Paul Winkler: Welcome. This is the Investor Coaching Show. I’ll be getting into some of the technological breakthroughs that are supposedly happening out there.
Investing Strategies
Some of the data on various markets this year is interesting. One of the things that I find with investors in regards to investing information is that a lot of it sounds good.
Various strategies are thrown around. You ought to try this strategy and this is a really good strategy for protecting yourself as an investor. Or maybe this is a really good strategy for such and such.
Sometimes people let the tax tail wag the dog, so to speak.
They’ll hang on to an asset they should get rid of because they’re going to be avoiding taxes by hanging onto it versus getting rid of it.
But there was a commercial that I heard this week that I thought I had to share with you, and I’ll make a comment afterwards.
Crypto Ad: Crypto markets may be down this year, but there is one silver lining, tax loss harvesting. Tax loss harvesting involves selling positions that are in the red and rolling into an alternative exposure. So if you’re down on Bitcoin, why not exit that position and find a new crypto asset to invest in that lowers your tax bill for this year, but keeps you involved in the crypto markets? And that’s one thing to know about crypto.
PW: So you see a commercial like that and think, “Hey, wow, what a great idea.” This thing that got you into trouble and was a bad investment, well, why not make lemonade out of the lemons.
Sell it and be able to have a loss on the books, then write that off against income and against capital gains, then reinvest it in another thing that isn’t any good.
That’s the definition of insanity, right? Doing the same thing and expecting a different result.
Answering Your Own Questions
People will come in and say, “Hey Paul, what do you think about investing in gold,” because they’ve seen the commercials on gold.
I’ll reply, “Have you watched what gold has been doing?” And they’re like, “Well, no, not really, but I see the commercials and it seems to make sense that I should invest in a hard asset like that to protect my money against inflation.”
I like to have people answer their own question. Let’s say the price of gold goes way up and the dollar drops in value and you could get a lot of dollars for your gold.
Say there’s a lot of money to be made by selling an ounce of gold. As a rational human being, it would seem to make logical sense to pour more money into mining.
So you put more money into mining and then do what? You, hopefully, will find more gold.
Great, then you’ve just increased the supply of gold. And what happens to the price of gold when you have more gold to throw around?
It goes down. So now there’s the answer to that question.
I get people asking about interest rates going up, who are thinking about putting more money in higher interest rate investment vehicles.
Then I have the same conversation. Say you take your money out of stocks and put it in fixed income investments.
Now if the interest rate 3%, you’re only losing 4% after inflation. “Well, my inflation rate is different.”
Sometimes you hear people say that. Well yeah, you might have a lower inflation rate right now, but if the dollar keeps going down in value, it’ll catch up.
In other words, if you look at the basket of goods that you buy versus what somebody else might buy, your inflation rate will be different from other people’s. Maybe temporarily. In the short term, your inflation rate is actually lower than what somebody else’s inflation rate would be, but eventually everything goes up in price.
If we have broad-based inflation, everything goes up.
So maybe right now you’re not seeing huge increases in the price of your telephone bill or heating bill.
Electricity and energy can fluctuate. A lot of the time the inflation rate actually excludes food and energy, which a lot of people say is convenient.
Those two things are volatile. But you can have a different inflation rate for a while, but you’re looking at something that will not have the ability to stay paced with inflation.
Markets and Inflation
It’s a fixed income investment like CDs or savings accounts or annuities that are fixed annuities and things like that. They’re giving you a fixed return because they’re bond backed.
And if we go back a hundred years we will see that the rate of return has been at or around inflation. Now if we look at stocks, we see the return being above inflation historically.
Historically, these various asset categories have a return above inflation, because what’s inflation?
Inflation is when prices increase.
Companies will raise prices in order to make up for the fact that the dollar is going down in value. Now, we might be tempted to look at this and think that the rate of return on the CDs and the short term stuff has been higher than stocks have been over the past year.
And yeah, some areas of the market aren’t down much. But if you look at markets around the world and in the U.S., everything is down in general.
What happens when it goes down and price goes down is that people pay less for every dollar of earnings. So they’re paying less for every dollar of earnings.
So let’s say that you used to pay $20 for every $1 of earnings. I get $1 of earnings for every $20 I pay.
One divided by 20 equals 5%. So that’s my earnings yield.
Now if you are not going to pay $20 for the dollar earnings but only $10, what has happened? One divided by 10 is 10%. The earnings yield has gone up.
When markets go down, investors get paid more for the use of their money. When someone buys stock, they are actually paying a lower price, which gives them a higher earnings yield.
Now, Warren Buffett basically said, “Stocks are bonds in disguise.” What you’re buying is the rights of the earnings and those earnings are going to be higher compared to the price that you pay; therefore, the earnings yield is higher.
Investors are going to be rational. If they are going to take the risk of stocks, they want a return that significantly exceeds the risk.
Price-to-Earnings Ratio
A lot of companies are going to other countries for supply chain issues. So therefore what happens is companies are looking for everything they can do to reduce expenses and everything they can do to increase sales.
When an analyst looks at all of that data, they come up with a forward earning estimate. In other words, what do we think earnings are going to be over the next year?
That’s the number that I’m always looking at because you can hear people talk about PE ratios and what they’re talking about is backward-looking.
They’re looking at prices right now based on earnings before. Well, what do we know about earnings over the past year for a lot of companies? It’s been really good.
So the earnings number would be high compared to the price. Or you might have some companies whose earnings are very, very low.
So if the earnings are low and they didn’t have good earnings over the last year, their PE ratio would look totally different because the price would be very high compared to the earnings.
In essence, you can get really fooled by looking at backward-looking price-to-earnings ratios.
Now even looking at price-to-earnings ratios is problematic because price-to-earnings ratios only tell me about what is going to happen or what is likely to happen over the next calendar year.
The next calendar year may not be indicative at all of what will happen in year 2, 3, 4, 5 or whatever going forward. So it really can get you as an investor to just look at that.
What happens when somebody puts all their money in and says, “Hey, I think I’m going to slide it a little bit more in here because I’m getting a little higher interest rate on this CD than I did in the stock market over the last year.”
There are two problems with that. Number one, that is assuming that the forward returns of the market will be lower than what the CDs are going to pay, or the fixed income investments, whatever they are, are going to be over the next year.
Market Timing or Mere Prediction?
Number two, and this is the trickier part about it, that is engaging in market timing and probably not willing to see it as such. Market timing by definition is any attempt to change the mix of your portfolio based on a prediction about the future.
You may not think of it as so, but predicting that things are going to get worse going forward and the stock market is likely going to be bad compared to fixed income investments is a prediction about the future.
It is a prediction really because if you look at the earnings yields of some of these things that I told you about, you’re saying that that’s wrong. You are assuming that you know better what those earnings are actually going to be.
Well, the reality of it is that data is the best estimate. Could they be wrong? Absolutely.
They probably will be wrong. But they could be wrong to the downside or the upside. But if we look at what the expected return is, it is based on all the data that we can have knowable and predictable information.
Now if we look at around the world, a lot of bad stuff has been going on, and that’s why the prices are so low. Investors demand a higher expected return and therefore get that by paying the lower price.
Some investors shoot for a higher expected return by paying a lower price so that the earnings yield will be higher.
When somebody does that and says, “I’m going to shift over to here or there,” I remind them, “Look, you are market timing.”
Skill Versus Luck
Now what’s the problem with market timing? We know that professionals, and I’ve done this many times, they can’t get returns higher than the market.
But here’s the problem. If you look back 10 years, 5% of investment managers actually had a higher return than what the market did on its own.
What does that tell you? That tells you that not too many people beat the market, number one.
That also tells you that the people that did beat the market over the past year, there’s a high incidence of those people thinking that it was something other than luck, that it was skill.
It is very hard for our egos to take the idea that when we do beat the market, it wasn’t skill, just luck.
So what we do is we attribute it to skill and then we pat ourselves on the back until we underperform, then we shut up about it. We don’t say anything about it at that point, right?
As an investor, a question to ask is: what should I do differently? And the answer, if you have a properly mixed portfolio and it’s well allocated, maybe the answer is nothing because you don’t know what’s going to happen next.
If you have the humility to say that you don’t know what’s going to happen next, then maybe if the portfolio’s properly mixed, the right answer is to do nothing.
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