By Brad Thomason, CPA
If you’ve ever slipped a canoe into a stream you found out pretty quickly which way the current was going. Canoeing on a stream is essentially an exercise in starting here with the intent of ending up there.
When performing investment analysis, it is often the case that the focus is simply on what the opportunity looks like today. But for an asset which will be held any length of time, looking at the future picture is an important part of really knowing what you’re getting into. It’s important to get a sense of what things might look like once you get downstream.
A popular newsletter advocates the idea of buying stocks of companies with a habit of increasing their dividends every quarter. Why? Because, that 6% yield you are buying today could morph into an 8% yield within a couple of years if everything goes well. And if you get really lucky, that higher yield could also lead to an increase in value (i.e. because more people want the bigger dividend and buying pressure causes the price to rise). So you’ll be earning more dividend income on your original investment and you’ll have an unrealized capital gain, too. Smart idea, and good when it works.
Contrast this with something like a CD or a bond. The terms you agree to are the ones you are going to have for the life of the investment. Well, if the issuer runs into problems you may get less than you were expecting. But you aren’t likely to get more. There’s simply nothing about the structure of those assets which would lead to that sort of changing situation.
Now, it is fair to point out that technically, investing on the basis of something which could develop is not without risks. It is in fact the very definition of speculation. You can take anything too far, and this is certainly something to be careful about. Venture capital (VC) investments are maybe the ultimate expression of investing in a situation today which you hope will be different tomorrow. VC investors write-off a lot of situations that never go anywhere at all, in the process of booking the relative few that actually take off. They are used to it and plan for it. Us mere mortals usually find losses harder to stomach, and should invest accordingly.
One downstream investment which we’ve had some involvement with is an office complex owned by one of our clients. The rental rates were initially set below market, in order to attract tenants and give the place a vibe of activity. Ghost towns are harder to lease, you know. This was possible because they got a good price on acquisition, and even with the lower rate the offices still made money for them.
Fast forward a couple of years and occupancy was over 90% and open space didn’t sit very long. So they started edging up the rates. Overall return levels rose because the future picture was different than the picture on the day they bought it. It was all just part of the plan, but the point is that they might not have done the deal in the first place if they’d only looked at the situation when it was empty space with no revenue.
Another one we like: buying a rental house and putting a mortgage on it. Even if the rents never go up and even if the property never appreciates, it can make more money in the future than in the present. How? Because the tenant is paying off the debt. That decreases the interest expenses that are hitting earnings, and improves the owner’s equity position at the same time. A double win. Best of all, the initial rents are often a higher yield than the investor was getting on bonds or other investments, and at least a portion of the income may be tax-preferenced, due to the depreciation deduction. You start out with a winning return and improve from there. Hire a pro to manage it, and it’s no harder to own than something which pays a much smaller yield.
Investing analysis has to look at the merits of the investment on the day of acquisition. Anything which may or may not happen in the future has to be understood as merely a maybe. But that said, if you don’t look into the paths the future could take, you may not have a full appreciation of what you are investing in. Ending up with a nice surprise is certainly not something to be too worried about. But passing on an opportunity because your analysis is too one-dimensional is probably not where you want to be.
By Brad Thomason, CPA
It’s quite possible that here lately you have been asking yourself whether the market will go up or go down from present levels.
Today I’d like to suggest a different question for you to consider.
If you go ahead and assume that the market falls significantly from here, what would you do about that?
I’m not saying I think it will. I’m just asking you to imagine what you would do about it if it did.
The first thing to make note of I think, is that the implications are different for someone who hasn’t retired yet retired, than they are for someone who has.
If you haven’t retired, the answer is that you probably wouldn’t do much of anything. It’s not so much that you aren’t impacted; but it probably doesn’t have any immediate effect on you. And once the price decline bottoms out and starts going back the other way, new money put into the market during such periods typically does pretty well.
It’s potentially a whole other story though for someone who has already retired, though.
We do not believe that it is a foregone conclusion, no matter who you are, that you have to have a stock allocation, at all. Stocks aren’t the only way to deploy capital in pursuit of meaningful returns. We further believe that if you have already retired, there’s a pretty good argument that you shouldn’t have a stock allocation. We’ve articulated this viewpoint in any number of past blogs and presentations, spanning a period of many years.
That said, if you are going to have stocks in the mix after retirement, you have an engineering issue to deal with: how you will handle “the V.”
The V is the dip in the price chart that takes places any time there’s a major market downturn. It’s the period of time from start of the fall, until the price eventually makes it back up to its former level.
The V associated with the Tech Bubble lasted from the summer of 2000 until the spring of 2007 (about 7 years).
The V associated with the Financial Crisis lasted from about August 2007 to November of 2012 (a bit over 5 years).
The V is extremely significant for those who are already relying on their portfolio/savings to fund monthly income. That’s because anything you withdraw during the entire run of the V will never have a chance to recover its lost value (at least not all of it).
So not only will the block of capital associated with your stock allocation not earn anything for a period of months or years, without some sort of per-planned means of coping with it, the V will force you to lock in some losses as well. A true case of adding insult to injury (or maybe just adding injury to other injury).
There are two broad approaches for dealing with a V. If you remain invested in stocks, the goal becomes to diminish the effect of the V. This can be accomplished by taking steps (whether through active management, derivatives, etc) to either shorten the duration of your personal version of the V, lessen the degree of your V’s decline, or some combination of the two. A briefer V decreases the number of months that the withdrawals should ideally be put on hold; a shallower V means that the losses you book are not (quite…) as serious. But do note that under any of these scenarios you don’t come out unscathed. Maybe just less injured.
The other approach is to diversify to other asset classes, and use those other allocations to supply income until the V is over. If all of your money is in stocks, waiting it out probably isn’t an option. If most of your money is elsewhere, it might be possible. It might even be easy. Just depends on how much of the capital is outside of stocks (prior to the beginning of the V) and what it’s earning.
As you might expect, none of these workarounds just happen. They require thought, planning , and most of all, action. Once you figure out what you ought to do, you still have to do it.
While everyone is attracted to the idea of seeing their money grow because the market keeps inching higher, there’s no getting around the fact that making money is not the only important consideration. Making it and then losing it yields no benefit; and is actually harder on a person, psychologically speaking, than never having had the money in the first place.
So while it is natural to have some preoccupation with the question of whether or not the market will go up from here, a more useful question to focus on may be what you are going to have to do if it goes down. That second question may give you much clearer guidance on what your next step ought to be, than the first one.
Older blogs (2015-2017)