## Empower young investors with savings plans.

May 29, 2016

The purpose of this article is to help young people make long range savings plans.  It’s a three-step process: 1) Set the goal. 2) Adjust for inflation. 3) Make recurring payments. I begin by presenting a retirement savings plan and conclude with a generic process for making other savings plans.

### Planning for retirement

QUESTION: How much money should I save to start retirement?

ANALYSIS: I know people save money for future expenses even though inflation increases those expenses. Thank goodness my current budget is designed to pay for emergencies and pay all debt before retirement. If I live within my means and save 25 times my annual salary, I could safely withdraw 4% of those savings in the first year of retirement and keep withdrawing that amount, adjusted for inflation, each year of retirement. Life would be good! [refs 1-3]

GOAL: Save \$25 per dollar of annual salary, plus an adjustment for inflation. The goal has 2 parts: 1) The savings account should hold at least \$25 for every \$1 of gross annual salary. 2) Every saved dollar should be inflated to match the Economy’s inflation rate.

STRATEGY: Start to invest regularly at the beginning of my career.

1. Starting at approximately age 25 and finishing at approximately age 75 will provide 50 years of opportunity to save for retirement.
2. At an annual inflation rate of 3%, the average price of everything that costs \$1 today will likely be \$4.38 fifty years from now (check this estimate with a future value calculator).
3. My real savings goal is \$25 X \$4.38, which rounds to \$110 for per dollar of salary.  The planning table in Fig. 1 will help me select a regular deposit.

Fig. 1

For instance, a stock index fund that’s expected to earn a 10% annual rate of return could accumulate \$110 when 9 cents per year are deposited into the account for 50 years.

How does this apply to me?  Suppose I start earning \$50,000 a year at age 23 and invest in a stock index fund that earns an 8% rate of return. Thanks to the help from my parents, I already have \$1,000 to open an investment account. According to the 50-year plan in Fig. 1, I will choose to deposit 18 cents per year for every dollar of salary. That means my annual deposits will be \$9,000 from the \$50,000 salary. If things go right, my investment account will be worth \$5,546,902 after 50 years. Really?!!?

• The future value of \$1,000 is \$46,902 based on an annual return of 8% for 50 years {test this calculation with the future value calculator}.
• The planning table in fig. 1 is designed to earn \$110 by making regular deposits for every \$1 of salary; \$110 X \$50,000 = \$5,500,000.
• \$46,902+\$5,500,00 = \$5,546,902.  Happy retirement!

THEN WHAT? Plan on safely withdrawing 4% of your savings at the beginning of retirement in order to match your annual salary before retirement; 4% of \$110 is \$4.40. Next year withdraw the same amount plus extra cash to adjust for inflation. The adjustment factor is (1+I) for the annual rate of inflation. Assuming that I is a 3% rate of inflation, (1+0.03) X \$4.40 = \$4.53. Each succeeding year, withdraw the same amount as the previous year plus an adjustment for inflation. In the first 5 years of retirement your annual withdrawals will be \$4.40, \$4.53, \$4.67, \$4.81, and \$4.95 per \$1 of pre-retirement salary and you will have plenty of savings for the rest or retirement [refs 1,2].

### Risk management

There’s no guarantee that your plan will work. What could go wrong and how do you avoid failure? Some likely risks are missed deposits, taxes, low rates of return, brief time, and market declines.

1. Missed deposits- Deposits energize the process of compounding interest to accumulate savings [ref 4]. Avoid missing deposits by making automatic payments through an employer sponsored savings plan –e.g., 401(k), 403(b)– or through payroll deposits into an individual retirement account (IRA).
2. Taxes- Tax-deferred savings plans reduce your taxes. Deposits into employer-sponsored retirement-savings plans and traditional IRAs are not taxed until withdrawals are made after retirement when the withdrawals are taxed as regular income. Deposits into a Roth IRA are taxed at the time of deposit, but never taxed again. If the traditional and Roth IRAs are not affordable for you, the U.S. Government offers an affordable Roth IRA called the MyRA. If you wish to invest in Treasuries and corporate bonds, beware that they ares taxed at a higher rate than the long term capital gains from stocks.  Use a tax-deferred account to invest in bonds [ref 5].
3. Low rates of return- Stocks reputedly pay higher rates of return than bonds. Investing in individual stocks is a risky and time-consuming effort; joining an investment club may be helpful. Consider buying shares of index funds that invest in market sectors with the understanding that investing in market sectors is riskier than investing in broad markets.
4. Brief time- Start investing while you’re young. Starting later will require larger payments.
5. Market declines- Since 1929 the average stock market cycle was 40 months divided into 30 months of price inclines and 10 months of price declines [ref 6]. The net effect was an uptrend in prices over long time periods. Individual investors can protect their investment returns from market declines in two ways: 1) Continue investing during market declines when regular deposits will purchase more securities at lower prices. 2) Diversify by adding bonds to your stock portfolio. This is best done by making supplemental payments for bonds in tax-deferred accounts such as MyRA.

### Generic savings plan

Any long range savings plan can be made in 3 steps:

1. Set a goal for how much money you want to save. Your goal becomes the accumulated amount calculated by the compounded interest calculator [Fig. 2].

2. Adjust for inflation by multiplying your goal by the factor (1+I). I is the decimal value of the annual inflation rate. If you choose last century’s average annual inflation rate of 3.2% [ref. 7], the factor is (1+0.032). If 3.2% seems too high, use your internet search engine to discover more recent inflation rates.

3. Determine recurring payments needed per \$1 of annual salary.  Display them in a customized planning table similar to Fig. 1.  Here’s how:

• The columns are values of N for the number of years. Choose at least 2 time periods for the sake of versatility.
• The rows are values of R for an investment’s annual rate of return. Choose a practical range of stock and bond returns for the sake of versatility.
• The cells display fractions of \$1 for making the minimal recurring deposit (d). Determine the deposits by testing trial values of d in the compounded interest calculator (Fig. 2). For example, start with d = 10 cents at the highest rate of return (R) for the longest time period (N). 10 cents represents the idea of depositing 10% of every dollar in your annual salary [Hint: it’s practically impossible to deposit more than 50 cents per dollar of salary].
• In Fig. 2, the value of PV can be \$0 unless you already have an initial deposit.

### Appendix: All-purpose Savings Calculator

Try fig. 2’s all-purpose savings calculator that’s in the open-source publication of PracticalMoneySkills.com [ref. 8].

Fig. 2

Note: Fig. 2 can be validated by tests using the compound interest formula for annual additions discussed in ref 4.

### References

1. Jane Bryant Quinn. How to make your money last. The Indispensable Retirement Guide. 2106, Simon & Shuster, New York. 366 pages.

2. William P. Bengen. Determining withdrawal rates using historical data. Journal of Financial Planning, pages 171-180, October, 1994.

3. Craig L. Israelsen. The importance of diversification in retirement portfolios. AAII Journal, April, 2015. pages 7-10. American Association of Independent Investors.

4. Miranda Marquit. How does compound interest work for investments? ©️2016 empowering media inc. 2/18/2016.

5. Types of Retirement Plans. IRS.gov, 10/7/2015.

6. Paul A. Merriman. 22 things you should know about bear markets. Aug 24, 2015. MarketWatch.Inc, ©️2016.

7. Tim McMahon. Average annual inflation rates by decade. June 18, 2015.

8. Compound interest calculator. PracticalMoneySkills.com. ©️2010 Visa.

## Book review: The Index Card, by Helaine Olen and Harold Pollack

May 5, 2016

The Index Card. Why Personal Finance Doesn’t Have to Be Complicated. Helaine Olen and Harold Pollack. Penguin Random House, New York, 2016.

### Genesis

The authors converged their experiences from  journalism (Helaine Olen) and academia (Harold Pollack) into the worthy effort of demystifying the world of personal finance for everyone’s benefit. Author Pollack began the process by devising an index card of rules for recovering from financial hardship and staying solvent. Author Olen’s experience with the Personal Finance Industry validated Pollack’s scheme. Together, they explain the index card to readers of this valuable book.

### Rules from the Index Card

1. Strive to save 10-20% of your income.
2. Pay your credit card balance in full every month.
4. Never buy or sell individual stocks.
8. Insurance- make sure you’re protected.
9. Do what you can to support the social safety net.
10. Remember the Index Card

### Highlights

Rule #1. The household budget is essential for living comfortably. Be sure to save 10-20% of your income for future needs. The most important savings account is an emergency fund; every household should save 3 months of income in an accessible savings account to use for emergency expenses. —An emergency expense is both immediate and necessary; something bad has happened.—

Rule #2. Unpaid debt has top priority in your budget. Credit card debt is a preventable financial illness that must be corrected. Other forms of debt must also be managed within the framework of a budget.  Unfortunately, there may be unpreventable causes of overwhelming debt such as health care bills and other catestrophic events. Overwhelming debt may require seeking legal advice to file for bankruptcy; don’t feel ashamed.

Rule #3. The second most important savings account is your retirement fund and/or educational savings account. Start while you’re young to take advantage of the compound interest (a.k.a. compounding returns) from investments in either account. DON’T REJECT employer-sponsored retirement savings plans and DO participate in them to the full extent. You can also open personal retirement savings accounts. Facilitate your savings plan by making direct deposits into the retirement and educational savings accounts.

Rule #4. The media’s ‘toxic’ message is that playing stocks is easy and fun. But no matter how much research you do, buying stocks is still a matter of speculation. Stocks are a pay-to-play business where only the broker can always win. Forego the dream of a big win by investing in a small selection of index funds.

Rule #5. Index funds are designed to automatically match the performance of a selected stock- or bond market index. Index funds are true buy-and-hold investments. Most exchange-traded funds (ETFs) and a few mutual funds are index funds. They charge lower management fees than the actively managed mutual funds. Actively managed funds charge higher fees in order to pay for the research needed to outperform the stock or bond market. Few actively managed funds succeed in their effort to beat the market on a sustained basis. Annual management fees for index funds (~0.12%) are lower that for actively managed funds (~0.89%). The average household loses \$155,000 in potential investment gains due to the unnecessary fees of actively managed mutual funds.

Rule #7. Spend no more than 30% of your budget on housing. There are risks and advantages to either renting or buying a home. The authors discuss both.

Rule #8. Insurance is complicated but necessary. Don’t be exploited by salespeople. The 6 Golden Rules of Insurance are:

5. avoid complicated annuities
6. keep an emergency fund

Rule #9. We can’t protect ourselves from everything; sometimes we need a little help. The government is our insurance-backer of last resort. 96% of us have used government financial support to improve our financial situation. Isn’t it our fiduciary duty to Society to support the best government insurance programs?

### Conclusions

I concur with the authors’ advice. The strength of their advice is supported by pages of references at the end of the book. Read and re-read their book.

## Book Review: Blue Chip Kids, what every child and parent should know about money, investing, and the stock market.

April 24, 2016

Blue Chip Kids, what every child and parent should know about money, investing, and the stock market. David W. Bianchi. John Wiley & Sons, Hoboken, 2015. 234 pages.

Author David W. Bianchi wrote this book for young people who are interested in spending money. He wrapped the uses of money into 3 important topics: 1) All about money; 2) Ways of investing money; and, 3) Stock markets.  Gambling was excluded from the discussion.

I was interested in learning to coach my granddaughter on ways investing money. Bianchi exposed me to very low-, very high-, and mid-range risks of investment (I wouldn’t advise my granddaughter to invest at either end of the spectrum!). Here’s my synopsis:

Chapter 1 has one of the best sections in the book which describes ways of earning money throughout life. Money is a “currency”. Don’t be surprised to learn that there are many different currencies with constantly changing values. Chapter 2 describes ways of paying for things.

The best ways of borrowing money are discussed in Chapters 9-11. If you want to avoid a penalty, repay your debt on time. Payments of interest on loans are called coupons. Coupons are a cost to the borrower that are paid to the lender. Some borrowers must pay simple interest and others pay compound interest. Lenders usually prefer payments of compound interest.

Borrowers are expected to show that they are reliable (“credit worthy”) people. For example, bankers will ask to read your financial statement before giving you a loan. Your financial statement is a document that lists the total value of assets (things that you own) and liabilities (money that you owe). The difference between total assets and total liabilities is your net worth.

Governments earn money by charging taxes and selling bonds. Everybody has to pay taxes. Failure to pay any of the many taxes described in chapter 12 may lead to a government audit and penalty. Chapter 13 reveals that the U.S. Government owes 17 trillion dollars to lenders from around the world! All of us face serious consequences if our government fails to pay its debts! Meanwhile, we can protect our personal financial reputations by avoiding default and bankruptcy. Better yet, don’t borrow money. Create a budget to “live within your means”.

Chapter 15 explains the challenge of retirement, which is to continue paying bills after you stop working for a living! After you graduate from school to begin a career in early life, start saving for retirement later in life at age 60-75 years. The author wisely advises to “give yourself the ability to retire if you want to”. Your retirement income will come from retirement savings, social security, pension plans, and annuities.

### Investing

Investing is all about risk and return. Treasury bonds are considered no-risk investments that return about 3% annually. The investment choices that Bianchi offered to his readers were stocks (chapters 3,8), options (chapter 5), funds (chapter 6), bonds (chapter 7), and private companies (chapter 14).

A Stock is a certificate of ownership, also called a security. Brokers don’t issue the certificate, they send a confirmation that serves as evidence of ownership. The market value of the stock usually rises when its company earns profits.

Options are contracts that guarantee the trade of an asset at a fixed price for a limited period of time. The seller earns a fee for guaranteeing the trade. The buyer pays the fee in turn for the right to execute the trade before expiration. The buyer may benefit by 1) using the option as an insurance policy, 2) exercising the option at a favorable price, or 3) trading the option in the options market.

A Fund is a pool of money collected from many investors to invest in a group of assets. The advantages of the fund are that investors don’t spend considerable time doing research and don’t spend large sums of money for a diversified portfolio. Among the types of funds are

1. Index funds, which copy a security index and charge low fees for the service.
2. Mutual funds, which don’t copy a security index and do charge several fees for the service.
3. Hedge funds, which invest in anything and charge very high fees. Hedge funds have strict rules of eligibility and charge “2 and 20” fees (2% annual management fee and 20% management ‘tax’ on investment returns).

A Bond shows that you lent money to the company on condition that it returns the money, with interest, at the maturity date.  The bond’s face value is the original price (printed on the face of the bond); it is the redeemable amount!  The yield is the bond’s annual rate of return; Yield = Interest / Price.

A Private Company does not trade its stock in a public stock exchange. Private company stocks are illiquid because they don’t have an open market. Venture Capital and Private Equity firms buy stocks in private companies. Venture Capital is money invested in start-up companies. Private Equity firms inject money into established private companies in exchange for the companies’ stocks.

### Stock market

Advice: It’s difficult to predict the ‘top’ and ‘bottom’ of market prices. Do homework to buy quality stocks at a reasonable price.

Chapter 3 explains that the stock market is a place for orderly buying and selling of stocks (and other securities). There are many stock markets that vary according to listed stocks and total market capitalization (‘market cap’ is the total value of the company’s shares).  Chapter 8 describes how to make stock-buying decisions, how to participate in the stock market, and how the market behaves.  David W. Bianchi, if I misread your book, then I apologize for citing 2 nearly insignificant errors that were made about investing in stocks:

1. Contrary to statement, there is no P/E ratio = 0.  Ratios of x/0 are undefined.  Financial websites don’t report the P/E as a number when company earnings are negative or 0.
2. A share buyback doesn’t raise the price per share of stocks; only trading activity in the market can raise the price.   A share buyback raises the earnings per share (eps), which then may raise the share price.

## Book review: How to Make your Money Last. The Indispensable Retirement Guide. by Jane Bryant Quinn.

March 22, 2016

Jane Bryant Quinn, 2016, Simon & Shuster, New York. 366 pages.

### Synopsis

This book should be read by everyone who needs to plan for retirement from the workforce.  Author Jane Bryant Quinn is an acclaimed financial journalist with excellent credentials. In this book, she draws from credible research to describe principles and checklists for retiring with a practical financial plan. She speaks from firsthand experience about reinventing life after leaving the workforce: “once again the future is a blank slate” that needs to be filled with activities for a meaningful life (chapter 1). Those activities need the support of a dependable income managed by a practical financial plan.

In her opinion, your default plan is to maximize social security benefits and gradually increase the market value of your retirement portfolio (a.k.a. retirement savings) while maintaining a monthly paycheck for the duration of retirement. The financial core of a good retirement plan is based on 3 principles (chapter 12):

2. Maintaining a cash reserve throughout retirement (chapter 9)
3. Making safe withdrawals from your retirement portfolio (chapters 8, 9)

Quinn provides practical checklists for transforming various sources of retirement income to a homemade paycheck.  In addition to building a retirement portfolio by ‘bucket’ investing (chapter 9) are the supplemental sources of income from Social Security benefits (chapter 3), traditional pensions (chapter 5), simple annuities (chapter 6), and home equity payments (chapter 10).  She also provides practical checklists for securing retirement income with the help of spending rules (chapter 8). Quinn’s valuable checklists help manage the financial risks of inflation (chapters 2-4, 8), taxes (chapter 7), costs of healthcare (chapter 4), and spousal protection (chapters 3, 4, 6, 7, 10, 11).

### Janet Quinn’s Core principles

BUDGET GAP (chapter 2). The 3 important numbers in your retirement plan are its budget gap (chapter 2), cash reserve (chapter 9), and safe withdrawal (chapter 9). Calculate your budget gap before retirement. It is the difference between future income and expenses. The future gap can be minimized by staying in the workforce (to build a larger retirement portfolio) and spending less money.  Significant adjustments to financial assets and regular income may be necessary to support your desired level of spending later on. Estimate the future annual amount of money you can safely spend by using the following formula (chapter 2):

safe spending = (0.04*financial assets) + regular annual income – estimated taxes

CASH RESERVE (chapter 9). Create a cash reserve at the start of retirement. It will be an important source of money to pay for any budget gap that develops during 2 years of decline in the financial markets.

SAFE WITHDRAWAL (chapter 9). The “safemax” is a percentage of your retirement portfolio that you can safely withdraw in the first year of retirement (chapter 8;“safe’ means “as far as we can tell”). The amount withdrawn, plus an adjustment for inflation, practically dictates how much you can withdraw every year to ensure the 30-year longevity of your retirement portfolio.

Here’s the 4% rule (chapter 8): Withdraw 4% of your retirement portfolio at the start of the first year and safely store the money to pay bills throughout the year. At the start of the second year, withdraw the previous year’s amount adjusted for inflation. For example, assume your retirement portfolio holds a \$50,000 investment in stocks and \$50,000 investment in bonds for a total of \$100,000. Even if you make no more contributions to the porfolio, the following annual withdrawals could be sustained for 30 years when adjusting the previous year’s withdrawal for a 3% rate of inflation and rebalancing the portfolio to maintain a mixture of 50% stocks and 50% bonds:

year 1- \$100,000 * 0.04 = \$4,000 withdrawal
year 2- \$4,000 * 1.03 = \$4,120 withdrawal
year 3- \$4,120 * 1.03 = \$4,244 withdrawal
legend- \$100,000 is the portfolio’s initial value, 0.04 is the safemax, \$4,000 is the first annual withdrawal, 1.03 is the inflation factor, and \$4,120 is the second annual withdrawal.  there is no adjustment for taxes in this calculation.

NOTE: The amount withdrawn by the 4% rule is directly related to the initial market value of the retirement portfolio. For example in year 1, the amount safely withdrawn from a \$200,000 portfolio would be \$8,000, etc.

Protect yourself from the hidden risks of greedy salespeople as you get older and less interested in managing your accounts. Appoint a trustworthy person as your durable power of attorney and use a written investment plan.

### Life-time income

Life-time incomes offset the risk of outliving your retirement portfolio. The reliable life-time incomes of retirement are Social Security, Pensions, and Annuities.

SOCIAL SECURITY (chapter 3). Social security benefits include a guaranteed income for life, protection against inflation, tax benefits, and protection of your spouse without the risk of market fluctuations and without paying investment fees. Beneficiaries can maximize their income by delaying the onset of benefits to age 70 instead of starting at age 62 (be sure to enroll in Medicare at age 65). A survivor’s benefit is based on the earnings-record of the deceased. The spousal benefit is automatically upgraded to a higher survivor benefit.

PENSIONS (chapter 5). Traditional pensions offer either a monthly lifetime payment or a lump sum payment that can be rolled over to an Individual Retirement Account (IRA). The rollover incurs an investment risk (investment risk is the possibility of incurring a loss from your choice of investment or the investment’s fluctuation in market value).  Government pensions (except municipal pensions) are reliable.  Most private pensions are protected by the Pension Benefit Guaranty Corporation (PBGC.gov). If you are ineligible for a pension, consider buying a lifetime annuity.

ANNUITIES (chapter 6). Annuities aren’t a do-it-yourself investment; they are a tool for managing the risk of outliving your portfolio. Find a good advisor who isn’t a salesperson and avoid buying variable annuities with living benefit guarantees. Simple annuities are purchased with a lump sum in return for monthly lifetime income.

1. The Single Premium Immediate Annuity (SPIA) pays benefits until death unless purchased with payments “Certain”. The SPIA is not designed to create a legacy fund. Its advantage is the payment of benefits that exceed the interest of bonds and dividends of stocks. The insurance company’s rating should be at least AA- (Fitch, S&P), A (AM Best), or Aa3 (Moody’s). [The tax deferred variable annuity can be converted to an SPIA. Find the best available benefit-payments in ImmediateAnnuities.com and switch companies.]
2. The Immediate Pay Variable Annuity pays monthly benefits that change with the market. The benefit is a percentage of the investment portfolio value. The assumed interest rate (air) is your selected rate of withdrawal from the investment portfolio. The investment risks are volatility and choice of investment portfolio.
3. The Inflation Adjusted Immediate Annuity pays monthly benefits adjusted to last year’s inflation. There is no inflation or investment risk. The monthly benefits are lower at the beginning than later on. This annuity is more appropriate for younger people with a longer life expectancy.
4. Fixed Increase Annuities pay monthly benefits that rise at a fixed rate of 1-5%.
5. With a Deferred-income Annuity (“longevity insurance”) there is a time delay to the initial benefit followed by monthly payments for life. The reasons for owning this annuity are 1) protection from outliving retirement portfolio, and 2) providing your spouse with guaranteed income after death.
6. Fixed-term Annuities start paying benefits immediately. This is desirable for people with illiquid investments such as delayed social security.
7. The Charitable Gift Annuity gives a lump sum to charity that guarantees a fixed monthly income for life.

The variable annuity is a pure investment that risks poor performance in the market. Its insurance company offers a guaranteed living-benefit rider (LBR) that provides a minimum lifetime income regardless of the investment’s performance. Taxes on the accumulating returns are deferred until withdrawal, then taxed as regular income (unless “qualified” in a Roth). The tax is proportional to the ratio of investment return to invested capital.  The goal of a variable annuity is to allow growth of your investment above the guaranteed minimum. Success depends on a 90% allocation of stocks in the investment, yet most insurance companies limit the stock fund to 65% stocks. Why? The insurance company is protecting itself by using fixed income from the portfolio to pay the LBR instead of the company’s own money. Living benefits are first taken from the investment portfolio while you continue to pay the annual fee! This seems unfair, so try to exercise your right to withdraw from the investment every year up to a fixed percentage amount. Even if you draw down to \$0, the company will continue to pay your benefit. Spouses are usually not covered by a variable annuity. Rather, the death benefit is an insurance payout that doesn’t replace the annuity’s investment return a survivor might lose. If you bought a variable annuity, it’s too late to extend to your spouse. But you can switch to a better annuity in a tax-free exchange or buy more insurance. Variable annuities often charge excessive management fees of 3-5%.  For a second opinion, consult the Marco Consulting Group at Annuity Review (AnnuityReview.com). They will analyze 2 variable annuities for a fee of nearly \$300.

HOME EQUITY (chapter 10). The equity of your home is a ‘piggy bank’ that can be used for income or passed to your heirs. There are several ways of squeezing income from your home equity:

1. take a Reverse Mortgage to create a 20-30 year spending plan
2. borrow to pay a large bill
5. take a boarder after first checking on possible restrictions imposed by homeowners associations, zoning laws, etc.
6. sell the house and lease it from the new owner (i.e., Sale/Leaseback). Consult a lawyer before selling the house.

The reverse mortgage is a loan against the equity of your home in which the lender makes tax-free payments to you because they are loans. You pay all maintenance costs. Don’t repay the loan while living in the house; proceeds of the sale will repay the loan. You keep the excess proceeds, but otherwise are not responsible for a loss on the sale.

The Home Equity Conversion Mortgage (HCEM) is issued by private lenders and insured by the FHA. The HCEM offers 3 types of payments:

1. lump sum at the beginning
2. monthly payments
3. borrowings from the principal

At your death and before selling the house, your heirs will have the option of buying or selling the house before foreclosure. Seek more information and advice from Jack Guttentag on his website, MtgProfessor.org.

### Portfolio management

SPENDING RULES FOR THE HOMEMADE PAYCHECK (chapters 8, 9). The basic rules are to make buy-and-hold investments in your portfolio, withdraw funds using the 4% rule, and rebalance the portfolio after you make an annual withdrawal. Based on Quinn’s research up to the year 2016, the 4% safemax may be modified in one of several ways:

• 4.5% if your stock allocation is 45-65%
• 5.5% if you reduce the withdrawal in declining markets
• 3% to ensure surviving the next 30 years
• adjustments to the Shiller PE Ratio
• 4% if P/E10 >20
• 5% if P/E10 = 12-20
• 5.5% if P/E10 <12
• 6% is too high and your portfolio may only last 15 years. Instead, borrow on your house through a reverse mortgage.

The amount of annual income withdrawn from your retirement portfolio is determined by your safemax rate of withdrawal (discussed above in the core principles). Be consistent in withdrawing from your portfolio except when the market is depressed. Then withdraw from your cash reserve to pay bills. When the market starts to recover, tap the investments to restore the cash reserve and resume withdrawing at the safemax.

Skip an annual withdrawal when you don’t need it. If the required minimum withdrawal from tax-deferred accounts exceeds your planned annual withdrawal, reinvest the excess amount. Here are 2 ways to preserve capital:

1. Withdraw from investments that have increased in value, otherwise from investments with the lowest potential return.
2. Withdraw from taxable accounts before tax-deferred accounts. Within the taxable accounts, withdraw a blend of gains and losses to minimize taxes.

PORTFOLIO INVESTMENTS (chapters 8, 9). Bucket investing is done by putting money into different funds (‘buckets’), each having a specific purpose. First, create a cash reserve (‘cash bucket’) that will pay bills for 2 years when added to pension checks. 90% of the remaining retirement portfolio is allocated to investments and 10% to a discretionary bucket. Allocate 40-65% of the investments to stocks and the remainder to bonds [the author discussed additional guidelines for adjusting your allocation of stocks and bonds according to age (chapter 8)]. The discretionary bucket is used for big, extra items (e.g., new car).

Your allocation of bonds and stocks depends on your capacity for risk, not your tolerance for risk. The capacity for risk depends on how well you are funded and able to pay bills with pension funds. If your risk capacity is low, don’t risk too much on incurring a loss in the stock market. Do you need to risk a stock investment? Not if all your expenses, including health, are covered for life. People older than 80 tend to fall into this category. Younger people with at least a 10 year horizon have more time to survive market fluctuations. The S&P500 Total Return index has never declined over 15 years. Otherwise, you need to invest in stocks if all expenses are not covered for life. The reasons for investing in stocks are to hedge inflation (low allocation of 20-30%) or create a legacy fund for heirs (high allocation of 40-80%).

There are several important advantages to investing in index funds instead of individual stocks and short-term bonds.

• index funds are easier to rebalance each year
• you will earn the return of the whole market
• you will own a portfolio of diversified investments
• index funds are easily converted to cash
• short term bond prices aren’t as volatile as long term bond prices

What if you don’t want to rebalance the retirement portfolio?

• invest in a target-date fund
• use a rebalancing program
• pay a low-cost online advisor (e.g., betterment.com )
• hire a good fee-only financial advisor and avoid paying high fees. consult FINRA.org for help finding a reputable financial advisor.

### Risk management

TAXES (chapter 7). The main categories of tax-deferred retirement savings accounts are employer-sponsored plans and personal IRAs. The typical employer-sponsored plan allows investments in mutual funds. After leaving an employer you can keep the plan, merge it into that of a new employer, or convert it to a rollover IRA. Personal IRA’s expand your investment choices, some of which require a trustee to make the transactions (e.g., precious metal trust, real estate trust). Be aware of the costs of converting a traditional IRA to a Roth IRA. At the time of conversion you must pay regular income tax on the investment returns. You may also incur a higher medicare premium and pay possible tax on unearned income. To minimize taxes when you withdraw funds to pay bills, withdraw from the taxable portion of your portfolio first, the traditional IRA second, and the Roth IRA last.

If you inherit an IRA from your spouse, your choices are these:

• ask the trustee to name you as owner
• rollover to a new IRA owned by you
• rollover to an IRA already owned by you
• create an inherited IRA if you are younger that 59 1/2 years.

If you inherit an IRA from someone else, your choices are these:

• take your full inheritance now and lose the tax shelter
• retitle it as an inherited IRA to keep the tax shelter

HEALTH INSURANCE (chapter 4).  The Affordable Care Act guarantees your eligibility for health insurance irrespective of your state of health. There are 3 general healthcare plans: HMO (Health Maintenance Organization), POS (Point of Service), and PPO (Preferred Providers Organization).  In each plan, your cost share is capped by the annual maximum out-of-pocket payment.

The government’s Medicare program is comprised of part A for hospitalization, part B for outpatient services, part C for extra benefits plus prescriptions, and part D for prescriptions. You pay premiums for parts B-D, but not for part A. There are cost-sharing charges for services in parts A-D. Medigap is a private healthcare insurance designed to supplement Medicare and used to replace Part C of Medicare. Don’t miss the enrollment dates or else pay a higher premium!

LONG TERM CARE (chapter 4). If you become incapacitated and require long term healthcare outside the hospital, your costs may exceed \$85,000 per year. Consider purchasing long term care insurance, but don’t spend more than 5% of your retirement income on insurance premiums for long term care. Group policies are cheaper. Minimize your premiums by choosing a 3-year benefit period (instead of 5 years), avoid paying for inflation adjustments later in life, insure 50-75% of your expected cost, and extend the waiting period to 6 months. The alternatives to long term care insurance are:

1. join a continuing care retirement community that offers a nursing home benefit.
2. self insure by selling your home
3. use Medicaid as a safety net.

LIFE INSURANCE (chapter 11). Don’t buy any if you are a single retiree without dependents. You’re better off investing the saved-premiums. Consider owning life insurance if you have dependents and want to leave a legacy fund or charitable gift. Chapter 11 describes how to extract more value from a life insurance policy.

SHELTER (chapter 10). Younger retirees like living in an active community and older retirees like their “independent living” in a more secure location. The choices for independent living are to remodel your existing home as needed to compensate for a handicap (e.g., wheelchair) or change homes. For example, move to an active adult community (consult 55Places.com; ensure that you will continue to receive healthcare).

Retirees seek “assisted living’ when they need help with the basic functions of living.  The choices for assisted living are to receive in-home healthcare or move into an assisted living facility (consult ALFA.org for choices).

Downsize to make life easier!

## Income statements can surprise investors

March 15, 2016

No other report of profit exerts greater influence on the Stock Market than that of a company’s net income. Why? Stock analysts make predictions of future net income that influence the decisions of investors.  Eventual announcements of actual net income may be very pleasing or disappointing news to investors who then generate a surge of trading in the market place.

The company’s only sources of income are customers, investments, and investors.  For an established company, customers are the preferred source of profit!  Operating income (a.k.a. EBIT) is the profit earned from customers.  The adjustment of EBIT by extra items yields net income.  Net income (a.k.a. Earnings, EPS) represents the profit that a company can share with its stock holders. Market regulators require companies to reveal the operating income and net income in quarterly and annual income statements.

### Structure

The Income Statement is one of 3 financial statements that companies report to investors on a quarterly and annual basis. Accountants prepare the statement by consolidating all of the company’s non-cash transactions into a standardized ledger that measures the business operations used to earn a profit. Chart 1 shows the main elements of an income statement:

Chart 1

Total Revenues are also called the top line of the income statement. They measure the net sales of all products. Operating expenses are used to acquire, sell, and distribute the products. Extra items are additional transactions that don’t generate sales, but increase or reduce the profit from sales. Net income is also called the bottom line of the company. Net income is the profit that a company can share with its stock holders.

### Relevant information

In my opinion, the “LINE ITEM” column in Table 1 lists the income statement’s most relevant information for individual investors. The “\$” column shows the relevant measurement in units of U.S. dollars. The “% OF SALES” and “PROFIT MARGIN” columns display convenient ways of analyzing the income statement. At the time of this writing, I collected the “\$” and “% OF SALES” data from a company’s ‘financials’ tab in morningstar.com. I simply toggled the statement’s ‘view’ command to switch from \$ to %.

Table 1.

“Revenue” (a.k.a. Total revenues, Sales) is the total value of all products shipped to customers during the reporting period. The revenue is usually recorded at the time of delivery before any cash payment is made by the customer. “Gross profit” is the remaining revenue after deducting all costs of production from the Sales. “Operating income” is the remaining revenue after deducting all other expenses of operating the business from the gross profit. “Income before taxes” is the remaining revenue after adjusting the operating income available to pay taxes. Net income is the company’s earnings after the revenue is reduced by all operating expenses and extra items.

There are several line items of net income listed in every income statement.

• “Net income available to common shareholders” represents the residual net income after payments of dividends to the company’s preferred shareholders.
• “Diluted Earnings per share” (EPS) is the portion of “net income income available to common shareholders” divided by diluted shares. Diluted shares are all outstanding shares (“basic shares”) plus the potential gain of shares from convertible securities.

### Fundamental analysis of profitability

Profit margins are percentages of Revenue that represent intermediate and final profits. The profit margins in Table 1 measure the impact of production, operating expenses, and extra items on the company’s sales. Here are the units of measurement:

• Gross margin = 100 * Gross profit / Revenue = 41.3% = 43.1 cents of every sales dollar.
• Operating margin = 100 * Operating income / Revenue = 22.4 % = 22.4 cents of every sales dollar.
• Net margin = 100 * Net income / Revenue = 14.2% = 14.2 cents of every sales dollar.

In table 1, the gross margin reveals that after paying all costs of production, the company is left with 43.1 cents from every dollar of revenue to pay for the remaining operating expenses. Costs of production include all expenses of manufacturing goods and providing services. The manufacturing process requires equipment, labor, and basic materials to build an inventory of finished goods. The provision of services requires labor and equipment. A company can be more profitable by reducing its costs of production.

The operating margin (Table 1) represents a residual revenue of 22.4 cents per sales dollar after paying all costs of production plus the costs of maintaining the business and selling the product. Think of the operating margin as customer-derived profit.  A company can earn more profit from its customers by cutting some of its operating expenses.

Net income is the remaining profit after paying operating expenses and adjusting for extra items such as government taxes. In table 1, the net margin is 14.2 cents for every dollar of revenue. The company could be more profitable by cutting some of its expenses or earning extra income. The net income is available to reward share holders in a variety of ways that eventually translate into capital gains and possibly dividends. For example, the earnings per share (a derivative of the net income) enables thousands of stock market participants to place a value on each share of ownership in the company. An increase in market value would allow stockholders to sell their shares for a capital gain.

### Fundamental analysis of the competition

The business performance of 2 or more companies in the same industry can be compared by assessing their profit margins. Table 2 provides an hypothetical example of how 2 competitors manage their business revenue. For every sales dollar, company A is less profitable than company B as revealed by A’s lower profit margins. Why is B more profitable? Its 66% gross margin reflects a lower cost of production that ultimately generates a higher net margin of 24%. Game over!

Table 2.

Notice that company A is more efficient at maintaining its business and selling its product. Company A’s 19 percentage-point difference between 41% and 22% is less than company B’s 33 percentage-point difference between 66% and 33%. For every dollar of sales, Company A was better at squeezing some profit from its customers with lower maintenance and sales costs. Also notice that the impact of extra items (e.g. potential taxes) was nearly the same for both companies; 8 percentage-point versus 9 percentage-point differences between the operating and net margins.

### Conclusions

Income statements report a set of measurements that investors can use to analyze a company’s business operations and its ability to earn a profit. The company’s operating income (‘EBIT’) and net income (‘EPS’) are the key elements of an income statement.  Operating income is used to calculate the operating margin, which measures how much profit the company earns out of every sales dollar from its customers.  The net income  depends on total revenue and efficient management.  For every dollar of revenue, the company that operates more efficiently has a better chance of earning a net income as measured in separate ways by the net margin and EPS.  The company’s earnings per share (EPS) represent the profit that the company can share with its stock holders. There are several ways to increase the EPS: boost sales, trim costs, retrieve shares, and seek extra income.

## Websites for retirement-planning

February 19, 2016

### Resources

http://DOL.GOV/EBSA/PDF/RETIREMENTTOOLKIT.PDF , federal programs and retirement calculators
http://SOCIALSECURITY.GOV , benefits & ‘retirement estimator’
http://MEDICARE.GOV health insurance for retirees
http://WISERWOMEN.ORG Women’s Institute for a Secure Retirement
http://HHS.GOV/AGING , health- and legal information
http://USA.GOV/BENEFITS-GRANTS-LOANS , federal benefits
http://AGING.OHIO.GOV , quality of life
http://economiccheckup.org , to plan retirement, reduce debt, find work, and cut spending.

### Money management (‘financial planning’)

http://DOL.GOV , search for “Taking the mystery out of retirement planning” and download this excellent pamphlet of useful advice.
http://MYRA.GOV , A safe, affordable Roth savings account for wage earners.
http://WESTERVILLELIBRARY.ORG , search for “Investments 101”

### Portfolio management

http://apps.finra.org/Calcs/1/RMD , find link to “required minimum distribution”
http://BANKRATE.COM , click on “RETIREMENT” tab, then on “Retirement Calculators” subtab, then on “Asset allocation calculator”
http://53.COM, click on “Financial calculators”, then click on the “Retirement Planning” tab, then click on the “Retirement Income Calculator” to estimate your longevity of savings; click on the “Retirement Account Calculator” to compare retirement savings accounts.

### Risk management

http://IRS.GOV , search “identity protection”, about Identity theft
http://FINRA.ORG (securities help line for seniors, 844-574-3577), Check the credentials of a broker or financial advisor; about Investor protection; http://apps.finra.org/meters/1/riskmeter.aspx to assess your risk for Financial fraud
http://LONGTERMCARE.GOV , about LTC health insurance
http://PBGC.GOV ,  to assess pensions
http://immediateannuities.com , to shop for simple annuities
http://annuityreview.com , obtain a second opinion about variable annuities

## 2015

January 17, 2016

The investment goal of the Small Trades Portfolio is to outperform its benchmark index, the Standard & Poor’s 500 Total Return.  Regretfully, this has not happened (chart).

The chart compares the growth of \$1.00 invested in the portfolio to a theoretical investment in its benchmark index and the inflation of U.S. consumer prices.  A decline of the benchmark during the 2008 Recession recovered in 2012 and grew to \$1.66 (66% above baseline) by the end of 2015.  But the portfolio declined and never fully recovered.   Revised operations after the Recession managed to stabilize the portfolio by reallocating 80% of the portfolio’s principal to exchange-traded funds (ETFs).  The ETFs are invested in underperforming asset classes that will eventually recover.

There are encouraging signs of investment performance found in the trends of compound annual growth rates (next chart) and stock performance (subsequent chart).

The compound annual growth rates of the benchmark index are leveling off while those of the portfolio are rising.

Revisions in my investment philosophy for stocks also show an encouraging response.  For every \$1.00 invested in the portfolio on 12/31/2013,  the portfolio’s stocks outperformed the benchmark index and portfolio ETFs for two successive years.

### Discussion

The portfolio is intentionally overweighted by index ETFs.  Among these, the equities ETF (ticker: VT) has 75% of holdings in developed markets and 25% in emerging markets. The returns from emerging markets were disappointing due to economic and political factors in foreign countries. The 2015 decline of gold prices was expected, given the global deflation of prices.

### Strategy

I prefer to invest in healthy emerging markets and when that occurs, I will trade the world-market ETF (ticker: VT) to a riskier emerging-market ETF (ticker: VWO). A continued decline of gold prices will likely cause me to rebalance the ETFs to equal portions of 25% among four asset classes of emerging markets equities, U.S. real estate, U.S. bonds, and gold bullion.  25% allocations of emerging markets equities, U.S. real estate, gold bullion, and U.S. bonds collectively impose a higher risk-return quality to the ETF portfolio compared to a 60:40 allocation of U.S. stocks and bonds.

My investment strategy for stocks is evolving from placing conditional trading orders on cyclic stocks to buying good growth stocks for the long term.

Douglas R. Knight

## Lead article: Stock Index Funds

January 16, 2016

The only way an individual investor can quickly invest in hundreds of different stocks is to buy shares of a stock index fund. The tremendous advantage is an immediate ownership of a diversified portfolio in one affordable investment. It’s the surest way of earning the stock market’s returns provided the correct investment is held through a series of ‘bull’ and ‘bear’ markets. Selecting the ‘correct’ fund requires only a few hours of easy research based on the following information:

INDEX. Stock index funds are passively-managed investment funds designed to imitate a stock index. The index measures the investment performance of a hypothetical portfolio of stocks. Some indices are riskier than others by virtue of the underlying securities in the hypothetical portfolio. For example, micro-cap stocks are riskier than all stocks combined by virtue of differences in turnover, liquidity, and diversification.

FUND MANAGEMENT. The investment fund is an actual portfolio of stocks that are managed for the benefit of the fund’s shareholders. Passive management is an investment style that imitates the performance of the selected index. Active management intentionally avoids imitating the index and is a more costly endeavor.

The legal structure of an index fund regulates its style of management. A unit investment trust (UIT) is bound by a trust agreement to manage a portfolio of fixed composition. The UIT has an unmanaged portfolio because there is no allowance for adjustment of composition by the manager. The open-end investment company (OEIC) operates a managed portfolio of adjustable composition. The OEIC is bound by its investment strategy to operate either a passively or actively managed fund. OEIC managers of an index fund are bound to passive management but have leeway to supplement the fund’s income by revising, lending, or borrowing a minor portion of the portfolio. These operations may increase the risk and tax burden of investment.

PRICING. The pricing mechanism of an index fund is closely regulated. Mutual funds are OEICs that trade shares at net asset value (NAV); in other words, they are priced at the fund’s net worth-per-share. The mutual fund’s share price is not quoted until the next day because the NAV is determined after trading hours from closing prices of the underlying stocks. Mutual funds are marketed through an authorized broker and guaranteed to be priced at the NAV. Exchange-traded funds (ETFs) are OEICs or UITs that trade the fund’s shares in the stock market, which means that the share price is quoted by public auction during trading hours. ETFs are traded the same way as stocks. The intraday net asset value (iNAV) and share price are continually updated and reported by the stock market. The fund’s share price is linked to the fund’s iNAV by arbitrage. Individual investors can neither participate in arbitrage nor redeem ETFs at NAV.

FEES. Managers of investment funds are compensated by charging an annual expense ratio that diminishes the NAV. Competition has decreased the expense ratio of stock index funds to only a few basis points (1 basis point = 0.01%), but beware that the expense ratios of bond index funds and actively managed mutual funds are typically higher; read the prospectus. Mutual funds are notorious for adding special fees to trades and imposing minimal holding periods; check with the broker and read the prospectus. New, small index funds are at risk for early termination when the NAV fails to grow above an estimated fifty million dollars. The expense ratios of small funds generate insufficient compensation for the fund sponsors, so they close shop.

TAXES. OEICs and UITs are registered Investment companies (RICs) that pass all income taxes to the shareholders. The amount of tax depends on dividends and capital gains earned by the fund. Managed portfolios incur a higher tax burden due to the more frequent turnover of portfolio securities. Consequently, mutual fund shareholders pay taxes on unrealized capital gains that ETF shareholders don’t have to pay. In theory, UITs are more tax efficient than OEICs.

INVESTMENT PERFORMANCE. During the 10 year period of 2006-2015, the compound annual growth rate of Standard and Poor’s 500 Total Return Index was 7.2%. In comparison, the growth rates of an index ETF (ticker: SPY) and an index mutual fund (ticker: VFINX) were 7.1% and 7.0% respectively. The slight differences in performance were due to an expense ratio, tracking error, and pricing error of the investment funds compared to the index.

OTHER INDEX FUNDS. There are indices to measure the investment performance of bonds, commodities, precious metals, and other assets. Likewise, there are mutual funds and ETFs that track the various indices. Bond index funds are managed by OEICs and require frequent turnover of the underlying bonds. The index funds for commodities, precious metals, and other assets are structured as grantor trusts, partnerships, or debt instruments. Stock index funds are generally less expensive, taxed at lower rates, and less risky than other index funds. Leveraged ETFs are exceptionally risky investments designed for same-day trading.

CONCLUSION. A broad-market stock index fund is the correct investment for earning returns from the entire stock market or a sector of the stock market. Simply choose an established, reputable index for the particular market that interests you. Then choose an established, reputable mutual fund or ETF that imitates the index. Use screeners or reputable fund families to select appropriate funds. Verify the fund’s expense ratio, extra fees (if any), NAV, longevity, and passive management by reading the prospectus and/or research reports. XTF.com is a free and excellent rating service for screening and assessing ETFs. Cross check your research with a trusted broker.

## What is a good growth stock?

December 22, 2015

### Theme

—profitable companies attract investors—

A good growth stock represents the profitable company that sells desirable products. The company’s business earnings should grow nearly 6% annually so as to match the growth rate of the U.S. Economy (about 3.5%) and compensate the rate of U.S.Inflation (about 2%); otherwise, the company might do well to liquidate its business and reinvest in securities.

Growth stock investors seek an annual rate of return that exceeds the U.S. Stock Market’s historical 8-10% annual rate of return. The basic approach is to buy stocks at a low price and sell them at a high price, but that is easier said than done. Investors can help realize high returns by selecting stocks from well managed companies, holding the stocks through an adequate growth period, to offset price volatility, and diversifying their stock portfolio.

### Evaluating the company

Does the company earn respectable profits with a sustainable business? The answer is yes if the company has a:

• growth rate of earnings that surpasses 6% annually.
• future growth rate of earnings that surpasses 6% annually.
• durable business with a sustainable growth rate.

Growth rate. The company that recognizes and satisfies the needs of customers will accumulate sales with the demand for its product. Profitability is the combination of sales growth coupled with efficient management of business expenses. In other words, the profitable company has a respectable growth rate of sales with respect to time, respectable rate of earnings with respect to sales, and consequently, a respectable growth rate of earnings with respect to time.

Earnings are the net income from sales after payment of expenses. The growth rate of earnings matches the growth rate of sales when the company runs its business in a consistent manner. Both sales and earnings should grow annually by at least 6% to outperform the national economy and compensate for the effect of inflation. Growth investors typically monitor the company’s earnings per share (EPS) on a quarterly basis. The EPS should grow at a compound annual growth rate of 6%, or more, as determined from at least 5 years of historical data. When evaluating a company’s earnings, consider the possibility that management is manipulating the EPS to earn higher compensation.

Future growth rate. The earnings estimate is an analyst’s quarterly or annual forecast of the EPS. The estimate is more uncertain when the forecast extends to 3-5 years. Investors use the earnings estimate to track a company’s performance and to derive a future range of share prices. The growth investor should seek companies with earnings estimates above the 6% compound annual growth rate.

Durable business. Any company can be driven out of business by an economic disaster in the entire industry, strong competition, and a declining market for the company’s product. The durable company has sufficient financial strength to survive hard times coupled with the competitive advantages needed to maintain its market position. The sustainable growth rate is a measure of the company’s capacity for earnings growth, assuming there’s room for growth of sales in the product’s market. An analysis of market opportunity is used to estimate the future demand for the company’s product.

### Evaluating the stock

If a profitable company attracts investors, its stock price will rise with investors’ demand for shares. The attractive stock may be detected by a:

• favorable valuation
• price momentum
• projected annual return above 10%

Favorable valuation. Growth investors place a high value on the company’s EPS for the simple reason that EPS represents the net income that generates an investment return. The 2 sources of investment return are dividends and capital gains. If the company choses to pay dividends, they are derived from the net income. Capital gains are the amount of profit from an increase in share price generated by investor-demand.

The price of a growth-stock tends to increase with the rise in EPS. This relationship is measured by the price-to-earnings ratio (P/E or PE). The current P/E is today’s price divided by the EPS of the past 12 months. The current P/E reveals what investors are willing to pay for each dollar of company earnings. The relative P/E is a ratio of the current P/E to past P/Es or to some benchmark P/E such as the average P/E of the stock market. At parity, the relative P/E is 1.0. Stocks below parity are undervalued by market participants and may be trading at prices that favor buyers. Conversely, stocks above parity are overvalued and may be trading at prices that favor sellers. There are other ways of assessing the value of a stock such as the calculation of fair value performed by stock analysts.

Price momentum. Another characteristic of the growth stock is that its share price is likely to continue in the direction of an upward trend as long as there’s a demand for shares. A review of historical prices will reveal the direction of price momentum.

Projected annual return. The reason that growth investors should seek returns above the 8%-10% total return of the stock market is that an alternative investment in index funds will capture the market’s return. One way of projecting the stock’s annual return is to multiply the future EPS by a P/E ratio to obtain the future share price. The difference from today’s price represents the future capital gain. Factoring in the stock’s dividend yield will give the projected annual return.

### Risk management

The primary hazards of incurring a loss are,

• company risk
• market risk
• portfolio risk

Company risk. Poor management can weaken the company and reduce its profitability. A fundamental analysis of the company, which includes a review of the financial statements, can help reduce the possibility of investing in a poorly managed company. Periodic reviews of financial statements and company news are needed to reassess the company’s management efficiency and help prevent a serious capital loss from investment.

Market risk. Volatility is the moment-to-moment fluctuation in share price that results from trading activity in the stock market. Greater volatility produces greater upside and downside risks. Upside risk is the potential gain from an investment. It represents a reasoned guess of the future peak share price. Downside risk is the potential loss. Volatility, upside risk, and downside risk are calculated in several ways. Generally speaking, riskier investments should be held for longer time periods to improve the chance of earning an estimated return.

Portfolio risk. A concentrated portfolio has a large investment in one stock compared to others. Any capital loss from the largest holding could seriously degrade the investment return of the whole portfolio. The potential impact of capital loss from a large investment can be reduced by re-allocating the principal among stocks that are diversified with respect to industry and company size.

### Conclusions

A good growth stock outperforms the stock market because the company’s earnings grow faster than the Economy. One way detecting a good growth stock is to find the company that has a good sales record, bright future for earnings, and durability. Then determine what value other investors place on the stock in today’s market and future years. A potential capital gain of 10% or higher is a good growth investment.

## Business stories in financial statements

December 11, 2015

[updated on 2/6/2016]

Companies report their business results in financial statements on a regular basis.  Otherwise, how could they, the companies, attract serious investors?

Financial statements describe the use of money to sell products and grow a business.  The statements are prepared by accountants who consolidate business transactions into standardized measurements of profitability, cash flow, and net worth.  Those measurements represent stories of business success. The purpose of this article is to describe the framework and core stories of financial statements.

### Accounting

Companies use financial accounts to perform a large variety of business functions. The effective use of accounts generates a profit for the company and its investors.

There are accounts for banking, payroll, supplies, customers, investors, shipping, advisors, taxes, and many other essential functions. Non-cash and cash transactions are recorded in the appropriate accounts. For example, each sale to a customer is initially recorded as a non-cash transaction in the customer’s account based on the price in the shipping statement. Later, the customer’s payment is recorded as a cash transaction in the company’s bank statement. In another example, the company initially records its purchase of supplies as an non-cash transaction recorded on a receipt. Later, the company’s payment to the supplier is recorded as a cash transaction in the company’s bank statement.

Accrual accounting. Accrual accounting is the practice of recording non-cash transactions at the time of transaction. The data are collected from invoices, promissory notes, and other documents of unpaid transactions.

Non-accrual accounting. Non-accrual accounting is the practice of recording cash payments. Data for cash payments are collected from bank statements and other documents of paid transactions.

GAAP. U.S. stock companies are required to publish financial statements that conform to Generally Accepted Accounting Principles (GAAP). Foreign countries may allow companies to publish financial statements using non-GAAP methods.

### Framework

Numerous financial transactions during the entire fiscal period are consolidated into line items of the income and cash flow statements. The values of all assets and liabilities at the end of the fiscal period are consolidated into line items of the balance sheet.

Income statement. The unpaid transactions of business operations are organized into revenues, expenses, and net income (Eq. 1). The statement’s top line is called total revenues and represents all recorded sales during the fiscal period. Every sale is typically recorded at the time the product is shipped to a customer. Cash payment is expected at a different time and is not recorded in the income statement. The statement’s bottom line is called net income and represents the residual value of all sales after deduction of all the expenses incurred during the fiscal period.

net Income = Total revenues – Total expenses          (Eq. 1)

Cash flow statement. The company’s payments are separated into categories of net operating cash flow (CFO or OCF), net investing (CFI), and net finance (CFF). The net value of each category is the balance between total cash inflow and outflow for the entire fiscal period. All cash surpluses and deficits are relegated to the category called net Cash Flow (Eq. 2). Companies that focus on growth attempt to maintain their net Cash Flow close to a zero balance. Investments in growth are paid through the CFI with funds obtained from the CFO or the CFF.

net Cash Flow = net CFO + net CFI + net CFF          (Eq. 2)

Balance sheet. The total book value is the net value of all corporate assets and liabilities at the end of the fiscal period (Eq. 3). The total book value is sometimes called the shareholders’ equity, net worth, or net asset value.

Total book value = Total assets – Total liabilities          (Eq. 3)

### Core stories

Financial statements are designed to measure profitability and cash flow during the fiscal period and net worth at the end of the fiscal period. A simple analysis of measurements can reveal the company’s business performance.

Profitability.  The income statement describes how the company used sales and expenses to earn a profit during the fiscal period. The income statement might reveal that expensive business operations forced the company to sell a large number of products in order to be profitable.

Cash flow.  The cash flow statement describes how the company used its money during the fiscal period. If the company paid for growth, the basic scheme was to use its cash from customers or investors to grow by purchasing more assets for the business or investing in other companies.

Net worth.  Net worth is measured by the total book value at the end of the reporting period and provides a momentary valuation of the company. A company with considerable net worth has much greater value in total assets than in obligations to pay future expenses. The investor would judge that company to be financially strong.

### Publications

Companies distribute their financial statements to the U.S. Securities and Exchange Commission (SEC), investors, financial services companies, and brokerage firms. Free copies can be obtained from the SEC.gov website, corporate websites, financial websites, and brokerage firms.

Domestic companies listed in U.S. stock markets file forms 10-K and 10-Q with the SEC. Form 10-K is an annual filing that contains financial statements for the fiscal year. 10-K is useful for performing a fundamental analysis of the company. Form 10-Q is a quarterly filing that also contains financial statements. 10-Q is useful for making quarterly reviews of the company.

### Summary

Financial statements measure a company’s profitability, cash flow, and net worth. These measurements reveal the company’s business performance as a factor for making investment decisions. Free copies of financial statements are available in the internet.