Sunday, February 7, 2010

Ten Rules for successful investing from the book of Godfried

The 10 commandments of investing are based on my personal experiences over the last 25 years or so. Many of those rules have been stolen, copied and plagiarized from numerous newspapers, books and other sources including REIN:

1. Cash flow is Number One.
Financial independence means your investment income (dividend, rent, interest, or distributions) exceeds your cost of living. You also need to generate cash for new investments this is done in 3 ways:
a) Live below your means – i.e. save money for investment.
b) Only invest in self-sustaining investments (i.e. it generates cash or it does not require additional cash)
c) Sell current investments that met your investment goal(s) and re-invest

2. Survive the ‘flue’ in your financial life.
Have sufficient money to avoid forced asset sales of stocks, real estate, paintings and your favorite yacht in Belize. There will always be times of hardship during market crashes, economic down turns, high rental vacancy, loss of work, unexpected medical expenses, and the early demise of your gold fish. You need enough cash reserves to get through these times for cost of living expenses and, very important, for buying opportunities in depressed markets.

3. Diversify but don’t diworsify.
Diversity of investments is a must, i.e. don’t put all your eggs in one basket. So buy real estate, gold, resource stocks, financials, pharmaceuticals, bonds, mortgages, etc. Subdivide those investments in cash flow generating investments and appreciating investments. Often, stocks bought at a good dividend yields (note: NOT EXTREMELY HIGH) tend to outperform most others most of the time. Investments that provide pure appreciation are gold, some real estate, some stocks, some bonds (coupons).

The big mistake with diversification is that one tends to buy everything including the kitchen sink and sometimes only kitchen sinks. This, Peter Lynch calls ‘Diworsification’.

If you have a small portfolio, index funds (example: S&P/TSX60 i-shares Symbol: XIU) can be bought to buy Canada’s top 60 public companies or a basket of Dow Jones or S&P500 companies. You can buy small amounts of these index funds at regular intervals regardless of price for many years and concentrate on real estate as your prime form of investment.

4. Don’t sell in a market or personal panic
All markets go up and down, some more so than others. It is nearly impossible to predict and time when markets top or bottom. Therefore buy when prices become attractive based on fundamentals and sell when you have made your price targets (unless your fundamentals have changed – then you re-asses). Always buy and sell in small, but meaningful chunks. If you have 100million then buying chunks of $1000 is meaningless. If you have $2000 to invest, the same $1000 represents half your portfolio – that would be clearly too much. If you think in allocation percentages, you can more easily determine what is meaningful. Suppose you have 40% in real estate, 30% in a diversified stock portfolio, 15% in fixed income and 15% in cash. A typical stock portfolio has 30 to 50 different stocks and with holdings forming between 1 and 10% of your stock portfolio.
 In that case, you buy or sell stocks of in chunks of 0.5 to 1% of you stock portfolio, while in your real estate portfolio you might buy or sell in chunks of 5 to 10% of that portfolio. If you have only one index fund in your stock portfolio, you could buy in chunks of 1 or 2%. This approach will prevent you from selling and buying with emotion during market peaks and crashes. Emotional buying and selling mostly ends with unnecessary losses. This approach will also give you time to study your investments – my experience is that you are more knowledgeable of an investment once you own a bit. In other words, doing (owning) it is a much better teacher than only studying (and being afraid to act).

5. Sell when you made your profit (set a price target) – don’t try to scrape the bottom of the barrel
The Wall Street expression ‘Pigs get slaughtered’ says it all. John Templeton used to say that you should always leave another 10% upside for your buyer. This because when you want to sell at the absolute peak, there will not be a buyer. Investment is not about greed, it is about making an appropriate rate of return. Sometimes a stock or investment rises at neck break speed and you will have to ask your self if is this investment is truly worth the current market price? Would I buy it now? You may conclude that its price is not realistic. If you made the money you targeted, be happy and sell.

Example, although I am an oil price bull, when the oil price hit $140 per barrel, I felt that this was overdone and that the economy would not be able to handle such a price shock. I sold some of my oil holdings to get cash for a rainy day. I was lucky, the stock that I sold a few months ago for $110 trades now at $67. Maybe I’ll buy some back from the ‘pigs’ who are now selling in a panic.

6. Market timing is impossible but you can buy when a good investment is on-sale
For real estate I use Don Campbell’s fundamentals and behind the curtain. For stocks I use my stockbroker (for over 20 yrs now) and Canadian Share Owner’s database (on-line or CD) of Great Stocks & Grief Stocks. These are the fundamentals of North America’s stock market companies in one reliable database. When real estate is priced for attractive cash flow, I buy real estate (I bought 3 properties this year and try to sell one). When stocks are priced attractively I buy stocks – I have been buying for the last 3 months [written in late 2008] by bits and pieces and will keep on-doing so. With current prices my mouth is watering – especially Canadian Banks, Pharmacy and Oil(&Gas). I buy with a 5 to 10 year time horizon.

7. Understand what you buy
I buy companies, bonds, mortgages and real estate. I don’t buy hedge funds (I am too stupid too understand their logic, besides those guys don’t tell me what they do in the first place). I don’t buy uncovered options, but take them when my well researched employer allots me some – and hold them for the long term. I only sell options, when my asset allocation gets out of whack or when I can’t sleep at night because of the overexposure to one company.

Owning in a company where you work allows you to take a much larger chunk than when you own a stock of say BCE or the Royal Bank. Because the latter you know only from a distance, and you have no clue how much their managers disclose or how reliable the research on the company is. That is different from owning the company where you work. So, I suggest typically that you can own up to 30% of your net worth in the company where you work. This of course differs with your circumstances, when you are young just out of school, your net worth is little and you may have 50 or 60% of your net worth in your company’s options. When older and near retirement, try to stay below 30%. Remember the people that lost their retirement when Dome Petroleum went under in 1982?

8. When investing in stocks avoid leverage and buying derivatives. Buy a business.
In 1987, a particular financial planning company was in vogue in Calgary. That summer, I had just paid off my mortgage and wanted some investment advice. So, I made an appointment and showed my financial data. Alarm bell 1: The planner was a petroleum engineer who had been laid off a couple of years earlier from the oil patch. What did that guy know about investing? He just took any job he could get! Alarm bell 2: The planner proposed to take a new mortgage on my house and use the proceeds to buy into mutual funds which in the previous years had returned 15% per year. I

magine what would have happened had I fallen for this misguided joker? Three months later, in October 1987, we experienced the largest stock market crash since the 1929 depression, while the oil patch was in lay-off mode since 1982 and did not turn around until the mid 1990s or better until 1999. By the way, the financial planning company went broke a few years later… and rightly so.

Leverage magnifies your profits but it CERTAINLY MAGNIFIES YOUR LOSSES. What are you going to do when your own capital is wiped out during a volatile downturn, you just lost your job and the bank is knocking on your door?

9. Buy large companies with a good dividend and ‘reputable???’ management.
The most volatile and risky part of the market are small companies. During downturns, small companies are more likely to fail. In downturns the weak fail and the strong become stronger in the subsequent recovery that nearly unavoidably follows. Numerous analytical studies show that companies that pay dividends, increase those dividends on a regular basis, and trade near book value (net asset value) almost always outperform in the long term.

10. Buy real estate, which is unique in that you can set your own dividend (cash flow), growth (appreciation) and risk level (leverage).
Real Estate is an essential part of your portfolio including your own house. Stock markets on average appreciate 6% per year, similar to real estate. Real Estate pays positive cash flow; stock markets pay dividends. The difference is volatility and the fact that they are not always performing the same way at the same time. Stock market volatility is much higher than real estate’s; hence real estate is more suitable for leveraged investment techniques. However, it is also very labor intensive and less liquid. Real estate and Stocks are asset classes that supplement each other. They both belong in a serious investment portfolio.

I know, many real estate investors do not consider a personnel residence as an investment. I disagree from personnel experience. Your personnel residence is the single largest investment many people make. It is an inflation hedge, and it appreciates in real value as well. Whether you pay rent to a landlord or to yourself makes no difference. Yes there is one big difference: You are a lot more reliable than the average tenant and you love the place and will take good care of it. There is one caveat: don’t buy a house that is larger then you need. As always, live below your means that is how you accumulate assets.

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