Closed-end Funds July 30, 1997March 25, 2012 “How do you buy shares of closed end funds selling at a discount? Why would they be selling at a discount? I thought that closed funds meant that you can’t get into them.” Some open-ended mutual funds close temporarily (or permanently) to new investors — but that’s an entirely different thing. To redeem your shares, you still send them to the mutual fund company and get 100% of their then net asset value. A closed-end fund is sold like a new stock, typically at $10 a share. Never buy them on the offering, because the underwriter takes his fee out of your funds and you are in effect paying $10 for $9.50 (or whatever) in assets. But after the initial public offering — perhaps 20 million shares are sold at $10 each — the only way to buy the shares is from someone who sells them. And the only way to sell them is on the open market to someone who wants to buy them (i.e., you can’t redeem them with the fund company). Typically, they sell at a discount for several reasons. One is that most money managers can’t beat the averages — so why pay 100 cents on the dollar for assets out of which is typically taken 1% a year in management fees? If GM is worth $50 a share, wouldn’t GM’s performance-minus-1%-a-year be worth only $45, if that? Well, a closed-end fund may own GM and 50 other stocks, and the same reasoning applies to the whole batch. If you think this money manager can outperform the market by 1%, thus covering his fee and matching the market, then the fund should sell at 100 cents on the dollar. If you think she cannot just beat the market by enough to pay her own fee but add an extra 1% or 2% or 5% of performance to boot — as few can — then you might reasonably pay a premium. Another reason closed-ends typically sell for a discount is that people know they do, expect them to — and thus resist bidding them up to full value. Or look at it this way. They know closed-ends rarely sell at a premium but can drop to 90% or 80% or in a bad market perhaps even 70% or 65% of net asset value. (Some, of course, will do better than others.) Knowing that, why risk paying 100 cents on the dollar. You expect a bit of a bargain to induce you to take this extra risk. Theoretically, closed-end managers could end the discount and enrich their owners by going “open-end” — i.e., offering to redeem whatever shares were tendered at net asset value. Suddenly, each $1 of assets would be redeemable for $1, so the fund would sell for about 100% of its value. But that could mean less money under management and, in turn, less money for the fund manager. So instead they often do the opposite. Rather than offer to redeem your existing shares, they “force” you to buy more. How? By offering you and all the other shareholders the “right” to buy additional shares at 5% or more “off” the going market price. You’re not literally forced to buy, of course; but if you don’t, your own shares become a little diluted in value by the discount given those who do accept the offer. (Closed-ends know many shareholders don’t like these rights offerings but make them anyway to expand the pool of capital they have under management, from which they can take fees.) In short, closed-ends can offer great value. Or not. Only buy them when they do.
Fidelity versus Vanguard July 29, 1997February 3, 2017 From Randy Bartlett: “Aloha Andy: You’ve espoused upon the virtues of index funds such as Vanguard’s in the past. Any comments on the info below?” The information Randy refers to comes from Mutual Funds Magazine on-line (www.mfmag.com). “Although Fidelity’s performance lagged in late 1995 and in 1996, in the first half of this year it is once again among the leading fund families. In fact, the average return of Fidelity’s and Vanguard’s domestic diversified stock funds so far this year is within three-tenths of a percentage point. And, over the long-term, Fidelity’s actively managed fund approach beats Vanguard’s indexing philosophy.” While I have high regard for the folks at Fidelity, I don’t think Fidelity can beat the market averages consistently — they’re so big, they ARE the market averages, more or less. Given that, the extra handicap of their low-load sales commissions (in some cases) and higher expense ratios (in most cases) make it unlikely to me that over long periods Fidelity will beat the index funds, let alone by enough to make it worth risking the possibility that they won’t. (Some of Fidelity’s hundreds of funds will do considerably better than average for a long time, but neither they nor we know which.)
The Lawyers Fess Up July 25, 1997February 3, 2017 Score one for the good guys. THE BACKGROUND Regular readers of this comment will know that Californians got to vote on three ballot initiatives last year — Props 200, 201 and 202 — that came down hard on lawyers. “The tough 200’s,” we called them. “The terrible 200’s,” the lawyers called them. The goal, of course, was not to harm the lawyers, any more than the goal of Automatic Teller Machines was to harm human tellers. The goal was to make life better for NON-lawyers. Not surprisingly, the lawyers defeated all three. On Prop 200, which RAND estimated would have cut auto insurance premiums dramatically, the lawyers ran millions of dollars of advertising claiming that rates would go UP 40%. They had to know this was a lie, but with it they succeeded in hanging on to the $2.5 billion a year that they take from the California auto insurance system. On Prop 201, which would have done at the state level what Congress had done federally — discourage extortionate class-action securities suits while leaving the door open for those with substantial grounding — they lied and said it would prevent defrauded shareholders from suing. They ran ads morphing Seagate Technology founder and CEO Alan Shugart back and forth with Charles Keating, convicted felon — never mentioning that anyone who had bought Shugart’s stock around the time of his alleged transgression would, by the time of the ads, have about tripled his money. A few law firms that specialize in these suits thereby succeeded in hanging on to the several tens of millions of dollars a year they make from these suits. On Prop 202, which would have limited a lawyer’s contingency fee to 15% when an acceptable settlement offer was made within 60 days of the initial demand letter, they ran ads claiming that lawyers would cease to work on contingency if Prop 202 passed — they’d all quit, presumably, and become gym teachers. It was not a great day for democracy, because — as usual — the electorate was not presented the facts objectively and given the opportunity to make an intelligent choice. The lawyers were working with a particularly maddening formula. First you do something really rotten; then you point to that rotten thing itself as proof you’re right. Not very elegant the way I’ve phrased it, but highly effective the way they did it. To wit: First you sue Al Shugart, co-founder of Seagate Technology, three times for alleged insider trading (the first case was settled for pennies on the dollar to get rid of it, the second was thrown out of court after eating up $3 million in legal fees, the third is still pending); then you blanket the airwaves with commercials implying he’s a stock swindler because “he’s been sued three times for insider trading.” You morph his face back and forth with Charles Keating, the notorious convicted S&L felon, never mentioning that investors in Seagate — unlike investors in Lincoln Savings and Loan — have made, not lost, a pile of money. First you sabotage the early 1970s drive for no-fault auto insurance by giving states “no-fault” in name only. (In states like Massachusetts, there’s all the suing and fraud there is in California. You just need to chalk up $2,000 in medical bills to be eligible to sue — which gives some people an incentive to rack up $2,000 in unnecessary medical bills. The year the threshold jumped from $500 to $2,000, the average number of treatments following a car crash jumped from 13 to 30.) Then, 25 years later when the next generation makes another run at it, you simply point to “no-fault” states like Massachusetts and Connecticut and say, “See? No-fault doesn’t save money. It’s a disaster. An old idea that hasn’t worked.” First sabotage it, then point to the wreckage to prove it doesn’t work. (In Michigan, the one state that comes fairly close to the true no-fault that Prop 200 would have provided in California, people actually do pay substantially less for auto insurance than in California, while enjoying VASTLY better protection if they’re badly injured.) THE FOREGROUND That the lawyers played dirty was plain. Getting them to admit this, even after the fact, is naturally next to impossible — but, as it happens, not entirely so. Al Shugart sued the trial lawyers for libel. I had all but forgotten about this until last week, when I heard the news: The case had been settled. The California trial lawyers have agreed to place full-page ads of apology and to contribute $350,000 to charities of Shugart’s choice. Anyone else might have been able to weasel and say, “We just couldn’t afford to fight this suit.” But 5,000 trial lawyers? So, clearly, they were admitting to having used deceptive tactics to defeat Prop 201. In my view, they did the same on Prop 200, defrauding California consumers out of billions of dollars a year, to their own benefit.
More on Home Mortgages July 24, 1997February 3, 2017 Writes Jack (as I’ll call him): Recently my Sunday paper’s real estate section guru-consultant-wizard-know-it-all trotted out the old ‘pay a few bucks principal a month more, and save gazillions!’ This was then followed with a nice little table showing all the money you get to ‘save’ by making your 30 yr mortgage a 20 yr one instead (or a 15 yr one). I see this advice at least once a year in his column. WELL, this is always stated as an absolute truth, and is very misleading. The ultimate extreme of this technique would (obviously) be: buy your home for cash & save a fortune! Yet compare mortgage rates the last couple of years with Vanguard 500 fund, and I know where I would want my money to be. A personal story to illustrate the point: I bought an ‘income’ property near Hughes Aircraft 8 years ago ($250,000 then, $160,000 today — something to do with the disappearance of my ‘endless’ supply of aerospace engineers to rent to after all the plants closed). Global peace can be hard on the pocketbook. Thank goodness I went for maximum leverage (smallest possible downpayment), and put my monthly disposable income into MSFT, instead of HOUSE! Ultimately, the 30-yr fixed mortgage I had was so far ‘upside down’, that it made no financial sense to keep it alive. The real estate market would have had to rocket up for the next decade or two for me to come even close to break-even. I did a ‘short-pay’ instead (essentially walking away from the property), even though I could have sold my MSFT and paid the loan off in cash. I was ABLE to do so, because I had so LITTLE of my money into the deal. Had I made accelerated payments (or, God forbid, paid cash), I would have taken a bath. Well. Clearly it would have been brilliant to buy Microsoft (MSFT) or even just the Vanguard Index Trust eight years ago rather than put that money into a larger downpayment. As described yesterday, you can’t count on this always to be the case — especially if you don’t have the luxury of walking away from a debt you’ve incurred, and not paying the piper, as Jack did. (Someplace in here there’s a great pickled pepper possibility, but I’ll spare you.) Technically, Jack didn’t default. He got the bank to take the property back without the bank’s going to the considerable expense of foreclosure, in return for its agreeing not to pursue him for whatever they lost on the loan. Maybe they didn’t know he owned all that Microsoft. Technically, too, Jack should declare as taxable income the amount by which the loan balance was forgiven, but he says he’s hoping the bank will forget to report it, in which case he will feel no obligation to do so. I was curious whether Jack had any qualms about any of this. He explained his reasoning: If the bank wants to be nasty, they can report the ‘forgiven’ amount to the IRS as income. So, instead of owing the entire amount to the bank, I may owe TAX on it instead. Still a lot better than owing the entire amount. As best I can tell, this tax liability reporting is done inconsistently, depending on the lender & admin procedures. Haven’t heard anything yet regarding any tax liability (it has been a while — and I’m not about to ask the bank & remind them!). For a while, there were even some outfits in So. Cal. you could deed your property to first (for a fee), and then they will default on the loan on your behalf — this loophole took the tax liability away from the original loan holder. It sounded a bit too shady for my liking — and I know the authorities are prodding & poking at this loophole as well. Credit-wise, my ‘short pay’ is better than a ‘foreclosure’ which is better than a ‘bankruptcy.’ It also stays on your record shorter. I agonized for a while, but then how much money should one be willing to pour into a black hole to keep a perfect credit record? There must be SOME limit, right? Also: I had a partner in all of this who disappeared (back to India, I think), leaving me to hold the bag & make mortgage payments for the last two years. Since my credit record is spotless (including mortgages on other properties I have), I will play up the ‘abandoned by business partner’ angle in a letter to explain this one particular ding if it ever comes up. Since so many thousands of aerospace folks lost their jobs in So. Cal. & lost their homes, a ‘short-pay’ is pretty common in these parts, and not the sudden death & stigma it used to be to your credit rating a decade ago. I’m young (well, – late thirties), have a six-figure income, AND been socking almost 40% of my gross earnings (living below my means — I read your book!) into equities for the last decade (and boy, oh boy, those MSFT leaps I’ve been buying the last couple of years…), and have no foreseeable need for credit (other than my existing mortgages; and credit cards – which I pay off in full every month – also from your book!). All of the above just to say, yes, there may be consequences to “short pays,” so, if you have a CHOICE in the matter, like I did, be sure to take all of the above into account. My own old-fashioned feeling is that, if you have a choice in the matter, make good your debts — and declare all your taxable income. But I found Jack’s perspective informative, at the very least.
15-Year Mortgage Sap July 23, 1997February 3, 2017 “With respect to your piece on Home Mortgage Deductions, could this reasoning also apply to paying down your mortgage? I feel like such a sap getting a 15-year mortgage at 8% instead of a 30-year at 8.25%. We’re sending about $300 extra to the mortgage company each month. Being in the 15% tax bracket and filing a joint return, are we doing an OK thing? — Mitch” Don’t feel like a sap, Mitch. By doing this, you are “earning” 8.25% risk-free on all the extra money you use to pay down the mortgage, all those $300 checks. I.e., not having to pay 8.25% for 30 years is as good as earning 8.25%. That may not sound like much when the stock market is rising 15% in a single quarter, but it won’t sound bad at all in quarters when the market drops 10% or 15%, and we’ll have some quarters like that one of these days, too. (At least, we always have before.) What’s more, the 8.25% you are “earning” on your additional principal payments is “tax-free” if you don’t itemize your deductions, or only lightly taxed at 15% if you do. (In other words, just as the 8.25% interest you’d pay on a 30-year mortgage really is 8.25% after-tax if you don’t itemize deductions, or else about 7% if you do, so, too, is not having to pay it worth either 8.25% or 7% to you.) Indeed, it’s even better than this, because not only are you “earning” 8.25% on those extra $300 monthly payments, you are also reducing the interest rate from 8.25% to 8% on the portion of the loan you would have paid even if you had gone for the traditional 30-year mortgage. So that extra $3,600 a year is saving you interest two ways. That bumps the rate you’re earning on it up to about 9% by my Intuitive Calculator. Unfortunately, I couldn’t figure out the way to calculate it precisely on my Real Calculator, but the great thing about the audience for this column is that several of you, I know, will ride to my rescue. I await your e-mail. The point is: 9% risk-free and virtually tax-free is terrific. What’s more, this is a form of forced saving, and who among us can’t use a little help from time to time saving money? That has some value, too. If you were in a high tax bracket, the case would be less clear. Say you lived in a high-tax state and between federal and local income tax were around the 50% bracket. That 8.25% 30-year mortgage would really cost you roughly 4.25% in interest after tax, so not having to pay it would be like earning only 4.25%, or perhaps a bit more than 4.5% after giving credit also to the lowered interest rate on the rest of the loan. If you could afford the risk and thought you could find a company whose stock would grow at 10% compounded over 30 years — free of any tax until you sold it, and then taxable at only the long-term capital gains rate, which is likely to be lower than your current 50% rate — you would clearly come out far ahead taking the 30-year loan. (But not far ahead of Mitch. Mitch, if he doesn’t itemize, is earning close to 9% after tax by taking the 15-year loan. You, in this example, are earning 10% that is not risk-free and will eventually be taxed.) Mitch: If you have a safe way to earn 18% instead of 9% — paying off your credit card debt being the only one I can think of — then maybe you are a sap for taking the 15-year loan. Otherwise, 8.25% (or in this case more like 9%) guaranteed, and in easy little increments, is just fine as one element of your investment mix.
Three More Uses for the Web July 22, 1997March 25, 2012 Depressed? Check out this site to see some of the famous people who’ve suffered the same nightmare. A brilliant and, until recently, suicidal friend turned me on to it. (He tried a year-long saga of esoteric drugs, even electroshock therapy at some of the country’s finest institutions — no help. But today, on Prozac, he’s back, productive, his old annoying self.) Ready to roll? "Wherever you go, that’s where you’ll be," another friend used to say when people talked of trying to solve their problems by changing the scenery. But of course that applies to congenitally happy people as well as those in pain — wherever they go, that’s where they’ll be — and so, in the hope that you’re happy wherever you are, I commend you to this site (scroll down when you get there) which I used to plot a trip through Connecticut, Massachusetts and Maine. For each leg, I’d just enter the "city pairs" — cities like Oakland, Maine, and Cornish, New Hampshire (combined population, about 14) — and up would come the maps and directions, which I’d then print out. Scroll down a little further and you can get points of interest by zip code. (I skipped that. You’ve seen one giant ball of twine, you’ve seen them all.) Need Wheels? In my case, Hertz provided the transportation. But if you’re in the market for a new vehicle, check out this beta site and let me know what you think.
Strange Correspondents July 21, 1997March 25, 2012 I know some of you think I’m a bit strange from time to time — but what about you? You think you’re all portfolio management and pinstripes? I don’t think so. Witness a random (well, fairly random) slice of a recent evening’s e-mails from this page: From Tony Spina: "I have it on good authority (the Roswell Aliens) that the Dow will be at 9200 on October 1 this year, and at 4900 by January 1, 1998. How do I invest to make the most money?" Answer: Write a book about your contact with the aliens. Alternative answer: In case you’re serious about the question, if not its premise, you’d buy far-out-of-the-money October calls now; sell them September 30 and then put every cent you’ve got into far-out-of-the-money January puts. Of course, this would be really dumb, because as strong as your hunch might be, no one actually knows where the market is going short-term — least of all a bunch of dummies tethered to parachutes being pushed out of Air Force planes in New Mexico — and options are a less-than-zero-sum game. Steer clear. Out-of-the-money options, by the way, for those unfamiliar with the jargon, are those whose "strike price" is above (in the case of calls) or below (puts) the price at which the stock itself is trading. As a result, they’re relatively cheap, because they’re a long shot, but provide terrific leverage in case you win. I almost always lose money on options, but still remember the time, decades ago, when I bought way-out-of-the-money Merrill Lynch calls (not from Merrill Lynch, on Merrill Lynch), and watched in greedy awe as the underlying stock price rose to approach my strike price (already pushing up the value of my options), then reached and crossed the strike price — still with months to go to the exercise date — then rose higher and higher and higher. Calls I had bought for 37 cents each ($37.50 for a call on 100 shares) ultimately would have been worth about $20 each ($2,000 per call) had I held on all the way to expiration. From Sudhindranath Sira: "You wrote on ceres.com dated 06/30/97: ‘… This is undoubtedly true. But bear in mind that long before Perot …’ I request you not use the dreaded B-word! Shall we instead say ‘keep in mind’ from now on? Just kidding! 🙂 — Sira." Thanks, Sira. You need not worry about the bear word. Only a handful of people have any idea what it means any more. From Donald Rintala: "The great windmill of our age is the battle between capitalism and collectivism. Anyone who can seduce the masses to fall in love with capitalism deserves a medal. So here’s the plan: you team up with Steve Forbes to form the Compound Interest Party. Your slogan: no more class war between the rich and the poor. Now, we all get rich! I’ll bet the country could work fabulously on a *total* tax take of 15%. Countries like the Bahamas don’t even have an income tax. Ever feel tempted to move there? Somehow, I think we’ve missed it big in the US — betrayed our origins and ended up performing way under our abilities. Only the Compound Interest Party can get it back together! — Don" Interesting, Don, but I am struck by the fact that the Bahamians, with no income tax, seem largely to be poor, while we visitors from high tax jurisdictions are rich. Must be that we have more air conditioning. From Roger Simmons: "Were you a third class Midshipman on the cruiser Albany?" Not even a fourth class midshipman, Roger. Finally, from Toby Gottfried, reacting to my definition of "millionaire" (anyone with $5 million): "If ‘millionaire’ means ‘really really rich person,’ then in the old days, it was someone who had a million dollars. Now it’s someone who makes a million dollars." Ah. You couldn’t be more right — except from a billionaire’s point of view.
401(k): Just a Tax Break? July 18, 1997February 3, 2017 “Please do not include my name or E-mail. I am 24 years old and have recently started to invest in the 401K. I am putting $45 a week into (Growth Company) and (Growth and Income) with Fidelity. Split 50/50. I have a total of about $2000 in there now. I just received my dividends for one of them and they were barely anything. How is it that I can make any money with these well known funds, when I am not getting big dividends? What if the price is at 45-50 for the next 10 years and then drops to 30 due to a market drop; without the dividends how can I make any money. Please try to help me out on this. I am very confused on how I am going to get ahead. Everyone I seem to ask is confused about it as well. They view the 401K just as a tax break.” Well, and a good tax break it is, too. But it’s much more than that. While the market, and individual funds, will have their ups and downs, if you just keep plugging away at this with your current employer, and then one way or another with future employers (or via a Keogh Plan or S.E.P. if you should become self-employed), you will have a comfortable retirement. At 24, of course, you can’t imagine ever being 60. But 60 isn’t ordinarily the end. By the time you’re 60, 36 years from now, you may well have yet another 36 years beyond that. Right now you may think those years won’t mean anything to you, but of course that’s ridiculous. There are lots of happy senior citizens, lots of unhappy senior citizens — and your being in this $45/week habit in the 36 working years immediately ahead makes it a lot more likely you’ll be one of the happier seniors in the second, leisure 36. Let’s assume that you have $2,000 now and are contributing $45 a week, as you say. Let’s further assume that your 401(k) investments manage to earn 10% a year, although some years they will do worse, some better. Doesn’t sound like much, I know — $50 a quarter right now on $2,000. Fifty dollars is barely enough for dinner and a movie. Let’s further assume you up that $45 a week by 2% a year as your earning power grows — meaning, for example, that next year you’d up it from $45 to almost $46. Apart from whatever other assets you wind up accumulating in life, that would put you, 36 years from now $908,159 ahead of the guy next to you who figured it wasn’t worth bothering with a 401(k) and spent the money on beers and a couple of Oasis and Spice Girls CDs each week. He winds up with a gut and some CDs long since rendered obsolete by whatever the prevalent music medium then is (telepathic disks?). You wind up with enough to withdraw a taxable income of $93,000 a year for 36 years (assuming the unwithdrawn portion continues to grow at 10% along the way). Of course, if we average 3% inflation along the way, that $93,000 will really only be about $32,000 in today’s money at first, and just $11,500 by your final year. Which is why you have to do even more than the 401(k) if you want to build a really nice little fortune. But it’s not bad for $45 a week. Especially since without the 401(k), a good chunk of that $45 would be whisked away by taxes anyway. Don’t focus on the quarterly dividends. (And don’t worry about the literal dividends, if that’s what’s got you bugged. The stocks growth mutual funds invest in generally don’t pay dividends. The funds pay out paltry dividends, plus trading profits realized from selling stocks. But to the extent they don’t sell their winners, there’s nothing to distribute, just a higher share price for the fund.) Focus on the distant horizon. Finally, if your company is like most, it kicks in a little of its own money, typically 25 or 50 cents, for each dollar you put in a 401(k). If that’s the case, then this is truly irresistible. Free money! You must promise me, in that case, you will always contribute every last dollar that qualifies for this matched contribution. The aforementioned $93,000 a year for 36 years would in that case be even 25% or 50% more. Free money, Jeff! Free money!
Pay Off Student Loan? July 17, 1997March 25, 2012 CONFLICT OF INTEREST, as recently defined in this space: When you’re earning 5% interest in a money market account and paying 18% interest on a credit card. "Aahhhhh," responds Glenn Doherty, "but what if I’m only paying 8% on my student loan and I can make 15% on the market, should I only pay the minimum on my loan each month, drawing it out while investing that "saved" money? Or is it still better to do what I do now and that’s pay double the required monthly payment in an attempt to finish off the loan early so that the total interest paid is minimized? The obvious answer is to invest it, but then again what if my picks don’t go up 15%? My gut tells me no debt is good debt, though I’ve also read debt is a good instrument for creating wealth and shouldn’t be feared. Still learning the ropes." Well, the first thing to say is that there is no one right answer. You have a good gut and should enjoy the satisfaction of getting that debt paid off. As we’ve been saying the last couple of days, not having to pay 8% is as good as earning 8% risk-free and (because student loan interest is not deductible) tax-free. Show me a triple-A municipal bond that pays anywhere near 8%. What’s more, even if you could earn 15% in the market — which on average over long periods very few people consistently do — it would be less than that after taxes. So long as you’re not cutting it so close to the bone by making those double payments that you risk running up credit card debt, say, at 18% or 20%, I’d say: keep doing what you’re doing. Another exception would be if, by paying more than you need to, you find yourself without the money for some tool or tuition that could prove a great investment in your own job skills or earning power. If you’re a graphic designer who needs some amazing software program to compete, say, you could earn several hundred percent return on the investment in that software, let alone 8% or 18% or 20%. But you don’t need me to tell you that. One last exception, because you are young: If you do not already have the habit of sending some small chunk of dough every month to a no-load, low-expense mutual fund or two (or to buy shares in a couple of closed-end mutual funds selling at discounts), it’s worth getting into that habit right away — and maintaining that discipline for the next half century (only raising the size of the chunk as your fortunes allow). To my mind, the market is high here, but that’s fine if you’re just getting started: if it goes down at some point, even if it should go down at some point severely, you’ll just be able to get stocks "on sale." Over fifty years of steady investing, you should do very well. So if it means easing up on your student-loan prepayments, even if the numbers don’t necessarily work out to your advantage right away, it’s worth it just to get into the habit. Long after your student loan is history, this habit will be worth a fortune to you.
Stop In Case You Drop July 16, 1997February 3, 2017 Yesterday I answered a question from Pieter Lessing about stop-loss orders. If you don’t know what they are, check it out. Today, the rest of Lessing on losses: Could you comment on STOP LOSS ORDERS AS PART OF AN OVERALL INVESTMENT STRATEGY? I have stop loss orders on most of my equity positions (approximately 20% below the current trading price) for the following reasons: To lock in a profit, once I have one. I finally decided that buying a stock at $18, see it zoom to $40, then down to $7 in less than a year is dumb, not to mention painful. To have sold at $32 ($40 minus 20%) would have been just fine. It would have worked in this case, because the climb up to $40 never had dips as big as 20% along the way. Protect against catastrophe. I travel internationally, and am out of touch w/ quotes & brokers for weeks at a time. If the big one hits while I don’t have access to my account, I have a theoretical limit to my loss. (I realize that I may lose more than 20% if the dive is REAL fast, but since I’ve made quite a bit more than that in most of my positions, I’m willing to accept that.) If the Dow zips down to 2,000 in an hour, I figure we have bigger problems to face anyway. However, if it takes a few days to get down to 2,000, I would be in an all cash situation, buying like crazy! Set the limit of loss when buying a new highly speculative stock. (Sure, it may triple after first going down 20%, but it can also keep on going down.) Preservation of capital. PS: Just like any other investment strategy (or Vegas gambling system), the above does have its weaker points (tax implications, commissions, etc.). PPS: I prefer the above to selling calls (or buying puts) — lower maintenance. Pieter goes on to say that he’s not dogmatic about that 20% number. He may set his stops looser, allowing for even more of a dip, if he thinks the stock is very volatile and/or if he has a really big profit in it. So what do I think? I think, mainly, that for Pieter this is a good strategy. It gives him peace of mind. Indeed, for anyone lucky enough to have gotten into this market in the last few years and doubled or tripled his or her money, it’s something to consider. The benefits, as Pieter has listed them, are clear. (But for the record, the Dow can’t drop to 2000 in a day, for two reasons. First, as I’m sure Pieter knows, there are “circuit breakers” that kick in at various stages to keep the market from falling off a cliff. Second, at least two Dow components, Coke and GE, only go up.) But the negatives of this strategy keep me personally from using stops very often. If you’re speculating in stocks because they may go up, this is a strategy to consider. If you’re buying them to get a stake — perhaps at what you consider a bargain price — in a company you want to own, whose profits you want to share, and in whose growth you want to participate, then this is not such a good strategy. It means that you will frequently find yourself selling stocks you thought were worth owning at one price for no reason other than they are now 20% cheaper (if you set your stop at a 20% loss). When a sale is triggered, you have that 20-plus percent loss (plus, because it’s not unlikely that, as the stock is dropping, your sell order will fetch a still lower price). You incur a brokerage commission (happily, this has become all but trivial). You eat the “spread” between bid and asked prices (not so trivial on some stocks). And, if it’s a stock in which you have a profit in a taxable account, you give up a chunk to Uncle Sam. Granted, if you’re holding a stock at $150 a share for which you paid $28, it’s not too terrible a prospect. You may think of this as play money to begin with. (You know how magnanimous you get at Monopoly when you have hotels every place and there’s no way you won’t win? How when your cash is piling up and you land on someone else’s pathetic little property, with $23 rent, you flip them a hundred and tell them to keep the change? That’s what’s going on here.) And then there’s the conundrum of just how tight to set your stops. The tighter you set them, the less you’ll lose on any given position — but the more you may lose in the long run, as you are whipsawed out of stocks that are basically headed up, but dip occasionally by enough to trigger the stop. A final conundrum is whether to place a straight “stop” or a “stop limit” order. With a stop, when your stock trades at $25 (or wherever you set your stop), your broker will automatically enter a market order to sell your shares. In a thinly-traded stock dropping fast (in part because you are not the only guy who’s been setting stops), that could mean getting your order filled not at $25 or $24-3/4 but $16. Literally. It can happen. To protect against this, you can enter a “stop limit” order — to sell if the stock trades at $25, but only if you can get at least $24, say. That way, you know for sure the worst price you’ll get is $24, which is a big plus . . . except that it also may defeat the whole purpose of the stop in the first place. Because if this is the next Bre-X and you want out at any price, there you will likely sit with the stock at $2, wishing you had set no limit and gotten “just” $16. There’s no free lunch. On balance, and though it will vary tremendously from investor to investor, stops probably cost stock-market investors more than they save them. But that is simply the price you pay for peace of mind. # Where stops do make lots of sense is in commodities speculation, where you can actually lose more than your entire stake, and where your reason for buying coffee futures wasn’t that you actually wanted to own a few tons of coffee, just that you thought the price might go up. Commodities speculation is an idiotic enterprise for lay investors like you or me, but downright suicidal without stops. (And I am so sick of all the innuendo and misinformation about Hillary Clinton’s commodities adventure, I’d like to stop your snickering right now. The full story is laid out in great detail in Jim Stewart’s Blood Sport, and it turns out that — other than handling the public relations aspects of the episode very badly — she did nothing wrong. I’ll bet not one American in 100 knows that.)