Saturday, November 6, 2010

The third light is about to turn 'green'

This is one of the best analogies for investing; I heard it first from REIN’s Don Campbell and I would like to share it with you. It is about traffic lights and when you should start driving. Before giving you the analogy, a short introduction.

Investing is about risk management, we all want this risk free 20% ROI. We say things like, “I only count on cash flow, because including appreciation is speculative!” So, let’s look at this statement. Say cash flow in the form of dividends, is that risk free? Certainly not! The economy may go bad and even some of the best company’s may end up cutting dividends. Rental income, now that must be risk free! Duuh! NOT! Mortgage interest and payments may go up, there are vacancies, and the tenant may trash the place; you think that is risk free? What about 20% GICs? I invested in one and the GIC provider went broke and... if you get 20% on a GIC then inflation is probably close to 16% and taxes are high. So you get an after-tax return of say 20% x 50%= 10% and inflation is 16% or a real after tax return of -6%!

No investment is free of risk and appreciation should not be dismissed as being ‘speculative’. In my books, ‘speculative’ means excessive risk often for a low return. Example: low interest, medium to long term U.S. treasuries in today’s market. Oh, and investing in lottery tickets.

So going back to the traffic light analogy. Say we are in a green wave zone somewhere in downtown; there are five traffic lights in a row all on red. The depth of the 2008-2009 stock markets may have seemed like that. Now when do you start to drive or invest? When the first light goes on green? Speculators may push the gas pedal fully down, but most investors wouldn’t budge. What when the second light goes on green? Prudent investors would start to buy; we can start driving slowly and shop for the best deals – good companies on sale; affordable and rentable real estate in prime locations. The third light does not jump right away, but then after awhile, it jumps on green too; yes there is risk, but a lot is cleared up and the cheap deals are disappearing with it. The fourth light is on green and you are fully invested! There are still some stragglers, but you are well ahead of the crowd who is still waiting for all lights to go green.

When all five lights are on green everyone is blasting full speed over the road, ignoring pot holes and blinded by past profits that were missed, you, the prudent investor, knows that the lights are soon switching back to orange and before you know all is... red. So when all is green you take profits and let the masses go crazy; you build up cash while even the most fanatical GICer is about to buy dividend paying stocks (which are by now low in yield and near the top of the price range). When all lights are on green, the risk that a number of them will turn to orange and red is highest; when all light are on red, chances are that one will turn green soon with more to follow.

Right now, the third light is about to turn green!

No comments:

Post a Comment