Exit Before Enter – What you should know before you invest…
Today I was at Best Buy, one of my favorite stores, shopping for a new laptop. One of the models I was looking at was priced at $679. And because I treat many purchases like investments, I immediately thought, “How does someone know if this is a good deal?”
Obviously, shoppers will compare this computer’s specifications to other brands at the store that are similar. They’ll also typically shop competitors to see whether they have a better deal, or have this same item for less.
In other words, shoppers will determine what is “fair value” for the item (using comparison), and then look to find the best deal, which is probably an item below fair value. So, in this case, most brands hovered around $749 (“fair value”) for the specifications I was looking for, making the $679 price look very attractive.
Why don’t investors do this?
Because most investors are not skilled in fundamental and technical analysis. The mathematics of which can be fairly complex, and none of which is covered in basic high school or college courses. Heck, even most financial planners/advisers do not understand either (keep in mind that brokers are salespeople first and foremost, and planners too often depend solely on planning software for analysis).
The fact is, you should know these facts before investing in a stock, mutual fund (more difficult), or exchange-traded fund (ETF):
1. Current Fair Value – What is it worth right now?
2. Price – What can I buy it for?
3. Exit Price – What should I sell it for?
You see, in our laptop buying example, by purchasing for $70 less than “fair value”, I’ve essentially built in some profit. Not only does this reduce risk (what if this is a crappy laptop?), but I’ve essentially bought it for more than it was actually worth.
You should do the same with investments. By performing a thorough analysis of an investment, you can not only identify whether the current price is of good value (or not), but also identify an exit price. What is an exit price? That is simply the price that would trigger you to sell it immediately.
For example, with our laptop, if someone turned around and offered me $850 for it right after purchase, what would stop me from selling it? Nothing!
If someone offered me fair value, $749, assuming no sales tax, what would stop me from selling it? Nothing! In fact, I’d do that all day, wouldn’t you?
So by identifying fair value first, then buying below fair value, and then selling once the investment reaches or exceeds fair value, you can successfully generate returns in any type of market. By defining your exit strategy in advance, you can take greed out of the equation, and reduce fear by buying at below fair value.
This strategy will be of utmost importance over the next 10+ years as we enter the age of turbulence in our markets.
What is “long-term”?!?!
What is “long-term”?
This phrase is used frequently to describe a specific type of investor, one that invests for the long-term. But what exactly is “long term”?
Is it a time period? 5 years? 10 years? 20 years?
When it comes to institutions, long-term can mean many decades, even centuries, before invested funds may need to be liquidated. That, is clearly long-term.
But when it comes to individuals, long-term is all relative. And unfortunately, it creates mass confusion in the marketplace. Are you a long-term investor? How do you know? What characteristics define you as such (or not)?
When investing client assets, I focus on designing mini-portfolios for each goal, and each specific goal has a term. But none of these goals are considered “long” or “short”.
Rather, I believe that no individuals are “long-term” investors. Institutions and trusts can be, but not individuals. Individuals simply do not have the luxury of time.
You see, an institution or trust can live for centuries. Some individuals will be investors for 40, 50 years or more, which certainly seems like a long time. But individuals do not have a singular goal. Individuals have a variety of dynamic and ever changing goals, all of which have different timelines, most of them much shorter.
For example, imagine a 22-year old straight out of college. If they begin investing right away, they may have 48 years until retirement (@70). But, in the meantime, they may have kids, and each child’s education fund will have its own timeline. This saving could interrupt retirement saving, because of its typically higher priority. They may have smaller goals to save for, like a down payment on their first home, or weddings. All of these goals must be managed individually. Each payment into savings has its own timeline, so the only retirement assets to actually have remained invested for 48 years would be those bought at age 22. (Money deposited at age 50 only has 20 years, etc.)
Much like being a captain of a ship and navigating rough ocean waters, a portfolio must be watched carefully, with small adjustments made as tides change. A little mistake here or there could cause a portfolio to be off course by a significant amount. In fact, the longer you invest, the greater impact these inefficiencies have on your desired outcome.
Over 40 years, a 1% improvement in annual portfolio performance would equate to 46% more money come retirement! Next time you think hidden 401k fees aren’t a big deal, or big annuity fees, or 2-3% advisory fees, remember this! Imagine if I could save you 3-5%, what would your retirement savings look like? Efficiency matters!
There really is no “long-term” or “short-term”. An investment is either appropriate to own right now or it isn’t. As a student of Benjamin Graham, Warren Buffett, and other value investors, I believe in thorough fundamental and technical analysis (combined with low fees, efficient investments, and tactical asset allocation).
The truth is, life changes. Goals change. Companies change. This is why an investment that was appropriate when you bought it may not be so now. And the difference between an institutional investor, like David Swensen (whom I greatly admire), and individual investors, is simply the dynamic of time. Swensen can afford to hold an investment and hope that the tide turns in his favor. We, however, cannot.
Does this mean we should become short-term traders in the market? Absolutely not. What it means is that you should know what your investment is actually worth, in relation to its price, and when the dynamics of the company, sector, or market change, you must be willing to make the necessary adjustments.
We all would love to be long-term, buy and hold investors. The concept is so easy. But making the money in the stock market is no easy task. Integrating one’s goals and dreams with their portfolio is a challenge most cannot handle without the assistance of a professional.
What works… and continues to work… and will always work… is a “work hard” approach to investing. This avoids the whole short-term vs. long-term argument, in favor of an investment process. This process works like such:
1. Perform rigorous analysis using fundamental and technical data.
2. Implement portfolio using high-efficiency investments.
3. Monitor portfolio for changes in overall analysis.
4. If outlook has changed, make necessary adjustments. If it has not, then repeat step 3.
5. Have emergency plan for when all hell breaks lose (“fat tail” events).
Insurer Ratings Seemingly Unimportant to Most Advisers
In an article today from Investment News (a trade publication for financial advisers), survey results of almost 1000 advisers resulted in 58.6% of them indicating that an insurer’s financial rating was the most important factor they considered when recommending life insurance to clients. This was up from 47% a year ago. While the positive spin noted that advisers are increasingly aware of how important an insurer’s balance sheet is to their client’s future, more shocking to me is how incredibly low this number is!
Look at it another way… These numbers indicate to me that almost half of advisers are indicating that an insurer’s financial stability is not of supreme importance, seconday to other factors such as price (that came in 2nd). What good is price when your policy is not there because a company went out of business? Insurance policies can be in force for decades, so financial stability should be a primary concern in both the short and long term. (Btw, I’ve discussed state guaranty assocations before, and why not to count on them.)
A chief responsibility of any financial adviser is to prudently manage risk, and not considering the financial stability of an insurance company, which is guaranteeing the benefits that clients are purchasing and relying upon, is inescapably unprofessional and inadequate. And after the past year, where balance sheets of insurance companies are still in disarray, you would think that this number should clearly be in the 80′s or 90′s. But 58.6%? With only a modest 11.6% increase over the prior year? Ridiculous. Period.
A Riddle Wrapped in an Enigma
This phrase, coined by Vinny Catalano, CFA, in his recent blog really struck me. He wondered how the US might reach a sustainable recovery without the US consumer. I’m highly concerned about this myself. The fact is, there is extraordinary pressure on small businesses, which create the vast majority of jobs and is widely considered the backbone of our economy.
Until this pressure is relieved, there is no way for us to stave off unemployment. As unemployment increases, consumer sentiment will go down as will consumer spending, which is already at low levels. Many small businesses are unable to get the capital necessary to stay in business, and those that rely on credit cards are having their limits cut or rates increased. Banks are putting the squeeze on not just the consumer, but small and medium-sized businesses. This is in contrast to the President’s desire for reinvigorating the economy.
Yes, there may be good news and the worst of the recession may indeed be over, as Ben Bernanke has publicly announced. However, we are in the first few miles of a 10k run and there is a long way to go before a full recovery is in order. We may desire a “V” shaped recovery, but it just may end up being a “W”, meaning another dip is on the way.
The S&P 500 as a whole is clearly overvalued when looking at P/E. When current price is over 100 times earnings, you have to be concerned. Take a look at this chart from late August, and tell me that it’s not scary! Obviously, prices have not dropped as far as earnings, leading to an inflated P/E ratio. However, since the present value of any investment is typically defined in terms of discounted future cash flows, and these cash flows will be suppressed over the coming years, it is safe to say that today’s market is overly optimistic.
That’s not to say that there are not investment opportunities out there, because there surely are. But general market indexing will not be able to find these values. Only careful and detailed fundamental and even technical analysis of individual securities reveals these opportunities. This is the time for financial advisors to shine, creating value and properly assessing and managing risk. No one needs an advisor during a bull market. It is times like these where advisory services can deliver.