Damned if I Do, Damned if I Don't

By Dennis Miller, Money Forever

David F., a Miller's Money Forever subscriber, recently sent me a question that hits close to home for many of us.

David F. wrote:

"I have looked at a lot of dividend-paying stocks, but I have been reluctant to buy because my sense is that the market as a whole is overvalued and ready for a dramatic decline. Based on past experience, such a decline will affect all stocks, not just the most overvalued ones. If I buy dividend stocks and there is such a decline, I could be looking at a 40% loss. Even if I defend with stop losses, I could expect a 20% hit. What is your strategy for dealing with this situation?"

Fear of investing is real and understandable. And I can certainly relate to David's fears. As I approached 60, my wife and I had decided on a "magic number" - the amount we thought we needed on top of Social Security to retire comfortably. When we finally hit our magic number, it was a huge cause for celebration.

But then 9/11 happened. We took a huge hit and dropped back down well below our magic number.

We were devastated, both financially and emotionally. The red numbers on our Quicken report sent me into shock. It took such an emotional toll, I promised my wife that once we got back over that number, I would never let us fall back into that position again.

Instead of gearing down to retire, we shifted gears and started working harder than ever.

After a few years, we were back where we needed to be, and I made good on my promise. I took all of our money out of the market and built a CD ladder. It averaged around 6%, and I thought we were home free.

Then the first TARP bill was passed, and the banks called in all our CDs. (You can read the whole story my book, Retirement Reboot.) We were 100% in cash, and I started over. I must admit I felt smug because we didn't lose a dime in the market, as many of our friends had. But what I didn't realize at the time was that I too was putting my money at considerable risk.

It wasn't until the fall of 2011, when I attended the Casey Summit in Phoenix, that I realized how dangerous my "all in CDs" approach really was. There were three speakers there who shared personal stories of hyperinflation in their home countries. Had we experienced any kind of hyperinflation when all our money was in CDs, we could have lost everything. The bottom line was, seniors and savers were wiped out.

So there we sat. The market had just collapsed; my wife and I had more cash in our cash account than ever before; and I was scared to death to put any money at risk in the market. However, since then, I've taught myself how to manage our life savings differently (and better) than I had in the past.

Wading Through the Warnings

People are scared, and that's understandable. There are plenty of sources out there warning us of the dangers -sometimes with conflicting points. I read a report indicating that US corporations are sitting on trillions of dollars in cash, afraid to spend it. When major companies have cash and are reluctant to invest in their own businesses, it should concern you.

I've also come across reports warning investors against investing money they can't afford to lose. Makes sense, but isn't holding it in cash a risk as well?

Then there are the articles about the government printing money like never before. Holding on to a currency that's experiencing high inflation is a sure way to lose money. The Casey Summit speakers who recounted hyperinflation in their home countries convinced me that this is a real worry.

Oh yeah! Let's not forget to add that the entire stock market is a house of cards propped up by the Fed's printing press. Your fear of money-printing should be double-barreled - it can bring both inflation as well as an artificial bubble in the market.

So you want safe investments? I just checked my Schwab account. The best rate they have for a five-year CD is 1.5%. Who'd want to tie money up for five years for an interest rate below the current inflation rate? I sure don't! Forget about hyperinflation - today's tame inflation numbers will still crush your investment.

There are just too many financial warnings for folks to keep track of: "Don't invest money you can't afford to lose; safe investments won't keep up with inflation; invest and compound your growth or you'll have to keep working; enjoy life and sleep well, etc."

We recently completed a subscriber survey, and David's concern was voiced by many. One comment summed up a lot of fears: "I would rather have a lesser return and a guaranteed return of my money than a return on my money."

The real dilemma is how to define a return of our money. In last Friday's Casey Daily Dispatch, we provided an analysis of an investor buying a five-year CD at the going rate of 1.5%. If you believe the government-provided 2% rate of inflation, at the end of five years the net inflation loss would be $9,400. If you believe the true inflation is 6%, as I do, then you will lose $25,750. Neither alternative is appealing. Why would you invest in something that all signs point to losing and the only difference is a matter of how much? Aren't we really looking for a "return of our buying power?"

I'd rather invest in something where at least I have a fighting chance of making a gain. With a CD, I'm almost guaranteed to lose the purchasing power of my money.

So what is the lesser of the evils? My choice is to work with our research team to try to find good businesses that will survive in tough times. Many have dividend yields well above the current rate for CDs and have the potential to not only have capital gains, but for their dividend to grow as well. Even when our research team has found good options, I still recommend modest investments in those picks with only a portion of your portfolio. With such low yields out there, I feel like we are being forced into the market. But at the same time, it's doesn't have to be "all-in" decision. We could put some money in the market and keep some dry on the sidelines.

The trick is finding the right balance for yourself. It's no wonder a lot of older folks have to take pills just to sleep at night! I hope David F. understands that he's not alone; a lot of folks share his concerns.

You Know the Problem, but What Can You Do?

• The Fundamental Rule. Start with the fundamental rule of investing: Don't invest money you can't afford to lose.
  
  I have to remind myself that investing in good-quality companies most likely will not make me lose all my money. While they can take a hit in bad economic conditions, you really have to be playing with fire to get completely wiped out.

• Keeping Perspective. The first big lesson I learned during my own retirement reboot was to put my fears into perspective. You cannot allow fear to immobilize you.
  
  While I took comfort in not losing a dime in the market in 2008, I shuddered when I realized my "all-in" CD position was putting our entire life savings at risk.
  
  All in the market, all in cash, or all in anything is dangerous. Returning to the market was scary. It took a long time for me to regain confidence in myself as an investor.
  
  Having money in the market is like working on high-power lines. While you may have confidence in what you are doing, you'd better take all the necessary steps to protect your safety. We have all been burned.

• Dividend-Paying Stocks. David F.'s question was a response to my article Twelve Tips for Buying Dividend-Paying Stocks. While I'm not going to repeat all twelve steps, I want to elaborate on a few points.
  
  I am a strong believer in using stop losses, especially trailing stop losses. They usually work best with heavily traded companies, with millions of shares traded. Also, when I refer to "dividend-paying stocks," I mean stocks bought for the dividend income, not speculative stocks that might happen to pay a dividend.

• Limit Risk. There are ways to limit risk and still play the game. If you don't put more than 5% of your portfolio into any one investment with a 20% stop loss, the most you could lose is 1% of your entire portfolio.
  
  In David F.'s letter, he mentioned losing 40%. If you limit your investment to no more than 5% of your portfolio and then get stopped out at 40%, your portfolio won't drop more than 2%. I have had more than one friend say to me they wish they'd had 20% stop losses in place before the 2008 crash. They would have saved a lot of money and would have a lot more confidence in themselves today.

• Worldwide Presence. Buy companies which have a worldwide presence, dominate their market, and have a history of paying and regularly increasing their dividends. If you buy the right stocks, their dividends continue to grow, and it won't be long before your return can be close to double digits. When there is a drop in the market, you should ask questions like: Do they still have the ability to pay dividends regularly? Can I get a similar or better yield elsewhere with the same or less risk?

• Keep Enough Cash. If you're being conservative, you should have about 33% of your portfolio in cash. There may be buying opportunities during a market downturn; if you have the cash, you're in a better position to take advantage of them.

• Go International. International diversification may be right for you; it's an important option to consider. There are many domestic companies that are diversified internationally, and there are also many foreign company stocks (or ADRs) you can buy here in the United States. Shell, a Dutch Company, and Nestle, based in Switzerland, are both good examples, although I'm not recommending them.
  
  While all world markets are interrelated and could crash at the same time, diversifying internationally will take some risk off the table, as some countries will always do better than others.

The Value of Doing Your Own Homework

Vedran Vuk, our senior research analyst, has taught me the real value of doing your homework. Vedran was behind the wheel for our upcoming special report Money Every Month, which is targeted for a November 27 release. It's an in-depth analysis of the top-yielding dividend stocks - a virtual encyclopedia of when they pay, how much they pay, and other important parameters. (Vedran and I also work together to produce Miller's Money Forever, a monthly advisory that will help you build an inflation-proof retirement portfolio. Our subscribers will get the Money Every Month special report along with their regular subscription.)

When you find a company you're interested in, go to your online brokerage account, click on the "research" tab, and read up on the company using some of the guidelines I mentioned earlier, such as the 12 tips for dividend-paying stocks.

If you subscribe to paid services, take a really look at the model portfolios. Don't just read the newsletter's in-depth investment write-ups a single time. Go back every once in a while and check to see how companies have done since they were originally added. Are they still growing and paying (and increasing) regular dividends? Are they meeting the goals originally set in the recommendation?

After reading stock write-ups, I usually know a heck of a lot about the company. Many times I ask myself if I would like to be a part owner of the company I'm reading about. Until you can imagine yourself being a happy (and well-paid) part owner, keep researching and looking at other candidates.

And when you find what you're looking for, remember to buy in moderation.

The Risk of Doing Nothing

Do not minimize the risk of doing nothing. The biggest financial risk I have ever taken was holding our life savings entirely in CDs. Honestly, my parents had done that, and it worked well for them. I was under the illusion that our money was safe. And it was safe - if the bank defaulted.

But I realize now that it was at huge risk if we experienced any kind of high inflation. I was 68 when the banks called in our CDs. A "do-over" at 60 - when I had totally left the market after 9/11 - was difficult, but I was still working. Starting over now would be a real disaster. While inflation might not seem like a big deal now, it's something almost guaranteed to be a problem with the rate of today's money-printing. Being all in CDs now is about as smart as being all in stocks in 2008. You've got to find the right balance between the allocations to protect yourself.

A Buy Recommendation Is in the Eye of the Beholder

By Vedran Vuk

When I was still taking classes at Johns Hopkins University, we had the fortune of occasionally having speakers from established financial institutions address the class. One day, we got the head of research at a major asset-management firm. The company managed billions -and I don't mean billions in the single digits.

During the Q&A session, I asked the head of research, "So you manage a team of nearly 30 research analysts with varying views. How do you come to an agreement on macroeconomic viewpoints? For example, if you're projecting financial statements into the future, what kind of interest rates do you forecast? If it's an oil & gas company, how do you come to a consensus on commodity prices? Even for basic revenue growth rates, how do you make sure everyone's projections are assuming similar economic conditions?"

At Casey Research, we're a growing company, but still small, so these issues aren't such a problem. We're constantly discussing our viewpoints with each other, so that everyone can be on the same page. With my question, I wasn't trying to bust the guy's chops - I honestly wanted to know the process for a larger institutional firm. In a very annoyed tone, the speaker responded, "We don't do any of that." Essentially, he explained that their goal is to find companies which are outperforming their sectors. As a result, they don't have to worry about most of these macroeconomic issues.

OK, that sort of makes sense. Regardless of what happens, you're better off holding the best company in the sector than an average company. We're all in agreement there, but shouldn't there be more to the company's investment criteria? Following up, I said, "I get what you're saying. You're always better off holding the best, but at the same time, don't you need some bearing on the economy? I can pick the best bank in the US, but if the market crashes tomorrow, the financials will likely be the worst place to put my money. Or I might find the most exciting oil company out there, but if WTI crude falls to $40 a barrel, things won't turn out so well. To make an investment in these sectors, don't you necessarily have to hold some opinion of the underlying macroeconomic fundamentals?"

He answered with a very long rambling and even more annoyed response which had little if anything to do with my question. His evasiveness would have made the Romney and Obama debates look like straight talk. I really didn't want to be a jerk, and I got his viewpoint. So I didn't press him further, and said after his long statement, "Oh, OK, thanks."

Here's his investment philosophy in an analogy: These analysts know everything about every single model of car on the market. They know about the smallest details from the horsepower to the mpg to where the parts are manufactured - they even have every gadget on the console memorized. After researching all of the choices, they finally find the perfect car and purchase it at the dealership. However, before driving off the lot, they first blindfold themselves and hit another car the second they pull away.

With a philosophy like that, is it such a surprise that their investments crash? Yes, technically, they have found the best car on the lot, but what does it matter if you drive blindly straight into oncoming traffic? If you can't see where you're going, the car is useless. In fact, you'd probably be better off driving a lemon with no blindfold on.

Honestly, that's probably true. If you picked a below-average gold mining company right before a huge hyperinflation, you're going to do better than holding the best financial stock. Seeing what's coming is extremely important.

This lack of bearings on the economy isn't uncommon. Take for example two companies with plenty of Wall Street coverage, Barrick Gold and Citigroup. Let's start with Barrick Gold. It has 7 strong buy recommendations, 11 buy recs, and 10 hold recs. Citigroup has 7 strong buy recs, 15 buys, 6 holds, and 3 underperform or sell recommendations.

Essentially, the Wall Street analysts are telling you to buy or hold both Citigroup and Barrick Gold. Think about that from the perspective of a portfolio. If I were really bullish, I would buy Citigroup. In fact, I would load up my portfolio with Citigroup and other banks. However, I wouldn't hold Barrick. If the market is headed for a continued slump or inflation is a serious concern, then gold makes sense.

The Wall Street firms give overwhelming buy recommendations for both, yet they don't necessarily make sense in the same portfolio. One stock is bearish, and the other is extremely bullish. Perhaps this works for some sort of bipolar portfolio, but certainly not ones most people are trying to construct.

To project the financial statements of any company, an analyst must have certain beliefs about the economy. And if the analyst's beliefs don't match your own, then a strong buy recommendation might be a strong sell in your book. As I said with Citigroup, if you're bullish, it probably is a strong buy. However, that buy recommendation has a lot more to do with a general prediction about the economy than the strength of the company.

There are few stocks out there that are truly buys under any circumstance. So the next time you're looking at recommendation from a big financial firm, don't completely disregard it, but also take it with a grain of salt as well. A buy recommendation is in the eye of the beholder. It might be a good company, but right now might not be a good time to own it.