which you should still try to max out anyway – before the Fed took rates down to zero, most online savings banks would give you 2%+ here, but good luck getting more than 80bps now), but having a siloed DO NOT TOUCH account. I really like this idea as a hedge for unexpected setbacks and a “go-to-sleep-without-worries” account. No correlation to market, and hopefully keeps up with inflation. Most importantly, the existence of an emergency fund avoids the need to sell stock if you need liquidity in an emergency. Being a forced seller is a situation I never want to find myself in.
Bazooka fund – The Bazooka Fund is money you invest during a crisis (08-09 financial crisis, Feb – March 2020 COVID, maybe a little bit during mini crises like 2015-16 or December 2018). The Bazooka Fund is meant for deployment during true freakouts and events people call “once-in-a-lifetime” (funnily enough, it seems like these are once every decade or so now). For sizing, I think having it be the same size as the emergency fund is a great start and increasing steadily when the market is making new highs makes sense (although letting cash grow to over 10%+ seems like leaving returns on the table – note that I haven’t backtested this, I’m more thinking of the Peter Lynch advice that more money is lost waiting for the next correction than the correction itself).
People say these are hard to identify at the time, but in my mind all are marked by media panic, CNBC “special” coverage, 10%+ corrections and media saying stocks are a dead asset class. Most everyone will say the market has lower to go at times like these, and it probably does – but missing the exact bottom is not punitive over a long-time horizon. Remember in 09 we bottomed at SPY 66.6 – wouldn’t you have been happy to have bought anywhere under 100? March 23rd bottom this year was SPY ~223. Missing the exact bottom can also be somewhat offset by careful dollar cost averaging. If your bazooka is 50K, you could deploy 10K over 5 months. Additionally, because of zero commission trading, it’s now possible to deploy small amounts of capital without racking up big trading fees.
There are also plenty of tools at your disposal to identify market panics. The VIX – a measure of forward volatility – will usually be making highs, and CNN’s Fear / Greed Index ideally would show extreme fear.
I think it’s important to remember that when everyone turns bearish on the market, there are no sellers left. People who are going on TV expressing caution and dire warnings have already sold.
Expenses – Finding a dollar of expenses to cut at a certain point is easier than making an extra dollar. This does not mean living a monk-like lifestyle, but at least for me putting a fine tooth comb to my credit card statements revealed some stuff I could cut. I think one hour per month reviewing expenses and actioning low hanging fruit (ex. unsubscribing on memberships not being used) is well worth it.
Money saved on unnecessary expenses can then be deployed the the Emergency Fund if not full or to the Bazooka Fund if below 10% of assets (otherwise, continue onto below).
Once retirement accounts, cash and expenses are taken care of, I think it’s fair game then to start talking about traditional investing stuff like asset allocation.
Stock picking is great with limits based on 1) how much time you can allocate to research and 2) your tolerance for underperforming. I love picking stocks – that’s what this letter is about. That said, trying to outperform the market statistically has been a fool’s gambit over time and there’s a ton of selection bias in what you see in the media. Most “professionals” underperform index funds. Using Wealthfront or Fidelity Go for 100% of your non-retirement account investing I think is a fine strategy if you don’t want to allocate time to researching stocks and want to perform with the market.
If you do want to pick stocks and can deal with underperforming, I think a good starter distribution is 70%/30% automated/picking that can grow to 50-50 (that’s where I am). Recently what I’ve been doing is buying $1 of SPY for every $1 of new positions I take on (this is much easier to do now through fractional shares on Fidelity).
A note on underperforming – remember that if you lose 25% one year and the market returns 10% that year and the next year, you have to make 60%+ in Year 2 to keep up. Stock picking is not for the faint of heart. If you can tolerate the risk, I do think the rewards can be worth it:
– You learn a ton. Most of what I know about businesses and how companies allocate capital are from lessons I’ve learned the hard way or the nice way – losing and making money. There is no better forcing function for learning than having skin in the game. I truly believe reading company filings and earnings transcripts gives you better insight into the economy and business than news articles. Companies have a legal duty to report the truth and disclose material information; the media does not.
– Great stocks can be life-changing. Catching a compounder and holding on can be life-changing. My buddy told me a story about one of his friends whose dad gave him 10 shares of Apple in 1998. I encourage everyone to see how much these shares are worth now after stock splits, price appreciation and dividends. If you believe you have a company in your portfolio with superior management that can reinvest cash flows at a high return on capital, holding for decades can make all the difference. William Thorndike’s book The Outsiders does a great job profiling some of these companies and explaining why certain companies can produce such spectacular returns in the long run.
I thought here would be a good place just to list out the books that have become particularly impactful for me for stock picking:
– One Up on Wall Street, by Peter Lynch – first investing book I ever read. Lynch does a really good job of talking about sourcing ideas through every day products you use and evaluating companies through price relative to fundamentals.
– You Can Be a Stock Market Genius, by Joel Greenblatt – despite the horrendously kitchy name, this was a good overview on how being one retail investor and not a big fund manager gives you a huge advantage. Institutions don’t care for spinoffs or strange securities from mergers or small caps or OTC stocks; all of these can have really high quality value if you look hard enough. The parts of this book on spinoff situations specifically I thought were excellent.
– Millennial Money: How Young Investors Can Build a Fortune, by Patrick O’Shaughnessy – another one where just ignore the bad title and read the book. I like Patrick’s simple advice to find shareholder friendly companies with great free cash flow and just pick a couple names you can focus on if you’re going to pick stocks. He has some specific stock screening methods he recommends that I think is really good for stock discovery. I think too often I source stocks from stuff I’m specifically interested in (tech, sports gambling) and need to be better about being industry-agnostic and letting great metrics guide me to great businesses. As an aside, I think Patrick’s podcast when it’s not focused in on venture capital investing is worth subscribing to.
The common themes in all these books and the one I try most to think about is one that the book Quality Investing summarizes well:
Find companies that:
– Have great cash flow generation
– Have great returns on capital
– Have great growth opportunities
Buffett has an awesome related quote:
“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”
Some more quick thoughts on stock picking
Another quick thing I want to point out – P/E is a metric that needs to go away for most companies as a thing investors care about. All of the books above except for the Peter Lynch one which is old do a good job of breaking down how earnings can be gamified through accounting and why free cash flow (revenue – operating costs – cash taxes – capex) is what matters. Real cash coming in is what companies can pay out in dividends, buy back stock, pay off debt, reinvest in the company at a higher rate of return than the cost of capital and do things that will help you as a shareholder. Additionally, low P/E companies generally trade at low multiples for a reason (industry in secular decline, earnings are at-risk, etc.).
Another theme I think has been common in books / podcasts I like is that it pays to find great businesses first and not great prices first. In my opinion it’s rare to find a truly great company that sees its stock fall simply because its “overvalued” (which is really a meaningless term anyways – every price movement is someone selling what they perceive is overvalued). On the flip side, companies trading at lower-than-average P/Es don’t magically go back to trading at average P/Es.
One of my friends and I have a running joke that if the only reason you can find not to buy a stock is valuation, buy the stock immediately. It’s really only a half joke; I truly think paying reasonable premiums make sense for great businesses. Similarly, if the primary reason to buy a stock is that it has a bunch of great value metrics and is deeply “discounted”, I’d be very wary. The companies I have most gotten burned by were ones that were value traps (didn’t help that the market has much preferred growth over value in last few decades). For isolating business prospects instead of valuation, I’ve found some framing questions that put you in the seat of owner-operator help:
– Would you want to own this business if you could buy it? How excited would you be coming into the office?
– Could this company double in size in the next five years? (could be on an earnings, free cash flow or other basis)
I’m also reading Expectations Investing right now which is a really interesting take on how a stock’s price represents the expectations investors have for company cash flows. As you’d expect, during crises expectations weaken, to the point where the market clearly thinks some companies will go BK and recovery value will be less than book (look at what happened to the bond market during COVID for further proof BK was being priced in for many companies). I’m excited to work Expectations Investing into my methodology.
At the risk of sounding obvious, my best returns are from being aggressive during market crises (2015-16 market crashes, Christmas Eve 2018, COVID 2020 – see above section on Bazooka Fund). I knew stocks I liked from previous research and had a decent research process down for new names, so it was much easier to buy with conviction for companies I knew could weather no sales for six months.
Be extremely careful with new asset classes – the opportunity cost is investing in stocks, which have historically excellent returns and liquidity. I’ve had too many conversations about crypto, art, Lending Club, wine, secondary shares in private start-ups, angel investing and more “alternative asset classes” to count (IMPORTANT NOTE – traditional alternatives that have been around for a while like private equity and hedge funds I’m excluding here) because the prospective returns are super attractive. All of these investments have people claiming they’ve outperformed the S&P with less risk. Crypto especially seems to fascinate a ton of people because of how the Fed has printed money during C19 and the meteoric rise of BTC from inception to 2017.
Like my point on stock picking, I want to call out that alternative asset classes require research and time and for the new ones I listed, I don’t trust other people to manage them for me or hold them on my behalf (remember that Coinbase has had issues with people arbitrarily getting locked out of accounts and taken weeks to get people withdrawals). I have an Ether and Litecoin allocation at <0.5% of my portfolio mainly just as tracker positions because of intellectually curiosity in crypto (IMO it helps to research something when you have skin in the game) . I think I have an edge in Daily Fantasy Sports and sports gambling because of years of pulling statistics and writing code to optimize lineups, but even then I’m below 1%. New asset classes usually mean less liquidity, higher volatility and more difficult to value assets. If you can live with those risks, I think the potential returns make a small allocation worth it, but this is money that could go to zero.
Very corporate slide overview:
Long post, but that’s the gist of what I’ve told everyone who who has got more interested in investing during the COVID era. Some of this is probably misguided and as always, please reply with feedback.