Money Talk

Episode 47

Asset Volatility

Some people are just better off not paying attention. Our guest bought two Iowa farms … and never saw either one of them. It’s like saying you never saw your child. Don’t fall in love with the farm. Don’t fall in love with Apple. Nobody’s saying that you must own stocks, but if you do, you’ve got to make your own decisions.

Welcome to our listener-supported podcast Money Talk. Uncompromised Absolute Financial Truths behind Financial Perceptions with hosts Ed Sutkowski and Chuck LeFebvre. Let’s listen in.

Chuck: This is Chuck.

Ed: I’m Ed.

Chuck: This is Money Talk.

Ed: Today we’re going to visit about asset volatility.

Chuck: I already know the solution.

Ed: What’s the solution?

Chuck: Close your eyes. Just don’t pay attention. I heard a story. This is many years ago. It was actually in the time of this 2007-2008 financial crisis. This person was talking about a conversation that she had with her, it wasn’t really her paid financial advisor, but it was her friend who helps her. She didn’t really have a financial advisor, but she had a friend who would help her sort of like pick out what to put in her retirement plan, which mutual funds to buy, or whatever. She was all upset with him because she opened up her statement and she said, “I open up this statement and I’m looking at all of this red ink on here. I lost all this money. I’m concerned that these investments that I picked because you thought they’d be good for me, are the wrong investments.” He said, “Well, okay, let’s recap a little bit now. Has anything changed in your health?” “Well, no.” “Is your target retirement day any different now than it was the last time we spoke?” “Well, no.” “You’re not at risk of getting fired or anything?” “No.” “Well, I think the problem that we have is not an investment selection problem is a frequency of statement generation problem.”

Ed: That’s right.

Chuck: Ed, there’s real truth to that. I know you like to look at this stuff all the time, but you have the constitution to be able to look at it with perspective, which that’s what today we’re going to maybe help other people gain. For some people, they’re just better off not paying attention.

Ed: Well, it’s really a function of the percentage that asset occupies of your entire net worth. For example, I know some folks have more than $100 million. Well, we know by operation of the exclusion amounts for fed and state. Round numbers, if you have more than $25 million, 40%, it’s going to go to the government some time.

Chuck: Right.

Ed: Unless you do some charitable gifts and lifetime, you do all kinds of things with tools that we use all the time. Some are hammers, some are knives, but we’ve got tools to solve that problem. When you’re looking at an individual where if you are an individual with $100 million, and you know that everything over 25 is at 40%, so what’s my risk-reward on this excess? I can be a little more aggressive than the average duck.

Chuck: True.

Ed: That gets to the qualitative nature of your perspective. Are you a person that’s got to trade every day? Do you have to clean your car twice a day? If that’s the kind of person you are well, maybe you should be going to the river boats and gambling. This may not be the avenue for you.

Chuck: Right.

Ed: Asset volatility, it’s a function in my world, largely of interest rates. Challenge me on that. I’m thinking of a private equity investment. If this private equity organization is to buy a business, the price to be paid for that business is a function, in large part, of the interest rate. Part of it is going to be equity. Part of it’s going to be a debt.

Chuck: Right.

Ed: The lower the rate, the greater the value. Conversely, the higher the rate, the less the value. If you’re capitalizing an income stream, a cash stream from a building, it’s $100,000. You’re going to capitalize that what? 10% or at 5%, and you find out what the present value is. You’ve got to think about what is the cash being generated from this investment, whether it’s stocks, whether it’s bonds, apartments, private equity. Whatever you’re doing, the bottom line is how much is being generated in the form of cash.

Chuck: Right. Dividends.

Ed: Interest

Chuck: Dividends, interest, cash flow.

Ed: You’re right. I know a fellow that has a 32 or 36, I don’t know, apartment building. Let’s say 32 units of the cash flow is the measure value. The brokers, “Look, well, it’s so much a unit.” What are you talking about? I am sorry. This is not talking to the client. This client is not valuing this on the number of units. It’s the cash!

Chuck: Right.

Ed: Do you get that? Well, we don’t want to talk about that. Why? Because that means we’re not going to sell it because it’s such a good cash flow animal.

Chuck: Right. Right. If you think of it as a black box, anything could be inside that box, but a certain amount of money comes out.

Ed: Right.

Chuck: Then the amount of money that comes out, you compare that to really prevailing interest rate. That tells you how much value to put on that black box in very simple terms.

Ed: You also look at, in the case of apartments or commercial real estate, which is a whole another sector. I’m not sure I would have the patience to invest in commercial real estates without knowledge. Matter of fact, I am sure I don’t have the knowledge. The only problem is I’m getting to realize, I don’t know much about anything.

You look at capitalizing the rate on any investment, a bank stock that’s selected to be taxed under Subchapter S, How much are the distributions? That’s the value.

Chuck: Right.

Ed: I don’t care what someone tells me the value is by using all this data, I’m talking about cash.

Chuck: Yes.

Ed: Then cash is return on your cost basis.

Chuck: Yes.

Ed: That’s the key. What is your investment return on which you paid for the asset?

Chuck: So, the longer you’ve held it, the lower cost basis is, the more valuable it is to you to hold.

Ed: Why would you sell?

Chuck: Yes. So, there’s a step in the logic there that probably is worth articulating, which is that if you have a low basis in this investment, then getting out of it is more expensive because that means selling it, which in turn means paying tax on the gain.

Ed: Right.

Chuck: That’s what’s really driving you. Not because there’s an emotional attachment, but because there’s an actual transaction cost associated with getting out of that particular investment.

Ed: You got to measure that, and you cannot fall in love with a stock because you had coffee there.

Chuck: Right.

Ed:  Or you’d shop at Walgreens.

Chuck: What if your cost basis is above the current value of the–?

Ed: Well, then you look at your other stocks and say, “Well, do I have some stocks here that I really would like to get rid of, but not performing, Walmart, for example?” On my analysis, we talked about one of the prior times, Walmart return on a one-year basis was 9%, three years was 53%, and five years 126%, versus Apple, which is 425. Maybe I want to unload some of Walmart. I’ll take a look at my cost basis and say, “Okay. If I’ve got a nice cost basis on the profit in this one group of shares of this stock, and I’ve got this loss on the others, ah, okay, I’ll sell both. ”

Chuck: Right.

Ed: Apply the loss against the gain and go on my way.

Chuck: Right.

Ed: Pocket the cash and see what else I want to do. You do look at your portfolio. I’m sure I look at portfolios of other folks and I don’t do investing, but point of interest is, “What’s going on here? Why is this happening?” Really, the issue is qualitative. How does this fit for you and what should you do?

Chuck: You know, this process you just described, there’s an opportunity for people to do that. When they decide they’re going to take over their own investing on an account that has been managed by an advisor or who would– they’ve just been buying whatever the advisor has recommended for years and years and years. Then suddenly you look at this thing and there’s 150 different positions in this account. Some of them are underwater. Some of them are currently, the basis is higher than the current value. Whenever I see that, one of the things is just, “You don’t want 150; you just want to clean it up.”

Ed: How can you trade?

Chuck: I would just say the starting point there is, you sell everything that is currently trading at a loss so that you’ve got a long-term loss. Then how many of these other positions can you get rid of just to clean things up? Then you have instead of 150– We’ve literally stepped people through this before, where you start out with 150 positions and you get done going through this process and now, you’re down to 50, which is still an awful lot.

Ed: A recent history within the last 10 working days, we are involved in and you filed an estate tax return that showed how many different issues? I want to say 150.

Chuck: That was about there.

Ed: With stocks of Boeing at 200, five shares of Boeing. What is going on here?

Chuck: Right.

Ed: What is the theory? Is there a theory?

Chuck: Oh yes. Some of these are just completely scattershot. Just people understand, there’s nothing wrong with broad diversification, but there’s such a simple mechanism for doing that which is to buy an ETF. Just by the universe.

Ed: Buy an index fund.

Chuck: Yes. Just buy an index fund or an ETF, and then you’ve got the entire stock market. That’s great. In fact, that’s sort of the starting point is get some kind of an index so that you’re broadly invested in the market. Then these individual holdings should be a list that you can understand if there’s any at all.

Ed: Fewer than 10.

Chuck: There’s nothing wrong with that number being zero.

Ed: That’s right. Your S&P over the five-year period is 92%. Three-year period almost 60 in one year. In one year, these are all as of March 25, only 16%, but still, the point is, what is your comfort level?

Chuck: Right.

Ed: What is your genetic makeup for risk and reward?

Chuck: There’s a real practical aspect to this, which is that you touched on it before, which is that the more these investment accounts have the look or the feel to you personally as a game. It’s not going to devastate you if the values go down, the easier it is for you to ride out these waves when the market is volatile, and you see these values go down. Of course, the irony there is that in order to get to that state, in order to get to the point where it’s very easy to not be stressed out when this volatility comes your way, is to early in life, and early in your career, to invest aggressively. Right? So that the nest egg has grown. So that by the time you’re older, and it’s closer to retirement age, and you’re starting to look at this as, “Oh, wow, someday I’m going to be living off of this” It’s robust enough that it’s easy to be rather blithe about the fact, “Oh, today the market went down.”

Ed: So, what?

Chuck: It’s going to recover again. This isn’t going to be the end of the world for me.

Ed: If it doesn’t recover, so what? The problem that I hear, “Oh, is this is going to happen. It’s a wholesale. The end of the world depression. Everyone’s going to be wiped out.” My response is, “So what?” I don’t think it’s going to happen.

Chuck: Right.

Ed: But fortunately, this would be recorded in hundreds of years from now after the world has ended. They’re going to say that “Ed, doesn’t know whatever he’s talking about because the world did end.”

Chuck: Right.

Ed: I have a little more confidence in capitalism and our society to think that notwithstanding the ups and downs, these stocks are going to be good ones.

Chuck: Well, there’s historical precedence for that. The market always recovers. It always has recovered including some pretty serious body blows that are far more significant than anything we’re really even anticipating having to deal with anytime in the next foreseeable few years here. The people who really get harmed are the people who do get scared. After the values have dropped, they say, “Oh my gosh, I need to move everything to cash.” Now you’ve just locked in your losses when you do that.

Ed: Chuck, you don’t know how correct you are. I received a call from the president of the bank, so bright. This guy is off the charts academically, which by the way, in itself is a danger.

Chuck: Right.

Ed: You see too many problems.

Chuck: Right.

Ed:  But any event, he said, “Ed, I lost X thousands of dollars.” I said, “Oh, so you sold the stock?” “Well, no.” The thinking is there’s reds in my monthly report, but you haven’t lost anything until you sell it.

Chuck: Right.

Ed: What are you worried about?

Chuck: Right, well, again, that comes down to this comment about there being a frequency of statement generation problem

Ed: That’s right.

Chuck:  Because folks like that will often say, they’ll turn to something like farmland and they’ll say, “I’m going to invest in farmland because it’s more stable.” “Well, we don’t actually know that. It’s just that you’re not getting a statement every month.”

Ed: Right. I will tell you since you touched on the topic of farmland has done as well if not better depending on the purchase date and holding period as the stock market.

Chuck: Oh yes.

Ed: You really understand, you have to know what you’re doing investing in farmland.

Chuck: Right.

Ed: Although I have to tell you a personal story. I don’t know how many years ago. For some reason, I was borrowing money, which is the nature of the game. You always borrow money. People are willing to loan it. Banks, they won’t loan till you borrow it. I was in our building and the bank office was located on the ground floor. Their farm advisor said, “Ed, these Iowa farms are really good ones.” I said, ” I’m from the south side of Chicago. I don’t know anything about farms.” He said, “Oh, they’re good ones. I’ll manage it for you.” I said, “Fine.” I went downstairs, talked to the commercial owner. I said, “I need to borrow X dollars to have a down payment on this contract for these two Iowa farms.” He said, “Well, why you are buying these farms?” I said, “Well, your farm advisor there said these are good.” “Oh, okay.” They made the loan. I sold them I don’t know how many years later, how long years. I never saw the farms. I never saw either farm.

Chuck: Right.

Ed: The point is don’t fall in love with the farm.

Chuck: Right.

Ed: Don’t fall in love with Apple, with Walgreens.

Chuck: You’re making more and more enemies every time you open your mouth.

Ed: I know they’re all coming to the gravesite to make sure that I’m there. No, but the point is–

Chuck: When you say, “Don’t fall in love with the farms,” those are fighting words for some people.

Ed: I respect that.

Chuck: Right.

Ed: You talk to a farmer that’s got X thousands of acres. Let it go out there and I walk around, and I can see my farmland.

Chuck: Right. I think it’s very different for the guy who’s actually farming the ground versus you as the investor.

Ed: Oh yes. These farmers are fantastic human beings by the way.

Chuck: Oh, yea.

Ed: I could have a practice with nothing but farmers that would be my favorite

Chuck: Right.

Ed: Everything about them. On the other hand, it’s a different mindset.

Chuck: Right.

Ed: It really is. The theory is they’re not worried about asset growth, the dividend ratios, rankings, it’s “That’s my farm.”

Chuck: Right.

Ed: When I’ve told several other farmer clients that story that I never saw the farms, they said, “You what?”

Chuck: Gosh. Yea.

Ed: It was a mortal sin.

Chuck: Yea. It’s like saying you never saw your child.

Ed: I said no, but it’s a whole different. Chuck, I want to talk about, I’ll call it “Skin in the Game,” which happens to be my favorite topic. Looking at an investment, whether it’s farms, whether it’s stocks, bonds, or whatever, if someone’s suggesting this is a good investment, the question is, “Well, how much of it did you own? Do you own?

Chuck: Right.

Ed: Tell me your gain?” If you get no answer, don’t buy it.

Chuck: Right.

Ed: I was looking at some spreadsheets that my assistant Loretta put together here on the director ownership of a company of shares. I’ll give you some numbers. One gentleman who’s on this board for 12 years and he has under 2,000 shares. There are two individuals, one female is on the board for three years owns no shares, but to get all the perks as a director. Also, another lady under 2,000 shares. The greatest number of shares outright are owned by a gentleman who was the president and ran it. I don’t get it. Then you convert that to dollars, and you’ll see what portion of the shares were purchased with cash of the director generally from other sources. Then I looked at the officer ownership of shares and also you converted to dollars. I must tell you I made a decision, “I don’t think anyone should buy that stock. The officer didn’t have enough their own money in the game.”

Chuck: That’s very strange for a publicly traded company.

Ed: Yes. The idea if you have the patience to go through the proxy statements and look at that yourself, that’s a different issue than what we’re– I think it’s the same or what percentage of the stock is owned by a group of people. Are they directors? Are they officers? Do they really have something at stake?

Chuck: Well, the other thing is that when one of those officers or directors buys that stock, they should, you can assume at least that they’re buying it to hold.

Ed: Right.

Chuck: Right. People really start paying attention if an officer or a director starts selling stock. They’re fairly careful when they’re sitting on the Board of Directors or if they’re one of these reporting officers for a publicly traded company. They’re fairly careful about not buying stock with the intention of selling it, because they know that when they sell it, it gets reported, and people start paying attention. They just have to be careful about that. If they’re not owning it, it means, maybe they’d be willing to dabble in it, but they don’t really think of it as long-term.

Ed: If a director doesn’t own shares in the– have been there, they own no shares, that’s a sign.

Chuck: Yes.

Ed: That’s a sign. I shouldn’t say that’s the only sign because there are exceptions. The founder of the company’s got all these shares. Well, he’s going to bail here, or she’s going to bail them out periodically to reduce the holdings because the market is not going to absorb all those shares in one day.

Chuck: Right.

Ed: The point is, this is just something to be considered. Return on invested capital, cost basis, share ownership, direct or outright, and how does that compare with other investments? If this turns out to be less than a game for you, you shouldn’t do it. This has got to be a game. This has got to be fun. Yes, you’ve got to be careful, but understand the qualitative side. Are you in a position to assume this risk? If not, don’t do it.

Chuck: Right.

Ed: No one’s saying that you must own stocks, that you must own apartments, must own farms. There’s nothing wrong with having no assets. Matter of fact, some of the happiest people I know are those that are not worried about this sort of thing.

Chuck: Right.

Ed: But, if you happen to have inherited or hopefully earn some of these assets, you got to pay attention, but you’ve got to make the decision by yourself!

Chuck: I agree with that.

Ed: Self-realization. If you don’t make the decision, it’s the wrong decision. I’m overstating it, but that happens to be my view of the world. You got to make a point. Sometimes you have to take a ball back out, a bat ball out to hit someone over the head.

Chuck: We had like five baseball analogies all mixed up into one there?

Ed: Yes, that’s right.

Chuck: Metaphors, I guess.

Ed: By the way, I was a horrible baseball player. The point is it’s competition, but it must be with you.

Chuck: Right.

Ed: You’ve got to make decision. If it’s a bad decision and you’ve made it that’s okay.

Chuck: Right.

Ed: But, if Peter told you to invest in it and it went south, that Peter is a jerk!

Chuck: Right.

Ed: It’s a wonderful world and I think we enjoy the process, Chuck.

Chuck: Oh, yes. I do.

Ed: It is the destination, is the process, and if you’re not having fun, I’ve said, “Go sell shoes, better yet, go run a Dairy Queen.” By the way, Berkshire Hathaway owns the Dairy Queen estate.

Chuck: I saw it.

Ed: Why would Warren Buffet, he drinks what? Five Cokes a day, owns a Dairy Queen

Chuck: Right.

Ed: And his view of the world is, “The key to success is living longer and compound interest.” There’s something to that.

Chuck: That’s actually a very good way of crystallizing exactly the point. Now you can’t necessarily control how long you live, but you can control when you start getting into the game, right?

Ed: Yes. The sooner that you start investing, the better off you’re going to be because it then becomes fun.

Chuck: Right.

Ed: This isn’t like getting your teeth cleaned. It is actually fun. Picking up the Journal and saying, “Oh, something happened to Amazon. Something happened to Alphabet.” Now, that’s fun.

Chuck: Right.

Ed: We’ll see what’s going on. It’s a game and again, the destination is the journey. We lose sight of that; we lose a view of life that’s very important.

Chuck: True.

Ed: We’ll sign off and next time.

Thank you for listening to Money Talk. Please, join us again and do check out our previous Money Talk topics.

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