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What I have learned from the "Credit deflation" thread


BurntBread
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JoeDavola

Following this topic, and looking forward to seeing what gets posted.

I think that one way for me to start investing might be via my workplace pension - I can collect a lump sum when I retire so putting some money away every month will give me a 20% boost on the tax saving, as well as a natural 'dollar cost averaging' effect since I'm not putting a load of money in one go.

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BurntBread

Part 2. What do I want to achieve?

The person who should be writing this post is @Harley, who has written some very valuable material on portfolio planning and risk profiles. This contribution will not even be a pale imitation.

Before investing, I needed to think about what I wanted to achieve. To take a silly example, I might be planning to buy a house in the Spring, and wondering whether to bung the deposit in the stock-market for a few weeks in the hope it might double. This would not be investing, it would be gambling. On that time-frame, I will get all the risks and none of the benefits of the market. However, it is at least a (unreasonable) plan, with a goal and a time-frame.

In general, the things to think about are: what is my time-frame? What do I want to achieve at the end of it? How much risk am I willing to take? Do I want to protect some of my wealth in forms that are "safe" (so almost certain to return the capital, even if that is somewhat eroded by inflation)? Do I want to invest some money in things that are a hedge against specific outcomes (inflation, war, marriage, and similar calamities), or some fraction into assets that are higher-risk, but potentially have higher rewards?

As I said above, I was nearly entirely in cash until last year. This was mainly due to neglect and inertia: having been unsuccessful by most standards, and having managed to avoid (or fail at) nearly all the things people are ambitious for, I was just happy to lead a simple life, and not think about finances. I had decided a long time ago that houses were not good value (when taking into account my tendency to get fed up and drift from place to place), and their rocketing prices were at first a source of resentment, then alienation, and finally complete not-giving-a-shit-ness. That journey however meant that my savings gradually built up over time, and it's not a bad life: lack of ambition can be very liberating. I work PAYE, but the freedom to be able to ditch that at any time, and not look back, is important to me. That freedom comes from having enough savings to spend a protracted period of time not working.

My motivation for investing is the realisation that inflation may become a serious risk to my finances. I want to always have the freedom to give up working, for a fair few years if absolutely necessary, and I would also like to accumulate something of a pension. Because of moving around (including overseas), my work pensions are fragmentary, deferred, and not of high value. At some point (probably retirement) I would like to have the option of buying, outright, a very modest home in a cheap part of the UK.

So, my time-frame is multi-year, up to multiple decades (estimated time of death). I want to invest at least some of my cash in places that will hedge against future inflation (which I see as the biggest risk in my previous nearly-all-cash stance). I am in fact not really investing to buy anything physical, but to create freedom for myself. I am, perhaps unusually, someone who can handle unlimited freedom without causing anyone else any problems, probably as I have no desire to control or change anyone. More than just finding it benign, I run on freedom like it is some kind of high-octane fuel, and I treasure it as a principal good in my life. Probably this is because I have struggled to keep enough of it over the years. In principle, buying freedom with money is a bad idea, or at least you get a very poor exchange rate. The correct currency to use for freedom is sacrifice, and I will indeed rely upon sacrifice -- learning to be happy with a simple life -- to do much of the heavy-lifting in my financial plans.

So, that's the plan, which gives some context for the cautious approach below. Other people will (I assume) be less weird.

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@BurntBread What a great idea for a thread.  It will be helpful for me to re-cap in my head what I've learned by going over your posts.  As well as giving a fantastic thread some appreciation. 

Not today though, as I've just got in from 11 hour day at work an hour ago, xDand I want to give this its deserved concentration 

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desertorchid

I will be interested to watch your observations unfold and try to contribute when time allows. Love this comment and feel it is something that ties many dosbodders together:

"I am, perhaps unusually, someone who can handle unlimited freedom without causing anyone else any problems, probably as I have no desire to control or change anyone. More than just finding it benign, I run on freedom like it is some kind of high-octane fuel, and I treasure it as a principal good in my life."

Just an early thought: If you do go on a journey such as this one try and keep a very open mind. Investing wisely requires removing a great deal of prejudice or bias in ones scope of thinking. For example I have continually dismissed crypto currency out of hand due to first hand experience of 1998-2001 dotcom, this may not be have been wise. Equally, to pursue a diversified inflation protected portfolio requires serious consideration/ comparison with BTL, which understandably is a dirty word in these parts. Any commitment into equities, or even bonds is likely a movement along the risk curve, which reading between the lines is not necessarily what you want. Also, I would add, exploring overseas investments should be encouraged. There is a good range of posters who who live and invest overseas who can offer some great insight.

 

 

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BurntBread

Part 3: The morality of investing (a very personal perspective)

Just before getting on to the bits which are useful, I want to say something about how I see the morality of investing. I don't expect anyone else to care about, much less share, my views; but this was one of the psychological barriers I had to think through before starting. Hence the portable freak-show to follow.

A quote from Lewis Thomas. "Everything used to be very straightforward: ethics meant money, and morals meant sex." So, to be clear, I'm not talking about cocaine and strippers in the City, I am talking about my concerns over the source of any money that arises from my investing. Do I feel comfortable about where it comes from?

I have worked as a salary-man since leaving education. Most of my bosses I have got on well with, and they have largely left me to get on with my work and make my own mistakes. I regard "line management" as a waste of time, or a "token role" for someone who should spend most of his time doing useful work. My favourite line managers were the ones I never spoke to. In my line of work, it's the (good) project leaders who have a useful function of actually bringing people together to get things done. They have authority, but it is technocratic authority: their knowledge and connections make other people more effective, and in return those people willingly acknowledge the authority over them. Bad management, beyond being useless, is purely parasitic on the labour of others. I have seen multiple cases where that controlling parasitism has destroyed the health of colleagues (and almost my own), and it makes me sick to the stomach. The authority wielded by such management is autocratic and hierarchical, and there is no sense in which it is freely and gladly acknowledged by us as underlings.

My overriding concern with investment is that I do not want to be a parasite.

On a similar theme, I have always rented, rather than owned my own home, and I see landlordism as straddling the divide between providing a useful service (now a small minority of the private rental sector), and the now much more common role of "grabbing rows of seats in the lifeboats and charging the passengers a stiff fee to be allowed on" (to use a redolent phrase from ToS). I wouldn't want to be part of buy-to-let, as I have seen how it robs people of stability and self-determination.

So, with that, why would I even contemplate owning stocks, which funnel the parasitised labour of the workers up to the owners of the company (the shareholders), while losing some to the layers of management on the way?

The conclusion I have come to is as follows: I am working in a corporate environment, so the company is giving me only a part of the value I create (it's also not a zero-sum game: the company, if well-run, creates value that would not be present with people working independently). By owning shares in a range of companies, I am re-capturing some of that lost value, in an entirely free-market and non-coercive manner. Margaret Thatcher spoke well, I think, when she talked about a "share-owning democracy".

There is also a sense of the turning of generations: we start our lives dependent on our families; we contribute during adulthood, both to our own families and the wider society, and then we become dependent again in old age. The state pension may look like a savings scheme, but it is really the current working population paying the older generation, almost in gratitude, for the world they have created and maintained. It is one of the things that weaves the generations together. Even savings (saved labour) only have value because there is a functioning, working society at the time you want to use them. So, some form of extracting "rent" (in the broadest terms) from society, at a suitable time, is inevitable, and I should acknowledge that. It's insanely harsh to adopt the "whiskey and revolver" pension-plan that I have always previously had in the back of my mind. Maybe I am getting soft in my old age.

If I am going to be a shareholder though, I want to try to do it properly. I want it to help tie me into society. In some sense, I want to actually behave as an owner of these companies (which I will be, legally, despite the fact my say in their running is minuscule to the point of being negligible). I will try to find out a bit about them, vote when there are shareholder decisions to make, and above all, I want to be proud of the companies that I (in part) own.

Other people will take a different view, for example treating them as things purely to be bought and sold, and that's perfectly fine too. But, I think a more considered view, and longer-term holding, fits better with my own desires and weaknesses. It will also affect the choices of financial instruments I hold: I prefer producers of commodities (for example miners or chemicals manufacturers) over entities that could be seen as hoarding them (physical PM ETF's, for example; more details below). I might also avoid certain companies because I don't feel comfortable with what they do, even though I am not altering that by owning a non-controlling stake. I may however violate all these good intentions, because I am a hypocrite; but at least I will have thought about them first!

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Popuplights

@BurntBread Thanks for starting this thread. It would be helpful to know how old you are, to help make sense of your investment timescales. No problem if you don't want to say....

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BurntBread
1 hour ago, Popuplights said:

@BurntBread Thanks for starting this thread. It would be helpful to know how old you are, to help make sense of your investment timescales. No problem if you don't want to say....

I'm late 40's, Mr Lights, and in good health, so still some time to make mistakes and recover a bit with future earnings. As you might have read on the "Elaborating" thread (somewhere quieter) though, I'm not overly confident of those future earnings.

I'm reluctant to be very specific about myself, not just for reasons of privacy, but because the version of me that lives in these posts is a little bit cartoonish. It's recognisably me, but I'm emphasizing some of my sharp edges and eccentricities. I'm simplifying and being stark about my motives, and I am slightly better insulated than my pension-plan comment above would indicate (but that comes mostly from "wanting less" rather than "having more").

If you were to cross-examine me, I'd be forced to explain myself, and emerge as a more confused character, with the investment motives in this thread being just one of several possible paths. So, I'd rather dump my emotional baggage in the first couple of posts, sketch roughly where I'm coming from, and then fade into the background to write more about the things I've learned.

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Tingles

@BurntBread Great idea for a thread and thank you for taking the time to provide the content.  Following and looking forward to reading as the thread develops.

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BurntBread

Part 4: Three generally-accepted rules

If you register with an online broker, they will typically point you to a few pieces of good advice. This is because they don't want you to go bankrupt (or, at least, not before they have had a good chance to get some brokerage fees out of you).

1. Diversify

The first rule is to diversify your investments. That means splitting them across broad classes, and within classes, perhaps into sectors, and then individual investments. The reason for this is that individual investments bounce around distressingly, and some of them die, leaving you with a total loss. Even if they don't actually blow up, they sometimes turn out to be full of rottenness which you didn't expect when you bought them. Concentrating too much of what you own into one, or even a few, investments, exposes you to a lot of risk which can (mostly) be avoided.

Diversification is probably the most important thing you can do to reduce the risk of large losses.

Common classes of investments are: cash (usually in bank accounts), stocks or shares (part ownership of a company), bonds (where you are essentially lending either a company or the government money, and they pay you interest on the loan, and eventually return the capital), real estate (usually your own home, which you may choose not to look on as an investment; but also potentially other people's homes (buy to let), as well as commercial real estate), and precious metals (gold and silver -- either as coins, scrap or jewellery, either stored by you or by someone else). Other things like fine art, wine, classic cars, more complex financial instruments, personal obligations owed to you, and old copies of The Beano could also be seen in this way.

If you only own cash, then you are exposed to the risk of inflation, which is a certain, but fairly predictable loss, so may be worth bearing for a while in a low-inflation environment. However, you may also be subject to sudden loss if you have more than the £85k FSCS (financial services compensation scheme) limit in any one UK bank which then explodes; or you may get hit by a bail-in, like in Cyprus, or maybe windfall taxes from whatever crazy totalitarian regime you happen to suffer under. Holding some cash is useful for day-to-day and unexpected expenses, but it also lets you take advantage of bargains in other investment classes. One of the few ways that a small investor has the edge over large investment funds, is that he can stay out of the market during risky times, while a large fund is usually under pressure to put all its money to work.

I won't say anything here about bonds, other than that they are traditionally seen as an essential part of a diversified portfolio, especially later in life. However, the thesis of the "deflation" thread considers them a poor choice for most of the coming decade.

Back in the day, when brokerage fees were high, and it was difficult to do any research on companies, Ben Graham suggested the rule that if you were investing in stocks, you should buy into about a dozen, well-researched, conservatively-financed, companies, across a range of sectors. For someone who wants to hold individual companies, a minimum of a dozen (or maybe twenty) is still a good rule of thumb, to reduce the risk of catastrophic losses, and also to average out the large fluctuations in prices that happen for individual stocks. There are broad changes in profitability that different sectors undergo over time, so diversification across sectors is also important. By "sectors" I mean things like "oil and gas", "telecommunications infrastructure", "finance industry", "retail", "pharmaceutical", "base metal miners" etc. These are broad industry categories, usually defined very fuzzily, but it's clear that different ones do well at different times: "big tech", for example, has been powering ahead recently, and "oil and gas" stocks often have similar prices to twenty years ago (albeit they have been giving out dividends over that time).

Ben Graham suggested that one of the greatest innovations in his time for small, retail, investors was the introduction of "index funds". These allow you to essentially buy into all the stocks in one of the indices (for example the hundred stocks of the FTSE100), without paying the brokerage fees on each of the individual transactions. This allows you to get a lot of diversification very quickly. Traditionally, and for this reason (plus the fact that the funds charge you a small fee for holding them), index funds have been promoted as the best way for small investors to buy into the stock market, and they have done very well over the decades. For reasons to follow, it is part of the "deflation " thread thesis that we may be entering a time when it is better to hold individual, well-chosen, stocks again.

If you do own individual stocks, a slightly embarrassing question arises, which is how do you count them? I have ended up with a wide range in the amount of different companies I own. To take a trivial example, suppose my portfolio consists of exactly two shares: one share in Alphabet (i.e. Google, currently costing £1400), and one share in Vodafone (currently costing £1.22). Trivially, I own part of two companies, but in terms of sleeping well at night, I'm much more worried about the Google share price halving than I am about Vodafone's. So, in this case, from a risk point of view, I really have essentially only one (or slightly over one) company in my portfolio. I had a think about this, and my idiosyncratic solution is to assume (quite wrongly) that shares fluctuate independently by some unknown percentage, which is the same for all shares. Having more companies then reduces the fluctuations in my overall portfolio, and it's a simple matter, in this case, to work out how many equal-sized holdings I need to match the instability of my actual portfolio. I do this by putting the values (in pounds sterling) of my individual holdings into a range of spreadsheet cells (say "A1:A12" in spreadsheet parlance). I then then work out the "effective number" of shares from the spreadsheet function: "=SUM(:)^2/SUMSQ(:)". I have found that useful during my chaotic purchasing history. In the silly example of one Alphabet share and one Vodafone share, I would count the effective number of companies I hold as 1.0017. My current portfolio gives a number of about 24.

2. Don't trade

It is possible to make a lot of money if you are good at trading, and the popular view of investors is of young men, with something of the look of a terrier at a rabbit-hole, bathed in the green glow of a cathode ray tube, buying and selling stocks every few seconds as they go up and down. As a beginner, you will not be good at this, and in fact most of the really good traders lost a lot of money (usually other people's money) acquiring their skills.

It is natural to come into investing thinking that you will "buy low and sell high", and that this is both easy to do and the way to make money. While it is undoubtedly true that buying low and selling high (i.e. capital appreciation) represents part of the gains from the stock market, it's only part of the story, and not nearly as easy as it sounds. For example, a little thought will tell you that it is not obvious what "low" means for an individual stock ... but then you might reassure yourself with the thought that you can always buy one that is going up, ride it for a while, and then sell when you have made a profit.

Even this modified plan falls apart for a range of reasons. Firstly, stocks very rarely just "go up" in a straight line: they fluctuate, surge, drop, rally, and crash, on all kinds of timescales. People's natural instincts, honed on the African plains to prevent them getting eaten by lions, lead them to sense danger and sell up after the stock drops steeply. This can be a good idea, if done quickly enough (what is "quickly enough"?). The stock may then suddenly go up instead, and people then fear losing out, and eventually buy back in, just before the next drop. The natural emotions therefore tend strongly to the outcome of "buying high and selling low" (called "being whip-sawed" in the trade, when done repeatedly).

Secondly, even if you have a reason to suppose that a share is broadly going up (e.g. you bought Zoom near the start of the pandemic), it is very unclear how long this can continue, so when do you get out to take your profit? In a bubble, most people who know it is a bubble, ride it too far, right over the top, and end up selling lower than they bought. It is very rare to get out at what, in hindsight, turned out to be the "top". Isaac Newton was a classic example in the South Seas bubble of the 18th century. Third, trading costs money. You may pay as much as 1% during each trade (in or out), depending on how large a chunk you are trading. If you are in and out of a share even a couple of times in a year, you have squandered most of the dividends. The real benefits from investing come from the accumulation of small percentages (especially dividends) over many years. Trading quickly wipes that out.

Fourthly, stocks move in the short term according to information you probably don't have. Some of it may be corruptly-, or illegally-, obtained insider information. More will be from specialist knowledge of the sector, or dedicated people trawling the news for relevant stories, and making deductions. You don't have that information soon enough to benefit you. On longer timescales (by following a "buy and hold" strategy), the information asymmetry is less pronounced, the important news is likely widely disseminated, and so you are more or less on an equal footing with the big investors. This seems to imply that you will never have an advantage because everyone else will know it too; but firstly, the broad market tends to go up anyway, so just following that can give you gains; but also there are persistent irrationalities in the market, which can sometimes let you spot under-valued investments. Some of these lie at the heart of the arguments made in the deflation thread.

Since you have to trade each stock at least once (in order to buy it), it is still worth thinking about how to take the emotion out, in terms of timing. One way to do this is to set buy-points in advance. Advice from the thread is to set "ladder" points, and buy chunks of a stock as it (hopefully - and I say that paradoxically) gets cheaper and reaches particular price-points. Other people buy on the way up, hoping to take advantage of the "momentum" of a particular stock; but the main thing is to have a plan in advance, so you are not emotional when you act. The aphorism to have in mind is, "plan the trade, trade the plan". The same is true for getting out: have an exit strategy. Currently, I don't have one, and this could be a problem: I'm "buy and hold indefinitely" (with some exceptions for precious metal miners), as I simply don't trust myself to do any trading. As I say, this may turn out to be a big mistake. My hope is that I have bought well-managed companies at a good price, so holding for many years is a viable approach.

There was a study done many years ago by one of the big brokerages. They looked through the investing history of all their clients, with the idea that from this "big data" set, they could distil the essence of what made some investors successful, and others less so. After a lot of analysis, the clear pattern they found was that the vast majority of the most successful clients on their books were either dead, or had forgotten about their accounts.

3. Benefit from time in the market

This relates to the previous point. Most of the gains in the market are from the compounding of small gains, through re-investment of dividends. The important thing is to allow time for that to happen. A typical piece of advice is "time in the market is more important than timing the market", with the corollary that it is a sensible strategy to regularly put in money into the companies in your portfolio (for example every month), regardless of the precise share prices that day. The idea is that sometimes the shares will be a bit expensive, and you could have done better; sometimes they will be cheap, and you will benefit longer-term as they return to "fair value", but you may struggle to know which is which, so just close your eyes, and all will be well. This strategy is called "dollar cost averaging", or "pound cost averaging." It has been a successful strategy for American pension investors for several decades.

Although the "deflation" thread is strongly of the opinion that "time in the market", and compounding of reinvested dividends is extremely important (even essential), there is a view (but not a consensus) that "just buy every month" may not a great strategy, particularly this year, as I'll discuss in more detail in part 6.

 

Lastly, I'll re-iterate the disclaimer: the "you" above is not "you, the reader", but a younger me.

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Popuplights
6 minutes ago, BurntBread said:

Lastly, I'll re-iterate the disclaimer: the "you" above is not "you, the reader", but a younger me.

Oh yes. I really wish I had started investing in my twenties, rather than my late 40s........

I will be referring my 3 kids to this thread.

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goldbug9999

What I've learnt is that traditional investing is a right ball ache, seems like you have to study for a second degree and then take on a second job just to be able to beat inflation by a few %. For fuck sake all people want to do is save some money that doesn't devalue over time, how fucking hard can it be ??. I mean at least give people the opportunity to make money from sound companies with sensible P/Es because thats what inflation is for right ? - to force you to invest constructively. But no apparently thats not going to happen, the little people cant be allowed to accumulate wealth.

Thing is, no matter how good you get, no matter how much effort you put in, they can beat you just by typing some more numbers into the BoE computer ... unless of course ... well you all know what I'm talking about.

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@goldbug9999 the thought of all the brain power and electrical power/resources spent first coming up with all these schemes, then administering them, then someone else trying to find a way around it etc etc makes me feel very despondent.

I'm not saying it's not clever, it is, but what else could those minds have achieved in an 'honest' system?

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BurntBread

Part 5: Investing versus speculating (thoughts on value investing from Ben Graham)

Benjamin Graham (1894-1976) was one of the first people to take a data-driven -- almost scientific -- approach to investing, and is famous for a number of reasons. He was probably the most successful investor of his time, consistently out-performing the market (not by a lot, but if you do it consistently over decades, the effect is huge). He had a student, Warren Buffet, Chairman of the Berkshire Hathaway fund, and called "the sage of Omahar", who learned his trade under Graham, and has had even greater success, and much more political influence. Graham wrote two important books: "The intelligent investor", aimed at general investors, first published in the 1940's, and updated through to the 1970's, and still widely read (you can pick up pdf's on the internet, and it's jolly good); and "Security analysis", for those people who will typically then become very rich, if they actually read it, and follow the advice.

The approach behind his work has been termed "value investing". He is not interested in stock-market charts, Elliot waves, or Fibonacci numbers. Instead, he tries to give tools for people to decide whether a stock is currently selling at a price which might be considered "cheap", or at least for which the risk to the down-side is as small as possible, while there is considerable possibility of gain.

He was a very risk-averse character, and for each possible investment, he was always thinking, what could go wrong? What are the risks? What price am I prepared to pay so that those risks are worth taking? Much less is he concerned with whether a stock will "go to the moon": indeed the idea of "growth stocks", where the price is high (compared to his assessment of fundamentals), but people buy because of projected future profits (or worse yet, because they think the price will go up), gave him a lot of anguish. He had to come up with some ways to judge these stocks though, because at times, a great deal of the market can consist of them, and there is undoubtedly money to be made (albeit with commensurate risk).

He opens the book "The intelligent investor" with a series of linked chapters, distinguishing between "investing" and "speculating", and saying that he has nothing further to say to speculators. In the second group he would include day-traders, and indeed anyone who was chasing hot stocks, jumping on chart patterns, or riding bubbles. For him, an investor is someone who first and foremost is looking to reduce the risk of losses in his investments, and will not buy a stock because it is "hot", or try to trade a trend, but because it is good value and that value merits the risks. How much work is required to be an intelligent investor? From analysing a lot of past data, he finds some disturbing truths: Firstly, and surprisingly, it is very easy to perform as well as the broad market (taking the Dow Jones industrial average as a measure of this, for example). All one has to do is invest in a fair number of conservatively-chosen, large companies (suggested with advice from your broker, once you have told him your intention is to buy large, well-run, conservatively-financed corporations -- note, he was writing originally in the 1940's, when brokers behaved a bit more like butlers), and the portfolio will typically perform about as well as the broad indices. This is usually a good thing, and will almost certainly be great over long time-frames of multiple decades. You could even buy all 30 stocks in the DOW, for example, and do exactly as well as that index.

You might want to re-balance the portfolio occasionally (maybe once a year - but not too often, as brokerage fees are significant), and so long as you resist the temptation to fiddle, or go chasing after the latest fashion, then in all likelihood, all will be well and you can look forward to a comfortable retirement. He strongly recommends this approach to anyone who does not have the time or energy to be an "active" investor. The creation of broad-market index funds (see later) has made this approach even easier. As @Frank Hovis will show you, investing in the broad market has, on average, been a great thing to do for the last 250 years. There are a few wrinkles with that, such as the fact that most of the gains happen over periods starting from low stock valuations, but for a long-lived investor, matching the broad market is a very good approach.

More worryingly, despite how easy it is to perform as well as the broad market, two other facts emerged: Firstly, most people perform worse than the broad indices, often by a lot. Second, although you might think that, "if zero effort gets me to average performance, surely a bit more effort will let me do better?", it is in fact very difficult to perform better than the broad market, over protracted periods of time. You either have to be very lazy, or very dedicated; there is no gently sloping meadow in between. The reasons for under-performing are varied, starting with those described above under the "don't trade" rule for beginners. All of our psychological instincts seem to be set up to make us lose when we try to be clever in the markets: from panicking at losses to fear of missing out on the latest fashion.

Nevertheless, Graham (of course) says that it is possible to be a successful, active, intelligent investor (note: not "speculator" or "trader"). To do so though, you must treat it like a second employment, as it takes effort and research. Someone who is willing to dig into company finances, take a reasonable interest in the broad issues of the sector concerned (for example reading trade journals), and adopt strict rules on the quality of a stock relative to its price (the last bit being key), can expand his horizons away from the largest-cap, ultra-conservatively-financed businesses, and potentially find unrealised opportunities. The book (and in much more detail, his second book, "Security analysis"), provides metrics on how to estimate the relative value of different stocks, and sometimes how to make an assessment of "fair value", which occasionally, but perhaps surprisingly frequently, can be a long way from actual market price ("efficient markets" be damned!).

One striking thing that he says is that "there is no such thing as a good (or indeed a bad) stock". There are certainly well-run companies and poorly-run companies; there are profitable, and not-so-profitable companies. However, for any stock, there is probably a price low enough that it is worth buying at that price, and a price high enough that if you owned it, you would be a fool not to sell it. The assumption that the market always sets a "fair" price, and there is never "money left on the table" turns out to be wrong; not very often, but surprisingly often, once you dig into the details. However, doing that digging, the analysis of securities, takes skill and patience, knowledge, and a suspicious nature (since a lot of mischief can be hidden in the balance sheets). The metrics to use, or rules of thumb, are around ratios of equity to assets, liabilities (current and non-current) and intangible assets, and about the history of dividends, and the stability, and (to a much lesser extent) the trend, of profits. You also need to develop some specialist knowledge, and be prepared to comb through financial statements.

He illustrates the idea of there being "no such thing as a good stock" with a famous allegory. Imagine you are a joint owner of a private business, and sit on the board with the other owners. He imagines that among these other board members is one called "Mr Market". Mr Market is a somewhat unstable character. Even while the business is generally doing OK, he is sometimes elated to the point where he thinks his share of the business is worth a ridiculous amount of money, and offers to buy some of your interest at that inflated price; and then some weeks later, he will be depressed, thinking of impending disaster, and beg to offload his holdings to you at what sounds like a ruinous price for him. The gyrations and vicissitudes of the business itself only exacerbate his mood-swings. Graham points out that every shareholder in a publicly-listed company is in the same position as the first board-member. The "real" Mr Market is constantly at his elbow, ready to transact at whatever price his bipolar mood implies that day.

I think many posters on the "deflation" thread are broadly in agreement with the ideas of value investing. However, what is distinctive about that thread is the presentation of a macro-economic thesis, according to which certain sectors are likely to do very well over the coming decade or so; while others will get punished. Those favoured sectors have, until recently, been rather neglected by the market, so for that reason are likely to be good hunting-grounds for investors looking for companies with both good value and good prospects.

Graham closes his book (at least the later editions), with a lament over something he failed at. He was very much of the opinion that shareholders, even small ones, should act as owners, turning up at AGM's, and making their voices heard. Most public companies are majority-owned by big, institutional investors, like pension funds, which typically take a passive approach, and leave the running of the business to the management. That sounds like a sensible (even an inevitable) idea, but there are important conflicts of interest between the management and the owners of the company. For example, any cash on the books belongs to the owners. Now, they may decide that they want to re-invest it to grow the company; but equally, the owners might have something better to do with it (including investing in some other company, if the current one doesn't have much prospect for growth), and so want it paid out as dividends. However, the management will usually want to re-invest profits, as it makes the business bigger, their roles more important, and potentially lets them increase their salaries. Also, if the management is a bit rubbish, the owners can legally decide to hire an independent investigator to look into the mistakes, and get the company to pay for this investigation. Management would typically not decide to do this.

Graham wanted more shareholders to be "activists" in the sense implied above, as he thought this would improve company management, and be good for capitalism as a whole. Unfortunately, the growth of institutional shareholders continued apace, and the relatively small number of scattered votes that were controlled by small shareholders became a source of demoralisation to the activist shareholder. This has pushed both shareholding, and the actual running of companies, to be a purely financial, and even cynical thing, rather than taking into account the wider responsibilities of companies to the society they depend upon. Very few people even turn up to the annual general meetings, even though for some companies, just buying one share would be enough to get you a buffet lunch every year worth more than the dividend.

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goldbug9999
3 hours ago, BurntBread said:

... Someone who is willing to dig into company finances ....

Doesn't mean jack shit anymore, with bond yields so low there is no impetus on companies to make an actual profit. Stocks are this point are almost pure scarcity/speculation plays who's performance are determined by some mix of:

  • Government policy
  • Central bank monetary policy
  • The whims of WSB/Robinhood army
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goldbug9999

So my two practical tips for investing are:

  1.  Don't be put off something because a bunch of people have already made shed loads of money. Its human nature to resent other people making money and write something off as a missed boat but that instinctive response will stop you making money. Unless your a genius investor you are very unlikely to early to any particular party. Look at something prospect going forward.
  2. Don't be afraid to change your mind.

ARGO was case in point for me on both those counts - I rubbished it last year but have now changed my mind and bought it after lots of people had already made 30x or better.

Edited by goldbug9999
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Tingles
On 02/03/2021 at 07:23, BurntBread said:

It is possible to make a lot of money if you are good at trading, and the popular view of investors is of young men, with something of the look of a terrier at a rabbit-hole, bathed in the green glow of a cathode ray tube, buying and selling stocks every few seconds as they go up and down. As a beginner, you will not be good at this, and in fact most of the really good traders lost a lot of money (usually other people's money) acquiring their skills.

Well put and did make me chuckle!

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22 hours ago, Loki said:

I'm not saying it's not clever, it is, but what else could those minds have achieved in an 'honest' system?

Having worked in quite a few investment banks, the number of people with degrees and PhDs in maths, nuclear physics, theoretical physics, organic chemistry... the list goes on... is really quite something. Everyone always dismisses "bankers" as a bunch of wankers, but the reality is, most of them are very smart people who would love to use their brains to change the world, but who at some point saw the system for what it is and decided to make as much money as they can in order to give their kids the best life they can.

I try not to think too much about it, as it just makes me angry that this is the way of the world.

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Part 6: More pieces of advice which look good to me

Here, let me summarise a few things which I have mentioned, or alluded to, above.

The first relates to Graham's observation that it is easy to do as well as the broad market (if you don't have itchy fingers), but surprisingly difficult to beat it. The small addition here is that it is fairly widely agreed that there may be some "timing of the market" you can do, which is worth at least considering, even if just from the point of view of avoiding risk.

The traditional advice about "dollar cost averaging" (drip money regularly into the market, and the ups and downs at the moment you enter will average out), is certainly a low-effort way to invest, and it is broadly successful over the course of an investing lifetime. However, as well as bouncing around on short timescales, it is clear that the market has great tides, which rise and fall over a decade or two. It is possible to construct simple measures of how expensive stocks are, for example price-to-earnings ratio, P/E (share price divided by earnings per share), or related measures, like CAPE (cyclically adjusted price-to earnings ratio, where earnings per share are inflation-adjusted and averaged over a 10 year period). Averaged across a market, these measures of expeniveness rise and fall, being high during the great bubbles, like 1929, 2000, (and the present day, especially for American stocks), and fall to low values during busts in the market.

If you buy broad-index funds, then it turns out that most of the gains occur starting from times of low market valuation, and running up to the great speculative peaks; while those people putting money in near the tops take much longer to get good returns. In terms of being an active investor, and picking individual stocks, it is certainly the case that "cheap" stocks (i.e. those priced low compared to fundamentals) can be found during times when the broad market is expensive; but they are hard to find, and also have a tendency to get caught in the down-draught during any big market crash that follows. On the other hand, when buying after a market crash, many stocks are comparatively cheap, and tend to get carried up with the tide over the following years in any subsequent bull-market.

The first piece of advice is therefore to take some account of the broad state of the market. In American stocks in particular, the market appears to be in a great bubble, comparable, and in some ways exceeding, that of 1929. If you are not a speculator looking to ride this bubble, then this is a time when one should be staying out, or looking carefully for value stocks, and be aware that they may be few and far between, and carry risks even if you have done due diligence. It is one of the anxieties of the deflation thread that having identified some sectors which are expected to do well over the following decade, some of which are (or were last year) pretty cheap, and "hated" by the market, there is a significant chance of an epic stock-market crash over the course of the next year or so. It is constantly discussed whether to try to hold through this, or to sell all (or some) and try to buy back later at a lower price. I'll say a bit more more about this in the "Big Kahuna" post, later.

Secondly, I'll reiterate Graham's point that there is no such things as a good stock. There are good companies, but whether to buy (or sell) a stock or other security is down to the market price compared to what you judge to be a fair value (or where you judge the balance between risk and reward to be).

Thirdly, I'll say a little about bonds, despite that fact I haven't had anything to do with them yet (and I'll talk a bit more about them later). These are instruments that pay a fixed "coupon", which represents the interest the company is paying on the money it raises (i.e. borrows, because it will have to pay back the principal) by selling the bonds. In his typical, sceptical style, Graham's first question about them is, "since I am giving up the potential of large gains that come with stocks, why would I buy a bond, which will only pay a fixed amount, no matter how well the company does?" There are some good reasons for doing so, most notably the reliability of the income (important to people during retirement), and so bonds are traditionally seen as an essential part of a diversified portfolio. Pensions are often put into 60% bonds, 40% stocks near to retirement, and converted into an annuity (which I suppose is a type of bond) at retirement. There is general advice to have a percentage of bonds in your portfolio roughly equal to your age. Lastly, Ben Graham, in "The intelligent investor" recommends having somewhere between 25% and 75% of a portfolio in bonds or similar securities.

Despite this, it is one of the theses of the deflation thread that bonds are in a huge, multi-decade bubble at the moment (something fairly widely acknowledged), and will do very poorly if inflation starts to take off. They may have one last day in the sun during a deflationary bust (as they did in March 2020), but longer-term they won't be a protection against inflation, and may suffer even worse than cash. I'll cover more of how that works later on. In the meantime, the (not generally accepted) piece of advice is to think hard about bond allocation at this time when we may be approaching a turning point in inflation and interest rates. I am departing from conventional investing wisdom by being entirely in shares and cash at the moment, and don't own any bonds (except in my company pensions). This may turn out to be a bad idea.

The last piece of advice I will mention is about taking the emotion out of buying (or indeed selling). DB is a proponent of the idea of "ladders". In this, you decide in advance how much of a stock you want to buy, and set a series of decreasing price points. For example, you may have four price points, each one 8% lower than the last. The idea is that you have identified a potentially valuable opportunity, which is hated by the market (maybe it's a company that burns car tyres & mahogany wood-chips in order to smoke veal), and whose price is going down. You then try to buy 1/4 of your allocation as the price hits each of the ladders on the way down. If it rises before hitting the last ladders, then you stop buying, and look for value elsewhere. This is a very sophisticated way to invest, and requires you to have an independent idea of the value of the company, which is at variance with the consensus view, and a steely determination to carry on holding if the stock continues down after your last ladder. The general principle of having a plan, and executing it ("plan the trade, trade the plan"), is very sound though, and can be adopted to some extent even by fools like me. What I have done is to exclude companies (for example those with very high debts, or high P/E), and then on a company I like, I will buy a first "ladder", or small slice. If, a few weeks or months later, it's seriously in the red, I'll have another look at the finances, and contemplate buying some more. So, I'm still overly emotional, and pitifully primitive in my analysis, but trying to move a bit towards steady, rational, behaviour.

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BurntBread

Part 7a (post 1 of 3): What are securities, and how do they make you money?

Suppose I believe that silver is going to increase in price. How can I profit from my insight? Well, I could log onto the Royal Mint website, buy some silver Britannias (paying VAT), put them under my bed and wait until they go up in price. When I sell them, I will probably get a poor deal, but (being legal coinage rather than silver bars), at least I won't have to pay capital gains tax. On the other hand, and a bit more abstractly, I could avoid the risk of burglary by buying them using "bullionvault", giving me legal ownership of some coins or bullion bars I cannot see, in vaults in various countries.

More inventively, I could use "securities", of which there is a large and somewhat disreputable, zoo. I could, for example, buy a part of a physical ETF like "PHAG", or a synthetic ETF ("paper silver"); I could buy a share in a silver mine, or shares in an ETF of multiple silver miners. I could buy a call option on a miner (or an ETF), I could find a bond from a very dodgy miner and buy it at a massive discount because of the threat of insolvency, expecting it to be saved by the rising silver price; or I could convince myself that silver going up is a mark of inflation to come, and short a treasury-bond ETF ... and there are probably more elaborate ways still to wring a buck out of the City.

What is all this madness? Well, a "security" is a financial instrument that is traded on the markets, and it can cover a multitude of sins. Here are some of the main ones...

1. Shares

Shares (or stocks) represent a small piece of an individual company. The fraction of the company you own by possessing one share varies a lot, and companies can "dilute" your ownership by issuing more shares (although this can of course be blocked by the owners, if they don't like the idea). BT, for example, has a market value ("market capitalisation") of £12.25 billion -- if you wanted to buy all of it. Each share can be bought for 122.95p, so there are roughly ten billion shares in circulation (and thus ten billion votes in any decision that needs to be made by the company owners; that is to say, the shareholders). One way to make money is to buy shares in a company, and then if the company becomes more valuable (that is to say if "Mr Market" is prepared to value it at a higher price), to sell at a profit. This is capital appreciation (or loss, as the case may be).

However, the business is also (hopefully) making money, and so accumulating profits while you own it. That cash on the books, in principle, belongs to the business owners (although the management won't feel that way), and can (and arguably often should) be handed out as dividends. The amount paid out, as opposed to re-invested to grow the business, or used to pay off debts, may vary from year to year (or may be nothing). This depends on business performance and a potentially tense relationship between management and owners. Some companies are more reliable dividend payers than others. Exxon Mobil, for example, will happily borrow to pay dividends if it hasn't made any profit (something which is legal, provided the net value of the company remains positive). So, a second way you make money is by being paid the dividend. Different companies vary as to when, and how often, they pay dividends. Many pay them each quarter; some only twice, or even once a year. The dates vary, but many are close to the quarter-days (end of December, March, June and September). The sequence of events is as follows: the company declares what the dividend will be (usually in pennies, or cents, per share). A bit later, the stock goes "ex dividend" (often marked XD on the broker website). This is the moment in time when it is decided who will get the money. If you own the share at this moment, then you will get the dividend, even if you sell the share immediately afterwards; and conversely, if you buy between the "ex dividend" date and the dividend actually being paid, then you get nothing that turn. A few days later, the dividend is paid (usually to your broker, unless you physically hold the share certificate, in which case, you might still get an old-fashioned cheque in the post). The broker subtracts any withholding taxes, and some days later the cash appears in your trading account, ready for you to either buy something with it, or transfer it out to your bank account.

In contrast to what might appear in films, a very large part of the gain of long-term investors is from dividends, provided they are re-invested into the markets, to compound up. Exponentiation is a powerful force, even when the time-constant is long. For example, a £1000 holding, yielding a 5% dividend (after taxes and fees), will compound up to £4300 after 30 years, even if the stock price doesn't change at all. Even in these times of vanishing interest-rates on bank accounts, there are some sensible companies that have more than a 5% dividend yield.

2. Funds.

A fund is simply a valuable collection of stuff. In common parlance, you might have a bag of change, which is a fund for tea and biscuits. In the financial world, a fund is conceptually exactly the same, but varies as to the nature of "stuff". A fund might, literally, be a sum of cash. It might be a big warehouse (or network of warehouses), filled with coffee beans, or vaults filled with silver. In these cases, it would be a "physical fund". Often, funds contain financial instruments: they may be a collection of shares in different companies, or of bonds or (commonly for pension funds), a mixture of the two. Where things start to get runcible is that these funds are then wrapped up into a legal entity (I guess either an actual company, or something legally similar), and are themselves floated on the stock-exchange, so you can buy shares in them, and legally own a tiny part of the fund. At this point, it becomes an "exchange-traded fund", or ETF. "PHAG" is a physical ETF of silver. "GDXJ" is a fund of shares in small gold and silver miners. "IBTL" is a pound-sterling-denominated fund of US treasury bonds. Some funds are built out of financial instruments, in such a way that their value mirrors that of something else (for example gold), without the fund actually owning that material; such a fund is called a "synthetic" fund.

Funds can make money if their contents (shares or bonds) churn out dividends or coupons, or if their contents go up in value; but they also typically charge the owners a fee, which is paid to the managers of the fund. Why do we tolerate all this chicanery, obfuscation and opaque fees? Well, because funds give you a simple way to buy and sell things that would otherwise be difficult to do. You might not have the wherewithal to store a tonne of coffee beans at home, but you could easily buy a share in a coffee-bean ETF. If you wanted to get a diversified share portfolio, based on the S&P500 index, it would be difficult and expensive (both because of share price and trading fees) to buy all 500 stocks in the index. However, it is a matter of a moment (and a small fee) to buy a share in an S&P500 index fund.

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Part 7b (post 2 of 3): What are securities, and how do they make you money?

3. Bonds.

Suppose you are a company (or a government) and need some money that you don't currently have. If you don't want to have an uncomfortable discussion with a bank manager, then one thing you can do is to sell bonds in the bond-market. A bond is a promise to pay the person who buys it two things: a fixed amount (the "coupon") every year for a number of years (the "duration"), and a lump sum (the "principal", or "face value") at the end of this period. The issuer will try to sell it at the "face value" during a bond auction, so it basically acts as a loan, where the issuer promises to eventually repay the amount loaned (the principal), plus interest every year (the coupon).

The bond market is where companies and governments have to go in order to borrow, so the price of that money, in the sense of what coupon they have to pay, has a huge influence on what is worth borrowing for, and how much. In recent years, money has been very cheap, and companies can borrow for reasons that would make no economic sense were money more expensive. Many corporations, especially in America, are carrying a lot of debt on their books. The leveraged buy-out trend, where you can borrow money to buy a company, then use its own balance sheet as collateral to borrow more money to pay off your original loan, plus pay yourself a big bonus, and leave a lumbering, debt-ridden shell behind, is all down to cheap money. If that possibility went away, it would be a different world; and even governments would struggle to fund their vanity projects, largess to client sectors of the population, and internationalist agendas. That is a world of distant memory now, and the 1992 quote from James Carville seems crazily anachronistic: "I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody."

Bonds are attractive to investors for two reasons. Firstly, they promise to pay a fixed amount each year, so owning them can be the basis of a predictable investment income (at least more predictable than relying on dividends or capital appreciation of shares). Secondly, if something goes wrong with the company (it goes bankrupt, for example, or simply runs out of money so it has to default on the coupons), then bond holders are near the front of the queue if the company is liquidated (after the government tax authorities). They can sometimes force liquidation, or take control of assets if the company is in default. They are therefore said to be more "senior" than the shareholders, who may be left with nothing. Ben Graham is very sceptical of this second reason, mainly because the book-value of a company may turn out to be exaggerated during liquidation (intangible "brand value" might have evaporated, for example), so you should really only purchase bonds in companies that you are pretty certain aren't going to need to default. The bonds of troubled companies, with a risk of default or bankruptcy, will trade in the second-hand bond market at a "discount to par" - that is to say, at a price below the "face value" of the bond, simply because of this risk of default. At the right price, they may still be worth buying for an adventurous investor.

The price of bonds (how much they actually sell for, rather than their face value) is very relevant to the thesis of the deflation thread, so I'll say a bit about it, even though I do not intend to buy any at the moment. The actual price of any bond is set by "Mr Market", and is an emergent property of many intelligent (and less intelligent) people making their own decisions. However, it is useful to have some idea of what a fair value "should" be, and if the logic is sound, this will usually not be far off the actual price you can buy it for. There are more sophisticated ways to value bonds, but in my laziness, let me just pull out of the air how I would do it, if I were armed with nothing but a bit of chutzpah and some school maths. Let's start with a government bond which won't default, and has an infinite duration. That is to say, it's a piece of paper which pays you a coupon c, every year, forever. How much am I willing to pay for this? One way to value it is to assume that I know "the" inflation rate; let's suppose it's 5%, which I write as i=0.05. So, in a year's time anything I want to buy today costing £1 will actually cost £1.05. The first coupon I get, in a year's time, will therefore only get me what I can buy today for c/(1+i), or 95.2p. Therefore the total value I will get out of this bond, all the way to the end of the universe, in today's money, is:

Fair value = c/(1+i) + c/(1+i)2 + c/(1+i)3 + c/(1+i)4 +....

This is easily added up, and gives c/i. At 5% inflation, I would therefore value the bond at 20 times its coupon, and this makes sense, since at that price, the coupon is compensating me for the loss of purchasing power each year. This picture doesn't make sense as the inflation rate gets very close to zero (or, heaven forfend, goes negative), but it's similar to actual market prices for long-duration bonds when inflation is moderate.

Here's the first interesting thing. If you are holding a long-duration bond like this, that was issued in a 5% inflation environment, yielding a coupon of £1 a year, you will value it at £20, and the government will be selling it at about that price - i.e. with a "face value", or "redemption value" of £20 (although in this case, the redemption is so far in the future we're ignoring it). Now suppose inflation doubles to 10% a year. Your long bond still pays you £1 a year, but its "fair" value is now only £10. That's all someone will pay for it on the second-hand market, even if it still has "£20" written on the top. The "yield" (coupon over purchase price) has risen to 10%, to match inflation. So, not only are you stuck with the value of the future coupons being eroded even more by inflation, but the re-sale value of your bond has suddenly halved. This is the situation someone finds themselves in in a rising-interest-rate environment.

Since yield is defined as coupon over current market price, and since the coupon is fixed, then if the yield has to go up to attract a buyer, the only way this can happen is by the price going down.

The situation is not so severe for bonds which are close to maturity. Under the same circumstance of 10% inflation, with you holding a bond paying a coupon of £1, having a face value of £20, but which is due to be redeemed in 2 years' time, then you will be able to sell it for more than £10. This is because you'll get £20 (the face value) back two years from now. Inflation has less effect on short-maturity bonds. You can use the model above to estimate fair value, assuming it pays a first coupon the year after you buy it, and also in the year it matures. Let the face value (called "par") be p = £20, then:

Fair value = c/(1+i) + c/(1+i)2 + p/(1+i)2 = £18.26.

If it's not a government bond, and there is a risk of a default each year, then you can bung that in the formula above, and it acts like the bond is "seeing" a higher rate of inflation, so its price (the amount someone will buy it off you for) will be pushed down; and more so for longer-duration bonds than for bonds close to maturity. The risk of default erodes its value, and conversely you could also look at inflation itself as a kind of gradual default created by government.

The formula above for the value of a long-duration bond, namely the coupon amount divided by inflation rate, c/i, becomes very silly as inflation goes to zero. For negative inflation (i.e. deflation, with prices going down over time, like in Japan after 1990), the formula gives a nonsense negative answer; but this is simply because the sum no longer converges; it's really infinite as the terms get bigger and bigger, and the negative number is an analytic continuation outside the disc of convergence, so isn't correct. For the case of very small inflation (say 0.1%), the value from the formula would be £1000 for a bond yielding a coupon of £1 each year, which also is ridiculous. The problem here is that most of the weight of the sum is from coupons being paid decades, or centuries in the future, which you don't care about. A sensible way to look at it is to terminate the sum after some number of years, say 30, 40, or 50, which represents you defaulting on the deal, by dying. You then get sensible numbers again, even for negative inflation.

What has this got to do with anything? The yield of a bond on the market is roughly founded on current inflation (as in the model above, for long-duration government bonds), plus corrections for various things. An investor will want a bit above inflation, or above bank interest rates (when they existed). Companies have to pay a higher yield because of risk of default, and the dodgier the company, the higher the yield it will need to pay on a bond issuance. To a certain extent, and unlike the simple model above, expectations of future interest rates are also priced in - but not completely, because those remain uncertain. What we have had for the last 40 years is (broadly speaking) declining inflation, declining interest rates, and declining bond yields. If someone has bought a bond on the assumption of constant inflation, and the rate of inflation then falls, then she gets an added bonus beyond what she could reasonably have expected at the time of purchase, due to the fact the resale value of the bond has gone up.

Because of the long-term trend, then in some sense, bond issuances have been persistently mis-priced for the last 40 years, and bond investors have continually got more than they planned for from their investments. In that sense, there is a 40-year bond "bubble", which has finally got to the point where a company like Vodafone can issue a 50 year bond paying 3%, or government can issue bonds with negative yields, and they still get bought, because, well, who knows? If that 40 year trend ever reverses to become a long-term upward trend -- and the thesis of the deflation thread is that we are at just such a turning point -- then bond buyers from now on are going to get repeatedly hit by capital losses on their bond holdings. That's a problem if they need to sell. If they just hold, they will still get the same coupon, but it's a declining income in real terms, and that means at some point they might have to start selling their bonds in order to eat. This is part of what DB calls a "distribution cycle": a time when people (like pensioners) who have accumulated assets, start having to sell them; to distribute them back into the market. Holding bonds in a rising-inflation environment is a recipe for pain, and this is precisely the pain that will be felt by everyone on classic 60/40 pensions. For this reason, I'm steering clear of bonds in my long-term portfolio, even though this violates decades of good advice. That may be a mistake on my part.

One last point on bonds. During market crashes, when everyone is selling stocks, big institutions which have just sold up shares have a lot of cash which they need to find something to do with. If you have a lot of cash, the £85k FSCS limit is peanuts to you, and it's also a pain to get hold of crates of £50 notes and keep them in the head-office, so companies are more or less forced to buy bonds. This pushes the price up (or the yields down). Stock market crashes are often associated with recessions, and therefore temporary lowered interest rates (helped by governments controlling the overnight interest rate), so inflation expectations also make people judge bonds to be more valuable. The buying pressure pushes the long end down more, and since institutions are typically front-running events, recessions are often preceded by a "yield curve inversion" where long-dated treasuries actually yield less than short-dated ones. Government bonds can therefore be good to buy early on in a period of market turmoil. Since the deflation thread is possibly expecting a big market crash later this year, there is debate as to whether to temporarily buy into bonds as a strategy to profit from it. This would have been a good thing to do (very briefly) in March 2020, during the last turmoil. I don't trust myself with timing, so I'm keeping clear of this debate.

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Part 7c (post 3 of 3): What are securities, and how do they make you money?

4. On being long and being short

If you think a stock (or some other security) is going to go up in value, then you can profit from that by buying it, and waiting. This is called being "long": "Go long pork-bellies!"

Suppose you were Xi Jinping or Klaus Schwab in 2019, and you had a premonition that British Airways might have a rough time ahead, what would you do? One way to profit is to find someone who owns the stock, and thinks it will go up (i.e. who is "long" that stock). You then offer to borrow the stock for some period of time, and hand it back afterwards. You will have to pay a fee for the privilege of borrowing it, because it will be out of the original owner's control: if he changes his mind during the period you have it, he cannot sell it, for example. But, for the right fee, he will be happy about this; after all, he thinks the price will go up, so he is in no hurry to sell. As soon as you have your hands on the share certificate, you yourself go out and sell it, in the hope that you can buy it back a bit later, more cheaply, and pocket the difference. This is called "shorting" the stock.

The danger to you is that the price goes up instead, in which case you lose money as you'll have to buy it back for more than you sold it (plus you've paid the fee to borrow it). If you own a share, the worst that can happen is the value of your holding goes to zero. If you are short a stock, though (and haven't put in place an automatic stop-loss to sell when things get moderately bad), there is no limit to the amount of money you can lose, as you might have to go back into the market and buy it back at a hugely inflated price. In fact, if lots of people are short, and suddenly need to buy the stock, this can itself push the price even higher (a "short squeeze"). This is part of what happened with Gamestop, but there (as I understand it), some of the hedge funds had played tricks by selling shares they hadn't actually borrowed yet, so when they needed to go into the market to "cover their shorts", they needed to buy more stocks than were actually on the market for sale. Eventually, the day was saved by other market participants, including regulators (who had connections to the hedge funds), who took illegal and immoral actions to spare the small investors from the burden of becoming rich. In this way, the natural balance of the world returned and confidence in the free market was restored. Perhaps we can even look forward to some nice talks on the speaker-circuit when the regulators have retired. Again: on short time-scales, there is an information- and power-asymmetry between small and large investors, but that gets a bit less crushing for small investors who buy & hold.

As well as being exposed to (potentially) unlimited losses, there is another fundamental difference between being long and being short. If you are long, you only have to be right. If you are short, you have to not only be right, but be correct at the right time. It's a strategy for braver men than I.

5. Options

There is a lot to be said about options, but the only one which seems to be reasonably useful to the posters on the deflation thread, is a call option. Buying one of these gives you the right, but not the obligation, to buy a share at some fixed price in the future. The idea is that you buy a call option for a price somewhat above the current market price. If, at the specified time, the share price is above the option price, then you exercise the option, and buy the share below the current market price. You can then sell the share, to make a profit. If the share price is lower, you don't exercise the option, and it expires, so you have lost the cost of the option. If you want to keep the option open, then you have to buy another one, and so you continually pay money to maintain the option of buying the share at your desired price.

If you think the share is going to go up, why would you buy an option, rather than just buy the share? The reason is that an option, provided it is for a price quite a bit above the current market price, is likely to be very cheap, since the seller doesn't think you will exercise it, so is probably just getting your fee, with very little chance he'll have to surrender the shares at a bargain price. This means that if you don't have a lot of capital to deploy, you can buy options for many more shares than you could have got your hands on with your current cash pile.

There is a whole world of options and options trades, and if you want to know about "theta" and "big lizards", then @MvR is the man to talk to. He has a thread on them in the basement. Again, this is a class of security I have not ventured near.

6. Preferred shares, convertible bonds, warrants and brown envelopes

There are other, old-fashioned, securities on the market. Most of these are rare as they are considered confusing and don't add much to the financial world.

Preferred shares are ones where the dividend is paid first, before that for the other, "ordinary" shares, and it is also more senior in event of bankruptcy (but bondholders are more senior still, so this isn't much of an advantage).

Convertible bonds start out as bonds but the holder has the right to convert them into a fixed number of shares. This gives the bond-holder the ability to catch some of the upside, if the company starts doing very well, or gets valued richly as a growth stock.

Warrants are basically call options, but used to occasionally be sold attached to other stocks or bonds. I think there were some shady dealings around them, and they have generally gone out of fashion.

The only case I remember (and that vaguely) when these more arcane instruments reached the news, was during the bank bailouts of the 2008 financial crisis. I believe some of the banks were forced to issue convertible bonds to the government as part of the bail-out conditions, so the tax-payer could get back some of the money. What was not advertised at the time, was that these convertible bonds gave the issuer (not the holder) the right to convert them, so they turned out to be a good way for the banks to screw over the taxpayer that bit more. Presumably whoever arranged that deal on the government side will turn out to be a great orator in his retirement.

 

Despite the cavalcade of madness above, I have so far pretty much only bought shares.

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Sasquatch

Holy crap. Only just spotted this new thread. Well done @BurntBread

I will need to set aside a few hours to properly digest. Probably some close parallels. I had not done any real investing or wealth planning until a couple of years ago. Up until then I'd simply worked like a dog in my business (earning well mind you). I'm not necessarily 'all in' but I (with input from Mrs S) have made lots of investment decisions in recent times, spurred on by the credit deflation thread and associated links to lots of additional interesting reading/websites.

This site is one of the most rewarding and interesting corners of the internet.

 

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Part 8: How to buy and sell securities?

You buy and sell stocks, and other securities, through a broker. There are a number of online brokers (or things that act like brokers), such as "Interactive Brokers", "Hargreaves Lansdown", "Charles Schwhab", "IG", "eToro", "Robinhood", and lots of others. Mostly, these brokers do not themselves directly buy or sell shares, but place orders for you with another party who has "direct market access" (or DMA) to the exchanges where the auctions actually happen. The broker will however typically hold your physical share certificates for you, handle dividends, hopefully give you summaries of your portfolio, and deal with some of the tax issues.

Shares are actually sold on a stock-exchange, which runs as a kind of auction, in fact a "double-auction". People who have shares to sell advertise them at a price, and anyone is free to accept the block of shares at that price. People wanting to buy shares advertise the price they're willing to pay, and anyone with shares can come in and sell at that price. People offering to sell at a low price get matched up right away and leave the market, so there is a kind of cliff-edge in the sale ("ask") price, with all the low offers cleared off the books, and above a particular price-point, higher offers hanging around waiting for a buyer. The same is true for buyers, but the other way around: the high-price buyers disappear immediately from the market as they find sellers straight away, but there is a lowest "bid-price", below which there are people still waiting to buy at that low price. In an active market, those two price points (the highest sale-price that gets quickly bought, and the lowest buyer's-price that a seller will quickly accept) are close to each other, but there is always a small difference (the "bid/ask spread"), and so you will always see a price to buy and a price to sell quoted separately.

In times of market turmoil, when nobody knows what is going on, because circumstances have suddenly changed, then offers can dry up, and the difference between the two prices -- the spread -- can get very wide. Rarely-traded stocks suffer from the same problem. It may be impossible to transact at sensible prices in either direction, or simply impossible to find a counter-party to your offer. Under those circumstances, because of the spread, it can be very costly to transact, but that may also be the time when you are desperate to do so. At those times, your only hope is to be dealing with a brokerage with direct market access, as then you will be on an equal footing with the big investors, and as likely to make a successful trade as anyone else. I think "Interactive Brokers" is one of only four online brokerages with DMA. I have never tried to transact during market turmoil, and probably won't, so this is not too important to me. However, bear in mind that most brokers can get a bit sketchy at times of high trade volumes.

Different brokers have different advantages and disadvantages. Some let you trade without a fee (but sell your trading information, or allow others to front-run your trade). Some let you buy and sell fractions of a share. Each has a different range of securities available, so if you want to buy (for example) Japanese stocks, you may be limited as to the broker you can use.

I have only used Hargreaves Lansdown ("HL"), so I'll only be able to cover my experiences there, and the idiosyncrasies of that platform. HL is a FTSE 100 company in its own right, and has, I think, around £100 billion of assets under management. It is structured as two companies. One of them handles all the transactions, the website, research into securities, salaries, management, and all the other things required to do brokerage. The other company just contains shares and other securities. The latter has no liabilities (other than to the owners of the securities -- i.e. you), expenses or anything complex. It just holds the certificates. This structure means that this second company cannot go bankrupt, and if the first one does, then you still have an unencumbered claim on the securities stored in the second company. Some of the foreign securities are stored by third parties, so you're not 100% safe if everything blows up: you would have to investigate the financial arrangements of those third parties.

You might have cash on account at HL, waiting to buy things. That cash is stored in bank accounts, with a range of banks (Lloyds, Barclays, etc.). HL claims that if you don't have other money in bank accounts outside HL, then the structure of HL's banking arrangements means that about £300k of your money is protected by the FSCS, as it is split across banks with different banking licenses.

You can have a look at some of the HL functionality before registering: all their pages with their research on different shares are openly available, and come up if, for example you search for something like "Hargreaves Lansdown BP". You can see the summary, "at a a glance" page, with the current buy & sell prices, market capitalisation etc., and a little share price chart. There are tabs for company financials, a summary of what the company does, any recent news, and the history of dividends. The latter is important, because the dividend percentage quoted on the "at a glance" tab will be wrong if the company has changed its dividend payment rate in the last year (which most have), so check this one. It's probably a good idea to check the stability of the dividends over the last 5 years, anyway. HL does not have a huge range of shares, but it has quite a few listed. However, for the smaller American companies, and even the big Canadian ones, it doesn't have any company finances (assets/liabilities etc.), so I'm looking for other good sources for this information. For a lot of companies you can find the annual reports on their websites, though.

To register, you'll need an online bank account, and I think I needed to provide my national insurance number, and passport details. I then got a good, old-fashioned letter in the post, welcoming me to the platform, and giving me a client number. I then logged on, and transferred, with some trepidation, £20k, across, to get going. I say "with some trepidation", because (and I'll say this quietly) that was the largest sum of money I have spent on anything. The last car I bought cost sixteen hundred pounds, but that was quite some time ago. I increasingly feel like I have fallen between the cracks of the 21st century. Anyway, it was reassuring to see that money appear in the HL account as "ready to invest".

What next? HL charges £11.95 for a trade (buy or sell), plus there is a "stamp" tax of 0.5% for buying UK shares, and of course a small spread between the buy and sell prices, even if the share price wasn't bouncing about like a slightly distracted bee. This means that you don't want to be buying much less than £1000 of something at any trade, because you will lose more than 1% getting in, and more than 1% later, when you sell it. Perhaps £500 would be a minimum trade, if you are planning to hold for some time (and I have gone below even that, on purchases I thought of as more of a gamble).

I can't remember what stock I bought first - possibly Stagecoach Group because I use them, and it's a nice idea to get them to pay me for a change. So, go to "deal", search for Sta..., and you get a list of matches, which narrows down, in this case, to one stock. Each company has a name, but also a "ticker" of a few letters, to identify it uniquely on the exchange. Stagecoach's ticker is SGC. The slightly annoying thing is that tickers are only unique on a single exchange. For example, "The Mosaic Company" (which is a big phosphate and potash mining company) is listed on the New York Stock Exchange with the ticker MOS. On the other hand "Mobile Streams" is a small company selling mobile content over the internet, and is listed on the London Stock Exchange, also with the ticker MOS. One poster accidentally made £100 in ten seconds by buying the latter, before realising his mistake and selling it again. Always double-check you're buying what you think you are, by looking at the company info page, and placing a deal from there.

You choose the amount to buy either in pounds, or number of shares (I chose number of shares, because I discovered to my embarrassment that I have a slight nervous tic, which makes me want to own a round number of shares), and then I hit "place a deal". The platform gets a quote, which comes up as a splash-screen, and includes the broker fee, and the UK government stamp tax of 0.5%, and you have 15 seconds to accept the deal, or "cancel". Bob's your uncle, and five seconds later I had some Stagecoach shares sitting in my portfolio, showing in red, because I would have been down on that investment due to the fees and suchlike listed above. The hope is that things get gradually better thereafter (albeit with large fluctuations up and down). For SGC, it continued to go down, and a few months later I was 40% in the hole. Since I was reasonably happy with the price when I bought it, then at that later point, it seemed like it had a "yellow reduced sticker" on it, and I bought some more. It was several further months before it gradually started climbing back up, and is now above the price I bought it at (shown as blue in the portfolio).

Sometimes (if a stock is very thinly traded), you may have difficulty buying it. You will get a splash screen saying "cannot get live quote". This is because, as they say, they cannot get a price for you at that moment. This can be a persistent problem, and the thing to do is to put in a "fill or kill" order. Despite the name, this is not a fast-food/contract-killing service for their more disreputable clients. Instead, here, you specify the number of shares you want, and the maximum price you are willing to pay, per share. The next time a chunk of shares comes up for bidding, they will either fulfill your order at the market price, or (if the price is too high), throw your order away. I tried this once, for Yamana (a gold miner). I had tried getting live quotes repeatedly over a couple of days, and eventually tried "fill or kill" instead. The order was filled within twenty minutes. There are also "limit orders", which I haven't tried yet.

Sorry for the teaching-grandmothers-to-suck-eggs-ness of that, but it was a somewhat tense experience.

You can also buy bonds (e.g. treasuries & gilts) on HL, but I have not tried this yet, so don't know any of the pitfalls. They come up as a search option when you are looking for things to buy.

Lastly, I'll mention some peculiarities of HL, which might also be true of other platforms:

Quotes jump around near the end of the day, as large institutional trades are settled (and sometimes at the start, when the European exchanges are switching on), so don't check your portfolio between, say, 4:30 and 5pm, as it might be wrong by a large amount. You might think you have enough for a deposit on a Lamborghini, when in fact you only have enough for a Ferrari (pizza oven); or you may get a heart-attack and start planning for rice & beans.

One of the data fields for each share in your portfolio is "average purchase price". If you have just been adding chunks of shares, this is calculated as you would expect. If you then start selling some of them, I think it is still correct (I haven't sold a share yet). However, if you then add more without running the holding down to zero first, then this field will be, as far as I can tell from their explanation, both bizarre and useless. If you need to calculate capital gains in this scenario, I guess you will have to look at your record of individual transactions (which is also conveniently available as a button next to each holding).

Lastly, to reiterate the point about dividends: don't use the advertised dividend yield on the "at a glance" tab about each stock. Dig into the "dividends" tab, and check their history.

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Part 9: Taxes and tax-wrappers

[What I am going to write here is my understanding, so may be wrong].

You will die (unless perhaps you are @MrPin); and you will pay taxes (even @Frank Hovis paid national insurance -- although he avoided income tax by using venture capital trusts, and VAT by buying second-hand).

1. Outside a tax-wrapper

If you just buy and sell shares and other securities, you will potentially be subject to four kinds of taxation.

First, there is a tax on dividends. If your total income, including dividends, does not exceed the personal tax allowance of £12500 each year, then you do not pay any taxes on the dividends (or the rest of your income). If your total income exceeds this, then you have a tax-free allowance for dividends, of £2000 per annum, and on the amount you get above that you will be taxed at 7.5% for a basic-rate taxpayer, and 32.5% for a higher-rate taxpayer (and 38.1% for additional-rate taxpayer).

Second, if you sell shares, you may have to pay capital gains tax. Capital gains is the difference between sale and purchase price, but you can subtract off broker's fees and also the 0.5% stamp tax on UK shares (tax number 3). You get £12300 as a capital-gains tax-free allowance. If you make this, or less, in one year from capital gains, you do not pay any tax on those gains. This allowance is for each year; you cannot carry it over to another year. Use it or lose it. If you make a capital gain that is more than this, then the extra amount above £12300 is taxed at 10% if it keeps you within the basic rate band, and 20% if you are a higher-rate taxpayer. For higher-rate taxpayers, this is better than the dividend tax rate; hence the advantage of taking dividends in scrip, when you can (see below). If you want to crystallise a capital gain, so you can use your allowance, you cannot simply sell and then immediately re-buy. You have to have disposed of the asset for at least 30 days before re-buying. If you make a loss on a sale, this can be carried over to subsequent years, to offset against future capital gains. I believe you have 4 years to declare your losses to HMRC on your tax return.

Fourth, if you own foreign shares, the governments of those countries may charge you a withholding tax on your dividends before you even see them (and which is therefore applied before the UK dividend tax). For some countries, this can be painful; for example, Belgium charges 30%. Some companies allow you to take the dividend not as a cash payment, but as "scrip"; that is to say, as additional shares. For countries charging withholding tax on cash dividends (e.g. Spain, for the oil company Repsol), this is a good option to take, as you avoid the withholding tax, and only (potentially) have to pay UK capital gains tax, when you sell.

There are also two tax-wrappers you can use: Individual savings accounts (ISAs) and self-invested pension plans (SIPPs). HL will administer these for you, but charge a percentage of the value of each, per annum, for that administration. I believe this is a good deal if you anticipate making any taxable income or gains from your shares.

2. Shares and cash ISA

This is a tax wrapper into which you can put up to £20k each year. You cannot carry over previous years' amounts if you didn't pay into an ISA in those years. You do not get any tax rebate for putting money in (so it is protecting your already-taxed money). However, you do not pay any tax on dividends or capital gains generated within the ISA (and those gains don't count against your £20k ISA allowance, so you can leave them inside the ISA to re-invest, and still put in £20k the next year). You can take out as much as you want, at any time, and you pay no tax taking that money out. It seems to me that it is always worth taking advantage of this when you can.

If you have cash ISAs with other institutions, that you have paid into over the years, and want to transfer them to HL, then you just need to tell HL the ISA number, and the provider name, and HL will "kick ass", as they say across the water, and the money will probably turn up in your HL stocks & shares ISA within about a week, ready for you to invest.

In principle, I think HL will pay you interest on any cash in your ISA, but it will be a typical savings rate, which is currently either zero, or so close as to make no discernible difference.

HL charges a 0.45% administration fee, per year, if your pot is less than £250k, and 0.25% if more than that.

3. SIPP

This is like an ISA, but the other way around, in the sense that you don't get taxed on the way in (or rather, you can claim back your income tax), but you will (probably) get taxed on the way out. If you put in, for example, £10k of your post-tax income, this appears immediately in your SIPP for you to invest. Six weeks later, the refund of your basic rate tax (£2.5k, to "undo" the 20% rate) will also appear in your account, and (I'm guessing now, because I haven't done it), maybe something magical happens with the higher rate tax you've paid, when you fill in the tax return.

Having put money in, however, you cannot withdraw any of it until you hit 57. At that point, you can take out 25% tax-free, and then get taxed, I guess like an income, for the rest. If your income is low enough, you won't get taxed much; but even if you are, you have had the benefit of that temporary tax rebate, sitting in the account, accumulating dividends over the years, so it's still beneficial to not be taxed on the way in.

The US (and Canada, I think), recognise UK SIPPs in the same way they recognise their own pension savings plans, so you won't get hit by US withholding taxes on dividends in your SIPP. I mostly have US stocks in my SIPP at the moment, for that reason.

HL charges the same administration fees for SIPPs as for ISAs.

There are other, perhaps morally dubious, things you can do with a SIPP. Because money you put in a SIPP doesn't count as income, you can use your building up of a pension to reduce your income to a low level, potentially to the point where you don't pay income tax; and indeed to the point where you can claim some benefits, like tax credits (I think -- I have never, thank God, had anything to do with the benefits system). I understand you can also use this trick to weasel your way out of paying child maintenance. Amazingly, the chancellor hasn't touched any of this in the latest budget.

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