The Wealthy Accountant gave away money this week! On Wednesday I set the random number generator a spinning and in a nanosecond a subscriber was $100 richer.

Sara N of Buffalo, NY was our winner. I give a choice of a PayPal transfer or an Amazon gift card. Sara asked for the gift card and Amazon emailed the code straight to Sara. Congratulations, Sara! Thank you for subscribing.

If you didn’t win this drawing there are plenty more. The dates and terms are published on the Where Am I calendar. There are two drawings for three winners in February. I never recommend the lottery, but if you get a ticket for free, why not!

 

I poked the hornets this week and ran like hell to no avail. I was stung. I made the mistake of mentioning on Facebook I moved to my highest cash position of my adult life in late January. Then the market introduced some reality this week.

Of course, if you call for a bitcoin decline and then it happens and do the same for the stock market you qualify as a guru. On the farm we call it being luckier than a two peckered Billy goat.

Before anyone starts to bow, please reference Elaine Garzarelli. She is the kind lady who accurately called the market crash of 1987 and hasn’t made many accurate calls since. A few, but not many.

My reasoning for the cash position is simple; I no longer understand how the market can go higher. Yesterday’s post explains my reasoning in more detail.

And now I’m getting lots of questions on how I think people should invest. Nothing has changed, kind readers!!! Steady as she goes.

Keep filling retirement accounts to the max. Stop watching market news if it bothers you or freaks you out. And for the love of God, DON’T SELL BECAUSE YOU ARE SCARED BECAUSE THE MARKET IS DOWN!!!

For readers with large net worth’s, consider moving some percentage of your portfolio to cash. Locking in a gain isn’t a crime, especially when the gains in the last decade exceed 400%.

I’m at 52% cash and my cash balance will not go higher. I’m willing to forgo future gains at this point. This level of cash is still a six figure income even with the low money market rates. I’m in no danger of starvation! (Though I have been looking a bit pale lately.)

Where will the market go from here? people are asking. How would I know? I’m just a country accountant from the backwoods of Nowhere, Wisconsin. But since you asked . . .

There tends to be a repeating pattern when the market gets carried away (goes parabolic). Without belaboring all the details, it seems to this accountant we are headed for a market crash. The tax cuts will overstimulate the economy, cause inflation (read yesterday’s post again), interest rates will rise and the market will catch a case of the hives.

This said, DON’T TRY TO TRADE AROUND THIS MARKET!!! If you do, I will find you and kick you in the . . .

The “crash” pattern usually starts with the warning shot across the bow as we had this last week. There generally is some type of recovery as the last buyers (the general public, aka the weaker hands) push in. New highs are not reached and the decline renews, accelerating until massive fear sets in and people rush the exits faster than they greedily wanted in.

If you have cash sitting around, I recommend casually buying when you see blood in the streets. When the crowd is in full panic mode start loading up on those index funds!

As your portfolio grows you might want pretty charts and data on your growing stash. PERSONAL CAPITAL is a program perfect for monitoring your net worth. You can’t control what you don’t know so it’s a good idea to have a firm understanding where you stand financially.

‘nough said about the markets. Time for some FUN!

 

What I’m Reading

This is the second book I’ve read in the last few months involving climate change and extinction. Chris D. Thomas did an excellent job of discussing the facts in our modern world as it relates to extinction of species. Inheritors of the Earth: How Nature is Thriving in an Age of Extinction set my heart at ease. All the Chicken Littles screaming something about the sky falling are way off base! Yes, species are going extinct, but diversity is increasing at an incredible rate, a rate even faster than the extinction rate. A highly recommended read.

 

What I’m Watching

There was plenty of cool stuff I saw when reviewing my YouTube history. The first was this short video from the Mars Curiosity Explorer showing a panoramic of everywhere the explorer traveled.

 

Here is an interesting video on the farthest look our species has ever looked into space. Fascinating.

 

Finally, a money nerd like me couldn’t go a week without falling prey to a money video on how the Federal Reserve works.

 

What I’m Listening to

Here is an oldie that rocked my office as I plugged numbers. It’s a catchy tune. If you remember when this song was all the rage, you’ve been dated.

 

Have an awesome weekend, kind readers!!!

Be good.

See y’all Monday!

Crying over spilled milk is an adage most of us first heard at a young age. Minor inconveniences are blown out of proportion when they happen. Eventually someone says you should stop crying over spilled milk

We’re living a spilled milk event as I write. The stock market and the economy have been growing steadily for about eight years now. Constant media covered convinced a large percentage of the population things were dire. We were scared shi+less and tucked our hard-earned money in the mattress. There was no way you would be tricked into investing in a bad economy.

The years kept rolling by as the economy ticked ever higher with the stock market in tow. You not only kept your powder dry, you spent a large portion of it (a 100% loss) and kept the rest in a 0%, or nearly so, bank deposit.

Now the media says everything is good news. The economy and stock market have bent heavy to the left as it heads for the stars.

Tax cuts will stimulate an economy at or near full employment. Things have got to be good. They have to be!

You missed the bitcoin craze, but you refuse to be left behind again. This is it! You’re going to do it. You’re going to jump into this high flying market for your share of the bounty even if you have to borrow to do it.

The Road Well Traveled

You might not believe it, but I’ve seen this storyline play out before. The last time we saw tax cuts of this size the DJIA was under 800 (that is NOT a typo). The year was 1981. Inflation and unemployment were both double digits and draconian measures were needed as the economy was heading into the back leg of a double recession.

By 1987 the party was in full swing before a sunny day in October refocused attention on reality. In a few years the market was at new highs again and all was good.

The dotcom bubble — like the Nifty Fifty of the early 1970s — promised a brave new world of ever increasing profits. Then the century turned and so did the market.

The beginning of the current run started in 2009 with people screaming the world was coming to an end and the sky was falling. The ugliness started a year or so earlier.

In each case the market found a bottom, the world went along just fine and the market eventually made new highs.

We had the Nifty Fifty of the 70s, the tax cuts of the 80s, the dotcom world of the late 90s, and the housing bust of 2008. Now we are back to tax cuts, low inflation, low unemployment and a market promising to rise every day as if the Lord promised it himself.

So now you’re ready to invest.

Reality Check

I’m the last guy to tell you to time the market. This thing could rock for longer than anyone expects. What is certain is the day will come when it will stop going up temporarily. That is the day greed turns to fear. And fear is a far more powerful emotion than greed.

If you stayed out the stock market the last ten years I have a suggestion. Don’t invest now! This is not a market timing call either!

The market direction or conditions should have a relatively small bearing on your decision to consistently invest.

After all these years of economic and market growth and only now you think it’s the right time to invest? If this is true you don’t have the temperament to invest in equities (stocks, mutual funds, index funds or ETFs). Buying because everyone is talking about it is insanity!

My granddad was a farmer who saved at an insane rate. The guy tucked away in the neighborhood of 70% of his income. When he hit retirement age his saved half or more of his Social Security check! (You read that right.) He even took a part-time job to fill his days when he was in his 70s and 80s and saved the entire take-home pay!

I always called granddad Doc because he always studied natural healing. Doc is a value lesson in today’s market.

Doc invested about 10% of his money at AAL, now Thrivent, the Lutheran investment house. The rest of his money sat in several banks. He had CDs, money markets, savings accounts and some land.

The 1929 stock market crash was etched into his young mind. He was born in 1922. The Great Depression colored his opinions on money.

Doc understood guaranteed money. Banks offered guarantees up to the FDIC limits. My dad convinced Doc to put at least something in the broad market. Only the investment house connected to the church could be trusted.

Better Safe than Sorry

Putting money in the bank is not a good way to build your net worth fast. Regardless, he managed a sizable (seven figures) of liquid net worth before the farming world collapsed and he lost most of his money trying to save the family farm.

Undeterred, Doc went back to what he knew worked. He started filling bank accounts again and had another seven figures liquid by the time he died.

To recap, Doc spent a lifetime building a seven figure liquid net worth, lost it in the farming crisis of the early 1980s, kept saving all he earned, put maybe 10% in a rip-roaring market, put the rest into bank deposits and had seven figures liquid again when he died ~ 10 years ago.

Not Cowardice

People are passionate about the market as I write. Netflix in the last month alone went from 187 to 272. From top to bottom this is a 45% gain. This is rare for any company to accomplish, but even more significant from a company slated to burn up to $4 billion in negative free cash flow this year!

Coupled with the recent bitcoin craze and people are primed for action. It has the feel of a casino! (As a reminder, the house always wins.)

There are only two mistakes that will kill you in the market. The first is getting enticed into buying when everything looks perfect and the market is parabolic. And second, getting scared out of the market when the market is suffering a gut wrenching decline.

Most people fail at investing because they trade the market. Emotions WILL get the best of you if you PLAY the market. Doc knew his emotional readiness and did what any smart man would: put his money in guaranteed bank deposits.

If you’ve been investing a portion of your income every month you have the emotional stability to weather the inevitable storm. (Or the intelligence not to look at your retirement account balance.)

Now is not the time to get brave and jump into the stock market. Even if you use index funds or ETFs. Odds are there will come a day soon when painful reality sets in temporarily. The last thing you want to do is buy now and find yourself waiting a few years for a new market high. Or worse, selling at the low due to fear.

Borrowing money to invest in stocks is the worst! You could find yourself forced to sell as the market declines if you buy with debt. DON’T DO IT!

Dos and Don’ts

Missing the current market rally is spilled milk. Chasing the market is a crazy idea. Here are a few dos and don’ts to consider in today’s investing environment:

DO —

  • Use index funds or ETFs
  • Keep investing in your work retirement plan at least to the matching level and to the maximum if you have the mental and financial will to do so
  • Keep calm
  • Stay the course. Stay invested and keep automated investing active. You and I both don’t know where the market will be over the short term so stay the course. The long game is higher

DON’T —

  • Panic
  • Borrow money to invest
  • Try to time the market by selling
  • Listen to the media hype. Wall Street loves the hype so they can sell to the greenhorns as the market weakens
  • Get too excited about your account balance. Those just hitting their FI (financial independence) goal might want to consider sticking around a while long as the FI number is built on a market spike higher with a real possibility these numbers could temporarily decline
  • Listen to your hairdresser, taxi driver, Uber driver, buddy at the bar, mailman, or even your accountant on hot stock tips
  • Look at your account daily

 

Young investors have it worst. They haven’t experienced one of these cycles before. The last real market decline was a decade ago!

This isn’t new either. Every 10 -15 years we rinse and repeat. Each cycle is slightly different while humming the same tune.

Investing, even in a hot market, isn’t necessarily a bad idea. Doing crazy stuff and getting greedy is!

No borrowed money for investments in the market! If you have a regular investment plan, keep it. Your investments will ride out the storm when it comes along. If you haven’t invested yet, now is not the time to be brave. Bravery is easy now because the feeling you have is really FEAR you’ll miss out.

The steady hand will always win in the end. Warren Buffett tells us to be fearful when other are greedy and greedy when others are fearful. Greed is rampant now so a healthy dose of fear is warranted.

Steady, kind readers. Steady.

 

 

The easiest way to invest in equities is with a mutual fund. The surest way to match market performance is to use index funds. Then there are times we get the urge to do things the hard way.

Of all investment classes the broad market has performed best. The stock market, for all its fits and starts, has outperformed over long periods of time without the need or risks of leverage to accomplish the goal.

A simple strategy of consistent investing in index funds has plenty of adherents in the FIRE* demographic. The reason for this is simple: it works! Depending on where in the market cycle you start, a decade to decade and a half if all that’s needed to fund your retirement. Start saving half you gross income at age twenty and by 35 you are ready to either retire or carve your own path in life.

The plethora of blogs in this demographic are a testament to the successful strategy of wealth building with index funds. What is often forgotten is that you are investing in real businesses even when using an index fund. And it’s business, not stocks, which create the real wealth.

If it takes a decade or so to create an adequate net worth to retire, business can get you there in a few years.

Buying an index fund is a sure way to enjoy average growth. Average is good in this case because the economy grows, always has grown and will continue growing into the foreseeable future. As productivity and other advances and new technology come online you are in for the ride because your index fund owns just about every winner in the crowd. You also own old school companies still growing and/or throwing off massive dividends. There are also a few stinkers in the crowd as some former success stories are headed for the exit.

With this in mind, intelligent people sometimes want to strike out on their own with a small percentage of their portfolio. If you possess the mind of an accountant and the discipline of a saint you can ferret out opportunities with the potential of outperforming the market.

And armed with this knowledge it becomes clear the pickings are slim when the market has been straight up for eight years. There are plenty of great companies, but most sell for a dear price, unworthy of additional investment unless available at some future date at a better price.

A Clear View of the Future

Exotic securities have been devised over the years to hedge various investments. These very same tools are easily used to gamble, ah, speculate.

Farmers have had futures contracts available to them since before the beginning of time. It makes sense for a farmer to use futures to protect their investment in an uncertain world. Agricultural products have thin margins and farmers know it. A small shift in commodity prices between planting and harvest can destroy a farm financially.

To limit the risk of prices changing, a farmer can sell his future corn crop in advance. It works like this: A farmer probably knows his input costs of fuel, seeds and fertilizer. He also knows if it makes sense to drill the seeds into the ground in the first place. If the input costs are more than he can expect at harvest he either needs to allow fields to lay fallow, plant a different crop or hope to Mother Mary prices turn around.

Even if the farmer sees current corn prices are higher than his input costs there are no guarantees prices will stay favorable. A drought can devastate his crop and prices tend to decline into harvest as more of the commodity becomes available.

To limit risk the farmer can sell his expected corn crop coming off the field in autumn before he even plants in spring! If prices go up the farmer loses on his hedge, but wins on the actual crop. In prices decline he loses on the actual crop, but profits from the futures hedge.

Futures contracts are a necessary part of farm living. Without the ability to hedge farmers are one, or at best two, bad years away from bankruptcy.

The same tools can be applied to almost any asset.

You Have Two Options

Before we start this part of the discussion I want to give a warning. This is more a case of do what I say, not what I do. I use some very advanced methods when protecting my investments and when buying them. This discussion is on options. I do NOT recommend options except to the most knowledgeable and astute investor! Consider the remainder of this post informational only.

If you are unfamiliar with options and how they work, here is an article on Investopedia and another from NotWallStreet. Do NOT let anyone, me, a broker, a TV talking head or internet article, talk you into options unless you know what you are doing. You don’t.

There are two options in the world: calls and puts. Like futures for a farmer, an investor can hedge her investments against the price on some future date. The market has been rallying hard for years. If you are worried about the market declining, you can sell your stocks or index funds and pay taxes on the realized gains or write covered calls or buy puts. Each action has its own associated risk.

Selling causes tax issues, but at least the damage is known. Covered calls only provide limited protection and if the market keeps climbing you are likely to lose out on future gains. A covered call might provide a few points in premium only. If the market decline is larger you will suffer paper loses. Buying a protective put is a cheap hedge and frequently the preferable route. If the market declines you gain on the put option; if the market rises or stagnates your only risk (loss) is the put premium.

But that is not what I use options for. I’d buy a LEAP call option on the S&P 500 if I got the same deal Warren Buffett did nearly a decade ago. (Buffett paid a small premium for an at-the-money S&P 500 index call with a 10-year time frame with the market off nearly 50%. I wanted the same deal but they showed me the door.)

I rarely use covered calls to generate premiums as the market likes to steal your stock when you do. I don’t speculate or gamble with options either.

The one time I love to use options is in a market like we’ve had the last several years. The market has been doing well for a long time and when I’m looking to buy an individual stock I sometimes use options. (You can use the same strategy with index funds, but I never do. I still invest excess capital into the index fund and wait like a good boy.)

The problem with today’s market is good companies are selling at too high a price. Now if I could pick up some Facebook (FB) at 100 or Apple (AAPL) at 140 I’d be excited. (FB last closed at 179 and AAPL at 170.15.)

Most stocks don’t have much of a premium for short-dated options way out-of-the-money. Some stocks do. The best way to show you how I spike my returns using options is to list what I have in my current portfolio.

First, when I sell naked puts I consider them long-term buy orders in companies I want to own more of when the price is too high. If the price comes down enough the options will execute and I’ll get my extra shares. If the stock doesn’t drop enough or advances I keep the premiums. I never use this strategy in a down market as I can just buy the stock without waiting.

Here are my current naked put holdings:

 

Company             Sold Date             # Sold    Option Date       Strike    Sold $    Current $

AAPL                     11/15/17              -2            Jun 15, 18            140         3.04        2.87

FB                           6/9/17                   -4            Dec15, 17             120         2.05        .01

FB                           6/29/17                -2            Jun 15, 18            100         2.00        .30

MO                        7/31/17                -2            Jan 18, 19             65           8.03        5.90

NFLX                      5/25/17                -2            Dec 15, 17            130         4.05        .05

PM                         10/30/17              -2            Jan 18, 19             90           4.33        5.25

TSLA                      5/25/17                -1            Dec 15, 17            220         6.68        .26

 

If every stock declined to the strike price or lower I would be on the hook to buy $175,000 of stock! As you can see most transactions will expire worthless before the end of the year and I keep the premiums.

MO is the outlier. Option premiums are low for MO so I sold a LEAP out in January of 2019. I also bought more MO in the low 60s recently.

I am willing to buy each one of these stocks at the strike price should the market decline to those levels and probably will even without the naked puts.

Risks

There are two risks to consider. The first requires self control. You only sell naked puts in the amount you have current funds available to buy.

The second risk you can’t control. If the story changes and the stock crashes, you will end up buying back the put at a loss or owning shares in a company where the story is no longer compelling.

Simply put (pun intended), there is no risk free investment. Just wanted you to understand the two risks in this scenario.

The Cash Hoard and the Friends I Keep

Whenever I mention I use this strategy people ask why I don’t stay 100% invested all the time. My answer is, for the same reason Warren Buffett’s Berkshire Hathaway has around $100 billion in cash currently.

The truth is I like to keep my powder dry. I never have 100% of my money invested. There are a few nickels in my pocket when I walk around town to avoid vagrancy charges. As a business owner I need liquid working capital so I always have something tucked between the mattresses. I also like keeping some money available in case an unbelievable opportunity arises.

You do the same thing on a smaller scale. You might have an emergency fund. If so, it’s probably earning a whopping 1% while it waits for work to arrive.

Another brutal truth to why I keep a larger amount of cash laying around is because I am different than you. The higher your net worth the more liquid cash you will tend to accumulate during certain times of the year and during market overvaluations. I consider the current market overvalued.

Does my opinion of the market conditions change my core investing style? No! I max out all my retirement accounts (Mrs. Accountant’s too) and put it all in index funds. Those suckers keep getting filled.

When it comes to individual stocks I need to build a reserve to buy companies when they are on sale.

I’m not alone in using this strategy to generate income. Back in the 90s Intel (INTC) sold massive quantities of put options with the intention of using a down market to buy back shares. (I’m not sure if INTC still does this or not.)

Over the years INTC had such a large income stream from the naked puts they listed the income separately in their earnings reports and annual report. INTC’s intention was to structure the naked puts to force execution so they could buy back the stock and keep the premium. There was serious money in this for INTC.

I owned INTC for a few years back then. It wasn’t my favorite investment, but it had potential until my research discovered a terrible truth. I went back and reviewed over a decade of financials for INTC and discovered they bought back more stock than their entire earning over the previous decade and still had MORE shares outstanding. Such is the world (and risk to shareholders) of employee incentive stock option.

We’ll leave that discussion for another day.

A Steaming Pile of Schmoo

This was harder than I thought. Novices will be left bewildered and experts already understand the program. How do you present a complex idea like options in under 2,000 words? You don’t! I feel like I left a mish-mash of information. The information is accurate! The issue is communication. Did I get my message across?

There is so much more to this discussion than I could pack into one post. Naked puts are a viable investment strategy if used in a limited fashion, even if INTC used it to the nth degree.

Options in and of themselves are not bad. They do have the potential to cause great harm however and they are easy to abuse. Consider options the opioids of your investment portfolio. They reduce pain at first, but can do lasting damage when abused.

So why do I do it? Because if the market doesn’t decline I keep over $6,200 in premiums. The extra cash, added to an already growing stash, will come in handy when the market does decline and some companies become a steal.

Or I might be an addict beyond help. You decide.

 

* Financial independence, retire early.

 

The biggest risk most people have when it come to building wealth is putting all their eggs in one basket. Having one full-time job supplying you with 100% of your income means you are either doing well or in a crisis.

Wealthy people and large corporations have multiple streams of income and continually work to develop more. Sometime the failures are huge. New Coke might be an example. In my practice I’ve had ideas cost serious money go down the toilet. I’ve also had spectacular successes.

Multiple streams of income are the only way to protect your wealth creation program. The same applies when you reach financial independence and decide to retire. All your eggs in one basket is a bad idea. Imagine busting your tail for a decade and having all your money in Enron.

Another problem revolves around active and passive income. Active income comes from work you do yourself. A job or small business is an example. There are only so many hours in a day to sell for income. You can work hard to increase your productivity earning more per hour, but you remain a slave to working for every nickel you earn.

Business owners have an advantage. Once the business begins operations employees become part of the mix. Part of what employees do end up in the owner’s pocket. If it didn’t, why would the own bother with the headache of hiring/having employees. Even though the IRS considers business income ordinary income, there is still a passive nature to the income stream.

Danger, Will Robinson! Danger!

The problem with working for every dollar is risk. If you become ill the income stops. Insurance can provide a backstop, but that is a limited solution you have only minor control over. A business owner can suffer catastrophic loss due to weather or other events. When the business suffers, profits evaporate. The worst case for a business owner is they are forced to choose between closing the business or feeding it to keep it alive.

The solution to these wealth building and preserving risks is diversification. More accurately, diversification into passive forms of income. Whereas, you have only so many hours in a day to trade for income, you have an unlimited ability to create and increase passive income. The best part about passive income is that most sources of such income reproduce automatically.

Mutual fund dividends and capital gains are easily reinvested. Rent can either be used to reduce leverage (mortgage debt) or to buy more properties. Interest breeds more interest.

Without a business your options are limited. Your main source of income is extremely top heavy with wage income. Even a business owner has risks. A handful of clients can make up a large portion of the profits. A large book of clients is a buffer between normalcy and disaster wage earners don’t have the luxury of. However, if you are in the retail music business things might be as bad as or worse than that of a wage earner. CDs and vinyl records don’t have the market they once had prior to digital music on the internet.

Passive Income Sources

There are a thousand sources of passive income. We will only focus on the big four today with an honorable mention to profits in a small business with employees running the place.

Dividends and capital gains are treated favorably by the Tax Code. Rent is considered derived from a passive activity and treated as ordinary income, but income property enjoys depreciation and other tax benefits. Interest is treated as ordinary income, but as we will soon see, a lot of interest is also treated favorably by the Tax Code.

According to Zillow, renters paid $535 billion in rent in 2015 in the United States. And the number is rising. There are about 125 million U.S. households and 43 million households rent. The U.S. also has about 250 million adults (adults, not the entire population).

Some simple math reveals an astounding amount of rent paid by renters/received by landlords. If the $535 billion in rent paid were paid evenly among all U.S. adults it would amount to $2,140! That’s right. Every U.S. adult would receive $2,140 of rent if it were divided evenly. If rent were evenly divided between all households it amounts to $4,280 each for 2015! Since renters probably don’t own income properties we can divide the gross rent paid by the approximately 82 million non-renting households and we get $6,524.

Most people don’t own income property, so the ones that do generate a very large amount of passive income. Of course, rent is not all profit. The mortgage requires servicing, maintenance is ongoing, and property managers need to be paid. Still, this is a staggering amount of passive income many people neglect. (Never mind my reality check on income property versus index funds.)

In the arena of passive income that takes effort is business income which we discussed above. Business income is “earned” for tax purposes. There are instances where it may be considered “unearned” and goes beyond the scope of this post. As mentioned above, a business can distribute massive amounts of money to owners. A manger running the day-to-day operations makes the income passive in reality, if not for tax purposes.

Work-Free Passive Income

When most people think of passive income they usually think of things you do once and then receive a long-term stream of income. Real estate can do just that if you have a good property manager. Real estate lacks diversification unless you invest in a security holding real estate. With a large amount of money you can invest in multiple properties around the nation to avoid regional economic risks. Or you can take on partners to spread risk, but partnerships have risks of their own.

True forms of passive income include dividends and interest. Before you roll your eyes, I want to share the incredible amount of dividends and interest paid out each year.

Before we continue, the statistics I’m using comes from the IRS, one of the most respected institutions of the United States. (Pardon me a moment while choke down that hairball.) There are other sources of information, but all are estimated using different methods of information gathering. The IRS data, while more accurate, is gathered based on reported income. Not all income is reported. However, reporting requirements (Forms 1099-DIV and 1099-INT) make the data reasonably reliable. Some dividends are so small they go unreported and older taxpayers may not have enough income to file. Interest is another animal. Form 1099-INT may be issued to most recipients of interest from banks and other large organizations, but land contracts and other similar devices may go unreported.

With the caveats in place, the IRS lists $254.7 billion in dividends for 2014. That works out to $2037.60 per household. It doesn’t sound like much, but two massive issues are missed here. One, most people have zero dividends, so those who do have a lot, and two, most dividends are paid to retirement funds or other corporations and aren’t included in these numbers.

Let me share a secret from the tax office. Most people have zero dividends to report. A few have a couple dollars to report and even fewer have up to $100 of reportable dividends. Then we get the people who receive real dividends. These folks report $87, 904 in dividends received from their non-qualified accounts alone. This number become more astounding when you realize the total market throws off about a 2% dividend yield. That means the value of their account is worth 50 times as much as the reported dividend!

These are normal people who invested and kept their fingers off it for a very, very long time! There is no big secret. Most never owned a business or inherited a substantial amount of money. They consistently invested with each paycheck and let it ride. Time did the rest.

It sounds like a lot, but a million dollars invested in a broad index fund should generate ~ $20,000 of dividends growing 5 – 7% per year. Starting is the hard part. Even harder is leaving your fingers off it. But for people just smart enough to invest consistently and refuse the temptation to play with their money, thinking they can outsmart the market, will do extremely well.

Interest in retirement accounts face the same issue dividends do. Much interest will not show up in IRS data. We’ll go with it anyway to see how much we can get ourselves.

The IRS reports taxpayers listed $93.9 billion of taxable interest and $62.5 billion of tax-exempt interest. This works out to $751.20 of interest income per household without consideration to interest earned inside retirement accounts and $500 of tax-exempt interest. Considering the low rates of interest today, this means the account values are at least 100 times larger, probably much larger!

Remember, this isn’t all the interest and dividends paid in a year. Corporations, banks and insurance companies earn tremendous amounts of income from these sources and are not included in the amounts. The numbers above are from individual returns only! The real total of passive dividends and interest paid is staggering.

Another difficult number to track is capital gains. The IRS says just over $705 billion in capital gains were reported in 2014. But how large is the amount of unrealized capital gains? It has to easily stretch into the trillion dollar arena!

Not only are you at greater risk when all your eggs are in the wage earning basket, but you get taxed hard.  Wages suffer income tax at ordinary rates, but FICA taxes as well. Rent, dividends, interest and capital gains receive varying degrees of preferential tax treatment when calculating your income tax, but they all avoid the FICA tax.

Remember the $535 billion in rent paid from above? Well, the IRS records show only $75.2 billion was taxed or a bit more than 14%. (Here’s my handkerchief. I know how much it hurts.)

Now I’ll add up the averages in non-qualified (non-retirement) accounts alone. Take the $4,280 of rent you should receive on average (only $1198 of which is taxed) and add $2037.60 in dividends and $751.20 of interest and $500 of tax exempt interest and the $5,640 of realized capital gains and we get $13,208.80.

Again, this seems like a small amount to the average reader of this blog. But these numbers don’t include earnings from retirement accounts. It also doesn’t include we can invest more and take a larger share from corporations, banks and insurance companies.

The real secret is in the value of the underlying accounts which reveals the staggering level of unrealized capital gains. In today’s low interest, low dividend environment, the average household holds north of half a million dollars! That means a lot of people are doing really well considering how many are doing so poorly.

And I never said a word about how much is stored in trust accounts!

Wealth is not a complex process. Consistency is the most important factor. Long-term investments in index funds have enjoyed superior performance historically. The amount of passive income to be had is large enough for everyone to do very well with only an average slice of the pie.

The question now is: Where are you on the scale? Average? Below average? 🙁 Above? 🙂

If you don’t like your level of passive income it might be time to do something about it now that you know where the money is.

When you begin your journey towards financial independence you can’t imagine some of the problems along the way. Investing starts out larger than life and scary until you see how simple index funds make investing in large successful companies is.

Before long you have a large nest egg in your 401(k) and IRAs. Eventually your savings rate starts building your non-qualified accounts (non-retirement) as well.

As your net worth reaches for the sky you have the latitude to try some alternative investing in a mad money account. You start reading books on super investors like Warren Buffet and Ben Graham and decide it is worth learning the process of buying outperforming individual stocks with a small portion of your portfolio. Besides, you might really have a feel for finding great underpriced companies to buy stock in.

Bad Choices

As you search for a diamond in the rough you give no consideration to your index fund investments. They always chug along with the market without any effort on your part. All automatic. Set it and forget it. But you are about to blow your portfolio out of the water without realizing it.

The tendency is to buy winners. Apple Inc. is at the top of the pile and is the largest market capitalization stock in the S&P as I write, which means you own more Apple in your S&P index fund than any other company. They have winning products and lots of cash to weather any storm so it sounds like a good investment. Heck, they just released a new phone for a cool thousand bucks! How can you go wrong? Good thing the index fund loaded up for you.

Index funds invest more in the winners by default. The bigger the company the larger the market capitalization (determined by the stock price and the number of shares outstanding) and index funds buy based on market cap. Therefore, since Apple has the largest market cap, the S&P index funds hold the most of it. The index fund’s next largest holding has the second largest market cap and so on.

As long as you are buying individual stocks you may as well diversify a bit. Facebook is a household name with plenty of prospects. Facebook, Class A stock is number three in the S&P 500 weighting list. Amazon is another highflyer at number four.

These winners are virtual no-brainers. It’s like shooting fish in a barrel. Warren Buffet isn’t so great after all. Your short list of winning stocks is on a roll.

Here is the current weighting of each company in the S&P 500. The list changes as the component’s prices change in relation to each other. Today’s top dog is not yesterday’s top dog.

Today’s king is dethroned without fanfare. Today Apple tops the list, unseating Microsoft. Someday Apple will be unseated, maybe by Amazon, who knows? If you look back in ten year chunks you will notice the top stock by market capitalization always changes! Eventually fallen kings leave the top ten list and some fall even further. General Electric and Wal-Mart are showing us how this is done live.

Portfolio Bloat

So what does this have to do with buying individual stocks when you also own index funds?

When you own an index fund you still really own a pro-rata share of the underlying securities in the fund. It doesn’t always feel that way, but when you own the S&P 500 index fund at Vanguard you actually own a slice of 500 companies!

Let’s go back to Apple. Apple is the highest weighted stock in the index at 3.948665 as I write. This means if I have a million dollars invested in the S&P 500 index fund I effectively own $39,486.65 of Apple stock!

If you don’t like the high price of Warren Buffett’s company, Berkshire Hathaway, don’t worry. As the sixth heaviest weighted stock in the index you own $15,824.96 of Berkshire through the index fund for every million dollars of index fund investment.

Then we get to the bottom of the list with News Corp, Class B. Your million dollar index fund investment grants you an effective ownership of $69.85 of News Corp, Class B.

Astute readers will have already noticed the problem. If you buy more of the winners, you are overweighting and already overweighed investment! You already have over 3.9% of your portfolio in Apple. We also know Apple may continue to rise for a very long time. But the record is clear; the top dog never stays on top for long.

Buying more Apple when history says Apple will not stay on top forever—even another decade most likely—means other companies will grow faster! Adding too many additional shares of individual companies already at or near the top of the index weighting leads to portfolio bloat.

As these winners keep pace you will be a very happy investor, but when it goes south it will create an overweighting of drag on your overall portfolio. Apple’s stock price affects the index fund the most and if you also own Apple individually as well, Apple will cause outsized moves in your portfolio. The real question is: Do you want to own more Apple if you already own more Apple than any other company through your index fund investments? You need to make the call.

Total market index funds run the same risk. All index funds will have a weighting of how much to own of each company. It would be impossible to own an equal share of the smallest firm as the largest. Bigger companies are therefore more important inside the index fund.

Buying a smaller company’s stock may therefore compliment your index fund as the smaller company could be on the rise as it heads to the top.

The Antacid for Bloat

Don’t be glum. You can have your cake and eat it too.

I bought my first shares of Phillip Morris (MO), now called Altria, back in 1984. Morris has been steady near the top of the list so it kept pace with the leaders while throwing off a massive and growing dividend I managed to reinvest in more MO stock.

If my count is correct, MO is number 40 on the current list, down from the top ten years ago. But. . . , MO did something in the mean time. It spun off Phillip Morris International (PM) several years ago and PM is the current number 23! The spinoff is bigger than the original firm! And both pay dividends like manna from God! (Yes, that is a lot of exclamation points. I made a lot of money from my MO investments over the years.)

MO isn’t part of my mad money account. It is part of an old DRIP (dividend reinvestment plan) portfolio I held in trust. There were twelve total stocks in the original DRIP portfolio. Only AFL and MO remain as memory serves. (Don’t trust an old farm boy’s memory too much. I didn’t double check to verify since it’s irrelevant to the story.)

Coke (KO), GE, ITW, JNJ, Hershey (HSY) and Paychex (PAYX) were some of the companies in my original DRIP portfolio. The one that bothers me most is Wrigley’s (WWY). My good buddy, Warren Buffet, funded Mars, Incorporated so Mars could pay cash to buy out WWY. Mars is a private firm so I received cash only and no stock in the new company. Bye-bye dividends and free case of gum every Christmas. (grumble, grumble) My kids still cry over that one. They also held Wrigley’s. Darn Buffett.

Many of these companies did well after I sold. I just wanted to consolidate. The index fund gave me diversification. My individual company investments needed to complement the index fund. I am not interested in top-heavy investing.

The best cure for portfolio bloat is to search for gems down the list or even from smaller companies not on your broad-based index fund’s list. The odds are better a company not at or near the top will outperform the index itself. And if you have no chance of outperforming the index fund (a tall order in and of itself), then why bother. Stick with the index and do something else with your time.

Finding Winners

The tricky part is knowing which companies will move up the list (performing better than the index’s average). The top market capitalization companies on the list can and frequently do rather well. But for your individual stock investments to do better than the index you need to buy companies which are moving up the list or if you buy the top dog, the top dog needs to keep expanding its distance from the rest of the pack.

The law of large numbers makes this harder and harder as time goes on. Getting on top is really hard; staying there a really long time is near impossible. In fact, nobody has done it for decades at a time. GE and KO and MO have been perennially at or near the top. But unless the company also throws a massive and growing dividend and still remains on top you will find buying these stocks on your own doesn’t help performance, it hurts it.

This post doesn’t have room to discuss how to find a quality company down the index list.

If you feel up to the task and have done your research, you can invest a small portion of your portfolio on your own. For most people the index will do better on its own without your help.

Of course, you can buy Apple because it is such a hot stock and awesome company. They could stay on top forever. This time could be different.

Or maybe not.

 

There is an old story on Wall Street about a young stock broker during the Cuban Missile Crisis. The world hung in the balance as President Kennedy came on television to inform the American people 50 Soviet cities were targeted by U.S. nuclear weapons if the Soviets attempted to run the blockade of Cuba.

Those who lived through it say it felt like the world would freeze. Tensions were high. Such threats under such an intense situation could only mean the Soviet Union targeted their nuclear weapons on U.S. cities as well. One misstep, one accident and the human race would end in the flash of an instant.

The stock market started to decline as fear grabbed Wall Street. The young broker started to scream, “Sell!” An old broker with over 40 years experience working next to him barely showed any concern. The old broker touched the young broker on the arm and shook his head. “Buy,” he said calmly.

“Buy! Are you insane! We could be destroyed in a nuclear war!”

“True,” said the old broker. “But if the missiles don’t fly the market will go back up and then higher as the crisis passes. And if the missiles do fly the trades will never clear.”

Fear and Panic: The Enemies of Wealth

Once again we find ourselves with the real possibility of a nuclear attack. The promise of the end of the Cold War has finally reached an end as massive risks still exist for life on our blue planet. North Korea continues to test ICBMs as they work frantically to build a rocket capable of carrying a nuclear, or even a thermonuclear, warhead to major cities around the Pacific.

Each nuclear test and missile launch sends the markets into a fray.

The whole exercise is pure insanity. If North Korea even twitches with a nuclear tipped ICBM, the U.S. is certain to retaliate. Mutually Assured Destruction (MAD) is back. One miscalculation, one accident could send a series of catastrophic events into motion. How can Russia, with 8,000 nuclear warheads, and China, with 250 nuclear warheads, remain natural when the U.S. retaliates against a North Korean nuclear launch at an American city or one of her allies? It is probably too much to ask the Russians and Chinese to stand pat when U.S. nukes are headed in their direction. It would get out of control quickly.

Each launch and detonation by North Korea ups the stakes. Each weapon is stronger; each missile more advanced. The world is on course for a head-on collision with nuclear weapons involved. Nothing deters Kim Jong Un. History has come full circle. The Cuban Missile Crisis is back, only on the other side of the planet.

Fear and panic are natural responses. It’s easy to connect the dots with no possible way to win. It feels like late October 1962 all over again. The only consolation this time is we take comfort in knowing North Korea doesn’t have thousands of nukes to launch our way. Regardless, one city anywhere hit by a nuclear weapon would be beyond devastating even if it didn’t escalate. The economy would collapse as the world froze.

Crises are nothing new. If it isn’t the Cuban Missile Crisis, it’s the sub-prime mess or a terrorist attack or higher interest rates. Markets are always looking for a boogie man around every corner.

We are very lucky as I write this. We have gone a long time without a serious crisis. It is unheard of in this nation’s history to go an entire decade without a major market calamity. Some would say we are due. Are you ready?

Let’s recap the list of world ending crises of the last 120 years. In 1901 President McKinley was assassinated followed by the Panic of 1907, one of many market panics driving down prices on Wall Street over the centuries.

The next decade brought us World War I. The 1920s started with a recession, but nothing too overwhelming. We almost made it through an entire decade without a calamity until the Smoot-Hawley tariff and the 1929 stock market crash.

The 1930s were consumed by the Great Depression followed by the 1940s occupation with World War II.

The Korean War (remember that; it’s important later in our story) launched the 1950s followed by an identity crisis for Americans when the Soviet Union launched Sputnik. The nice thing about the 1950s is Mr. Market was happy and content climbing higher at a nice clip. Wall Street seemed content to skip panic selling for at least the 1950s.

Vietnam occupied our minds in the 60s. Then we wanted to feel special in the 1970s by having Watergate, high inflation, oil embargos, American hostages in Iran and a flailing stock market. Sometimes a guy needs something to get the blood flowing.

Who can forget the double digit interest rates of the early 1980s coupled with two debilitating recessions to start the decade? Then things looked up. . . until 1987 when the Dow Jones Industrial Average took it on the chin by the largest one-day percentage drop (22.6%) in history.

The 1990s were pretty quiet. We did get the first Iraq War so we had a wonderful buying opportunity on Wall Street at the beginning of the decade.

Then we start the new millennium with a bang. Terrorist attacks on 9/11 set the tone. Stocks declined by 50%. But once isn’t enough! 2008 was a wonderful time to start a banking crisis due to lax lending standards and housing. This provided another 50% market correction buying opportunity.

After the 2008 crisis didn’t end the world we have been practically straight up. This is currently the second longest bull market in U.S. history. The current bull market is 101 months old on September 9th. People are understandably worried about our good fortune.

The Eternal Optimist

There is always something to worry about. The world is always ending. As soon as one predicted date for the end of humanity passes another steps forward. It’s a mindset sure to keep you poor.

Just because we haven’t had a market correction (10%+ decline) or a bear market (20%+ decline) in a while doesn’t mean we are actually due for one. There is no law saying a market decline must happen within a certain timeframe. However, given time, these events will happen again. Some market pullbacks are based on flimsy excuses. Other market declines are connected with political or social events. Either way opportunity awaits.

Worry is a waste. Warren Buffett has made a career (and a darn good one at that) by being an eternal optimist. He coined the phrase: Be fearful when others are greedy and greedy when others are fearful.

It takes a special person to pull the trigger on an investment or add to an index fund when the night is darkest. But if you want to succeed at building serious wealth you either must invest in quality companies when they are artificially on sale or invest in index funds and forget it. Time will heal all wounds in a broad-based index fund.

Here is why it always turns out okay. When the economy heads south or an event suggests it will the Fed tends to pump money into the system. More money in the system is eventually going to end up in sales and hence, profits. All companies as an aggregate will reflect all the additional money pumped into the economy. It’s not if, it’s when, stock prices reflect the growing business climate.

Optimists always win. Buffett is the poster child for the optimist of the century. No matter the event, he loudly proclaims things will be fine and then get better.

And Buffett has been right though a Great Depression and an 89% DJIA decline, a world war, numerous regional wars, high interest rates, terrorist attacks, a President’s assassination, a President’s resignation over scandal, and banking crises. The market keeps churning higher through it all with only a short hiccup to mark the event on the charts.

The Dow Jones Industrial Average started the 20th Century at 68.13. The Dow is at 21,784 as I write this. We had a bit of a run.

All of the wars, turmoil and social unrest, banking collapses, terrorist attacks and economic recessions were only a minor temporary blip in the upward march of equities. Businesses grow and keep growing. And as long as businesses grow, so does their value which eventually is reflected in their listed price.

Now is not the time to be afraid. The days ahead will have scary moments. Threats will be made and the matter in Asia could turn hot with guns blaring.

One thing is certain. The market’s current muted stoic response will give way to panic selling because the world is ending, for real this time. Staying the course and adding to your investments when it looks hopeless is how you will build a massive net worth.

And if I’m wrong the trade won’t clear.

 

dollarrThere are two dangerous times in a retirement plan: when things are going really bad and when things are going really good. We have been lucky the last seven and a half years. The market has marched higher at a steady pace with nary a pullback to be seen. There are people in their 20s who have only seen the mildest of market corrections (a decline of 10% or more) and have never seen a bear market (a decline of greater than 20%).

The steady beat higher for so long is unusual. Regular investments have only known one direction: up. Money invested last year is worth more this year, same for the year before that, and so on. It is easy to invest in such an accommodating environment. The goal of early retirement looks so easy when every year is an up year.

Now the election is over and we have seen a serious move higher in the stock market. Bonds have been down more than stocks are up. The rally is narrow. High dividend yielding stocks and growth companies are down significantly. Banks and other financials are drinking the Kool-Aid. For the first time in years I have clients calling and readers emailing me for my opinion on borrowing money to invest in the market. Ahhhhhhh!

Don’t Drink the Kool-Aid

Now is not the time to change your investment plan. On a regular basis you should be investing into index funds. Preferable, your investment strategy should be on autopilot. Every paycheck should see a large portion dropped into the investment plan. The level of the market never changes that. Chasing a market when it is higher is a Don Quixote move (look out for the windmills); selling out after the market drops hard is a Chicken Little move.

For the record, we don’t do Don Quixote or Chicken Little around here. We don’t drink the Kool-Aid the crowd is slurping up. Predicting the next 10% or 20% move in the market is nothing more than a guess. The best can’t do it consistently, indicating the ones who do for a short time are temporarily lucky. Luck is a harsh mistress in the investment world.

I can give you a number of reasons why we should dump out of the market: low dividend yields, high P/E ratios, lots of government debt. There are an equal number of reasons to double down in this market: Trump will spend like a drunken sailor (I apologize to any sailor I may have offended), higher interest rates will spur bank profits, and more spending should mean more jobs with higher wages. Each side has a point. At the end of the day one fact remains. The risk is to be out of the market.

A steady investment plan requires a steady hand. A drop in the stock market is not a reason to sell stocks. If anything it is a buying time. A market rocketing higher is dangerous because people place over-extended risky bets in the belief the Kool-Aid will not kill them. If you buy on margin (borrowed money) now, at a market high, you take the risk of a market decline exaggerating your paper loses. Worse, short-term paper losses can turn into permanent losses when you use borrowed money. You can’t be wiped out by a market decline unless you use leverage. (Don’t start with me. If the market drops 100% you are technically wiped out, too, without leverage. That will never happen and here is why.)

What’s the Plan?

How did you grow your portfolio to this point? By making regular investments automatically. When you play with the darn thing the wheels fall off. The computer doesn’t freak out and sell after a crash or buy on margin in the major rally. All the computer knows is to keep chucking more wood onto the pile day after day, week after week, just like the automated plan was set up to do. No emotions involved. Set it and forget it.

My wealthiest clients tend to take a disinterested view of the stock market. They have no idea where the Dow is or if the market has been rallying or collapsing as of late. All she knows is that her automatic investing plan will buy more shares when prices are cheaper and fewer shares when the price is higher. There is no need to fiddle with the equipment. It is working fine. You have a bit more this week than last. So what? It’s just a number.

Deciding to start an investment plan now is peachy! Where the market is today has no bearing on where it will be in 10 or 20 years. (Warren Buffett recently said the market will be higher in 10 and 20 years. The ’ol boy has been right a time or three so we might want to listen.) If the recent rally is your reason to start investing, good for you; if you are a fair weather investor, save your money. If you start an automatic investment plan you MUST stick with it through thick and thin. There are going to be serious down days. And I mean serious. If you can’t set it and forget it, you are doomed.

Exceptions to the Rules

I before E, except after C, and in proper nouns. People spell my first name wrong, a lot. If they remembered the grade school grammar rhyme, my name would never get butchered. Oh, well. Then some smartass asks, “What about ‘society’ and ‘science’?” If you are that guy, please sit down right now.

There are exceptions to the rule when it comes to investing, too. Example: I recommend clients already retired keep a few years of living expenses liquid. There is never a forced need to sell investments to cover living expenses when the liquid fund is always available. Now is a great time, with the stock market higher, to start increasing the value of the liquid portion of the portfolio. Once again, the process should be automated. As long as the market is up, keep taking a select amount to transfer from the index fund to a money market. (Bonds are a really bad idea right now.)

600px-black_monday_dow_jones-svg

The 1987 stock market crash. Looks scary up close. See the next chart to see how it looks from a historical viewpoint.

There are few other reasons to deviate from the program. I understand some of you have medical issues which may necessitate a change of plan. Other personal matters or an emergency might make changing your investment plan the smart thing to do. I’m good with that. As long as the current trend in the market is not clouding your actions, the decision is acceptable, if not always ideal.

After bragging about my oldest daughter retiring at 22, she was in tears when Donald Trump won the election. She thought her money would all be lost in a market decline. She has a lot to learn. And she learned a big piece of it this week. When the whole world felt the market would collapse over a Trump election victory, the world was wrong. Again. Even your favorite accountant thought a Trump victory would mean a market decline and an awesome buying opportunity. Good thing I don’t trade on my opinion.

Currently I expect more volatility in the market over the political environment. I could be right. But it makes no difference! The only thing to do is stay the course. No borrowing money to plow into an index fund. No selling without a valid reason. The S&P 500 throws off a dividend yield of a whisker over 2% as I write this. Those dividends keep reinvesting and growing like an army without an understanding of stop. Those investments in turn churn out an ever increasing stream of dividends.

My Plan

Every month Vanguard pulls money from my checking account and drops it into the 500 Index fund. The withdrawal is entered into the checkbook automatically. No action is required on my part. When I have extra money, I drop it into the 500 Index fund manually.

And I still make mistakes! I have a SIMPLE IRA plan in my office. Mrs. Accountant and I can contribute $15,500 each per year. I like to wait for a down period to make the most of the annual contribution. Mrs. Accountant and I have $5,000 in each so far this year. I should have spread it out evenly over the year. Instead, I played with my money and now will end up investing in a higher market. Somebody slap my paw and tell me to “Set it and forget it!” I guess I still dollar cost average on an annual basis.

daily_linear_chart_of_sp_500_from_1950_to_2013

Do you see it? The pimple in 1987. That was the 22.61% drop in one day. Seems small now compared to current prices, doesn’t it.

Take a look at a really long-term stock chart. See that little blip in the 80s? That was the big 1987 stock market crash. The Dow was down 22.61% in one day. It was a big deal back then. People all over town were soiling their shorts. Now look at it. It’s so small you might mistake it for fly shit on your computer screen. Forget about timing the market. By year-end I will max out the SIMPLEs and put it in the index fund. No waiting for the magical day I can buy cheaper. It might come; it may never come. If it never comes I lose big. If it does come I will have a speck of fly shit on my screen 20 years down the road. It is not worth it.

Emotions are running high. Whatever your reasons for modifying your investment plan, don’t. A new client informed me before the election he sold all his index funds and put the money into money market funds because the market was too high and if Trump won he would lose. I advised he reconsider that market timing strategy. Now it looks like selling was a bad idea. You can’t time the market accurately.

One thing seems certain. The low volatility market of the last seven years is at an end. We are back to normal. Unless I am wrong. Regardless, timing the market is a fool’s errand. End the stress and anxiety. Don’t watch your portfolio like a cat dancing on a hot tin roof. Each jig and jag of the market is just that, a jig and jag. There is only one way to keep your sanity and maximize your portfolio value: Set it and forget it.

Anyone for a hike?

23b65f55-97d0-408b-9215-14e47abb86fbI started investing in Prosper, the micro-lending platform where you can invest as little as $25 on a loan, back in June 2012. By investing a small portion in a large number of loans risk is spread out; no one loan going bad has an outsized effect on performance. I started withdrawing money after the returns plummeted after changes were made to the platform. Because it takes time to collect payments from loans held, it is an illiquid investment. My original investment of $13,400 is still worth $979 after withdrawing $15,430. Not great, but not bad either.

Before investing I did my research. I wanted to invest in Lending Club, but was unable to at the time because Wisconsin residents were not allowed. Prosper was my second choice so I took the plunge. Eventually I was able to invest in Lending Club, but because the rules were so easy to change (as I saw at Prosper) and the investment is illiquid I only added $5,000 to my Lending Club account.

When Lending Club went public I was allowed 200 shares of the IPO (I think, whatever the max was) at the IPO price. I sold within a day or so after it went public for a tidy profit. My opinion (and review of the financials) was investing in loans was better than the stock. My instinct served me well in hindsight.

I continued withdrawing money from Prosper, but did not continue adding to the Lending Club platform because I don’t like the way taxes are handled on these types of accounts. There were plans to have a post on The Wealthy Accountant promoting Lending Club as a viable alternative investment. Something in my gut held me back. I reviewed the financials of the company and tried to figure out how money ran through the system. Something did not make sense to me.

Then on May 6, 2016, Renaud Laplanche, Lending Club’s CEO, was forced to resign due to ethical issues. I did not need to see any more. My auto reinvesting of funds was discontinued and I started pulling my small investment from Lending Club too. So far I have suffered no lose of funds. I only withdrew $1,324 so far and my account value according to Lending Club is still worth around $5,190. Time will tell if I am made whole.

Where There Is Smoke There Is Fire

Rarely does one incident end the bloodletting. Laplanche is the face of the micro-lending industry and Lending Club. Some of the ethical issues reported did not pass the sniff test. There had to be more problems lurking below the surface. Bloomberg over the weekend had this report. You can read the lengthy details on your own. My worries were confirmed: where there is smoke there is fire. The stock price is down 80% from its IPO price and the possibility of the company failing is real.

Lending Club has always been a risky alternative investment best used by wealthy investors for a small portion of their portfolio. My maximum investment was $18,400 in micro-lending companies, plus the IPO stock investment I sold quickly after the stock started trading. I could afford to invest more, but I like to invest cautiously. I was always worried by the idea of super high interest rates charged borrowers, plus a loan origination fee. There had to be better alternatives for borrowers.

Greed caused me to invest in Lending Club as a lender. I justified my decision with the knowledge risk would be spread over hundreds of loans and that my investment was very small. I considered Lending Club as part of my mad money investment portfolio.*

Where to From Here?

The damage has been done to the tainted nascent industry. The stock probably continues down and I would not be surprised to see business failures in the industry. Adding money to a Lending Club investment account at this time is a bad idea in my opinion. (But what would I know; I’m only a wealthy accountant.) I encourage my clients to explore a different avenue for their alternative investment money. I am not bashful about telling clients I am withdrawing from Lending Club and Prosper and will continue until the accounts are depleted. I will not return to the industry for a very long time, if ever.

Lending Club is damaged goods. Too many ethical issues have cropped up for me to ever consider Lending Club again. My guess is this all ends badly for investors of the company stock. It is already down ~80%. How much more can it go down? All the way to zero, another 100% decline. No one knows what will really happen. We have seen this story play out before in the stock market. Those who leave the dance early fare best with rare exception.

Lenders on the platform also have risk. You can sell some of the loans you own, but I am not sure how good the secondary market operates since I never used it. The recent news probably has prices lower there too. The loans are illiquid. You only get money back as borrowers make payments. My feeling is lender accounts are secure from the company’s woes. I am personally withdrawing money as borrowers make payments, but will not sell notes. My risk is rather small at this time since I have been running for the door quickly since the first signs of smoke. If you have a large investment it might be worth considering some sales in the secondary market platform offered by Lending Club and Prosper.

Lessons Learned

The first lesson is to cut and run whenever there are ethics violations involving the CEO or CFO. It is the rare company that comes clean with all the ethical dirt in one disclosure; the board of directors probably doesn’t even know all the dirt and therefore can’t disclose it. Keep in mind this is different than non-ethical violations. An OWI/DWI charged against the CEO is different than an ethical violation. Ethical violations take a lot of digging to get the whole story. When you see smoke, cut tail and leave. You will save yourself a lot of pain and suffering later.

Lending Club, and Prosper to a lesser extent, was too good to be true. These companies offered double digit rates of interest in a negative interest rate world. This is distinctly different from investing in a business where returns on invested capital create value. Borrowing money to people paying 20% or more for personal spending is never a healthy investment. Readers here understand how important it is to spend less than you earn and saving half your income is the norm. I invested in people who spend well beyond their means and now it is time to pay the price for such a stupid decision. I was supporting bad financial decisions and I know better. It is only luck (or the grace of god) that will bail my ass out. I was lucky to start divesting early. Not everyone is as lucky.

Another lesson is always keeping the bulk of your money in broad based index funds. Index funds invest in the biggest and most successful enterprises on the planet. One or two companies might get in trouble, but the group as a whole will weather the storm better than most and do better in the long run. I understand each person needs a tailored investment plan. Traditional investments should comprise the bulk of your portfolio.

Excess risk means exactly that: excess risk. Lending Club was never a low risk venture. The stock’s continual decline after the initial jump after the IPO was a damning sign. Prosper’s declining opportunities and investor returns proved to be the canary in the mine. Don’t be surprised if Prosper and other companies in the industry also air out laundry. I am not accusing Prosper or any other micro-lender of malfeasance. What I am saying is some industry practices will come under greater scrutiny and probably will affect the industry adversely.

We can learn a lot from the currently unfolding Lending Club fiasco. If we learn our lesson and do not repeat the same mistakes we are all the better for it.

Special thanks to Pete at Mr. Money Mustache for tweeting the Bloomberg article, informing me of the latest issues at Lending Club. Pete is updating previous posts or providing a Lending Club update on his blog later this week.

 

* I keep around $100,000 in alternative investments as my mad money account. Sometimes I buy individual stocks I like after serious research. Currently my mad money account has a lot of cash. I said it was a mad money account, not a crazy money account. It is hard to find solid investments at current price levels. I still plow excess cash into index funds knowing full well the day will come when a correction arrives. However, cash never hurt anyone.