When investing for a lifetime, you need some kind of exposure to stocks for your entire life. If you don’t have the time to manage your own stocks, there’s no shame in going with a mutual fund or an index fund to get your stock exposure. No matter which way you go, stocks are key. High-quality, dividend-paying stocks are the single best investment over any twenty-year period, and that makes them an essential part of both your retirement portfolio and your discretionary portfolio. If you’re under 30, there’s not much reason for you to own anything but stocks across the board, whether we’re talking about retirement or discretionary capital. The line on stocks is that they’re more risky than bonds, but they also produce higher returns. That’s true, but I don’t think the risk should be overstated. Too many people are too conservative with their investments, believing that they’re being prudent when in fact they’re being quite reckless. Investing in stocks over a long period of time pays off, even if you do nothing more than put money in a simple S&P 500 index fund. That might be risky from year to year, but over the long term—and this book is all about the long term—it’s a great decision. Consider this: if you invested everything in the market on the Friday before Black Monday, the big crash on October 19, 1987, you got in when the Dow Jones Industrial Average, which is often used as a proxy for the market, was at 2,500. You’d have felt like a fool a year later because you bought at the absolute worst time to buy. (Interestingly, if you had bought just the ten most active large-cap stocks that very worst day, you would be in the black a year later on most of them.) But let’s take the long-term perspective, the right one. By the summer of 1997, the Dow had leapt more than 5,000 points. That’s a lot of performance to miss. And by the summer of 2007, the Dow hit 14,000. In less than twenty years the market went up 460 percent, and that’s if you got in at the worst possible moment. Believe me, you’re not being prudent if you avoid stocks; you’re passing up a truly incredible opportunity to make money, because you fear short-term losses. Don’t let the potential for downside tomorrow stand in the way of enormous upside in the years ahead.
Although everyone should own stocks, not everyone should own the same number of stocks or the same kinds of stocks. In the previous chapter I gave you a guide to the mix of stocks and bonds you should have in your retirement portfolio as you get older. Here are those numbers again:
AGE
PERCENTAGE IN STOCKS
PERCENTAGE IN BONDS
Under 30
100
0
30–40
80–90
10–20
40–50
70–80
20–30
50–60
60–70
30–40
60–Retirement
50–60
40–50
Retirement
30–40
60–70
My advice is more aggressive than the conventional wisdom, which holds that you should pare down your exposure to stocks and build up your exposure to bonds faster, and that you should own no stocks when you retire. This is another case where the standard advice sounds and feels more responsible than it actually is. If you start with the idea that stocks are inherently more risky and less reliable, then you approach them as a necessary evil. They’re not. People think they’re being prudent if they cut out stocks, because stocks are risky, and who wants to rely on a risky asset to fund their retirement?
That whole perspective is wrong. Yes, stocks carry more risk than bonds. They also have much more upside. What’s more risky: continuing to own stocks as you get older, or not having enough money to retire? For most people, not owning enough stocks means not making enough money. Yes, there’s some risk, but as I’ve said before, if you’re properly diversified—which you are in a good mutual fund or the right kind of index fund—over time the risk of owning stocks declines. On the other hand, the risk of not owning them stays the same.
It’s true that as you grow older, capital preservation—making sure you don’t lose money—is more important than capital appreciation. But that doesn’t mean you can ignore capital appreciation. If you don’t grow your capital, what’s the point of having it? If you have $100,000, and you decide you’re going to take it out of stocks and put everything into bonds, let me explain what you’re sacrificing for a sense of stability. After ten years, if your bonds end up compounding at 5 percent (they can compound because you can reinvest the coupon payments into more bonds), you’re looking at $162,889.46. If you kept all that money in stocks for the same ten years, and they compounded at 10 percent annually, which I’ll remind you is worse than the S&P 500 has done on average per year over the past thirty years, you would have $259,374.25. You’d make $96,484.79 more in stocks. That’s huge. That extra $96,484.79 could be the difference between being able to afford a home and being a renter. Of course, your bond returns are almost guaranteed, whereas with stocks you’re taking a chance. That’s why I agree that you need to decrease your stock exposure as you get older, and this goes for your discretionary portfolio as well as your retirement portfolio (for your discretionary funds, go with the higher-end percentage of stocks in the chart, so when you’re in your 30s, your portfolio should be 90 percent stocks). But your capital needs an engine to grow, and that engine is stocks.
Of course, not all stocks are created equal. Again, I don’t want to spend too much time focusing on stocks in this book because we’ve been there before, but there’s some stuff that absolutely must be covered here. There are different kinds of stocks. You can classify them as growth and value stocks, but here I want to look at what I’ll call speculative and High-quality stocks. These two types don’t cover the entirety of the market, not by a long shot, but they’re the stocks that are most sensitive to your age. Later on in the book, I have a great list of High-quality stocks that I believe will work for years to come, but of course, if the reasons I give for liking the stocks change, then those stocks will no longer be any good. That’s why we do homework. You can define speculative stocks as the ones with the greatest amount of risk, and also the most upside potential. That’s a true definition, but it’s also a terrible one because it doesn’t help you spot them. Usually a speculative stock will have several characteristics. First, its price, the actual dollar amount you pay for one share of the company, is under $10. Remember, no company deliberately sets out to price a stock this low. When a company issues a stock, the underwriter, who sets the price, rarely wants it to be below $19 for fear that it will look speculative. Second, speculative stocks are small, meaning their market capitalization (a way to measure the total value of the company, taking the price per share and multiplying it by the number of shares, giving you a picture of how the market values the company) is low, usually under $2 billion. Third, they are either not making a profit now or they may have been making a profit at one time and are no longer doing so. Fourth, when you buy a speculative stock, you should do so knowing there is some catalyst ahead, something—a bit of news, some company-shaking event—that could send the stock much higher or lower, depending on how it turns out. (The best example of this is a small biotech stock waiting for FDA approval on a new drug. If the drug is approved, the stock soars; if it’s rejected, the stock tanks.) I believe that everyone who owns individual stocks should speculate, but with less and less money as they get older. Stocks are the only truly fun investments, and speculative stocks are by far the most enjoyable, which is why everyone wants to own them.
Speculative stocks are great for the really young, especially college students and recent graduates, who have decades to win back anything they lose while speculating. My rule of thumb has always been that no one should speculate with more than 20 percent of his or her discretionary portfolio. But that number changes with age. People in their early 20s can get away with putting as much as half of their discretionary funds into speculative stocks. (I think it’s a bad idea to speculate in your retirement account, which shouldn’t hold investments that are this ri
sky.) But if you’re in your 50s, as I am, you shouldn’t speculate with any money you cannot afford to lose. And unless you’re rich, you can’t afford to lose any of your money. While it’s critical to speculate in your youth, because the gains can be truly enormous, that window starts to close in your late 20s. You should speculate less as you get older, with no more than 20 percent of your nonretirement capital in speculative stocks in your 30s and early 40s, and then scale down the size of your speculative investments after that.
Then there are High-quality stocks. You should always own some High-quality stocks, no matter your age, but as you get older you might want to make them a larger and larger part of your portfolio. I consider a stock high-quality if it has a significant buyback (this is when companies use their money to buy up their own stock and take it off the market; a buyback reduces the number of shares, and since a company’s earnings per share are the single most important thing to look at when valuing a stock, buybacks should make your shares more valuable); a moderate to large dividend (a dividend is money a company pays out every quarter to its shareholders) that has a history of increasing frequently; and a low price-to-earnings ratio relative to its growth (the P/E, or multiple, is the true price of a stock; it’s simply the stock’s price per share divided by its earnings per share). On my show I always use the example of Procter & Gamble. Here’s a stock with a gigantic buyback that has among the best records of increasing its dividend every year in the S&P 500. It is as close to a “blue-chip” as is possible, though I always rebel at that term because it lulls you into a sense of security that is reckless when it comes to any piece of paper. (If P&G were to report a series of bad years, it could quickly lose its blue-chip status, and you would be advised to make changes.) If a stock has these three characteristics, it’s a High-quality stock. That doesn’t mean it’s a stock for all seasons. You could have a High-quality automaker, but if the market for cars is bad, the stock will be bad too. General Motors, for example, has raised and cut its dividend so many times that it’s been a virtual yo-yo when it comes to yield. However, High-quality stocks tend to have less risk without sacrificing the ability to go much higher. That’s why I favor them, especially for older investors.
The buyback means that the company is buying, and that puts a cushion under the stock during bad days when the market’s going down and few investors want to buy. Many companies have buybacks, but I don’t consider a buyback good unless it’s shrinking the float (all the shares that trade on the open market) by roughly 5 percent. I don’t want you to think that a buyback creates such a level of security that you can ignore your holding. A company is allowed to buy back only a certain amount of stock as a percentage of the volume each day, and it can’t buy stock at the closing bell because it will be accused of manipulating the stock’s closing price. I find a buyback gives you a soft floor, and no more. Lots of times buybacks aren’t active enough for my tastes. That’s why I can’t wait to see the quarterly report of a stock I own that has a buyback. I like to see how many shares it bought and at what price. If you have a stock that has a buyback, but that information is not enclosed in the quarterly report, that buyback is probably not active enough to put down anything but a floor full of holes.
The dividend creates what’s called “yield support.” If a $100 stock pays out an annual dividend of $2 per share, its dividend yield, which is simply the dividend payment divided by the price per share, is 2 percent. As a stock’s price falls, its yield increases. So if that $100 stock fell to $80, its dividend yield would rise to 2.5 percent. And as the yield rises, the stock becomes more attractive to other investors, slowing and eventually halting its decline. I would like to see a yield of at least 2 percent on a High-quality stock, but a little lower than that is fine. High-quality stocks often don’t seem to have a high yield, but again, we return to the example of Procter & Gamble, which has a yield that seems small—but that’s because of the stock’s price appreciation. Often a good yielder does better than the stock market, but when you add in the dividend and you reinvest the dividend, the record’s much, much better than the market.
Finally, we want a stock with a low P/E. When I say low, I mean low relative to stocks with similar growth rates. The growth is just the increase in earnings from one year to the next, and it’s of critical importance when you value a stock. So if a stock has a price-to-earnings multiple of 20 (a P/E of 20) and a growth rate of 15 percent, but other companies with that growth rate have multiples close to 25, you can say that your stock has a low P/E.
A stock with all three of these traits deserves to be called high quality, and makes for a safer, smarter investment as you get older. Remember, Wall Street is just an oddsmaker. When you have stocks with all three characteristics, I believe you are likely to beat the odds, meaning outperform the averages. Not a sure thing, but certainly something that helped me beat the market for years and years at a time.
Back to Bonds
Now let’s go back to bonds. The big problem with everything but stocks is that they’re no fun whatsoever. I like to make investing as fun as possible, but even I have to face the inevitably boring task of choosing and describing bonds. There are many different types of bonds, and I’ll tell you about all of them. Bonds are tedious, but they’re absolutely necessary for building long-term wealth. Let me give you the pecking order, from best to worst, and then explain what you should do with them.
Treasurys are at the top of the pile. These are issued by the full faith and credit of the U.S. government, making them, for all intents and purposes, risk-free. There are three different kinds of Treasurys. Treasury bills mature in a year or less, which makes them the least risky, or the most risk-free bonds you can buy. Instead of paying a coupon (remember, that’s the interest), T-bills, as they are known on the Street, sell at a discount, so that a T-bill that costs you $98 will pay you $100 when it reaches maturity in six months. Treasury notes, or T-notes, mature in two to ten years, and they’ll pay out their coupon every six months. Treasury bonds (T-bonds), or the long bond, as they are known, mature in ten to thirty years and also have coupon payments every six months. All of these Treasurys are sold by the government but also trade on the secondary market. When we speak of bonds, as in “The bond market did well today,” we are speaking of the ten-year Treasury. Typically we are also speaking of the most current bond, the last one issued, which is called the “on the run” Treasury. If you were to buy a ten-year note, that is the one you would be buying.
After Treasurys there are agency bonds, which are issued by government-sponsored agencies like Freddie Mac, Fannie Mae, and Ginnie Mae. You probably won’t come near this stuff except in a bond fund, but for the interest of thoroughness I’ll explain them anyway. Fannie Mae and Freddie Mae are both publicly traded companies that were created by the federal government and still get huge benefits from being affiliated with the Feds, such as not having to pay state and local taxes and being allowed to borrow money at special low rates. Ginnie Mae is actually a part of the Department of Housing and Urban Development. There are other agency bonds, but these are by far the most common. They tend to generate better returns than Treasurys and are only slightly more risky because they have the implied insurance of the government entities themselves.
Then there are corporate bonds, which individual investors also probably won’t be buying any time soon. These also come in different forms. When a corporation issues first mortgage bonds, those are secured against its property, usually real estate and also machinery, and if the company goes under, these bondholders get first dibs after the U.S. government gets its tax take. You will most likely end up whole if you own these bonds, because bond holders have a call on the assets remaining that are sold in bankruptcy. Next in the pecking order of corporate bonds you’ll probably never own unless you’re a pro are unsecured bonds, which can be senior or junior. The junior bondholders have subordinated debt, meaning that if the issuer can’t pay, they have to wait until the senior bondholders are paid
off before they get paid off. Companies will also issue convertible bonds, or converts, which have lower yields but allow you to convert your bond into a fixed number of shares in the company. These offer some upside, because if the stock goes up after the bond is issued, you can convert the bond into stock and make a quick profit. Similar to convertible bonds are preferred stocks, which you can think of as a kind of cross between a stock and a bond. Preferreds, as they’re called, are basically special shares of stock that pay much higher dividends than common stock. These aren’t bad investments, because they have great yields, and if the stock tanks, you can hold the preferred stock until its maturity date and get back the initial amount you invested. There are also convertible preferreds that let you convert your preferred shares into a fixed amount of common stock, so once again you get upside when you convert to the common stock (as long as it has gone up since the convertible preferred was issued). You have to watch for opportunities when companies issue these kinds of pieces of paper. For example, Ford Motor Company recently cut the common stock dividend and soon after that issued a convertible preferred with a nice yield, much better than the yield on Treasurys. Yet, judging by the people who call me on Mad Money and want me to opine on Ford, few know that this is a much better piece of paper than Ford common stock because it converts into Ford common at only a few dollars above where the stock was then trading.
Now I know this stuff bores you to sleep, but it’s important to know what all of these bonds are just in case you end up in a situation where it really matters. What kind of situation? We had one in the summer of 2007. That was a good time to know about structured bonds, which are bonds that are created—packaged really—with the backing of assets; usually they’re backed with mortgages or auto loans. The mortgage-backed bonds blew up, and that led to a credit crisis. Who would have thought that such a little, obscure thing would put hedge fund after hedge fund out of business? But they did. Many hedge funds thought these kinds of structured products, meaning bonds that are literally crafted of lots of mortgages from around the country, some prime and some subprime, backed by mortgage holders of dubious quality with dubious credit, were so secure that they borrowed billions of dollars from brokerages to buy these bonds and pocket the interest differential between the broker loans and the mortgage-backed paper. When the price of housing collapsed and the mortgage holders began walking away from their homes, this kind of paper proved to be worth a lot less than the hedge fund managers thought. When the investors in these hedge funds recognized the problem, they tried to withdraw their funds with these managers. That led to the managers trying to sell the structured product, which typically had no buyers and even no market entirely, so they had to virtually give away the bonds. After the managers had paid off the brokers who loaned them the money, there was often little or nothing left for the clients themselves. That’s how the credit crunch spiraled and why the Federal Reserve had to get involved, if only so the borrowers underneath these securities could attempt to refinance their houses and stop defaulting. If at the very least you’d known about the existence of structured products, you would have been better prepared for the damage this problem did to the market. Always check to see if any manager you are with owns this kind of paper. Simply look at the prospectus or ask the customer service rep; they know what the paper is and they have to tell you whether the fund owns it. What is most outrageous about this stuff, by the way, is that the pricing was left to the manager, so the manager typically valued the bonds at the price they were purchased, not the dramatically reduced price that they really traded at. If you are with a hedge fund manager, ask for a valuation independent of the one the manager would give. If he or she won’t give you one, take your money out now!
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