The Standard & Poors 500 (500 leading companies in leading industries) and the Wilshire 5000 (publicly traded companies in the United States) are each a list of stocks that represent much of the stock market. Owning the entire basket of these stocks has outperformed the actively managed mutual funds (funds that buy and sell individual stocks based on some investment theory) over long periods.

Moreover, the likelihood that your fund manager will perform better than random has been getting worse. For detailed analysis, you may want to read the article False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas

“… the proportion of skilled fund [those with a positive alpha, net of trading costs and expenses] managers has diminished rapidly over the past 20 years, while the proportion of unskilled fund managers has increased substantially.”

Therefore, for the bulk of your investment, and until you believe your analysis will be better than those who are competing against you, consider index funds. The largest index funds are provided by Vanguard, and there are many others. Carefully look at the expense ratio. In progress is The Investing Channel’s index fund checklist. Another valuable approach is to invest in the best dividend stocks.

The Warren Buffett assumption

Warren Buffett has been quoted as preferring that companies he holds avoid paying dividends. Historically, capital gains have been taxed at lower rates than dividend income. In addition, a growing company may be able to earn more on its capital than its shareholders. However, this approach assumes honest financial statements, and that cash piled up will not be squandered on ill-advised acquisitions for empire building. For an example consider when Time Warner bought AOL. This happened while many people of the slightest technical sophistication were learning that internet access did not need the AOL training wheels.

Avoiding a Madoff situation

As many bad episodes have illustrated, a number called net income written on a paper may be false. It may be an outright lie, as was set out by Madoff. However, dividends cannot be lies, because cash is required to pay out the dividends declared.

Basic balance sheet and income statement numbers

Important ratios will be commented on. Also to be provided, a checklist to help ensure you are buying the best dividend stocks.

Too good to be true
A very high yield does not mean that the stock is good value, it usually means that the dividend will be cut or eliminated.

Future editing of this page will include a chart comparing the return from dividend paying stocks, to an index. The hypothesis is that the dividend paying stocks are more stable. In the meantime consider this checklist for investing in dividend stocks.

• Long term history of paying dividends
• Steady increase in dividends
• Reasonable ratio of free cash flow to dividend coverage
• Dividend ratio within normal limits (too high implies a market belief that a decline is imminent)
• No big decline on the horizon

A recent book How the Mighty Fall by Jim Collins points out some warning signs that a good company is in decline. Recommended reading for its long term perspective.

Current News: Investing Risk because of Europe Debt

The Greek debt problem, $236 Billion, is only a part of the much larger Europe debt problem. Italy, Spain, Ireland and Portugal each have larger debt than Greece. For a frightening look at the numbers, and the interlocking problem, see New York Times graph of five weak economies.

Investing Risk

Investing your money is not limited to stocks recommended by those who extrapolate past market trends, but with no awareness of risk.

For example, any investment in stock in any market will affect how you get to financial independence, and will affect when you are ready for retirement.

Financial decisions to allocate your capital into a portfolio must consider the most important and most basic rule for personal finance: preserve your capital.

Even real estate, illiquid for investors but previously thought to be safe, recently has been worse than mutual funds or individual stock market share picks.

The venture capital companies, and their investors, look for home runs every tenth investment or so. What can we learn from this example that can be applied to investing basics? Should some of your investments be in high risk businesses, or be in a mutual fund for diversification?

For investing guidance, this site is dedicated to the real contrarians, especially Nassim Nicholas Taleb:

” The best description of my lifelong business in the market is “skewed bets,” that is, I try to benefit from rare events, events that do not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur.
I try to make money infrequently, as infrequently as possible, simply because I believe that rare events are not fairly valued, and that the rarer the event, the more undervalued it will be in price.”

Ideas are Valuable

Taleb suggests the most conservative investment, United States Treasury obligations, for 85 to 90 per cent of your invested capital. The remaining 10 to 15 percent should be invested in bets that pay off big, preferably with no upper limit, if you win. None of the value investing analysis, because of the great adverse consequence of a big negative event.

This site will include sections on traditional conservative investing, including dividend stocks and mutual funds. But the imagination efforts will be about Google-like and Amazon-like bets on the future. These stocks not only had risk, but also had no upside limit on their return.

Effective January 1, 2010

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This video by Peng Chen, president of Morningstar’s Ibbotson Associate, points out how some simplistic attempts at diversification of your investments do not work. He comments on the fallacy of trying to diversify by allocating investment to out-of-USA stock, when we have a global financial market.

Just over 4 minutes of helpful information. Some quantitative recommendations would also be helpful.

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For the preservation of capital, with the occasional killing, better ideas are required.

Warren Buffett observed that the investor will only have five or fewer good ideas during his entire life. Do you expect to do better than Warren Buffet?