The Hidden Fees of Stock Picking That Will Make You Lose Over 50% of Your Portfolio

The stock market has been very sluggish over the past several weeks: the indexes are near 2017 and 2018 depression levels. The frightening news cycle and frantic financial professionals believe that the stock market can dip even lower. Recent data and the business shutdown are evidence that a larger recession is possible. I believe this recession, or fear of one, is positive for the US economy though. Remember, we have seen signs of life before, in every economic recovery, only to be largely disappointed. Regardless of where the stock market is headed in the short term, remember in the long-term popular stocks will always do well. In two years, the stock market could drop another 30%, but in 20 years, the market will historically provide a 60% or better return.

You are probably aware that studies show that professional investors have trouble outperforming the market through stock picking. But as with any statistical data, be careful around the academic subjects that have selected bias. Most of this data considers professional investors as anyone who can open a fund. Many well connected or trust fund babies like Chelsea Clinton’s husband, Marc Mezvinsky, always underperform the overall market. Pensions and endowment funds received 80 cents back for every 1 dollar of investment from Marc Mezvinsky. Most of these professionals are wealthy enough to utilize their capital or connected well enough to raise money from close networks. Only rarely do these groups of wealthy or connected professionals do the required investment due diligence. Buffet famously said, “Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway.”

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Losing out on other opportunities

In that respect are many hidden costs of stock picking. Remember when Real Estate Investment Trusts (REITs) were the best performing industry from 2010 to 2017, the entire industry quickly turned into one of the worst investment opportunities during and after the crash. This is because interest rates remain depressed while there was an oversupply of commercial buildings, primarily buildings such as shopping centers and malls. Malls were a great industry to buy between the 1970s and late 1990s; most developers focus their efforts to build out malls that are quickly becoming empty shells and debt load. So why am I talking about real estate?  If you didn’t know about the real estate information before reading this blog and you were buying REITs, then you are one of these stock pickers that got taken advantage of in the form of hidden fees. 

Nevertheless, too many people consider themselves a stock-picking genius. A majority of people will find themselves intelligent enough to invest, but being smart doesn’t compensate for higher investment returns. Being a business oriented individual or an entrepreneur doesn’t automatically make you a good investor either. Being an investor is a line of work, just like being an attorney. Anyone can be informed about their legal rights, but it doesn’t mean they have the knowledge to utilize this information to defend themselves in court. 

Many individuals lack the dedication to do investment due diligence. Anyone can attain a good, above-average return for a few years in a bullish time. To be clear, I define a stock picker as anyone who can’t explain the commercial enterprise model, can’t read a financial statement, often has short term gains in their portfolio, and a majority of their portfolio doesn’t include long term holdings.

The Hidden Costs of Trading – FIX Flyer
The Investment Hidden Fees

What are the other hidden fees of stock picking? I called it the T&T problems Time & Taxes

  1. The first cost is Time. If you have little knowledge and try to spend time learning, then you are running against the clock against someone that is simply more knowledgeable and prepared. Novice investors spend time picking stocks without ever learning about their investment through due diligence. Studying makes you informative but it’s a long process before you actually become knowledgeable to execute an investment. Being knowledgeable primarily comes from information and experience.
    Everyone on the internet is informed about politics, but not everyone is knowledgeable. If TV ran the news on disciplines like Biology and Chemistry 24/7, like they do political and financial news, we would all feel like we can discuss science topics like we are all Ph.D. certified scientists. I have another upcoming blog that will talk about the difference being informed and knowledgeable. If you keep picking stocks without being knowledgeable, you will underperform the market by 5% or more a year (50% in potential missed gains over 10 years).
  2. The second cost is Tax, if you’re trading in a taxable account. The difference between short-term and long-term capital gains is generally substantial. When trading stocks, it can be tempting to exit positions doing particularly well after only a few months. Doing this frequently results in higher tax costs and it is something I avoid. Capital tax gain taxes are 0% to 20% vs income taxes that can be around 25% to 40% depending on your tax bracket. Think about how much money you will leave on the table if you are paying income taxes on your investment returns. My investment strategy is to target long term positions over short term capital gains. Most people are happy to see short-term profit (but they don’t realize that they pay income taxes on it).
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Time & Taxes

I want to reiterate that it is vital to remember that the average investor seldom realizes the returns they see on the chart of that stock. Both taxes and time can seriously erode performance, especially for high-frequency stock traders in higher tax brackets. A lot of economic research studies show that these and other mistakes made by the ordinary investor can reduce returns by 4% or more a year relative to a stock index (which haven’t included the short-term tax fees). My mission is to give you the best possible after-fee and after-tax returns that matter for your long-term investments.

How to invest in stocks for beginners: Begin investing within 30 days

There are two ways to invest in the stock market. The first way is to invest in getting the average market return of 7%, just following the S&P 500. The second way is to invest in individual stocks to outperform the S&P 500 index.
***If you have specific inquiries or anything in my post that I can help clarify, please feel free to comment or email me (TomNguyen@agarwoodcapital.com).

1. Decide if you want to put in the time to beat the stock market average returns (Week 1)

Passive investing- The goal of passive investing is to achieve average stock market returns. The average return over the last 100 years in the stock market estimates at 7% – 8%. To start passive investing, you want to buy a mutual fund or ETF representing the S&P 500. Robo-advisors or standard investment advisors provide these mutual funds and ETF.

Robo-Advisor Services
  • For Passive investors, you only need to go with low and cheap online services (i.e., Vanguard and Fidelity), Robo-advisors (i.e., Wealthfront and Betterment), or anything that has management costs below 1% of your total asset value.
    • A note about indexes: The S&P 500 represents the largest 500 companies; therefore, it’s often used as a proxy benchmark for the US stock market performance. Other indexes represent niche industries or smaller size samples. For example, the Dow Jones (DJI) isn’t a great representation of the overall stock market because it includes only 30 US companies, so it’s just a small cross-section of the thousands of companies in the market. This is the reason why the S&P 500 is used as the standard benchmark instead of other indexes.

Active investing- The goal of active investing is to pick stocks and beat the stock market average, which is the S&P 500. Active investment requires putting in the time to research and analyze both individual stocks and the overall market. In becoming an active investor (or the DIY approach as I like to call it) you will want to learn key aspects to analyze a stock and strategies to end your year above the stock market average.  

  1. Learning about an industry, company, and competitors
  2. Learning about investment strategies can outperform the average return 
  3. Learning how to read and create financial statements

If becoming an active investor is the path you want, then continue reading.

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2. Start by reading about industries and companies that’re the most familiar to you. (Week 2)

Determine a business industry that is easy for you to comprehend. The easiest industries to learn are from your profession or products you regularly purchase.

For example, an apparel company usually has simple operations. Apparel companies make clothes that offer branding value with unique design distinctions. The apparel industry is a multi-billion-dollar investment opportunity, but it is a very competitive industry. Apparel retailers can offer their goods in physical and/or digital distribution channels: take note of these differences. For example, one of my favorite apparel business is Under Armour. 

At the beginning of your active investment journey, learn general facts, and find interesting tidbits on your chosen business. Ask critical questions because if you don’t have enough confidence in your research, it could cost you your entire life savings. But don’t worry, this should be a fun process! It’s like finding the perfect ingredients for a recipe so that you have an enticing outcome! Read everything you can on the company’s merchandise, management, and business risk. It may be tempting, but for now, let’s hold off on the financial statement. We should uncover the basics about the company first. Once you have learned about the company, the financial results will make much more sense. 

Here are some initial questions I might ask about Under Armour:

  • Why is Under Amour (UA) a better investment than its competitors?
  • What makes UA better than other apparel businesses?
    • Does UA have any patents on their clothes and shoes?
  • Who manufactures UA clothes? 
    • Is there a contract or partnership from the manufacturer? 
    • Why was this manufacturer selected?  
  • Who are UA shipping partners?
    • Is UA shipping partner contract?
  • Does UA have its own stores? Why does UA have its own stores?
    • How many stores does UA have?
    • How many retail partnerships do they have? 
  • Did Under Armour ship their apparel from a warehouse, and from which warehouse?
    • How did UA decide to pick this warehouse?
    • Where were the clothes made?
  • Who designs UA’s clothes?
    • What is the designing strategy, do they create athleisure clothes or not? 
    • Who’s the design team leader, how long did they work at the firm? Do they have experience at other firms?

Notice that I did not list any financial or math-related questions. The point of this exercise is to get familiar with the industry and business. As you are learning, there will be more financial jargon and it will get more confusing. Do not be discouraged. If it is confusing, you are learning.

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3. Learn about investment strategies (Week 3)

While there are many investment strategies, the best strategy to get an above-average market return is to buy undervalued companies called value investing.

The value investing strategy provides a strong foundation for an investor to learn about other investment strategies. Value investing is a popular strategy that created many billionaire investors, to name a few, notably Warren Buffet, Seth Klarman, and Bill Ackman.

What exactly is value investing?

Value investing identifies companies with a current market price that is less than their intrinsic worth, which means the stock or company is “undervalued.”   

How do I determine the value of a stock and know if a stock is undervalued?

The discounted cash flow – this method provides the net present value by estimating the company’s future profitability to help determine the company’s values. The discounted cash flow will help provide a range of value to the entire business. 

Another way to find undervalued stocks is by using the valuation ratio. A valuation ratio shows the relationship between a company’s market value or its equity and some fundamental financial metric (e.g., earnings). The point of a valuation ratio shows the price you pay for some stream of earnings, revenue, or cash flow (or other financial metrics).

  • Price/Earnings – The historical average of the S&P 500 index P/E is 15, therefore anything under 15 could be considered undervalued relative to the historical average of the S&P 500 index. 
  • Price/Book – Price is the stock’s current market price. Book value represents what the total asset of the company is worth. So, if the price of a company is worth $100M, and the book value is worth $110M, you will see a P/B= .90 ($100M/$110M).

Not all undervalued stocks are suitable investments. Some companies may reflect undervalued but aren’t performant and stay that way. We call these value traps. A value trap will have a valuation that appears cheap, but it has risks and troubles that will cause the company to continue declining.

Understand why stocks become undervalued

  • Missed expectations and lower guidance: Shares can plunge if the company provides quarterly and annual reports that misses target earnings or provides guidance below Wall Street estimates. 
  • Market crashes and corrections: If the entire market drops, it’s a great time to look for undervalued stocks.
  • Bad news: Just like when a stock misses an analysts’ expectations, bad news can cause a knee-jerk reaction from shareholders, sending shares plunging more than they should.

Cyclical fluctuations: Certain sectors tend to perform better at different stages of the economic cycle. Industries that are out of favor are the right places to look for bargains. Again, not all out of favor sectors will ever return to normal business operations. Think about how often restaurants and the retail industry go out of business.

Tesla stock priced at $200 could be a value stock as Apple is a value stock. Investors underestimated the technology and complexity of Tesla, comparing Tesla to other traditional auto companies. Similarly, it is much like how investors compared Apple’s iPhone to the BlackBerry Rim. Investors underestimated the software, ecosystem, and design of the iPhone initially. If you could buy a $100 bill for $70, wouldn’t you jump at the chance to do so? While value investing is a little more complicated than that, this is the general concept behind finding undervalued stocks that are perfect for your portfolio. Value Investing is not the only investment strategy, but it is the most straightforward and yet the most challenging strategy to master.


4. Learn how to read financial statements and how to create one from scratch (Week 4)

Financial statements will be disconcerting to learn. If math isn’t one of your strongest skills, it will be considerably more difficult. But, most of the investment math is simple algebra. If you cannot interpret a financial statement well, don’t rush to buy stocks. Start a stock account or paper trading account with only the amount that you can afford to lose, but still assert the same spending habits that you would with a larger account. The amount of money you need to buy an individual stock depends on your investment experience and skills. 

How do you know when you are fundamentally ready to invest? 

  • Q: Can you identify seasonality in a financial statement?
  • Q: What happens to cash flow if customers are paying with credit cards instead of cash?
  • Q: How much profit does a company have to pay off its current debt obligations? 
  • Q: Can you teach someone how to read a financial statement

 

 

The Millennial ‘Frugalpreneur’ Lifestyle

It’s 2020, it’s time for Millennials to live the ‘Frugalpreneur’ lifestyle, keeping the largest expenses as low as possible. You hear notorious stories about how entrepreneurs kept their expenses low as possible to fund their business. If Millennials and Generation Z can apply the same financial mindset as these frugal entrepreneurs, then finances will be considerably easier to manage. It is easy to save money, but why are some Millennials so broke? It’s about consistently making savvy financial choices; money is a limited resource just like your time. Learn to spend money wisely and avoid purchases that don’t add value to your life.

There are many overpriced ‘brand name activities’ in society that pressure Millennials to become burdened with expensive social obligations. Social branding activities like weddings, wedding rings, cars, luxury items, living independently, traveling, and many others are causing Millennials financial stress. Whom are you trying to impress? In reality, most of these social branding tactics are just ways for corporations to make money, they generally don’t add value to your life. If you can afford social branding, then do it wisely, just don’t socially brand yourself into debt.

The average professional Millennial makes about a $60k to $100K salary per year. HENRY (High Earners Not Rich Yet) Millennials make $100K and above. Saving and investing early on might not look like much. But just wait until you reach your 30s. Young Millennials AND Generation Z individuals, listen to me if you want a better life: your priorities will have to change. Money cannot solve personal life issues, but financial flexibility can relieve some of life’s hardship. Use your money on purchases that will add the most value to your life at the best price. Living a smart financial lifestyle does not sound sexy because society is dictated by marketing your life into perpetual spending habits with overrated experiences, temporary homes, and worthless cars.

Living independent – Very Overrated 

The easiest way to save money is to live with your parents or to have roommates! Rent is generally the highest recurring obligation: start cutting down on rent first because everything else is chump change.

Society should be impressed with Millennials living with their family or having roommates. It shows a sign of maturity and logical reasoning. Even if you make a lot of money, why bother living alone when living at home could be free or substantially less expensive? Unless there is a problem at home, living with your family should be the first obvious solution to save money.

The Millennials that cannot afford living alone are often pressure by society to rent their own place. People put themselves into so much debt to impress others that they are doing well by living alone or buying a new car, but none of these spending habits add value to Millennials’’ lives besides the illusion of their financial status. 

A few years ago, Kevin, one of my colleagues at KPMG asked me how I could afford to eat out for lunch every day.

Kevin’s background: Kevin lived with roommates for two years, and then rented his own one-bedroom apartment in Arlington, VA for $2,300 a month. 

Kevin: “Tom you are wasting a lot of money eating out.” 

Tom: “How much are you saving from not eating out?”

Kevin: “$200 a month” and he showed a big smile. 

Tom: “Wow that’s great, but I like eating out. I am sacrificing my personal space to live with roommates.” 

Kevin: “Oh you’re saving a lot of money living with roommates, I can’t do that though. I want my own space.”

Tom: “Yep, I am saving a lot of money,” I flashed a big smile back to Kevin and went out to lunch.

How much was I saving from living with roommates? 

$0 Dollars – I didn’t have to pay for rent at all.

During college and my first two years of my career, I paid $600/month living with my family. I saved a majority of my money to buy a home. After I saved for a down payment, I bought a townhouse near a college campus. My mortgage was $2000/month and HOA was $100/monthly. I did not waste any time posting up the available rooms. I lived alone for less than a month before I had a student roommate that moved into my home. By the 2nd month, all of the rooms were rented out. There were times I rented out my room on Airbnb, which was the master bedroom, and I slept on the couch. Sleeping on the couch was a bit extreme, but it helps accelerated my savings.

Some people have very bad experiences living with other roommates and it is understandable. Living with a roommate isn’t convenient. It takes time to interview roommates that have good etiquette.

I’m not saying Millennials have to live with their family, but who are they trying to impress? You can still be independent living with family by paying rent and helping to care of the house. If living with family isn’t a viable option, then find a good roommate.

If you want to live independently: rent an affordable basement and share a kitchen. Whatever you do, minimize your rental expenses as much as possible. Saving money on coffee, eating out, and being frugal with other smaller, discretionary spending does not comparable to saving money on rental expenses. 

Traveling often – Overrated

Traveling is great, but why are Millennials traveling so often? There should be a budget set for traveling. I am freaking out for my generation that are taken out loans and paying interest to travel more often. Does traveling often add value to anyone’s life? It could, but at what cost?

Eating out – Underrated

I can’t eat simple prepared meals like sandwiches, pizza, etc. I prefer meals that have a richer taste, which simply means a longer cooking time. I have to spend a lot of time grocery shopping, preparing, and cleaning just to make one meal. To me, it’s not worth the time to cook unless I’m cooking for a household of at least three people. The economic cost and time required to prepare a meal are wasteful. It would be just as affordable, and sometimes cheaper to eat out than making the food at home.

10% minimal saving & 10% Retirement – Very Underrated

  1. Pay off your discretionary debt that is above 5% interest. This means all credit cards should be paid off monthly. There are zero reasons to have a carry-over monthly credit card balance.
  2. After you pay off your credit card, then start saving 10% each month, but don’t let your cash sit in a savings account. Put your savings into a higher paying account like buying a stock market index, do not pick stocks (over 95% of investors will underperform the index) until you are educated about investment fundamentals like reading a financial statement, and financial risks.

Everyone should always invest in their retirement to get the employer’s match. The average employer’s match is 3%, which means it would require the employee to put in 6% to get the additional 3% from their employer. If you are 1099, or an entrepreneur, you should still have at least 10% of your income invested in your retirement.  

Buy a used, Affordable Car – Very Underrated

Again, you are not impressing anyone until you have a secure financial life. Having enough money to put down on a home should be your first priority. The only people that will be impressed by your nice cars are hidden fees that will view you as a financial resource for their amusement.  

Expensive Wedding and Wedding Rings – Overrated 

The average wedding in the United States costs more than $20K and it usually requires immediate payment. It’s crazy to hear how some people have to take out a loan to have a wedding… If you need a loan to have a wedding, forget it! Your close family and friends will still love and celebrate your union the same way! 

In many Asian cultures, cash is a standard wedding gift. My wedding was expensive, but our family and friends’ generous gifts helped recover a portion of the wedding costs. Although our wedding could have been a lot cheaper, my wife and I wanted our wedding to be a memorable experience in order to give gratitude to our family and friends for supporting us through our lives. We budgeted and postponed our honeymoon so that we wouldn’t incur any financial strife.

If you have the financial means for an expensive wedding and can afford a home quickly, then go ahead. But, if a wedding or wedding ring will delay your ability to purchase a home, then do not attempt to have an expensive wedding. Buying a house should be your top priority.

Birthday Gifts and Christmas Gifts – overrated 

We do not have to buy random gifts for an adult or kid. If you have to buy a gift for a special event, make sure it’s practical. Most of the time, we buy the wrong gifts or attempt to gift frivolous items that end up in the yard sale or donation pile. Instead, pay for an activity, lunch, or something that allows you to maintain a good relationship with the person you’re giving the gift to.

Fast Fashion and Cheap Fashion – overrated

Fast fashion clothes are usually just low quality. Buy quality items that cost a little more, and have less junk in the closet. Buy higher quality items like dress shoes suits and purses. Some items like Louis Vuitton are entry luxury items that come with lower end material that you would find in $300 items. If you can afford luxury, then buy a brand like Hermes because the resell value is better than most Louis Vuitton. I am not a fan of Michael Kors (MK): their $300 bags aren’t high quality vs other $300 bags out there… there’s a reason why MK has been losing their brand equity for a long time…

Used Electronics – Underrated

I rarely ever buy any new electronics. I will always buy cheap, used electronics on eBay. If you know how to get the max capability from an electronic product there is no need to waste your money on the newest electronics. Go for cheaper used 2nd or 3rd generational products that can get the job done just as well as the newer models.