Richard C. Young The Ten Commandments of Investing

Sometimes I come across something that is so good I can’t stand not to share it. This post is taken from “10 Commandments of Investing” by Richard C. Young. For the record the author is also the editor of a newsletter, Richard C. Young’s Intelligence Report. Most of the time I subscribe to this service; sometimes I drop my subscription because the editor includes too many political rants in his publication. I am not paying him to tell me what is wrong with the world. I am paying him to tell me how to invest in the world as it exists. Sometimes I let my subscription lapse because I know if I wait a month or two I will be able to renew at less than ½ price. Richard C. Young is an old school value investor, just like I want to be when I grow up. He is pretty good. He does make some horrendous mistakes, but if you follow his advice on diversification you will not be hurt too bad by an occasional disaster.

1: Capital Preservation

The first rule of making money is, “Don’t lose what you already have.” Keep most of your money in a wide variety of relatively safe stable investments. Don’t put too much at risk at one time. This is particularly true after retirement. When you are no longer a part of the workforce, it becomes very difficult to recover from financial disasters. When you are young you can take more risks, but only after you pay off those credit cards and build up an emergency fund. Investment grade bonds, Treasury Bills, Government National Mortgage Association (Ginnie Mae) funds, cash (insured money market funds and the like), and stocks with a low beta are all good bets for capital preservation. Beta is a measure of volatility that can be found on quote pages on sites like Google Finance. A beta of 1.00 means a stock is as volatile as the market. Less than 1.00 means it is more likely to be safe and boring. Greater than 1.00 means the stock moves faster than the market.

2: Dividends

I would changes this one to Income, but this list belongs to Richard Young not to me. Income includes dividends from stocks (almost all of my individual holdings pay a dividend) and interest from bonds, certificates of deposit, and the like. Income is the second concern of the retired investor. In a perfect world my lost income would be completely replaced by interest and dividends from my investments. Unfortunately, I don’t live in a perfect world. Even if you are young, consider something like half of all your gains are going to be generated by the reinvestment of your dividends over time. Stock price is not real until you sell your shares for a loss or a gain. Dividends are real. They are money you can hold in your hand.

3: Compound Interest

“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”
Albert Einstein

Compound interest is the miracle that allows you to pay $500,000 (over a 30 year time span) for a $100,000 house. It also allows you the opportunity to turn that daily cup of Starbucks coffee into a $500,000 retirement account. Right now savings are being punished by the Federal Reserve Bank. You can’t help that, so don’t be ashamed to pick up pennies. I do that every time I see one lying on the road. Remember that most brokers offer a free Dividend Reinvestment Program (DRIP) for American stocks. This allows you to use your dividends to buy more shares giving you the power of compound interest combined with the opportunity for capital gains.

4: Core Equity Holdings

These are the stocks you can ALMOST buy and forget. Sometimes they are called widow and orphan stocks. These are often low beta, dividend stocks. Dividend aristocrats are good candidates for your core equity holdings. A dividend aristocrat has increased its dividend every year for at least 25 years! Unbelievable! Unfortunately nothing is perfect. GE was a dividend aristocrat until it wasn’t. I took a beat down on that one. Various advisors would also include regulated utilities, consumer staples, and “wide moat” companies as possible candidates for your core equity holdings. A wide moat is an economic advantage that is very difficult to overcome. Imagine building a new railroad to compete with the Union Pacific Railroad out in California. That is a wide moat.

5: Buy Dividend-Paying Stocks During Bad Times

This can work really well. If you are lucky enough to buy an undervalued stock paying, let’s say a 3% dividend, and it doubles in price; you are effectively receiving a 6% dividend. The first quarter of 2009 was a perfect opportunity for this kind of bargain hunting. However, bottom fishing is not without its risks. Sometimes that stock is undervalued for good reasons and that juicy dividend is not sustainable. Watch the cash flow. Dividends should not be consuming too much of a company’s profit.

6: Automatic Withdrawal Programs

This is referring to the author’s variation on the 4% rule. Young suggests that retirees never withdraw more than 1% of their net portfolio value on a quarterly basis. Nice idea, but sometimes reality gets in the way. After I retire I will probably need to withdraw that much of my stash to prepare my house for the retail market. However, this is a good conservative rule of thumb. I would also flip the idea for folks still in the workforce. Save for retirement, your kids’ education, your next car, and similar long range goals using some kind of automatic investment program. Dave Ramsey recommends placing 15% of your total pretax income into tax sheltered investment vehicles as the long term basis for a good retirement program. The less you have to remember the better you are likely to do on this kind of savings program.

7: Avoid Investment Predictions

Much as I wish my combination of research and intuition could predict the future, no one knows what tomorrow will bring. Markets are extremely complex systems that are driven as much by human greed and fear as they are logical decisions based on knowledge and judicious analysis. Your investments will not go up forever. Some will make money. Some will lose money. Some will go up and down over time.

Make a plan and track the results. Jim Cramer recommends spending one hour per month studying each of your positions. That would include news articles, research reports, and technical analysis. I think that is probably a bit ambitious for most of us, but I would suggest that you check your balances at least once a month. If anything odd has happened dig into it. If you have built a portfolio with a foundation of bonds and low beta dividend aristocrats, chances are it won’t need a lot of daily attention.

If you picked a loser, take your tax loss; then go on and reinvest your money in something new. If a holding has grown over time until it is too large for a single position (say somewhere around 3%-5% for a single stock), don’t be afraid to sell a little. Rebalancing your portfolio from time to time is as natural and healthy as trimming the bushes in front of your house. As you put aside additional funds, invest them to maintain a balance that is appropriate for your age and your tolerance for risk.

I think this is a good place to mention high risk gambles. One of the weaknesses of my investment style is a complete inability to place a bet on a long shot every now and then. It is OK to invest a wee little bit of money every once and a while on something like a wild story about a micro-cap biotech firm with the next Viagra that is almost ready for human trials or the random fluctuations of a sick puppy like the Bank of America. Always remember if you can double your money overnight, there is a pretty good chance you could lose half of your money overnight.

8: Full Faith and Credit Investing

This goes back to rule number one, capital preservation. Treasury notes, insured bank accounts, U.S. Government bond funds, and Ginnie Maes are all backed by the full faith and credit of the United States of America. The only risk here is inflation. You will get your dollars, but what will they be worth when you need them?

I am beginning to change my mind on this one. I have owned foreign stocks for years, but never foreign bonds. To me full faith and credit has always meant a U.S. Government guarantee. Almost two years ago, I took my first baby step into foreign currency. I bought a little bit of a fund that buys short term notes denominated in Swedish Krona. Since then I have managed to loose about 2% of the money I invested in this new sector. The United States no longer has a AAA credit rating; might Swiss bonds be a safe place for a little of my money? Although I am afraid of the Euro, Europe is so impressed with German Federal bonds that the two year note carries a negative interest rate. That’s right. The rest of Europe thinks so highly of their German cousins, they are willing to lose a little in order to have the full faith and credit of The Deutsche Bundesbank standing behind their savings.

9: Avoid In-and-Out Trading

John Bogle, founder of the Vanguard family of funds, as well as numerous heavy hitters have demonstrated that it is almost impossible to beat the major averages over the long run. This means that the best plan for most of us is to invest our money in broad index funds and leave them there. Not only is it unlikely you can beat the computers that have replaced the day traders of yore, you will have all those additional brokerage fees eating into your profits. If you follow the mutual fund road, be sure to know all the sales charges and fees you are paying your fund manager and her salesmen. If you are totaling more than 0.5% a year you should probably walk away. Six and seven percent sales commissions as well as 12B-1 fees are a non-starter. If you see them run away. Vanguard is the world champion when it comes to low cost index funds, but there are others worth your consideration.

I believe I can buy shares in individual companies. I have done so and I have made money. I also have holdings in mutual funds and their more modern cousins, exchange traded funds. As my holdings have become more diversified, it has become harder for me to pick out individual companies from a class of stocks. Buying Chevron and Coca Cola were pretty easy decisions, but which Brazilian tree farm offers the best investment opportunity?

Again, technical analysis really works. Extremely disciplined traders using techniques based on sophisticated statistical methods can produce excellent results. This is just not my cup of tea. It would never be recommended by Richard Young. For those of you who want to learn more about this art, I recommend Technical Analysis for Dummies by Barbara Rockefeller. It is a good introductory text with an excellent bibliography.

10: Have a Plan and Patience

Young and a number of other authors suggest that you develop a written plan, a contract with yourself, before you start investing. This overarching plan will help guide your decision making process before you make individual decisions out of fear or greed. I would add, make this a joint contract signed by both husband and wife, as with the monthly budget.

There is more than one path to financial security. However, all of them require a systematic, disciplined approach over the course of an extended time frame. Don’t be tempted to alter your plan as the market rises and falls. Consider even minor changes to your contract with yourself an issue that will require serious study, thought, and discussion. This does not mean you will not sell a holding when it is overvalued or when it loses a predetermined amount of its value and triggers your automatic stop loss instruction. It doesn’t mean you won’t change your stock/bond/cash balance as you age. That sort of thing should be written into your contract. It is a strategic guide, an approach to solving problems over good times and bad.

In order to better understand the differences between strategy and tactics consider the American Civil War. At the war’s beginning General Winfield Scott proposed a plan to crush the Confederacy. First, use the Union’s superior Navy to enforce a blockade, depriving the Confederacy of access to foreign industrial products. Then seize control of the Mississippi, cutting the Confederacy in half. Finally, drive from the Mississippi to the Atlantic through the heartland of the South, while simultaneously driving South through Virginia. Although generals and tactics changed constantly and radically over the course of that long and bloody struggle, the basic Union strategy remained pretty much a constant.

One of the new things I have learned while writing this blog is the importance of time, not just the power of compound interest over time. I already knew that. What I have learned is your time frame is going to be a significant factor in the financial outcome of your life.

“The very poor think day to day.”

“Poor people think week to week.”

“The middle class thinks month to month.”

“The rich think year to year.”

“The very rich think decade to decade.”

Thanks to Marc Bastow of InvestorPlace for digging this jewel of a list out of the electronic storage bin.