This is a guest post from Rob Berger of DoughRoller.net
In May 2007, I started the personal finance blog, the Dough Roller.
And if you read my earlier articles on investing, you know that I am a buy-and-hold, low cost, Vanguard-loving, passive investor.
In that sense Jeff and I are a lot alike (his article on a random number generator beating the market 70% of the time is a must read).
But that all began to change about three years ago. Since that change, the investments I’ve made based on timing the market have far outgrown the rest of my portfolio. And it is a lot less risky and less expensive than you might think.
Here’s what happened.
The Problem of Cash
When I started my blog, like most bloggers, I wasn’t making any money and didn’t have a clue how to make money online. But slowly I learned how to blog and how to make money blogging. After a year or so the site started to make some real dough. At first, I just stashed the money in a high yield savings account like you can find here.
But by 2010, the blog was making enough money for me to open a SEP IRA. As you may know, you can contribute about $50,000 a year to a SEP IRA, which is a lot of money to invest at one time. And I decided to invest the money in individual stocks or industry-specific ETFs.
My First Mistake
I need to be honest here. As a passive investor I was scared to death to invest in individual stocks. But I wanted to give it a try. My plan was to invest in stocks and ETFs that were undervalued. And my first choice was Blockbuster.
At the time Blockbuster was struggling. The company had totally missed a new development in our world called the Internet, and Netflix was eroding its market share as a result. And if that weren’t enough, Red Box wasn’t helping either. But I decided to invest $4,000 on the hopes that Blockbuster could turn it around. Eventually, I sold my stock for $2,000 just before the company filed for bankruptcy.
Lesson Learned: Don’t invest in the hopes of a turnaround. Some make a killing doing this, but it takes a huge investment of time and research.
My Second “Mistake”
At the same time I invested in Blockbuster, I also put about $10,000 into Citibank (ticker: C). My reasons were quite sound—the financial industry was in ruins, and bank stocks were significantly beaten down as investors fled in fear. Since then I’ve added to my Citibank holdings, with a total investment of $31,305.20. The current market value of the investment is $33,629.80, for a total gain of just under 7.5%.
So why was this investment a mistake? In reality I don’t think this investment was so much a mistake as it was another lesson learned. Until recently, my investment in Citibank was at a loss. I held and added to my stake in the big bank for nearly three years before it finally broke even and then turned into a small gain. I expected banks to turn around faster than they did. But still, my “timing” of the market has paid off.
Lesson Learned: It can take years for a stock or industry to recover. This approach to investing is for the long-term.
My First Big Win
I invested in Citibank because the banking industry was in the crapper. Believing that Citibank would survive, I concluded it was only a matter of time before I made money on my investment.
At the same time, the housing industry was in the toilet, too. Builders were losing money, and their stock was in a free fall. Much like the banking industry, I knew that the housing market would eventually recover. I didn’t know when, of course, but sooner or later it would recover.
Unlike my investment in a single bank, with the housing market I invested in an ETF. The IShares DJ US Home Construction Index (ticker: ITB) holds the stock of homebuilders. My first investment in ITB was in early 2011, and I added to the investment in 2012. Total investment: $28,403.93. Today my stake in ITB is worth $43,722.65, for a total return of just under 54% (which includes dividends).
It was my investment in ITB that showed me the power of value investing. And Warren Buffett best sums up value investing: “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” And that’s the idea of market timing I’ve used in my investments over the past three years.
When I bought shares of ITB, other investors were fearful. And that fear caused them to sell and get out of the housing industry. Soon investors in the housing industry will start to get greedy. I’ll be fearful.
The above are just some examples of my investing style over the past three years. Blockbuster is the only investment I made that resulted in a loss. Every other individual stock or ETF I’ve purchased I still own, and all have gains.
Others include Ford (ticker: F), which I bought at a P/E ratio of less than 2. I’ve earned 10% in a few months. I bought Verizon because of its rich dividend yield when many were taking money out of the market, and it’s netted me more than 30% in one year.
But don’t index funds beat active stock picking?
You’ve probably seen many studies showing that actively managed mutual funds generally underperform index funds. I think there are three reasons that explain these results:
- Size: It’s one thing to beat the market investing $100,000. Try beating the market with $10 billion to invest.
- Cost: It takes a lot of resources to manage an actively traded mutual fund. Subtract these costs from the fund’s returns, and beating the market becomes extremely difficult. It’s a lot like swimming with an anchor.
- Impatience: Many investors are impatient. As soon as a fund doesn’t perform as they expect, net outflows from the fund accelerate. This causes fund managers to make investment decisions that may be reasonable in the short-term, but not so great in the long-term.
As individual investors, we either don’t have these problems (who has $10 billion to invest?) or we have total control of the risk (i.e., lack of patience).
It’s Easier Than You Think
My approach to value investing is embarrassingly simple. I look for industries that investors are running from because of cyclical downturns. Housing is a perfect example.
One didn’t need to be the next Warren Buffett to know that housing was struggling. In fact, the housing downturn was one of the worst we’ve experienced in recent memory. And that was the extent of my analysis. I purchased shares of ITB knowing that eventually the housing market would turn around.
There are a few things to keep in mind with this approach:
- Realize that this is long-term investing. My plan is to never sell these investments, at least not in the foreseeable future. So I’m fine if it takes years for the investment to finally show a profit. The point is that this approach is not for short-term investing.
- It’s not all or nothing. Most of my investments are still in index funds at Fidelity and Vanguard. But a growing percentage of my portfolio today is in individual stocks and ETFs.
- Patience is critical. You need patience both in terms of buying and in terms of holding investments for the long-term. During a bull market, there may not be any industries worth a significant investment.
One Final Consideration
One big advantage to buying individual stocks is cost. I’ve started investing more and more in dividend paying stocks. And the result is that my total cost of investing has come down significantly.
Here it’s important to keep in mind that the cost of a mutual fund is more than its expense ratio. The expense ratio doesn’t account for trading costs, which can be significant. With individual stocks, the only cost is the upfront cost to purchase the shares.
As a result of buying more individual stocks, the weighted average cost of my portfolio has fallen from 48 basis points down to just 30. While that may not seem like a lot, over decades of investing, the different can be tens if not hundreds of thousands of dollars.