Category Archives: Strategy

Intro to Stock Options

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“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.” ~ Warren Buffett

Options are financial contracts whose values are tied to another underlying asset.

Options trading can be an appealing way to build wealth or manage risk, especially if you’re looking beyond just investing in stocks, bonds, and other assets in your portfolio.

But options trading can be a complex and challenging endeavor. The key to success in options trading is understanding the basics, including knowing what options are and the risks and rewards involved.

Options Basics

Options are contracts giving the purchaser the right to buy or sell a security, like a company stock or exchange-traded fund (ETF), at a fixed price within a specific period of time.

Options holders can buy or sell by a certain date at a set price, while sellers have to deliver the underlying asset. Investors can use options if they think an asset’s price will go up or down or to offset risk elsewhere in their portfolio.

Options are financial derivatives because they’re tied to an underlying asset. Other types of derivatives include futures, swaps, and forwards. Options that exist for futures contracts, such as S&P 500 or oil futures, are also popular among traders and investors.

A stock option typically represents 100 shares of the underlying stock. Stock options are common examples and are tied to shares of a single company. Meanwhile, ETF options give the right to buy or sell shares of an exchange-traded fund.

An option is a contract between the holder and the writer. The holder (buyer of the contract) pays the writer (seller of the contract) a price – the premium – for the right to buy or sell the underlying asset.

Option holders can buy or sell the underlying security by a specific date (called expiration date) at a set price (called the strike price). If the option holder exercises the contract on or before the expiration date, the option writers must deliver the underlying asset.

Many investors get interested in options trading because it can be a way to generate income, speculate on the price movements of securities, as well as a way to hedge against losses. However, with these possibilities, they are downsides to options trading too.

Before diving into the world of options contracts and options trading, it’s essential to understand the benefits and risks of this investment strategy.

Some of the main advantages of options trading are:

  • Options give you the chance to make money whether the market is going up, down, or sideways.
  • Options may be an inexpensive way to participate in the market without tying up as many funds as stock or bond trading requires.
  • Options provide investors with leverage, which can help magnify returns.

Some of the main drawbacks of options are:

  • Options trading is a complex and risky strategy and one that requires a great deal of knowledge and experience to succeed.
  • Options involve a great deal of leverage, which can amplify losses if the trade goes against the trader.
  • Options contracts are not always as liquid as other securities, making them harder to buy and sell.

Options are a complex, risky market and may not be suitable for everyone.

“Successful trading depends on the 3M`s – Mind, Method and Money. Beginners focus on analysis, but professionals operate in a three dimensional space. They are aware of trading psychology their own feelings and the mass psychology of the markets. Each trader needs to have a method for choosing specific stocks, options or futures as well as firm rules for pulling the trigger – deciding when to buy and sell. Money refers to how you manage your trading capital.” ~ Alexander Elder

References:

  1. https://www.sofi.com/options-trading-101/
  2. https://www.sofi.com/learn/content/how-to-trade-options/

Peter Lynch’s five rules to investing

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“If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the car pool or on the commuter train—and succumbing to the social pressure, often buys.” Peter Lynch

Legendary American investor Peter Lynch shared five rules everyone can follow when investing in the stock market.

Within his 13-year tenure, Lynch drove the Fidelity Magellan Fund to a 2,800% gain – averaging a 29.2% annual return. It is the best 20-year return of any mutual fund in history. He is considered the greatest money manager of all time, and he beat the market for so long through buying the right stocks.

No one can promise you Lynch’s record, but you can learn a lot from him, and you don’t need a billion-dollar portfolio to follow his rules.

https://youtu.be/6oYc3RbLO3Q

Lynch’s five rules for any investor in the stock market are listed below.

1. Know what you own

The most important rule for Lynch is that investors should know and understand the company they own.

“I’m amazed at how many people that own stocks can’t tell you, in a minute or less, why they own that particular stock,” said Lynch.

Investors need to understand the company’s operations and what they offer well enough to explain it to a 10-year-old in two minutes or less. If you can’t, you will never make money.

Lynch believes that If the company is too complicated to understand and how it adds value, then don’t buy it. “I made 10 to 15 times my money in Dunkin Donuts because I could understand it,” he said.

2. Don’t invest purely on other’s opinions

People do research in all aspects of their lives, but for some reason, they fail to do the same when deciding on what stock to buy.

People research the best car to buy, look at reviews and compare specs when buying electronics, and get travel guides when travelling to new places – But they don’t do the same due diligence when buying a stock.

“So many investors get a tip on a stock travelling on the bus, and they’ll put half of their life savings in it before sunset, and they wonder why they lose money in the stock market,” Lynch said.

He added that investors should never just buy a stock because someone says it is a great buy. Do your research.

3. Focus on the company behind the stock

There is a method to the stock market, and the company behind the stock will determine where that stock goes.

“Stocks aren’t lottery tickets, there’s no luck involved. There’s a company behind every stock; if a company does well, the stock will do well – It’s not complicated,” Lynch said.

He advises that investors look at companies that have good growth prospects and is trading at a reasonable price using financial data such as:

• Balance Sheet – No story is complete without a balance sheet check. The balance sheet will tell you about the company’s financial structure, how much debt and cash it has, and how much equity its shareholders have. A company with a lot of cash is great, as it can buy more stock, make acquisitions or pay off its debt.

  • Year-by-year earnings growth
  • Price-to-earnings ratio (P/E) – relative to historical and industry averages.
  • Debt-equity ratio
  • Dividends and payout ratios
  • Price-to-free cash flow ratio
  • Return on invested capital

4. Don’t try to predict the market

Trying to time the market is a losing battle. One thing to keep in mind is that you aren’t going to invest at the bottom. Buy stocks because you want to own the business long-term, even if the share price decreases slightly after you buy.

Instead of trying to time the bottom and throwing all your money in at once, a better strategy is gradually building your stock positions over time.

This approach spreads out your investments and allows you to buy into the market at different times at varying prices that ideally balance each other out versus investing one lump sum all at once.

This way, if you’re wrong and the stock continues to fall, you’ll be able to take advantage of the new lower prices without missing out.

“Trying to time or predict the stock market is a total waste of time because no one can do it,” Lynch said.

Corollary: Buy with a Margin of Safety: No matter how careful an investor is in valuing a company, she can never eliminate the risk of being wrong. Margin of Safety is a tool for minimizing the odds of error in an investor’s favor. Margin of Safety means never overpaying for a stock, however attractive the investment opportunity may seem. It means purchasing a company at a market price 30% or more below its intrinsic value.

5. Market crashes are great opportunities

Knowing the stock market’s history is a must if you want to be successful.

What you learn from history is that the market goes down, and it goes down a lot. In 93 years, the market has had 50 declines; once every two years, the market declines by 10%. of those 50 declines, 15 have declined by 25% or more – otherwise known as a bear market – roughly every six years.

“All you need to know is that the market is going to go down sometimes, and it’s good when it happens,” Lynch said.

“For example, if you like a stock at $14 and it drops to $6 per share, that’s great. If you understand a company, look at its balance sheet, and it’s doing well, and you’re hoping to get to $22 a share with it, $14 to $22 is terrific, but $6 to $22 is exceptional,” he added.

Declines in the stock market will always happen, and you can take advantage of them if you understand the company and know what you own.

References:

  1. https://dailyinvestor.com/finance/1921/peter-lynchs-five-rules-to-investing/

What is Success

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“You are the only one who knows whether you have won.” John Wooden

The best definition of success I’ve read was written by legendary UCLA men’s college basketball coach John Wooden who knew and achieved extraordinary success on the college basketball hardwood. His definition of success was:

“Success is peace of mind that is the direct result of Self-satisfaction in knowing you did your best to become the best you are capable of becoming.”

As you can see from Coach Wooden’s perspective, each person is the only one who can ultimately determine his or her own success.

It’s up to you and every individual to become as good as you can become with your respective gifts and talents you’ve been given and in the environment you find yourself.

The author Napoleon Hill (Think and Grow Rich) dedicated his life and professional and career to understanding the work ethics and ethos of highly successful people like Thomas Edison and Henry Ford.

From his life’s work, Hill determined there were more than a dozen elements of success demonstrated by exceptional business and civic leaders that anyone can embrace and practice. A few of those elements are:

1. They have a definite aim in life.

Hill likens having just a vague aim to succeed to being a ship without a rudder. “Bear in mind that both your definite aim and your plan for attaining it may be modified form time to time… The important thing for you to do now is to learn the significance of working always with a definite aim in view, and always with a definite plan,” Hill writes.

2. They are self-confident.

To be capable of setting ambitious goals, you need to believe you can follow the plans to achieve them. And when you believe in yourself, others tend to believe in you as well.

3. They practice self-control.

Hill says that he did not start to become successful until he learned that he was working against himself whenever he gave into anger or arrogance. “No person ever became a great leader of others until he first learned to lead himself, through self-control,” he writes.

4. They are focused.

Successful people are able to concentrate their energy and skills toward specific goals without becoming distracted by irrelevant issues.

5. They are persistent.

Those who are able to achieve success are not stopped by the inevitable nonstop challenges and setbacks that are in their path to attaining their goals.

6. They are resilient.

“When you begin to realize that failure is a necessary part of one’s education, you will no longer look upon it with fear, and lo! the first thing you know, there will be no more failures!” Hill writes. “No person ever arose from the knockout blow of defeat without being a stronger and wiser human being in one respect or another.”

7. They work hard.

Hill says that this sounds simple enough, but it’s important to remember that even if you achieve your greatest goal, you need to continue pushing yourself or risk losing everything you worked for.

8. They are empathetic.

Hill’s favorite philosophical maxim is The Golden Rule, which states, “Treat others the way you would like to be treated.” He uses it as the final rung of the ladder to true success.

References:

  1. Wooden, John, and Carty, Jay, “Coach Wooden’s Pyramid of Success”‘, Revell Publishing, Grand Rapids, MI, 2015, pg. 12.
  2. https://www.businessinsider.com/the-magic-ladder-to-success-2014-8

Successful Investors are Patient

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“The stock market is a device to transfer money from the impatient to the patient.” — Warren Buffett

Patience is ofter referred to as the most underused investing skill and virute. And, learning patience could help you reach your financial goals of wealth building and finacial freedom.

Be extremely patient when investing in assets and wait until you can buy an investment at an entry price when everybody else hates the investment or are extremely pessimistic about the prospects of the investment.

In other words, wait until you can buy the asset at a extremely discounted price.  Keep in mind that every investment is affected by what you pay for it.  The less you pay, the better your rate of return on that investment.  Never, Never, Never…overpay for an investment.

People feel losses twice as much as they feel gains.

Successful investors develop a number of valuable skills over their lifetimes. And many report that patience is the most important skill to learn and master, but often it goes underused.

We’re not born patient. But, patience can be learned and, if you’re an investor, learning it could help you reach your financial goals.

Patience often involves staying calm in situations where you lack control. Even if we’re patient in some parts of life, we have to practice and adapt to be patient in new situations. Just because you’re a patient person while waiting in line at the DMV doesn’t mean you’re a patient investor.

Alway keep in mind and retain the mantra that…if there is a good opportunity now, a better one will come in the future.

Yet, patience can be difficult for investors to master, why it’s an important investing skill and how to apply patience to investing.

Why Is it so Hard to Be Patient?
Simply put, your brain makes it hard to be patient. Human beings were designed to react to threats, either real or perceived. Stressful situations trigger a physiological response in people. You’ve likely heard this called the “fight-or-flight” response — either attack or run away, whatever helps alleviate the threat.

The problem is, your body doesn’t recognize the difference between true physical danger (during which fighting or fleeing would actually be helpful) and psychological triggers, like scary movies. Being patient is difficult because it means overcoming these natural instincts. Turbulent financial markets can trigger the response too but, unlike scary movies, there can be real-world impacts you’ll need patience to overcome.

When markets are seesawing and you’re overwhelmed with negative financial media, as we experienced this year during the pandemic-driven bear market, your brain perceives a threat to your financial well-being. Even though stock market volatility isn’t a physical threat, the fight-or-flight response kicks in, emotion takes over, and your brain starts telling you to do something. Your investment portfolio is being harmed! Take action! Now! With investing, action too often translates into selling something because selling feels like you’re shielding your portfolio from further harm. But selling at the wrong time — like in the middle of a major downturn — is one of the biggest investment mistakes you can make.

Impatient investors let anxiety and emotion rule their decision-making. Their tendency towards “doing something” can lead to detrimental investing behaviors: checking account balances too often, focusing on short-term volatility, selling or buying at the wrong time or abandoning a long-term strategic investment plan. And those bad behaviors could damage investors’ long-term returns.

Selling out of the market during a correction might feel like you’re taking prudent action. And you may even derive some pleasure in seeing the market continue to fall after you’ve sold your equities. But that pleasure could soon be replaced by regret, because consistently and correctly timing the market by selling and buying back in at the right time requires an incredible amount of luck — and we don’t know any investors who have that much luck.

Investment entry point and investor patience are super-important too.

Benjamin Graham, known as the “father of value investing,” knew the importance of patience in investing. Patience and investing are actually natural partners. Investing is a long-term prospect, the benefits of which typically come after many years. Patience, too, is a behavior where the benefits are mostly long-term. To be patient is to endure some short-term hardship for a future reward.

The importance of being patient when investing can be best summed in this quote by Benjamin Graham…“In the end, how your investments behave is much less important than how you behave.”

“We agree with Warren Buffet’s observation that the stock market is designed to transfer money from the active to the patient. By only swinging at fat pitches and avoiding curveballs thrown far outside the strike zone, we attempt to compound your capital at an above average rate while incurring a below average level risk. In investing, patience often means the accumulation of large cash balances as we wait to purchase ‘compounding machines’ at valuations that provide a margin of safety.” Chuck Akre

Compounding works exponentially for the patient investor. The power of compounding is one of the most important concepts that investors need to learn and embrace. Since, patient and time are better friends to the investor than experience, expertise, and even research.

“A lot of people historically have done fairly well investing in companies they just genuinely like, whether it’s been Starbucks or Nike.” Gary Vaynerchuk, CEO, VAYNERMEDIA

References:

  1. https://www.thestreet.com/thestreet-fisher-investments-investor-opportunity/patience-the-most-underused-investing-skill
  2. https://www.nasdaq.com/articles/why-patience-is-crucial-in-long-term-investing
  3. http://mastersinvest.com/patiencequotes

Investing Principles and Rules

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Value investing is one of the most preferred ways to find strong companies and buy their stocks at a reasonable price in any type of market.

Value investors, such as Warren Buffett and Monish Pabrai, use fundamental analysis and traditional valuation metrics like intrinsic a value to find companies that they believe are being undervalued intrinsically by the stock market.

A stock is not just a ticker symbol; it is an ownership interest in an actual business with an underlying value that does not depend on its share market price.

Inflation eats away at your returns and takes away your wealth. Inflation is easy to overlook and it is important to measure your investing success not just by what you make, but by how much you keep after inflation. Defenses against inflation include:

  • Buying stocks (at the right prices),
  • REITs (Real Estate Investment Trusts), and
  • TIPS (Treasury Inflation-Protected Securities).

The future value of every investment is a function of its present price. The higher the price you pay, the lower your return will be.

No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on a margin of safety  – by never overpaying, no matter how exciting an investment seems to be – can you minimize your odds of error.

Knowing that you are responsible is fundamental to saving for the future, building wealth and achieving financial freedom. It’s the primary secret to your financial success and it’s inside yourself. If you become a critical thinker and you invest with patient confidence, you can take steady advantage of even the worst bear markets. By developing your discipline and courage, you can refuse to let other people’s mood swings govern your financial destiny. In the end, how your investments behave is much less important than how you behave.

Every investment is the present value of future cash flow. Everything Money

Three things to know is that it’s important to understand and acknowledge that a stock is a piece of a business. Thus, it becomes essential to understand the business..

  • Principle #1: Always Invest with a Margin of Safety – Margin of safety is the principle of buying a security at a significant discount to its intrinsic value, which is thought to not only provide high-return opportunities but also to minimize the downside risk of an investment. No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on a margin of safety  – by never overpaying, no matter how exciting an investment seems to be – can you minimize your odds of error.
  • Principle #2: Expect Volatility and Profit from It – Investing in stocks means dealing with volatility. Instead of running for the exits during times of market stress, the smart investor greets downturns as chances to find great investments. The guru of value investing Benjamin Graham illustrated this with the analogy of “Mr. Market,” the imaginary business partner of each and every investor. Mr. Market offers investors a daily price quote at which he would either buy an investor out or sell his share of the business. Sometimes, he will be excited about the prospects for the business and quote a high price. Other times, he is depressed about the business’s prospects and quotes a low price. The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists.
  • Principle #3: Know What Kind of Investor You Are – Graham advised that investors know their investment selves. To illustrate this, he made clear distinctions among various groups operating in the stock market.1 Active vs. Passive Investors Graham referred to active and passive investors as “enterprising investors” (requires patience, discipline, eagerness to learn, and lots of time) and “defensive investors.”1 You only have two real choices: the first choice is to make a serious commitment in time and energy to become a good investor who equates the quality and amount of hands-on research with the expected return. If this isn’t your cup of tea, then be content to get a passive (possibly lower) return, but with much less time and work. Graham turned the academic notion of “risk = return” on its head. For him, “work = return.” The more work you put into your investments, the higher your return should be.

Because the stock market has the emotions of fear and greed, the lesson here is that you shouldn’t let Mr. Market’s views dictate your own emotions, or worse, lead you in your investment decisions. Instead, you should form your own estimates of the business’s value based on a sound and rational examination of the facts.

References:

  1. https://www.investopedia.com/articles/basics/07/grahamprinciples.asp
  2. https://jsilva.blog/2020/06/22/intelligent-investor-summary/

Margin of Safety

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“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger the margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.” Warren Buffett

Billionaire investor Warren Buffett, Chairman and CEO, Berkshire Hathaway, said, “The three most important words in investing are margin of safety.” Margin of Safety is a measure of how “on sale” a company’s stock price is compared to the true value of the company. You need to be able to determine the value of a company and from that value determine a “buy price”. The difference between the two is the margin of safety.

Effectively, margin of safety means you pay less for an asset than what it’s intrinsically worth. It means to buy $10 dollar bills for $5 dollars. That’s the secret to great and successful investing. The margin of safety is the difference between the intrinsic value of a stock and the current market price of the stock. The intrinsic value of an asset is its actual value, that is, the present value of the asset found by calculating the total discounted future income it’s expected to generate.

The intrinsic value is calculated based on the 10 year discounted free cash flow (DFCF).

In other words, if the stock price of a company is below the actual value of the free cash flow (income) and assets of a company, the percentage difference is the Margin of Safety.  This is the discounted price at which you are buying a share in the company.

A higher margin of safety will reduce your investment risk. If an investor can buy a stock below its intrinsic value, the potential for a bad outcome, risk, is usually lower.

Warren Buffett likes a margin of safety of over 30%, meaning the stock price could drop by 30%, and he would still not lose money. Margin of safety is only an estimate of a stock’s risk and profit potential.

Buffett determines margin of safety by estimating the current and predicted earnings from a company from today and for the next ten years.  He then discounts the cash flow against inflation to get the current value of that cash.  This is the Intrinsic Value of the company. He bases intrinsic value on the discounted future free cash flows. He believes cash is a company’s most valuable asset, so he tries to project how much future cash a business will generate.

Margin of Safety is a value investing principle strategy. If the total value of all shares of a company is 30% less than the intrinsic value of that company, then the margin of safety would be 30%. In other words, if the stock price of a company is below the actual value of the cash flow and assets of a company, the percentage difference is the Margin of Safety.  This is the discounted price at which you are buying a share in the company. Most value investors believe that the higher the margin of safety, the better.  In reality, a margin of safety between 30% and 50% is reasonable.

The Margin of Safety is the percentage difference between a company’s Fair Value per share and its actual stock price. If a company has profits and assets that outweigh a company’s stock market valuation, this represents a Margin of Safety for the investor. The higher the margin of safety, the better.

Margin of safety is only an estimate of a stock’s risk and profit potential. Most value investors believe that the higher the margin of safety, the better.  And, the larger the margin of safety, the more irrational the market has become. 

One of the keys to getting a great margin of safety is to understand that price and value is not the same thing. Price is what you pay for something, but the value is what you get.

The stock market rises about four out of every five years or about 80% of the time, according to Nick Murray. Said another way, the market only falls 20% of the time. You can fear that 20% or cheer for it.

No one ever got wealthy paying full price or top dollar for financial assets, according to Buffett. Most successful investors got that way buying assets that were distressed, out of favor, and therefore on sale. Unfortunately, few people see it that way. You need to take advantage of the sale during market selloffs and corrections when it occurs. Your money literally goes further because you can buy more share at lower prices that lead to market-beating returns later on.

If you want to make good long-term investment returns, you need to minimize your risk by purchasing companies selling at a significant discount to their intrinsic value due to market volatility. 

References:

  1. https://novelinvestor.com/10-lessons-learned-nick-murray/
  2. https://www.ruleoneinvesting.com/blog/how-to-invest/how-to-invest-margin-of-safety-the-growth-rate/
  3. https://www.liberatedstocktrader.com/margin-of-safety/

Investors Need to be Patient and Rational

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“It’s a textbook example of why panic is not a[n investment] strategy, unless you’re deliberately trying to lose money.” Jim Cramer, CNBC Mad Money Host

CNBC Mad Money Host Jim Cramer made his comments after the stock market indexes moved higher after a previous major market downturn due to COVID-19 Omicron variant concerns and fear. Wall Street experienced a strong melt-up session led by the technology heavy Nasdaq Index’s 3% jump.

Markets had sold off sharply on November 26, with the Dow, S&P 500 and Nasdaq all losing more than 2% in market cap value as investors knee-jerked reacted to the discovery of the Omicron variant.

“I want you to use it as a reminder that, most of the time, it pays to wait for cooler heads to prevail rather than freaking out in a situation where everyone else is freaking out and lost their heads without complete information,” Cramer said.

“Look, it would’ve been great if you bought stocks something near the lows—that’s what I urged you to do, actually, even if you had to hold your nose because we were simply too oversold. I was relying on technicals,” Cramer said. “But the cardinal sin here was selling stocks out of fear, rather than sitting tight out of rationality.”

The obvious takeaway for investors is that fear and panic are not sound investment strategies, “…unless you’re deliberately trying to lose money.” Never make permanent investment decisions based on temporary market circumstances.

References:

  1. https://www.cnbc.com/2021/12/07/cramer-stocks-recent-rally-shows-need-for-investor-patience-not-fear-.html

Sequence of Returns Risk in Retirement

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A stock market pullback can pose a risk early in retirement.

Retirees face many risks when investing for retirement. Markets crash, inflation can eat into your returns, you might even worry about outliving your savings. And, there’s another big retirement risk: Sequence of returns risk.

Down markets can pose significant “sequence of returns” risk in the early years of retirement. Sequence risk is the danger that the timing of withdrawals from a retirement account will have a negative impact on the overall rate of return available to the investor, according to Investopedia.

A “sequence of returns” risk is basically about how the order, or sequence, of stock returns over time — combined with your portfolio withdrawals — can impact your balance down the road.

Once you start withdrawing income, you’re affected by the change in the sequence in which the returns occurred. During your retirement years, if a high proportion of negative returns occur in the beginning years of your retirement, it will have a lasting negative effect and reduce the amount of income you can withdraw over your lifetime.

Timing is everything. Sequence risk is the danger that the timing of withdrawals from a retirement account will damage the investor’s overall return. Account withdrawals during a bear market are more costly than the same withdrawals in a bull market.

“If there’s a big loss in the market and you’re taking withdrawals, you could be taking more from your portfolio than what it can make up for,” said certified financial planner Avani Ramnani, managing director at Francis Financial in New York. “If that happens early in retirement … the recovery may be very weak and put you in danger of not recovering at all or being lower than where you would have been and therefore jeopardizing your retirement lifestyle.”

One of the basic rules of investing is that a long-term strategy is self-correcting. And, for long-term investors — those whose retirement is many years or decades away — such market drops matter less because there’s time for their portfolios to recover from this risk before they need to start relying on that money for cash flow in retirement.

Retirement is a long game.

Since running out of money in retirement is the primary concern for most retirees, fortunately, there are options for mitigating the risk:

  • Plan to spend more conservatively since the less you spend consistently, the less you have to withdraw overall.
  • Withdraw and spend less when your portfolio performance is suffering. 
  • Reduce the risk in your portfolio by creating a low stock allocation early in retirement but increase it over time, or use bonds for short-term expenses and stocks for long-term ones.
  • Set aside assets outside your investment portfolio that can support your spending needs when stocks are underperforming.

You may simply be able to meet your goals without taking on the risk that comes with stocks.

Key Takeaways

Sequence of return risk is basically the risk that market declines in the early years of retirement, paired with ongoing withdrawals, could significantly reduce the longevity of your portfolio. Thus, timing is everything, and in retirement early market declines, particularly if they are paired with rising inflation, can have a huge effect on how long a nest egg can sustain you in retirement.

The recommended way to mitigate sequence of returns risk when you can’t predict future market performance or future rates of inflation is by managing spending and/or keeping a portion of your portfolio in liquid assets, such as cash or bonds, to ride out the market downturn.

When market returns are high and inflation is low, retirees can distribute more from their portfolios, according to Forbes Advisor Staff Editors Rob Berger and Benjamin Curry. When market returns are negative and inflation is higher than expected, retirees reduce the amount of their annual distributions.

Remember, no one can forecast market performance or economic inflation. Yet, by managing your spending, you can adjust annual withdrawal amounts to reflect inflation and market returns.

References:

  1. https://www.investopedia.com/terms/s/sequence-risk.asp
  2. https://www.thebalance.com/how-sequence-risk-affects-your-retirement-money-2388672
  3. https://www.cnbc.com/2021/09/21/stock-market-pullback-is-a-big-risk-early-in-retirement-what-to-know.html
  4. https://www.forbes.com/advisor/retirement/sequence-of-returns-risk/

The National Study of Millionaires

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“Anyone in America can build wealth. The only thing holding you back is you. Get out of debt. Save consistently. Keep your spending in check. Let time and compound interest do their magic. If you’re willing to work hard and keep the long-term goal in mind, you’ll reach the million-dollar milestone.” Chris Hogan

Summary

  • “The National Study of Millionaires” is the largest survey of millionaires ever with 10,000 participants.
  • Eight out of ten millionaires invested in their company’s 401(k) plan.
  • The top five careers for millionaires include engineer, accountant, teacher, management and attorney.
  • 79% of millionaires did not receive any inheritance at all from their parents or other family members.

The National Study of Millionaires by Ramsey Solutions concluded that millionaires successfully accumulated wealth through consistent investing, avoiding debt like the plague, and smart spending. No lottery tickets. No inheritances. No six-figure incomes.

Thus, according to the survey, there is positive news for Americans who may have lost hope that they can ever accumulate wealth. “The people in the study became millionaires by consistently saving over time. In fact, they worked, saved and invested for an average of 28 years before hitting the million-dollar mark, and most of them reached that milestone at age 49.”

The study’s results demonstrated a dramatic difference between how Americans think wealthy people get their money and how they actually earn and spend their money.

In a nutshell, regular, consistent investing over a long period of time is the reason most of the people in the survey successfully accumulated wealth. And, even when millionaires don’t have to worry about money anymore, they remain careful about their spending. Ninety-four percent of the people studied said they live on less than they make. By staying out of debt and watching expenses, they’re able to build their bank accounts instead of trying to get out of a financial hole every month.

ARK’s Cathie Wood

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“Cathie Wood is a star stock-picker and founder of ARK Invest, which invests in innovations like self-driving cars and genomics.” Forbes

Cathie Wood founded ARK Investment Management seven years ago in 2014. One of the biggest secrets to ARK’s investment strategy and noteworthy success, according to Wood, is “the willingness to step in when others are selling a stock for very short-term reasons. We get great opportunities like that.”

Wood said it “pains me more than anything” to think clients might be panicking and selling at the wrong time.

Thus, Wood isn’t focused on short-term fluctuations. She takes a long term and bold view. “We have a five-year investment time horizon,” she says. Since, the big ideas blossoming todaywere planted 30 years ago, she says: “We are ready for prime time now.

Additionally, Wood and her team has been early on many themes—they embraced active management when investing seemed inexorably tied to indexing; they implemented stock-picking in active ETFs while the largest asset managers said it couldn’t be done; and she bought companies that others thought were overpriced, a novelty, or both.

Investing in transformative technologies that are going to change the world

Wood’s focus has been on innovative companies with technology to disrupt the way we live. Her portfolios are loaded with stocks that have skyrocketed—for example, Tesla is a big holding in three of her funds. She is an advocate of a future where technology would make everything better, more productive and profitable.

As Wood and her company’s research frequently remind investors, electrification, the telephone, and the internal combustion engine turned the world upside down a century ago. Now, she believes that five technologies—artificial intelligence, blockchain, DNA sequencing, energy storage, and robotics—are bringing about an equally profound transformation of the economy. These innovations will converge, recombine into things like autonomous taxis and whatnot, and create a perfect economic storm of higher wages, falling prices, and wider profit margins.

Ark’s ideas start with their research. Wood researched stocks with dogged determination. “Cathie is insatiably curious; she was a voracious consumer of research from all over the Street. She read everything from everyone,” says Lisa Shalett, chief investment officer for Morgan Stanley Wealth Management.

For example, they state that they take a blank sheet of paper and just say, “What is an autonomous vehicle? What’s the right way to build one? What are the critical variables?” They believe that they will inevitably run into the companies that not only have good answers, but are leading the charge

She was on a mission to allocate capital to its best use—transformative technologies. Innovation is early-stage growth, and it is typically exponential growth. Companies developing these platforms can generate revenue growth of more than 20% [annually] for years and years.

Wood looked at places that other investment analysts ignore. She found stocks that sat at the intersection of multiple industries, and weren’t followed by analysts from any side. This, she realized, is where innovation happens.

Most growth companies have a decay rate, which means the bigger a company gets, the harder it is to grow. Exponential growth often includes network effects and virality, which means the more people joining the network, the more valuable it becomes, and the faster it grows.

Wood’s believes in transparency when financial firms don’t allow portfolio managers and analysts to use social media to share their research or even gather information. At ARK, Wood created an open-source ecosystem, where the team can share research and collaborate with scientists, engineers, doctors, and other experts. Every Friday morning, she convenes an investment ideas meeting with her analysts and outside experts that’s part business school seminar and part free-form futurist bull session. “Most compliance teams would not be comfortable with that,” Wood says. “From the beginning, ARK actively shares the knowledge they’re generating.

Conservative philosophy

The dawning of a high-tech future is central to Wood’s life philosophy. In starting ARK, her goal was “encouraging the new creation,” by investing in “transformative technologies that were going to change the world.” The triumph of innovation also fits well with her free-market views. To a younger generation tempted by socialism, she’s hoping to show that capitalism can still work its magic.

She’s conservative, both politically and economically. For decades she’s championed green investments. Wood has bemoaned President Joe Biden’s plans to spend big and tax the wealthy, even though many of his proposals are designed to bring the economy closer to her futuristic vision for it, and though higher capital-gains taxes could push more money into tax-efficient funds like hers. She warns that higher taxes on companies and investors will discourage future innovation.

References:

  1. https://www.barrons.com/articles/arks-cathie-wood-disrupted-investment-management-shes-not-done-yet-51614992508
  2. https://www.bloomberg.com/news/features/2021-05-27/cathie-wood-is-a-believer-from-bitcoin-to-tesla-even-as-arkk-fund-stumbles
  3. https://www.barrons.com/articles/tesla-telehealth-and-the-genomics-revolution-power-ark-funds-51603450802