Dead Cat Bounce: A Complete Guide

Dead Cat Bounce: A Complete Guide

They say that what comes up must go down, but an equally true and less discussed phenomenon is that what goes down must come up. At least, sometimes.

The idea of a “dead cat bounce” might sound somewhat alarming, but as long as you hear it mentioned within the context of trading, it refers to a particular phenomenon in the stock market.

The phrase comes from the idea that even dead cats will bounce if they fall from a high enough point. When asset prices reach high levels and then drop, they may recover temporarily — even though the asset is ultimately “dead” and will fall straight back down again.

Why should you care? Because, by following backtested trading strategies, you can use them to make a profit. In this article, I’ll cover:

  • What is it and how does it works
  • Why they happen
  • The economic forces behind them
  • How to watch out for your trading psychology while trading them
  • Real-life examples
  • How to trade the bounce

What is a Dead Cat Bounce?

The media often discusses asset prices as if they’re either on a consistent upward trend or a consistent downward trend. As an investor or trader, you’ll know that this is far from the full picture.

When a stock price decreases, it rarely just hurls straight down without experiencing a few peaks along the way. One extreme example of this is the dead cat bounce: when a stock price decreases, it may seem to undergo a slight recovery before returning to its previous low.

In early 2020 the stock market saw a rapid and sharp decline, it was a bounce that prevented an almost vertical line down.

Dead cat bounce stock chart

To look at how exactly this works, let’s trace what happens to a stock when its value begins to fall.

Most investors will panic — they’ll try to pull their money out, some traders will take the opportunity to make shorts, and very few buyers will be willing to invest. Even if we don’t act on it, we’re likely to feel panicked since the human brain is programmed to have an emotional response.

In reality, if we look at things rationally, we can see the price is unlikely to continue to decrease infinitely. At some point, the panic will subside, and the price will rise a little again. This is when traders and investors can spring into action — if they’re smart.

Unfortunately, many traders will mistake this little blip for a genuine recovery. At this point, you probably have one question in your mind: why does this happen in the first place?

What are the Causes?

A bounce happens when pessimism begins to set into a bear market. If the market continuously displays a downward trend for weeks on end, the conditions for a bounce begin to foster — and it’s made possible by the way different types of traders act.

The bears will engage in short selling, hoping that they can profit as the price continues to fall.

However, value investors (who look for undervalued stocks) may buy-in because they believe that the stock will rise in value.

At some point, the traders who are short will want to cash in and cover their short positions. Thus they turn from sellers to buyers adding to the value investors buying.

Despite the stock being “dead”, this activity results in a temporary increase in demand.

The market environment is dominated by this tension between bullish and bearish opinions and whether the market has fallen too far too soon or it has still a long way to fall.

The Economics at Play

As you’re probably well aware, the two main forces at play in economics are supply and demand

In the case of a bounce, the supply force is made up of the investors who are shorting, while investors drive demand because they believe the stock price is about to increase.

To begin with, the supply of traders looking to sell outpaces the demand, so the price keeps dropping and dropping (since the supply curve is shifting outward and the demand curve is shifting inward).

But when some people believe the price has become too low and want to buy, the demand curve temporarily shifts outward again, increasing the price — but it will soon move back in again.

Obviously, this is an extremely simplified way to look at a complex scenario.

The Market Psychology

In retrospect, the route to profiting from bounces appears clear as day. So why do so many traders get burned by them instead of profiting?

It’s partly because they’re blinded by short-term movements (the bounce) to notice the broader trends, and partially because they haven’t mastered their emotions related to their investing decisions.

Greedy traders don’t want to pat themselves on the back and bow out when a stock they traded at the bottom increases in value by 10% — or even 20%. So they hold for too long and end up making a loss.

Similarly, fearful traders are likely to panic the second they see one of their investments declining in price, even if a bounce is due at any point.

Lack of impulse control over greed and fear sets traders up for failure. Accept that you’ll never time the market perfectly (design a strategy that reflects this) — and that you don’t need to for success.

This is why I’ve invested serious time and money into working on my trading psychology, which has improved my decision-making to no end during these crucial moments.

Real-World Examples

Talking in theoretical terms is all well and good, but to understand how to trade these things, you must be able to recognize patterns.

They say that you can’t understand the future if you can’t understand the past, so here are three real-world examples.

These case studies all focus on larger trends that took place over weeks or even months, but dead cat bounces can also be over within a few days — as in the example of the 2020 crash I mentioned earlier. There’s no set time frame for when a bounce will start or end.

The Great Depression

Few periods in financial history are referred to more often than the Great Depression.

We tend to look back on it as a period with sharp and sustained falls. History gives us the luxury of forgetting because it wasn’t quite so straightforward at the time.

Following the initial crash in 1929, there was a 47% increase in stock prices from late 1929 right through to spring in 1930 — practically a full recovery.

As you can no doubt guess, prices were soon to fall back with a vengeance and soon declined 80%.

The Depression also included many other mini rallies and bounces along the way.

The S&P 500 in 1974

Unsurprisingly, you don’t have to go as far back as 1929 to find examples of bounces — although nothing else is quite so dramatic.

In November 1974, the S&P 500 plummeted, recovered around 17%, then plummeted back to its previous low.

The NASDAQ in 2000

There was a similar occurrence in 2000 with the NASDAQ. The index declined 27% between September 1 and October 17th, before unexpectedly recovering by 9% (and then falling again after).

Other indexes at the time displayed similar patterns, though not quite so pronounced.

These are three examples of many. Price never goes straight down (or up), so if you can think of any past examples of a stock bottoming out, there’s a good chance that it might have experienced a short bounce first.

Reversal or Bounce?

It’s easy to assume that a sustained period of decline will automatically result in a bounce — especially after the three historical examples we’ve just seen. But don’t be so confident. Sometimes, there’s a complete recovery and upward trend.

Spotting the difference between a reversal and a bounce is one of the toughest elements of this type of trading, and I wish I could give you a surefire trick for how to do it. Unfortunately, I can’t, other than recommending you to use your knowledge of market fundamentals and knowledge of your trading style and psychology.

However, here are some rules of thumb.

First, wait until the value is increasing, then look for some further signals of a bounce.

One telltale sign is a reversal or bearish pattern at the top of the dead cat bounce, like a double top that fails. At this point, you can proceed with a short with less risk.

Alternatively, you could wait until the price drops below the support levels (previous dips and rises before the significant rise).

Ultimately, you’re looking for a sign that supply and demand forces are altering

How to Hedge Yourself

After stock prices fall dramatically then begin to increase again, opening a short position can seem like an attractive prospect.

At this point, it’s essential to make sure you don’t misread the bounce as a reversal putting at risk more capital than is planned.

A “test” you can try is waiting to see if the price returns to its previous low. If a few days have passed and the price has remained comfortably above the previous low, it’s a sign that you might be facing a genuine recovery.

You can expect to see a kind of imperfect “W-shaped” recovery where the price consistently dips then rises back again.

When this happens, I recommend setting a stop loss just below the first V so it’s possible to exit if the price does collapse (more on risk and stop-losses later).

This leads to the part you no doubt want to read about: perfecting your strategy.

Dead Cat Bounce Strategy

Now you have a good understanding of how dead cat bounces work, we can get to the important question: how can you trade a dead cat bounce successfully?

The first thing to be aware of is that every dead cat bounce is slightly different, so don’t expect a textbook example each time. You can’t assume that the market is experiencing a bounce just because there’s been a dip followed by an upswing — this could mean anything (as we’ve seen already).

Now we’ve got that out of the way, let’s move on to strategy. You could probably talk to a hundred different traders about the best way to do this and get a hundred different answers, but I recommend using the bounce to enter a short.

It’s generally best to trade when you suspect prices are about to decline, rather than when you suspect the prices will increase — this carries less risk.

To do this, it’s essential to make sure you can tell the difference between a bounce and a recovery (which is bad news for anyone shorting) — use the methods outlined above to do this.

In the case of a W formation, after you notice signs of a slight bounce, wait for the price to exhaust itself.

One sign of this is the price extending during closing or approaching the opening price, and another is panic buying (the price opening higher than the closing price of the day before but then trending down to below the lowest point of the day before).

Don’t be tempted to short the bounce by joining the trend as prices decline. You may expect them to fall more, but this is rarely a good idea — it’s so easy to be caught out. Instead, wait until the low has been found.

Stop Placements and Targets

To effectively navigate bounces, stop losses and price targets are essential.

Place price targets for the short position above the low reached before. Then, when the price rises again, exit. When shorting, do the opposite. Make a stop-loss that’s just above the recent high.

As a general rule, try to keep stop placements and price targets outside of the range of normal fluctuations to ensure you don’t get caught out.

Bottom line

Trading a dead cat bounce successfully is no easy feat. It’s a somewhat risky tactic that generally requires a fair amount of practice to get right — plus a solid understanding of how to analyze asset prices and their patterns.

But done right, it can certainly be very profitable, and it’s an essential strategy for every trader or investor; to add to their bow.

This article originally appeared on Your Money Geek and has been republished with permission.

Money Lessons From Warren Buffett’s 2021 Letter To Shareholders

Money Lessons From Warren Buffett’s 2021 Letter To Shareholders

In his latest annual letter to shareholders, Warren Buffett, CEO of Berkshire Hathaway, wants you, the investor, to understand Berkshire Hathaway, the company he has steered since 1965. As in past years, I anxiously await Warren’s annual letter (he writes his letter as if he is addressing you personally, so hence my liberal use of “Warren”)  to learn or refresh my knowledge with his numerous golden nuggets.

Here is Warren Buffett’s letter that is a review of 2019

My Thoughts At First Glance

There aren’t any huge surprises though Buffett admitted to an error in overpaying for Precision Castparts in 2016. One of the best sections was his tribute to the founders of companies he purchased that show “success stories abound throughout America” as entrepreneurs without capital but with a strong work ethic. Look for “Mrs. B”  as a highlight that I embraced.

The letter is disappointing for what Buffett omitted. He mentions COVID-19 only once, alluding to it when he commented on the furniture company’s temporary closing. Yet, the pandemic destroyed small businesses and caused significant unemployment.

Another topic Buffett should be upfront about was the lack of making any acquisitions and his poor timing of selling stakes in banks and airlines during 2020. Buffett did talk about repurchasing more Berkshire Hathaway shares which may contribute to higher earnings with lower outstanding share count.

Labor Of Love

I read the letters and search for Warren Buffett money lessons, a task I enjoy since graduate school for business. It is my labor of love. My goal is to share his wisdom with others, notably with my college students and, of course, my readers. It is an exercise of enjoyable reading for American history buffs and those who are in finance.  

Buffett letters to Berkshire Hathaway shareholders go back to 1965 and chronicle the growth and challenges of the company’s businesses. I always uncover Warren Buffett’s money lessons as I did in the current letter on investing, diversification, overspending, debt reduction, entrepreneurism, ethics, and more.

Many of Buffett’s iconic quotes come from these letters filled with honesty, integrity, sardonic humor, and corniness when it comes to America. He and Vice Chairman Charlie Munger share their intellect, and at ages 90 and 97, respectively, it is no small feat. Longevity may just be one of the benefits of being a longtime Berkshire shareholder, as Buffett shares in this letter. 

The Letter At A Glance

There aren’t any huge surprises though Buffett admitted to an error in overpaying for Precision Castparts in 2016. One of the best sections was his tribute to the founders of companies he purchased that show “success stories abound throughout America” as entrepreneurs without capital but with a strong work ethic. Look for “Mrs. B”  as a highlight that I embraced. 

The letter is disappointing for what Buffett omitted. He mentions COVID-19 only once, alluding to it when he commented on the furniture company’s temporary closing. Yet, the pandemic destroyed small businesses and caused significant unemployment which remains high.

Another topic Buffett should be upfront about his lack of making any acquisitions, even after the market downturn. He also divested his bank or airline holdings in 2020, presumably due to COVID-19, but he didn’t explain his actions in the letter. 

Buffett Remained On The Sidelines

Most importantly, why was he uncharacteristically quiet in 2020?

If investors were hoping the 2020 letter would fill in some of the gaps in understanding Buffett’s uncharacteristic silence much of last year, they are going to be disappointed. What was going on that Warren Buffett did not take advantage of the dramatic stock market downturn in March 2020 to buy bargain stocks? 

He often is a voice of calm and reason when markets are extremely volatile. Typically, Buffett uses this scenario as an opportunity to pick up some bargains, either by purchasing equity stakes or making acquisitions. He remains healthy, and the letter does not cause us to worry about him, at least as far as being a 90-year-old man.

Uncovering Money Lessons From Warren Buffett’s Letter To Shareholders

 

Misses And Mistakes

Warren Buffett addressed the company’s two primary goals: increasing earnings and acquiring large and favorably situated businesses. Management met neither goal. However, they repurchased 5% of Berkshire Hathaway’s shares, which reduces the share count, raising EPS potential. 

Admits To An Error On Overspending

The Precision Castparts acquisition made in 2016 has not lived up to its profit potential. Berkshire took an $11 billion write-down. Buffett’s mistake of overpaying for this asset took him only four years to acknowledge compared to his 20-year famed struggle with the textile business he inherited at Berkshire. That is a big step in the right direction to acknowledge a mistake, Warren!

Berkshire Is A Conglomerate

Buffett describes Berkshire as a conglomerate,” but only in part.”  It differs from the prototype of “aspiring conglomerateurs” who will buy up for mediocre businesses.  Many conglomerates overpay for companies with overvalued stock. Tools to foster overvaluation involve “promotional techniques and ‘imaginative’ accounting maneuvers that were, at best, deceptive and sometimes crossed the line into fraud.”

“Financial history is replete with the names of famous conglomerateurs who were initially lionized as business geniuses by journalists, analysts, and investment bankers, but whose creations ended up as business junkyards.” I knew several candidates professionally he may have in mind.

Buffett is not a fan of Wall Street, particularly in this letter, as we discuss later.

Controlled and Non-Controlled Businesses 

Berkshire Hathaway is a holding company with controlled and non-controlled businesses. Their controlled businesses are typically those they own at least a 50% interest in and manage operations. Berkshire owns equity stakes or holdings of marketable stocks in non-controlled businesses they do not operate. 

 Buffett and Munger view Berkshire’s holdings of marketable stocks as a collection of businesses. These holdings had a year-end market value of over $281 billion in 16 company equity stakes, up from its $108.6 billion costs. For GAAP purposes, Berkshire can only book the dividend income from these companies, not their marketable (but unrealized) gains.

Four Family Jewels

#1 Property And Casualty Operations And Its Insurance “Float”

Berkshire’s insurance companies are its valuable businesses. They have unique characteristics that allow them to enjoy  $138 billion of insurance “float.” Like other insurers, premiums paid by customers can be invested in securities when customers pay premiums for policies and the time they make insurance claims that are liquidated.

The float is money that doesn’t belong to Berkshire and will go to intended parties in the future. It is free money in the meantime for investments.

Unlike its competitors, Berkshire follows an equity-heavy investment strategy not feasible for most of its insurer competitors with regulatory and credit-rating restrictions.

Instead, these competitors invest their premium proceeds in bonds that have to generate low-interest income from the likes of 10-year US Treasury bonds, yielding 0.93% at the end of 2020. Buffett worries that some insurers and bond investors may turn to increase their returns by buying more risky loans, which are “not the answer to inadequate interest rates.” It is hard to find income in a low-interest environment without adding risk as we discuss here.

However, the 10-year yields rose to 1.54% in late February 2021, above the year-end rate. 

Berkshire’s #2 And #3 Most Valuable Assets

Buffett’s points to the company’s second and third most valuable assets that appear to be a tie, and frankly, seems surprising.  The tie in Berkshire Hathaway’s most valuable assets is between Berkshire’s 100% ownership of BNSF, America’s largest railroad based on freight volume, and its 5.4% interest in Apple.

A 5.4% Interest In Apple, Helped By Share Buybacks

Roughly 42% of the marketable gain comes from its now 5.4% in Apple due to share buybacks.  Berkshire began investing in Apple in 2016 and mid-2018, representing an initial 5.2% stake, and realizing regular dividends of $775 million annually. They had an $11 billion gain from selling a small portion of their stake.

Through the math of Apple’s share buybacks and Berkshire’s repurchases, Buffett told investors that they “own a full 10% more of Apple’s assets and future earnings” than they did in July 2018. Q to Buffett Does he think that Wall Street analysts give proper credit to this non-controlled interest in their price targets in Berkshire.

 BSNF – Its Railroad Business

Tied with the Apple interest is its 100% ownership of BNSF, acquired in early 2010. It has been operating since 1850. It has required substantial investments since Berkshire’s purchase.  BNSF paid significant dividends of $41.8 billion in total to Berkshire after it fulfills its business commitments and maintains a $2 billion cash balance, reflecting a conservative policy.

Railroads are a fascinating industry for any Americana history buff. Their challenges are well documented from their early start and are in a more mature stage.

#4 Jewel – Berkshire Hathaway Energy

Berkshire’s fourth family jewel is Berkshire Hathaway Energy (BHE), owned for 21 years. Unlike BNSF and most electric utilities, it pays no dividends to Berkshire. BHE is amid a long-term $18 billion project to rework and expand a substantial portion of its outdated electricity grid throughout the West. The project began in 2006 with a  2030 competition date. This project is complex and essential to be able to deliver clean energy.

Berkshire Hathaway Ranked #1 As Largest Owner Fixed Assets

Berkshire is the largest owner of American-based property, plant, and equipment with fixed assets of $154 billion, followed by AT&T, at $127 billion. That Berkshire fact alone means it is an asset-heavy company that invests a lot of capital, not necessarily generating the best-earning results or even a good investment.

As most business college students learn in school, good returns can come from companies with minimal assets in high-margin businesses that have expanding topline growth. Simply being asset-heavy is not a reflection of a beauty contest.

Underperformance In Berkshire Shares

Indeed, Berkshire’s stock performance in 2020 was poor, up 2.4% compared to the 18.4% terrific climb for the S&P 500. Relative stock performance in 2019 was also weak, with 21% underperformance.

Investors would have done better with a passively managed Vanguard S&P 500 index fund paying an expense ratio of 0.14%. That means an investor would be paying about $14 fee annually for a $10,000 investment in the fund. Actively managed funds have higher expense ratios of 1% or higher, costing a $100 management fee for a $10,000 investment.

American Prosperity Fuels Business Creation And Entrepreneurship

Despite his age, Buffett is still playing for the long term with high confidence in Berkshire’s businesses, management, and employees. He is proud of his extensive property and casualty business and his smaller companies. They remain treasures within the Berkshire family, and he shared their beginnings as business creations by individuals that are American success stories.

One reason Warren Buffett may have less of need for Wall Street bankers is that he does his research, making purchases for Berkshire, even on a handshake after getting to know the founders and its business potential.

Berkshire’s Gems:

  • See’s Candy, a West Coast company acquired in 1972. Mary See began the business a century ago, reinventing age-old candy with new recipes such as Buffett’s favorite peanut brittle.
  • GEICO (Washington D.C.) began as an auto insurance company by the Goodwins in 1936. It became Buffett’s first love when he bought shares in 1951 as a Columbia Business student, purchasing GEICO for Berkshire in 1996.
  • National Indemnity (Omaha) began in 1940 by the Ringwalts to compete against well-funded giant insurers. It was purchased in 1967 and is Berkshire’s largest business.
  • Tennessee-based Clayton Homes and Pilot Travel Centers (38% interest but 80% in 2023) were each begun by young men, continued by their sons under Berkshire’s umbrella.

A Young Immigrant’s Story Seems Familiar

“One question I always ask myself in appraising a business is how I would like, assuming I had ample cash and skilled personnel, to compete with it. I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings.”

Warren Buffett, from Wikipedia

Buffett continued to buy Omaha businesses. Among those was the Nebraska Furniture Mart (NFM), with an enchanting story told in Buffett’s letter. The founder of NFM was Rose Blumkin (Mrs. B), who arrived in Seattle in 1915 as a Russian emigrant, unable to speak or read English. She settled in Omaha and used her $ 2,500 savings to start a furniture store in 1936.

By 1946, her business stalled, and she was down to $50. Louie, her only son, rejoined the store after four years in the Army. He earned a Purple Heart, having fought at Normandy on Omaha Beach on D-Day and sustained injuries in the Battle of the Bulge. He joined his mom, renewing the business, and by 1983, their business worth $60 million.

Buffett purchased the furniture business, leaving the Blumkins to manage the place. Mrs. Blumkin worked every day until she was 103, and Buffett wrote, “…a ridiculously premature retirement age as judged by Charlie and me.” The business still run by the third and fourth generation of the Blumkin’s and now has the three largest home furnishings stores in the US today.

 Immigrant Stories Are America

Their story reminds me of my own mother’s immigrant story. She became a thriving retail owner after coming to America as a Holocaust survivor with $5 in her pocket. My husband’s account tells me of his two great grandmothers’ export-import and furrier businesses. Each story is unique but has parallels of strong immigrant women, who came to the US with little money, didn’t speak English, were primary breadwinners in their families, and loved America.

Buffett’s post-script to the Blumkin story could be my family’s or the many immigrants that landed in this country. When Mrs. Blumkin’s large family gathered for holiday meals, she always asked that they sing before eating. That song was Irving Berlin’s “God Bless America.” I promised you corniness!

Buffett And Munger’s  “Special Kinship” With Individual Investors

In business ethics, stakeholders of a company have interests in the outcome of the decisions made. Typical stakeholders are the board of directors, management, employees, customers, lenders, and stockholders.

The BH directors want the company to delight the customers, develop and reward the company’s 360,000 employees, called associates of the company. It is up to the board to determine dividends, strategic direction, CEO selection, acquisitions, or divestitures to act in the corporation’s best interests and its owners.

The owners are the stakeholders that most matter in the letter written by Warren Buffett and to whom he most directs his comments. 

Owner Constituents:

  1. Warren Buffett’s Berkshire shares ownership will eventually be annually distributed to various philanthropies as part of his estate plan
  2. Passive investing is a fund strategy that tracks a weighted index such as S&P 500 index funds.
  3. Actively investing refers to a portfolio management strategy where portfolio managers make investments. Both active and passive investing are institutional investors who may either have a long-term focus or use computers employing algorithms to trade with a short-term mentality.
  4. Individual investors are investors whose purchases are of smaller volume than institutional investors. They may buy Berkshire shares for long-term investment or use Berkshire shares as a source of funds. 
  5. Warren Buffett’s special kinship for the individual investor comes from his early roots as a money manager through partnerships. He and his family invested in the partnership with these individual investors of million-plus investors who line up with Berkshire’s philosophy favored by him and Charlie Munger. They are more likely to have long-term perspectives. 

Original partners were longstanding holders of Berkshire shares, many of whom are descendants of the original partners. They share a commonality with Buffett by being old-fashioned long-term investors who trust the management to do the right thing.

Stepping Down To Retire? Nope

“Could it be that Berkshire ownership fosters longevity?”

Warren Buffett

Would it surprise you that there were no announcements of Warren Buffett or Charlie Munger stepping down and moving over for Vice Chairmen Ajit Jain and Greg Abel? Me neither. In their 90’s, they remain energetic and love their jobs.

Instead, Buffett spoke of Pilot Travel Center founder “Big Jim” Haslam, who recently authored a book at age 90.

Buffett pointed to the earliest investors–a group of Omaha doctors who formed a partnership. One of those veterans just turned  100 years old, and he and all the doctors kept their original Berkshire shares they received from the partnership.

Wall Street And Speculators

Throughout the years of writing letters, Buffett and Munger together have shown there is no love lost for Wall Street, notably the investment bankers, analysts, and those of that ilk. As a former analyst, I take no offense, recognizing the culture of working on “The Street”  is often difficult to maneuver.

This letter was no exception. I thought there was more than the usual Buffett bite in this read. We use his quotes when he refers to Wall Street.

On conglomerates, Buffett refers to the overvaluation of an overvalued conglomerates’ stock to make acquisitions, he says, “Wall Street loves the fees that deal-making generates, and the press loves the stories that colorful promoters provide. At a point, also, the soaring price of a promoted stock can itself become the “proof” that an illusion is reality.”

After his tribute to individual investors, Buffett refers to the tens of millions of other investors and speculators who have “a wide variety of equity choice to fit their tastes.” (His emphasis). According to Buffett, these investors will find CEOs, market gurus, price targets, managed earnings,  “stories,”  and “technicians” who will “instruct them as to what some wiggles on a chart portend for a stock’s move.”

The Monkey And Its Dartboard

Buffett believes many of these investors will do well, saying:

“Indeed, a patient and level-headed monkey, who constructs a portfolio by throwing 50 darts at a board listing of all the S&P 500, will–over time–enjoy dividends and capital gains, just as long as it never gets tempted to make changes in its original selections.”

His italicizing of “over time” reminds investors of the need for having a long-term perspective, something that may be lost in the world of computer algorithms and day trading.

Buffett’s Book Recommendation

Warren Buffett is well known to be an avid reader and shares many recommendations. In his letter, he recommends “Common Stocks And Uncommon Profits” written by Philip A. Fisher in 1958.

In the book, Fisher analogizes running a public company to managing a restaurant. He said, “If you are seeking diners, you can attract clientele featuring either hamburger served with a Coke or a French cuisine accompanied with exotic wines. But you must not capriciously switch from one to another.” You and your business’s message to potential customers must be consistent with what they find when going to your premises

Inflation Wasn’t Addressed In This Letter

Not surprisingly, Buffett did not comment on inflation as our economy is not yet near full employment. However, Buffett did comment in his 1980 letter when the inflation rate was 13.5%, giving us a glimpse into his thoughts on high inflation in the late 1970s and early 1980s:

“High rates of inflation create a tax on capital that makes much corporate investment unwise – at least if measured by the criterion of a positive real investment return to owners.

“This ‘hurdle rate’ the return on equity that must be achieved by a corporation in order to produce any real return for its individual owners – has increased dramatically in recent years. The average tax-paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil.”

Our recent post on Inflation And How To Protect Yourself From Its Effects

Final Thoughts

I learn from Warren Buffett’s letters to Berkshire Hathaway’s shareholders. The letters contain golden nuggets of money and life lessons. That doesn’t mean Buffett is beyond criticism, especially in his account of  2020 where omissions did not address many questions I would have for him. Becky Quick of CNBC in her standard interviews of Warren Buffett will ask the questions I raised in this article.

May 1st in the Berkshire shareholder meeting, and for the first time will be held in Los Angeles instead of Omaha. Buffett and Munger will be answering questions.

Thank you for reading! If you found any value in this post, please visit The Cents of Money for more articles like this. Why not become a subscriber so you can get our free weekly newsletter! Love to see you there!

 

 

 

 

 

 

 

 

 

 

All About The Personal Financial Statement

All About The Personal Financial Statement

By keeping tabs on your finances, you can create a secure and fulfilling future. That’s where a personal financial statement comes in. At its core, a personal financial statement offers an overview of where you stand financially at any point in time. It can help you succeed in various aspects of your life.

Why You Need a Personal Financial Statement

There are several reasons you may want to create a personal financial statement. It can help you if you’d like to:

  • Take out a loan.
  • Apply for financial aid.
  • Make a guarantee.
  • Design a retirement, estate, college savings, or other financial plans.
  • Lease a commercial office or other types of business space.
  • Develop strategies to reduce your tax burden.
  • Run for public office.
  • Keep track of your credit.

Ideally, your personal financial statement will show that you have a positive net worth and your assets are greater than your liabilities. This can allow you to position yourself as a responsible borrower and someone who knows how to manage their money well. It may also prove that you’re thriving with your finances.

How a Personal Financial Statement Can Change Your Money Habits

A personal financial statement can be instrumental in the way you think about your money and manage it. Here’s why: When you see your net worth, you’ll realize that many of your previous and future behaviors affect that figure. It informs you of whether or not you’re on track to meet your financial goals. A high, positive net worth, for example, may mean that you’re closer to your dream of:

  • Buying a dream home or rental property.
  • Retiring early.
  • Working part-time instead of full-time so you can spend more time with your family.
  • Donating more money to a cause or organization you value.
  • Funding your children’s college.

Low or negative net worth can give you a wake-up call. It may be just what you need to change your behaviors and be more cautious with the way you spend your money. You may be more likely to get out of debt, pick up a side job, and stick to a budget if you’re displeased with this figure.

What’s Included in a Personal Financial Statement

The three major components of your personal financial statement are as follows:

Balance Sheet

Your balance sheet is an overview of your personal net worth and will list all of your assets and liabilities. Assets may include your home, car, savings accounts, and investment accounts. Liabilities, however, might be your mortgage, auto, student loans, and credit card balances. Your balance sheet will state the difference between your assets’ total value and the total amounts you owe on your liabilities. It’s a great representation of your net worth.

Income Statement

Your income statement will consist of your salary, bonuses, and commissions. If you have other income from interest, a side job, or dividends, you’ll include this information as well. Your income statement will also outline your insurance premiums, income taxes, and any other consistent cash outflows you may have. With your income statement, you can determine whether you spend more than you earn and what you can do to improve the way you spend money.

Cash Flow Statement

A cash flow statement shows how you spend your money. It breaks down your cash into three main categories: fixed, non-discretionary expenses, variable, non-discretionary expenses, and discretionary expenses or fun money. It bridges the void of information from the Balance Sheet and Income Statement. You can use a cash flow statement to figure out if you’re on the right path to building wealth and meeting your goals.

What to Exclude From a Personal Financial Statement

Now that you know what’s included in personal financial statements let’s discuss what they should exclude. Your personal financial statements will not contain any business-related assets or liabilities. The only exception is a personal loan for your business or any other tool you’re directly accountable for.

Your personal financial statements mustn’t include anything you rent or personal belongings like household goods or furniture, as their values are rarely high enough to be considered assets.

How Often Should You Update Your Personal Financial Statements?

Once you prepare your personal financial statements for the first time, your work is not done. Since your finances will likely change regularly, your personal financial statements require frequent updates. It’s essential to review and modify your statements every month or every other month. This way, you’ll always be up-to-date on where you stand with your finances and can make adjustments to your spending and saving habits as necessary.

Personal Financial Statement vs. Business Financial Statement

Business financial statements usually consist of a profit and loss statement and balance sheet. As stated, personal financial statements include a balance sheet, income statement, and cash flow statement.

With a business financial statement, you can start or grow your business and obtain small business loans to help you do so. However, personal financial statements focus on your personal life and can help you achieve your personal financial goals like buying a house, retiring, or sending your children to college.

Ways to Increase Your Net Worth

Your net worth is essentially the value of your assets over your liabilities. You can have plenty of assets and have plenty of liabilities, meaning you don’t have a high net worth. On the flip side, you can have minimal assets but no liabilities and solid net worth.

So what is the ideal net worth? It depends on your age, unique lifestyle, and comfort level. There is no hard and fast number that everyone agrees with. However, you can use a formula developed by Thomas Stanley and William Danko, authors of the book “The Millionaire Next Door,” to get an idea of where your net worth stands. The formula is Net Worth=AgeXPretax Income/10. If your pretax income is $60,000 and you’re 35, for example, your ideal net worth would be $210,000, according to this formula. There are 18 financial ratios you should know, including this one.

Of course, this is just one way to look at your net worth and doesn’t necessarily mean that you’re struggling with your finances if you’re below the $210,000 mark. It’s all about what type of net worth you feel comfortable with. Another way to use your personal financial statement is to look at your liquid net worth that provides a more conservative view.

If your personal financial statements prove that your net worth is in the negative or lower than you’d like it to be, don’t worry. There are a variety of ways you can achieve a positive or higher figure. Here are several suggestions.

  • Cut Expenses: The less money you spend, the more you can use towards saving and investing. Take a look at your budget and figure out where you can reduce or eliminate expenses. If you rarely use that gym membership, for example, cancel it. If you tend to overspend on dining out, cook more meals at home. Remember that even a few dollars here and there can add up and increase your net worth in the long run.
  • Look for New Income Sources: If your 8 to 5 job doesn’t pay enough, don’t be afraid to earn money through other outlets. Depending on your schedule, preferences, and interests, you may want to take on a second job or freelance work. Or perhaps you have many items that you no longer need or want and can sell them on Craigslist or Facebook Marketplace.
  • Buy a House: If you’re currently renting, saving for a house may be a good option. Your mortgage payments can allow you to build equity, which can increase your net worth. If you do pursue homeownership, make sure you choose a home at or below your means. Otherwise, it can turn into a liability rather than a wealth-building tool.
  • Build an Emergency Fund: Unfortunately, life happens, and your car may break down, or your roof may need to be replaced when you least expect it. In these situations, it’s helpful to have an emergency fund. With an emergency fund, you can cover these unexpected expenses and avoid debt. Most financial experts recommend three to six months’ worth of savings in an emergency fund.
  • Get Out of Debt: Although it’s easier said than done, do your best to reduce or eliminate your debt. This includes your student loans, mortgage, credit card debt, car debt, and other places you make monthly payments to.
  • Invest: The sooner you begin to invest, the better. Once you have an emergency fund, make your money work for you via investing. You may want to consider some investment vehicles, including a 401(k), Roth IRA, Traditional IRA, and 529.
  • Get Insured: Insurance can protect you financially when and if the going gets tough. Life insurance, car insurance, and health insurance are important investments that can protect your (and your family’s) financial future.

How to Prepare Personal Financial Statements

If you’d like to prepare personal financial statements, you have two options. You can go the DIY route and complete them yourself. Fortunately, there are many free and fee-based templates available to guide you through the process.

Another option is to consult a financial advisor or hire a financial coach to help you. They can provide you with the expert guidance you need to ensure your personal financial statements are thorough and accurate. Even if you create your own statements, a financial advisor may review them and provide you with the peace of mind of knowing it’s in good shape.

A financial advisor can also help you increase your net worth. Once they learn more about your particular situation, they can make appropriate recommendations and steer you toward a healthier, happier financial future.

This article originally appeared on Your Money Geek and has been republished with permission.

Understanding Inflation And How To Protect Yourself From Its Effects

Understanding Inflation And How To Protect Yourself From Its Effects

We almost always have some inflation, meaning wages and prices increase which helps job creation and economic growth. The absence of inflation is deflation, which means declining prices and could cause or worsen a recession as businesses lay off workers.

For years, we have had low inflation with relatively stable pricing, largely due to the Federal Reserve’s efforts.  However, the low inflation levels could change as our economy rebounds from the pandemic. To find higher rates, you have to go back to 1990 when inflation was 6.1%. Double-digit inflation was more common in the 1970s, with its peak at 13.3% in 1979.

The Federal Reserve’s Monetary Policy’s Actions

The Federal Reserve has dual goals: maintaining relative pricing stability and sustainable economic growth with full employment. In the Great Recession and in March 2020, due to the pandemic-related economic downturn, the Fed steered towards accommodative monetary action to drop their fed funds rates to the lowest levels of zero-to 0.025% to stimulate the economy. 

Chair Powell and the Fed intend to keep interest rates low through 2022 and have said they would be more tolerant of inflation rates that exceeded their 2% target. There is a reasonable possibility that we will see higher inflation soon.

Will The Fed Stick With Their Accommodative Policy?

Despite their intentions to stay with an accommodate policy, the Fed’s policy mandate is to adjust their stance to changing information. The 10-year Treasury note’s yield has been rising and could signal higher inflation expectations. The Fed has tools to combat high inflation such as raising interest rates. 

It is not clear if the Fed will change gears but we can prepare ourselves. Should inflation increase to moderate levels above 2%, there are ways to protect ourselves from the potential erosion of our money. Moderate inflation may provide some benefits. You need some level of inflation to promote more spending.

Reasons Why We May See Higher Inflation

  • The Fed intends to remain accommodative for a while, with lower rates and liquidity.
  •  A potential $1.9 trillion fiscal support for those businesses and households in need is on the table.
  • The number of people getting vaccinated is rising, which may help boost the economy.
  • We are saving more with the latest US personal savings rate remaining high at 13.7%, about twice the rate seen in 2019.
  • Credit card balances at the end of 2020 reflect the largest yearly decline since 1999, reflects consumer spending is down.

These factors, if combined, may unleash consumer spending to kick up our economy and contribute to higher inflation. Offsetting these factors is high unemployment levels staying stubbornly high and may keep inflation low for now.

With low inflation, it has been difficult for anyone to earn any income in a low-yielding environment without taking on more investment risk. For investors with 60/40 retirement portfolios investing in stocks and bonds, respectively, some have shifted more significant proportion into stocks.

Investors will need to seek assets that are at least keeping pace with rising inflation. Holding cash in savings and checking accounts are suitable for liquidity purposes.  However, their safety feature will diminish as their values erode with rising inflation.  Later on, we have a list of investments that can protect you during a higher inflationary environment.

What Is Inflation And How Does It Affect Your Buying Power?

The definition of inflation is a steady rise in the general level of prices of goods and services. For example,  a gallon of milk cost $1.57 in 1975 rising to $2.20 in 1985 as a result of high inflation in the 1970s to early 1980s. It now costs $3.61 in 2021. The changes in prices are due to inflation, not scarcity. 

As a result of inflation, your purchasing power, the amount of goods and services that one’s income will buy, goes down. When prices rise, purchasing power declines, usually falling by the reciprocal amount of the price increase. Your paycheck may stay flat or go up more slowly, leaving you with less money. Union members may be an exception as they receive a cost of living wages as part of their contract.  

Calculating of Inflation

The US Bureau of Labor Statistics calculates inflation monthly using the consumer price index (CPI). The CPI is the best measurement of changes in prices of all goods and services purchased for consumption in urban households. This index tracks a market basket of food, transportation, housing, health care, and entertainment, broken down into over 400 subcategories bought by end-users.

The CPI is a cost of living index with a starting reference point from 1982-1984 as the base period of 100. The CPI for January 2021 was 261 reported on February 10, 2021, the cost of living would have risen 161% since the base period [(261-100)/100= 1.61 of 161%]. If car prices rose 15% over the past five years, you may be paying $34,500 for a car that had cost $30,000 ($30,000 x 1.15%).

Economists tend to look at sequential (quarter-quarter) or year-to-year changes in the CPI. The most recent sequential rise in January increased by 0.3%, and up 1.4% since a year ago. These price increases confirm the low inflation we have had since the Great Recession began in 2007.

The Purchase Pricing Index, or PPI, is similar to the CPI but measures wholesale prices from raw material through the production stages. When PPI rises, the higher costs often are passed on to consumers.

Low inflation has stymied returns from the low inflation environment from low-risk income-based investment portfolios as we discussed here..

What Contributes To Inflation?

There are various factors that may influence inflation.

Higher Demand

Demand-pull inflation occurs when total demand for goods and services in an economy outpaces supply. In the early 1970s, a strong economy caused oil prices to rise and pushed up inflation to 12% in 1974. Strong consumer demand for goods and services could result in higher spending leading to higher inflation.

Increase In Production Costs

A different way of rising prices than demand-pull can come from increases in production costs without higher demand is known as cost-push inflation. Higher production costs can come through increased wages, raw materials, depletion of natural resources, droughts, or higher taxes. Businesses are not always able to pass these higher costs onto consumers.

There have been conflicting views on whether raising the federal minimum wage to $15 per hour would cause inflation. One side of the argument points to wage hikes which have been slow to come for many employees, and therefore, increases are overdue. Wage growth often leads to a more robust economy.

However, the pandemic-related recession has caused high unemployment that has crippled many small businesses. Many believe that we should have an improved economy and higher employment before raising wages.

Natural Disaster Shortages 

Prices can rise when shortages in goods and services associated with natural disasters such as severe weather conditions, droughts, floods, fires, or avian flu. These disasters impact manufacturing plants, businesses, and residential areas. These unpredictable events may put temporary or long-term pressures on the production of goods, causing inflation due to scarcity.

In 2010, British Petroleum’s oil spill was the largest marine disaster in the Gulf of Mexico, causing higher gas and seafood prices. This area accounted for one-third of all seafood consumed in the US. About 40% of the Gulf waters needed to be closed to commercial and recreational fishing due to the spill.

Government Overspending

The US budget deficit has been rising from already high levels since the pandemic to counter the economic downturn. A government budget deficit occurs when expenses outpace revenues, not unlike the household budget.

Multiple fiscal stimulus packages related to hardships caused by the pandemic have been essential to provide funds to businesses and unemployed workers. This boost to government spending has required the US Treasury to raise capital and increase money creation by printing money. Both US Treasury and the Federal Reserve have increased money supply to increase liquidity and keep the financial markets calm, but a higher money supply typically leads to higher inflation.

Higher Prices From Higher Demand Post-Pandemic 

Many businesses lost revenues during the pandemic because of social distancing needs. As more people are vaccinated, our economy may rebound from strong demand in travel, entertainment, dining out, and going about life more normally. We may see some prices go up with increased demand and pressure to recoup lost revenues.

Different Kinds of Inflation

The various forms of inflation that are most worrisome are stagflation, deflation, and hyperinflation.

Deflation

Deflation is when there is an overall decrease in the cost of the economy’s goods and services. When price declines are minimal, consumers may spend more. When deflation is more pronounced, we may demand less, expecting more price declines. Businesses, anticipating lower spending, will cut production to prevent swelling inventories, and layoffs may result.

This deflationary scenario is considered the opposite of inflation and its evil twin. The Federal Reserve uses a 2% inflation target as part of its monetary policy, preferring low inflation to deflation. Deflation can send an economy into a recession or a worse downturn, causing layoffs.

Stagflation

Stagflation refers to a stagnant economy reflected in high unemployment and high inflation simultaneously. This problematic situation, spurred by an oil shock, lasted from the early 1970s into the early 1980s and was challenging to resolve. 

Hyperinflation

Hyperinflation has not been around for a while. The closest the US experienced hyperinflation was during the Civil War, and I think that is where everyone wants to see it, that is, in history. Between 1921 and 1923, the Weimar Republic, Germany’s government, experienced hyperinflation rising over 300%!

Relationship Between Inflation And Interest Rates

Inflation and interest rates are not the same thing, but they relate to each other. There is a tendency for interest rates and inflation to have an inverse relationship. When interest rates are low, it stimulates economic activity, and inflation rises. But, when interest rates are high, consumers slow spending, the economy slows, and inflation declines. It takes time for the economic changes to take place.  

Investing For Protection From Inflation

As an investor, you should have a better understanding of inflation so that you can protect yourself from its effects. Some investments keep better pace with rising inflation than others. Real or physical assets often appreciate at or faster than inflation, and can provide better returns for investors. It is helpful when investing to understand the economy as we discuss here.

Money Market Securities

Cash and cash-equivalent securities make poor investments in a low-yielding environment. However, when inflation rises, the annual percentage yield (APY) will increase. Seniors have been clamoring for 5% CD yields which do not currently exist. Should inflation rise to higher levels, having cash to investing in money market accounts that are FDIC-insured will be a desirable place.

Build CD Ladders

The six-month CD rate hit a high of over 17% in March 1980 when inflation was 14.8%. I don’t think anyone wants to see inflation reach those levels or expects inflation of that magnitude. However, you can build a CD ladder to take advantage of rising APYs offered by the banks and credit unions.

You can start with short-term periods such as three or six-month CDs as inflation rises, lengthening their maturities as high inflation stabilizes, locking in nice returns. CDs are a less risky way to earn higher returns, especially if inflation is over 5%.

TIPS And Other inflation-indexed Bonds

Currently, bonds at fixed rates do not yield meaningful returns. However, bonds with variable rates are worthwhile investments in rising inflationary environments.

Treasury Inflation-Protected Securities, or TIPS, are issued and backed by the full faith of the US Government. They are considered the safest security, most liquid,  and rated AAA for the highest quality. Holders receive interest income twice per year at a fixed rate. These securities are an excellent way to diversify your portfolio for the least risk among other inflation hedges.

As inflation-protected securities, TIPs provide investors with a guaranteed real rate of return. The principal of TIPS increases with inflation and decreases with deflation measured by the CPI. At maturity, you are either paid the adjusted or original principal, whichever is greater. Like all Treasury securities, TIPs are exempt from state and local taxes.

Municipal Inflation-Linked Bonds

 Like TIPS, investors can buy municipal (munis) inflation-linked securities that track CPI and adjust the bond’s principal. These securities can keep pace with inflation better than a municipal bond without this feature.

Compared to TIPS, munis do not have backing from the federal government, are less liquid, and its ratings vary by municipality.  Funding purposes are to build roads, schools, airports, or infrastructure projects. To offset its higher risks, holders of muni bonds are tax-exempt from federal income taxes.

Corporate Inflation-Linked Bonds

Corporate bonds may have inflation-linked features, similar to the other bonds, adjusting to the CPI changes to better pace with higher prices. These securities tend to have higher risks that vary by the quality of the corporation. These bonds are less liquid than Treasury securities (every investment is!) and don’t have any tax-exemption benefits for their holders like Treasuries or municipal securities.

Variable-rate bonds have floating interest rates for coupon payments. Municipal and corporate bonds may have this variable feature that is adjusted to the current money market rate for their interest rate.

Gold

Gold is an inflation hedge and offers diversification for any investment portfolio. As a physical asset, gold is in limited supply. Central banks own gold in their portfolios as part of their foreign exchange reserves.

Gold prices were up 25% in 2020, among the best-performing assets. You can buy gold in its physical form as bars or coins. Typically, gold doesn’t pay dividends. However, some gold mining stocks pay dividends (e.g., Newmont and Barrick) individually,  as gold miner ETFs or SPDR Gold Shares or GLD, the bullion is in a fund.

Silver is an inflation hedge with a lower price point, attractive for retail investors.

Commodities

Commodities are not just pork bellies. As an inflation hedge, it is a broad group with many different products you earn and store. There are three main categories:

  •  Agriculture commodities include food, meat, timber, and cotton.
  • Energy has crude oil and its refined products.
  • Metals categories are largely precious metals and industrial metals.

As the price of the commodity rises, the product that contains the commodity will likely rise. When aluminum or steel prices rise, manufacturers may pass on the higher costs to consumers.

Real Estate Investment Trust or REITs

Real estate property makes excellent investments when inflation rises, but it may require work to maintain. A REIT is a company that owns and operates income-producing real estate. There are many different REITs for equity, retail mortgage, health care or hospitals, and data storage, providing diversification for any portfolio.

They generate stable income from above-average dividend yields. That’s because REITs are required to distribute at least 90% of their taxable income to shareholders annually.

Common Stocks

Stocks, as an asset class, have historically provided returns that beat inflation. They are a sturdy investment for the 60/40 investment portfolio, with inflation-indexed bonds likely to do better when there is higher inflation.

Certain sectors may perform better than others. Energy stocks, much like the commodity itself, are often inflation hedges. Financial stocks earn better income margins on loans in times of inflation, and healthcare insurers have performed better when higher inflation appears.

We already mentioned REITs and gold stocks as a worthy area to invest in if inflation rises. Let’s add Dividend Aristocrat companies for inflation protection. They are represented by stocks that raise their dividends consistently for at least 25 consecutive years. There are different stocks in various sectors and are available as ETFs.

Another way to invest in stocks is to buy the S&P 500 index as a fund or ETF for inflation protection and diversification. If you choose to purchase stocks individually or as a sector, you may want to avoid utilities, consumer discretionary stocks, or companies with debt-laden balance sheets, like United Rentals.

Final Thoughts

Many are suggesting that higher inflation is on the horizon over the next few years. That may be as we haven’t had meaningful inflation since 1991. Higher inflation, so long as we don’t have stagflation or hyperinflation, is manageable. There are several investments that are attractive as inflation hedges for protection.

Thank you for reading! Share any comments or feedback, we would love to hear from you. Please share this post with others if you found something of value, and come join us at The Cents of Money!

 

 

Bitcoin ETF – How To Invest In Bitcoin and Other Cryptocurrencies

Bitcoin ETF – How To Invest In Bitcoin and Other Cryptocurrencies

It’s been a dismal year for the economy. But one bright spot amidst the recession has been the explosion in the value of Bitcoin and other cryptocurrencies.

Since its low in April 2020, Bitcoin is up almost 800% in less than 12 months!

So how can you take advantage of Bitcoin’s rise in the world economy? What is the best and easiest way to get exposure to cryptocurrency in your portfolio? Is there a Bitcoin ETF?

Read on for answers to all those questions and more.

Bitcoin Basics

In 2008, a person or persons using the pseudonym Satoshi Nakamoto released a whitepaper entitled “Bitcoin: A Peer-to-Peer Electronic Cash System” that described how Bitcoin would operate. Nakamoto mined the very first Bitcoin on January 3, 2009.

Bitcoin was a novel concept in that it was an entirely digital peer-to-peer currency. That means that it could facilitate payments between two people instantaneously without a third party (such as a bank) in the middle.

The Bitcoin cryptocurrency relies on a system of decentralized nodes that record all transactions on a blockchain.

A blockchain is a digital ledger of sorts that stores every transaction on the Bitcoin network. Each node keeps a copy of the same blockchain, and anyone can access and see the transactions. Because the blockchain gets duplicated thousands of times, it prevents cheating the system because each node contains all of the same information.

Bitcoin was initially conceived to take power away from banks and governments to artificially increase or decrease the supply of money and remove the need for a bank to be involved in transactions between individuals.

Per its design, there are a total of 21 million bitcoin that can be mined. After that, no more can be created. That means that supply is a known quantity, and thus demand will drive the price up or down.

Is Bitcoin a Good Investment?

Imagine you invested $1,000 in Bitcoin at the beginning of 2012. Can you guess what it would be worth today? $10,000? $100,000?Try $8 MILLION.

By comparison, $1,000 in the S&P 500 would be worth around $3,000; in the Dow Jones Industrial Average, up to $2,500.

There is much opportunity in the cryptocurrency market.

A single Bitcoin was trading at around $5 at the beginning of 2012. As of this writing, Bitcoin is hovering around $40,000 – 8000x what it was worth nine years ago. Even if you had invested $10,000 at the beginning of 2020, you’d have averaged making $200 a day since then.

What caused the enormous increase? In a few words, supply and demand. Bitcoin is a unique, innovative product that the world has never seen before. It offers a way to send money globally with virtually no cost and no intermediary, and by its design, there is a limited supply.

The Bull Case

Those who champion Bitcoin (the Bitcoin Bulls) see it as the equivalent of gold for the modern world. While gold itself doesn’t have any inherent value, other than for some industrial uses, there is a limited supply. That, coupled with the fact that most countries have moved to a fiat currency (i.e., one that is not tied to the value of gold or silver), makes gold an excellent hedge against inflation.

In the same way, Bitcoin’s value comes from it’s scarcity and the fact that as the world’s currencies become devalued by inflation and money printing, Bitcoin will hold its value. Even traditional Wall Street bankers and hedge funds are starting to see the potential.

One of the great hedge fund managers, Ray Dalio, sees its potential as a gold-like asset, calling it “one hell of an invention.” While Bitcoin’s future is still very much unclear, Mr. Dalio also admits that “Bitcoin has succeeded in crossing the line from being a highly speculative idea to something that could have value in the future.”

The Bear Case

Of course, on the other side of the coin (pun intended), Bitcoin is still relatively young. Many people have a hard time believing that an invisible asset is worth anything at all.

It is also beginning to be scrutinized by regulators and governments who see it as competition for their currencies. There is certainly the risk that it could be regulated out of existence or at least modified such that it bears no resemblance to the Bitcoin of today.

How to Invest in Bitcoin – Is There a Bitcoin ETF?

All of this leads to the big question: how can you invest in Bitcoin?

Until recently, the only way to buy Bitcoin was through specialized exchanges such as Coinbase or Gemini. You would then either keep it in an account with the exchange, which entails a not-insignificant risk of hacking and losing your Bitcoin, or transfer it into “cold storage” to a Bitcoin wallet. With this wallet, you would need a specific encryption key to access a 64 character long password of sorts.

In short, it is a reasonably clumsy process with a considerable downside risk of either hacking or losing your password and being unable to access your Bitcoin forever.

In contrast, in the traditional world of stocks and bonds, it’s pretty simple to invest in a company or an asset like gold or silver. These days there is a mutual fund or an ETF (exchange-traded fund) for almost anything. Want to add gold to your portfolio? Buy a Gold ETF, such as GLD.

Unfortunately, Bitcoin still has not reached universal acceptance by Wall Street and its regulators. Currently, in the U.S., there is no such thing as a Bitcoin ETF because it is not legally allowed.

However, many experts see it as a question of not if, given its rising popularity, but when regulators would work out the kinks to offer a full-fledged Bitcoin ETF.

A Bitcoin ETF would make it much easier for the average person to invest in cryptocurrency and open the door to broader investors’ adoption.

Benefits of a Bitcoin ETF

If you’re interested in cryptocurrencies and investing in a Bitcoin ETF, make sure you understand both the benefits and the risks of this new digital asset class.

As a relative newcomer to the financial industry, Bitcoin could be an excellent way to make extra money in your investment portfolio if you can withstand the volatility. Here are some of the benefits of a Bitcoin ETF.

1. Increased Investor Adoption

Investing in Bitcoin is not a streamlined process. Many investors may be interested in owning Bitcoin in their portfolio but are unwilling to open yet another account or dive into the specifics of holding Bitcoin in a wallet on their hard drive.

The introduction of a Bitcoin ETF would allow anyone with a brokerage account to invest in Bitcoin, which opens the doors to a much wider audience.

2. Lower Compliance Risk

Bitcoin is still in its infancy, and there is significant risk in the form of government regulations reducing its viability or outlawing it entirely.

The introduction of a Bitcoin ETF would go a long way toward legitimizing it as an asset and would force regulators to work out some of the hurdles to mainstream adoption.

3. Better Storage Solutions

The average investor does not want to mess with encrypted passwords, cold storage wallets, and other difficulties to hold Bitcoin in their portfolio.

Having an institutional investor in the form of a Bitcoin ETF manage all of this would remove the investor’s burden and provide added security and peace of mind.

Lower Transaction and Holding Fees

Currently, Bitcoin is a fragmented industry with new exchanges popping up frequently to compete with existing ones. Since they have to operate outside the efficiencies of Wall Street, fees can be high.

For example, on one of the most popular exchanges, Coinbase, fees for buying or selling Bitcoin range from 0.5% -1.5% or more. While that might not seem like a lot, at a current valuation of $40,000, buying one Bitcoin could cost you $600 in fees alone.

With a Bitcoin ETF, you would not be subject to buying or selling fees. Most ETFs charge a very low (0.1-0.25%) annual fee to manage the assets, which would bring costs down for individual investors.

Risks of a Bitcoin ETF

Investing in Bitcoin, whether as a Bitcoin ETF or owning the asset outright, also comes with significant risks. You need to understand your risk tolerance as an investor to see if Bitcoin should be a part of your portfolio or not. Even then, it would be wise to limit your allocation to a small percentage of your liquid net worth.

As there are many unknowns surrounding Bitcoin and other cryptocurrencies, they tend to exhibit extremely volatile, rising or falling in value by thousands of dollars in a single day.

1. Regulatory Risk

Bitcoin is a competitor of fiat currencies such as the dollar and the euro. There is a genuine risk that governments would want to regulate how Bitcoin is used, which would affect its value or make it outright illegal to own.

Also, the “seedy underbelly” of cryptocurrencies could lead to additional regulation.

In its earlier days, one of the prominent uses of Bitcoin was to facilitate transactions in the underground black market economy. The Silk Road was a dark web marketplace known for its illegal drug trade, among other things, and was only recently shut down.

Since Bitcoin transactions are untraceable and anonymous, it was (and still is) used in illegal trade for anything from drugs to weapons.

2. Security Risk

While Bitcoin has so far stood the test of time without any major hacking or security incidents, it’s still unknown whether the blockchain technology will hold up to future attacks.

Unlike gold, an actual tangible asset, Bitcoin is an ephemeral collection of ones and zeros on the internet. This makes tracing stolen Bitcoin all the more difficult if something were to happen.

3. Perceived Value Risk

There is still a lot of skepticism about a wholly digital, intangible currency that you can’t touch or feel. Bitcoin has value because people believe it does, and there is a demand for it.

If something were to happen that affected the asset’s demand, or people no longer believed it was a safe store of value, the price could plummet rapidly.

Best Bitcoin ETF Alternatives

While there is no true Bitcoin ETF, there continue to be innovations in the marketplace with new and easier ways to invest in Bitcoin and other cryptocurrencies.

Here are some of the best Bitcoin ETF alternatives available right now.

1. Grayscale Bitcoin Trust (GBTC)

Grayscale Bitcoin Trust is about the closest product available to a Bitcoin ETF. It trades on the market under the ticker GBTC and can be bought and sold like an ETF.

The main difference between GBTC and an actual ETF is that it is a closed-end fund. This means that it can trade at a premium or discount to the NAV (net asset value).

Historically, GBTC has traded at a 20-30% premium to NAV. So, in addition to the 2% annual fee, you could be paying $1.20 or $1.30 for each $1.00 worth of Bitcoin.

2. BlockFi

BlockFi bills itself as the “future of finance.” While it is not a bank, it offers many of the functions of a bank. You can buy and sell cryptocurrencies, hold cryptocurrencies on their platform and earn interest, and even take out a loan against the value of your Bitcoin.

You can currently earn 6% interest on your Bitcoin deposits and 8.6% on “stablecoin” deposits such as USDC. They can offer such high-interest rates because of the interest rates they charge when they loan money on the value of their deposits.

In a world of sub-1% interest rates in a “high yield” savings account, this sounds like a slam dunk deal. However, since BlockFi is not a bank, deposits are not FDIC insured. There is the possibility you could lose money if something drastic happened to the company or the price of Bitcoin.

3. Coinbase

Coinbase has been around for a while and is probably the most popular exchange to buy and sell Bitcoin and other cryptocurrencies.

While there are fees that can add up to 1-2% of the price paid, Coinbase provides a user-friendly and convenient way to buy and hold Bitcoin without dealing with encryption keys and cold storage wallets. It also provides a large assortment of other altcoins – non-Bitcoin cryptocurrencies – often hard to find.

4. Blockchain ETF

One alternative to a crypto ETF is to invest in the revolutionary technology that Bitcoin is based on – the blockchain.

Many companies are working on various uses for blockchain, from banking to public record storage.

A blockchain ETF such as BLOK would allow you to invest in the future of the underlying technology.

Bitcoin ETF:  Final Thoughts

Is there a Bitcoin ETF? That is one of the most-searched terms in the world of Bitcoin. While the answer to that is currently “no,” there are encouraging signs that may soon change.

In the meantime, many innovations are making it easier to buy, sell, and hold Bitcoin and other cryptocurrencies as an investment.

As long as you do your due diligence and understand the risks, investing in Bitcoin (even before the advent of a Bitcoin ETF) is not only possible but could be a worthwhile investment for your future.

Thank you for reading! Please visit us The Cents of Money for articles of interest, including A Letter To Young Investors During The Market Frenzy.

This article originally appeared on Your Money Geek and has been republished with permission.

7 Deadly Sins Of Investing And How To Avoid Them

7 Deadly Sins Of Investing And How To Avoid Them

In Seven, the neo-noir thriller, detectives David Mills and William Somerset (played by Brad Pitt and Morgan Freeman) track down a serial killer who uses the seven deadly sins as a motif in his murders. Investing may not be as lethal as a serial murderer. Here, we discuss the seven deadly sins of investing,  how they may impact our stock performance through destructive mistakes, and how we can avoid them.

What Is Investing?

Investing is a way to potentially grow the amount of money you have. The goal of making investments is to buy financial securities and hopefully sell them at a higher price in the future than what you initially paid. A saver can become an investor by giving your money a chance to work for you.

Investing is the best path to achieve wealth but it’s not a straight road. Unlike saving, investing involve some risks that could cause you to lose money.  You need to understand these hazards so you may be able to mitigate them. Investors purchase stocks and bonds with long term goals, unlike traders who have short term plans.

We can lose money when investing leads to emotional behavior or bad habits. Start investing as early as you can so you can earn money on top of the money you already earned, called compounding returns. Stay focused and purposeful so you can avoid behavioral biases which often play a detrimental role. Using financial discipline when investing can help you to achieve success

The seven deadly sins passed down from the Catholic Church of the Middle Ages may cause investors to perform poorly as modern examples for each deadly sin. The seven deadly sins are lust, gluttony, greed, sloth, wrath, envy, and pride.

1. Lust

When thinking of this deadly sin, I can’t help thinking about Jordan Belfort, better known as The Wolf of Wall Street. Belfort, or what we see of him, nearly defines every deadly sin. For that reason, he and the movie based on his memoir is pure entertainment and instructive for those who lust after sex and money.

As the first deadly sin, lust is a strong craving or intense longing such as sexual desire. It can also mean hunger for money. From an investor’s point of view, falling in love with your investments can be hazardous. Heavily favoring one stock may result in too much concentration risk in your portfolio.

Overexposure To One Stock Poses Concentration Risk

Take the example of Gur Huberman’s “Familiarity Breeds Investment” study in 2001, which involves ATT’s (“Ma Bell”)1984 breakup. When ATT split into the 7 Baby Bells, its shareholders received equal amounts in each new company.

Huberman found investors tended to retain a disproportionate amount of shares in their local Bell company. These individual investors held as much as $10K-$20K of a single stock, a higher concentration than the typical stock holding in a US household’s net worth.

Overexposure to one stock poses more significant risks to your portfolio that can sneak on you from slowing fundamentals. Investing in the company you work for is common for many people. However, if you have substantial ownership of shares where you work for and in your investment and retirement accounts, you have too many eggs in one basket. Instead, you need to diversify your portfolio with different stocks, industries, and asset classes.

2. Gluttony

Gluttony is the overconsumption of eating and drinking. We have all been there, gorging ourselves over an excellent meal, and feel our regrets afterward. Dante refers to this sin as “excessive love of pleasure.” We may be engaging in gluttony by overindulging our funds into less liquid investments without leaving a cash balance to buy stocks in a correction or pay off debt.

The recent excessive trading of GameStop shares by retail traders to shake up Wall Street seemed to be foolhardy, if not reckless. Sending that stock into the stratosphere caught everyone’s attention before coming back to earth but may have been costly.

Diversification, Asset Allocation, and Rebalancing

Alternatively, some people hoard their cash in a savings account, which generates little interest income, especially in this low rate environment. Investors need to be careful in allocating money into investments and having funds for emergencies, debt pay-offs, and retirement.

The antidote to gluttony is purposefully investing with strategies that embrace diversification, asset allocation, and periodic rebalancing.

3. Greed

“My name is Jordan Belfort. The year I turned 26, I made 49 million dollars, which really pissed me off because it was three million a week.”

The Wolf of Wall Street

“Greed is good…Greed, in all its forms, greed for life, for money, for love, knowledge, has marked the upward surge in mankind and greed.”

Gordon Gekko, Wall Street, the movie

Greed is not good, but it is very prevalent in the world of investing. The Wall Street (“the Street”) culture is all-consuming. It breeds greed and the need to make more than the person next to you. Not everyone working on the Street is greedy, or a criminal but temptations are there as they are everywhere.

The definition of greed as a sin is an intense and selfish desire for something of value, referring to wealth, material possessions, power, or food. Trendy investments are often collective greed that may become long term losers. Stock manias reflect “irrational exuberance,” a phrase used by then-Federal Reserve Chair Alan Greenspan when he commented on stock’s higher asset values than fundamentals warrant.

Bubble manias of the past–Dutch tulips, South Sea, Japan’s real estate and stocks, dot-coms, housing– should provide historical context to fear and greed in today’s markets. We hear about overbought markets but justify our purchases in SPACs, bitcoin, Tesla, Nio, so we aren’t left out of some of the apparent winners.

Lock-In Some Profits

How can we better deal with our greed, so we don’t become a casualty of fickle markets? No one gets hurt taking some profits off the table. I sell a small percentage of my gains regularly, usually, after a stock rises 20%-25%. This way, I may avoid my winners blowing up, an experience I have in my past.

Recognizing the need to be rational when investing is essential. It means doing your research, or if you feel you don’t have the time, are too emotional, or don’t have the inclination, you may be better off finding a financial professional to advise you in your best interests.

Take heed from another respected investor, Warren Buffett, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” There is a Fear and Greed Index (FGI) that measures investor sentiment for those opposing emotions daily, weekly, monthly, and annually. Too much fear can send stocks down, while greed indication may push stocks up.

4. Sloth

Why do they have to pick on this cute animal known for moving slowly and spending most of its time upside down in trees? As a deadly sin, sloth translates to an absence of interest or not exerting oneself physically or mentally. Said another way, it is the avoidance of hard work and perseverance, or simply laziness.

We can usually spot sloths who are lazy about physical exercise. However, investing requires cognition or understanding of what you are doing with your money. 

Laziness can hurt you when you are jumping into stocks without rhyme or reason. A slothful investor may under-invest or spend too little time reviewing one’s portfolio. Investing is not a “set it and forget it” activity. Investors may mistake the buy and hold strategy as akin to that. The buy and hold strategy means that you have a long-term perspective, but you need to adjust your portfolio for new or changing information.

Be Aware of Biases At Work

Making investments requires research. Even if you are planning to use a financial advisor, research is necessary. You still need to find a person or team that works to understand your financial goals to work with you on your financial plan.

Slothful people may be prone to procrastinate over making decisions. The status quo bias occurs when someone may be resistant to change. The endowment effect is similar, but it occurs when someone places a higher value on what they already have. Shortly after my parents passed away,  I inherited stocks, such as ATT and IBM, conservative names appropriate for their portfolio but not necessarily mine. Yet, I held on to their stock picks as an example of an emotional bond that was irrational.

How To Avoid A Slothful Nature?

If you intend to monitor your portfolio, recognize the need to be proactive in having diversification, taking some profits, and making adjustments as warranted based on changing company fundamentals. There are many different kinds of low-cost index funds that have other purposes of fitting your investment strategies. For example, you may look at target-date index funds that may appropriately adjust holdings based on your age.

Automation

You can automate your paycheck by allocating a certain amount or percentage to go into retirement savings, so you don’t have to remember to contribute to this account regularly. It is essential to use your paycheck to make it easy to make investments, save money, and pay bills.

Consider talking to a financial planner to help you with your financial goals and make investments for you.

5. Wrath

“Heeere’s Johnny!”

Jack Torrance, off-season caretaker in The Shining

There are many images of wrath, but Jack Nicholson’s character comes to mind. Wrath is defined as uncontrolled feelings of anger, rage, vengeful, and even hatred. Jim Cramer’s very rational rant in 2007 (and transcript) as the financial crisis was unfolding, but the Fed Chair was not yet cutting the fed funds rate or adding liquidity to the markets.

When the stock market becomes volatile as it did during 2007-2009 and in March 2020, we have wrathful states that pose dangers for any investor. We become angry at bad decisions for keeping stocks too long or selling them too fast as many jumped to do as the stocks sold off in March in the shortest bear market in memory.

GameStop As An Example of Irrational Buying

Retail traders who may lack experience may seek greater risk than they can handle and make irrational buying decisions.  We saw some recklessness as buyers were bidding GameStop shares up to crazy prices beyond their poor fundamentals.

It seemed as though traders were trying to punish short-sellers such as hedge funds by engaging in combat. Stories of young investors who took out costly loans to buy shares at exorbitant prices are heartbreaking. We wrote a letter to young investors you can read here.

Studies suggest that anger may increase our risk-taking. Don’t be reckless and engage in using leverage like margin trading.

Avoid anger and other emotions when making investments. The market doesn’t hold grudges, know how to be vindictive, or have a memory from day-to-day.  Investors need to make adjustments for changing circumstances.

Learn From Mistakes And Use Discipline

Learn from your mistakes to not sell as the market is plummeting unless you need liquidity. Stay rational by not impulsively trading or investing. Give yourself some discipline by selling a losing stock after it drops 7%-8% to avoid a more significant loss. Consider taking some profits off the table to lock in those gains.

6. Envy

Have you ever felt envious? Of course, you have. Envy is a feeling of resentful longing often brought on by someone else’s possessions, better standing, or luck. Envy often leads to conspicuous consumption to match those around them at work or in the neighborhood. The phrase “keeping up with the Jones” may mean buying a new car or a boat to fit in with other people around you.

Investing circles may envy those who are “killing in the market” when they share their wins in the most trendy stocks or funds. What they may not be telling you is about the mistakes they have made in the past. At one time, people envied Bernie Madoff’s clients for above-average returns, and we know how that movie ended.

Herd Mentality Bias

Merrill Lynch may still refer to its financial advisors as its “thundering herd,” but following or copying the herd is a negative sentiment. In behavioral finance, herd mentality bias refers to the investors’ tendency to follow what other investors are doing in the market.

Think of dot-coms, GameStop, or popular acronyms for groups of stocks such as “FAANG,” standing for Facebook, Amazon, Apple, Netflix, and Google, before it changed its name to Alphabet.

It is not always the wrong move for individual investors to buy rising stocks that reflect heavy trading volume. Sometimes that is a healthy indicator of institutional buying, and it is painful to go against the smart money crowd. However, it will financially hurt when large investors start shedding stocks in their portfolios.

Don’t Chase Hot IPOs

Individual investors, who typically do not have access to new issues, often seek the hot IPOs after pricing in the primary market. The average first-day pop in the post-IPO stock is 20%, but hot names have shot up 80%-100% or more. Six months later, many of these stocks have fallen below their IPO price as the aura on these stocks is gone, a casualty to weaker fundamentals than expected.

Instead of being envious, learn about investing, risks, and develop strategies that work for you. Remember that Madoff’s returns were fictitious. It is in our nature to compare ourselves with others. However, you cannot be sure that you are looking at anyone’s full picture. Don’t waste your energy on envy.

7. Pride

“Details of your incompetence do not interest me.”

Miranda Priestly, The Devil Wears Prada

Pride or extreme pride is hubris, a Greek cousin to pride. Hubris means self-confidence, arrogance, and corrupt selfishness. One who has hubris irrationally believes they are better, superior and has excessive admiration of their self-image. Having this kind of pride is a self-destructive vice, especially harmful when you are an investor.

It is hard to work for someone like Meryl Streep’s Miranda Priestly, who always desires to be right. As an investor, the need to be right can hurt your ability to make money.

You may hold on to a losing stock and an unrealized loss rather than admit you are wrong. The justification for holding on to the stock is that it is only a loss on paper until you sell it. However, a 10% unrealized loss can widen if fundamentals warrant it. Loss aversion bias is the tendency to prefer avoiding losses to acquiring gains.

Overconfidence Bias

Another bias is overconfidence, which means having an egotistical belief in your investing acumen. It is challenging to perform better than the market averages, but those who are overconfident tend to operate with the false comfort they can perform well.

Instead, having a fear of being wrong in many investing situations can help you stay on your toes. The best investors avoid overconfidence and consider worst-case scenarios as medicine to remain aware of downsides in the market. They recognize that there is much that you cannot control about the market.

Avoiding The 7 Deadly Sins With These Investing Rules

To recap some of the ways you can avoid the investing pitfalls associated with the seven deadly sins:

Avoid concentration risk by diversifying your portfolio and do asset rebalancing.

Be aware of the emotions and behavioral biases that impact our decisions.

Don’t dump stocks during times of market turbulence.

Buying hot IPOs post-pricing is not a good idea, as there will be a better time and price to do so. 

No one gets hurt taking profits off the table to lock in gains.

Don’t engage in reckless strategies such as short-selling or using leverage to buy stocks.

Use automation to move money more quickly from your paycheck to contribute to your savings, retirement, and investment.

 

Final Thoughts

When investing, you may have run into the seven deadly sins that can impact your performance. Counter each sin, often wrapped in emotion or biases, with purposeful investing to avoid common mistakes.

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