Today we are going to talk about a different way to think about investments in the stock market. Unfortunately, this isn’t the most common way to think about investments. It’s a way of thinking that is often decried as ‘old-fashioned’, ‘out of date’, and ‘irrelevant’ by many.
And I must admit, I used to be among them.
When I first started studying the market, I fell for just about every trap out there, and let me tell you, there are many. I analyzed charts, charted regressions and Fibonacci sequences and consulted any number of sages for what tomorrow’s price action would bring.
In short, I, and many others, gave no mind at all to the businesses that made up the market. We instead chose to focus our efforts on the charts themselves, attempting to gleam some magical formula from it’s ups and downs. In the end I tried many things and I was right less than half the time. A chimp flipping a coin would have picked better stocks than me.
Actually that chimp would have picked better stocks than most of the professionals out there as well.
This happened because we had the wrong mindset entirely. To really become an investor, rather than a delusional gambler, you must understand one basic premise about stocks. One that is so obvious everyone thinks they know it, even though the truth of it is missed by many (maybe even most).
That truth is this: When you buy a stock, you become a part owner of that company.
What It Means to Own
Before we get too far into this, let me make something clear. For illustrative purposes only, we will be discussing a single stock in a single company. In actual practice you will not be buying shares of a single company. You will be buying a fund that invests in many diverse stocks instead. Buying single stocks is a nearly sure-fire way to miss out on long-term profit. It is speculation and we do not condone or endorse that kind of thing.
For the purposes of today’s discussion, we will be using the most talked-about company in America: XYZ. XYZ is my company. I made it up. Just now. Please don’t try to buy shares in it.
Some details about XYZ:
- Share Price: $100
- Earnings: $15 million
- Dividend: $0
- Shares outstanding (how many pieces of the company you could potentially buy): $1 million
- Earnings per share: $15 ($15 million divided by 1 million shares outstanding)
Ok, so let’s say you decide to by one share of XYZ. What are you actually getting?
Ownership of XYZ. You own it. The company. How cool is that? I mean, you don’t get all of it. In fact you now only own 1/1,000,000th of it. But you still are an owner. You get ownership rights. You get to vote on corporate matters.
If this sound cool to you, GOOD. Most investors in the world today have lost sight of this basic truth. You should feel a little thrill. You should feel proud. You should feel powerful.
Most of your peers in the investing world think of their shares as throw-away things. To be held onto until a set amount of profit or loss is reached and then tossed away. They feel no love for what they own. They see no real worth beyond the money it might earn.
But not you! You understand that you now own a small part of a living, breathing enterprise. People rely on your company. They work for you. And I’m not just talking about the wage-workers on the bottom rung. I’m talking about management. The CEO works for you, the shareholder. His job is to make you money. You’re the one who votes on his compensation, or even if he gets to keep his job. A well-run business will place the interests of the shareholders above themselves.
This should bring you quite a bit of satisfaction. Especially since all this cost less than a night out with friends.
Now, if you bought your share of XYZ because some TV pundit screamed at you that XYZ was going to $150 (and then slammed a toy button for some reason-seriously who watches that guy?), then you missed out on this psychological connection. To you XYZ is just a means to an end. You want $50. You might even get your $50 dollars. That’s a tank of gas. Hooray.
But hang on, you say. I’m not running a charity here. Why would I spend $100 bucks just for some voting rights? I mean, at least the screaming pundit might get $50 out of the deal.
Because, ownership entitles you to more than just an ego-boost. It entitles you to profits.
Our Fair Share
When you bought that share of XYZ, you not only bought the rights to vote on corporate actions, you also bought the rights to your share of the yearly earnings of the company. In this case, XYZ is earning $15 million dollars per year. You own 1/1,000,000th of the company, so you get 1/1,000,000th of the profits. You get $15.
Now that company could just hand you your $15. That would be called a dividend. And you don’t want that.
Why not?
Two reasons:
- Tax: You would have to pay income tax on that money. So your $15 dollars could actually be as little as $12, depending on your tax bracket.
- Reinvestment opportunity: XYZ has the opportunity to invest in itself to earn even more money next year. It’s going to buy a new widget-tron to make even more widgets at an even faster rate. The value of XYZ will increase by $15 and its earnings next year will increase as well. Win-win! And you won’t pay tax on the profits. Win-win-win!
Now this is where many investors go astray. Because that money is not in their hands, they don’t view it as ‘real’ money. This is absurd. After all, is the money in your retirement account any less ‘real’ because you’ll pay a a penalty if you spend it? Is the money you put down on your house any less real because it’s bound up in your home’s equity?
The Problem with Dividends
What’s worse are those that think of themselves as ‘dividend investors’. These are investors that are only looking at the rate a given company pays a dividend. I know these guys well; I used to be one.
Back in my dividend phase, I would scour the blue-chip stock listings (solid old companies that are unlikely to go anywhere) for the highest dividend rate. This led me to do truly stupid things, like buying 100 shares of AT&T because it pays me 8% per year.
But 8% sounds great! I’ve even said in other posts that market as a whole and over the long term averages 8% after inflation. My thought process at the time was more or less “Hey, it earns the same as the market, so what the difference?” Well here is a list of the crimes I comitted against logic and sound reasoning:
- AT&T pays me 8% before inflation. The Market pays me 8% after it. So my 8% is actually 5%
- My (now 5%) dividend is taxed at 15%. Earnings not paid out in dividends are not taxed at all until I sell the shares. So my now 5% is down to 4.25%
- AT&T has had no meaningful earnings since I bought those shares. Basically all of its operating profits are being paid out as dividends and none of it is being reinvested for growth. (At the time of this writing, AT&T is earning less than it pays out in dividends) This means I cannot efficiently take advantage of the power of compounding. How did I forget about compounding!?
- AT&T, in the years that I have owned it, has regularly increased the dividend. Yay! No I’m kidding. Not yay. Because they have increased the dividend, but not increased their profits, the company is not just standing still, it might be shrinking. I suspect that some seriously complicated and near-tantric accounting methods have been employed to hide this fact. Which is probably why…
- AT&Ts market value has shrunk 5 times more than the dividends it has paid me.
- Meanwhile, VOO, has been growing by more than the 8% long-term average, increasing its dividend just as regularly as AT&T, and growing most of my share of the earnings tax-deferred and in such a way that it takes advantage of the power of compounding.
By the way, this is not because I hate AT&T. I just hate how foolish I was and I don’t want any of you to make the same mistakes.
What’s the Point of Money if I Can’t Spend It?
I mean, if all those profits are getting locked away in the company, I can’t spend it right? How do I get my money out?
Fair questions. If you keep buying shares of the company, you will become equity rich, but cash poor. The same thing happens to people that tie up too much of their money in their homes or retirement accounts. But, unlike homes and retirement accounts, we have a trick up our sleeve.
Let’s say this you have worked hard for a few years, invested into XYZ regularly, which has increased its profits due to reinvestment in it’s self, and this is now your financial situation:
- Shares owned: 10,000
- Market value per share: $500
- XYZ Earnings per Share: $20 (earnings grow over time)
- Your Yearly Expenses: $50,000
Now, with each passing year, your share of XYZ’s profits will be (10,000 x $20) $200,000. The market value will, on average, increase by a multiple of that $200,000 number.
So how do you get your hands on the money?
You sell some shares. Some, not all. In this example, you would sell $50,000 worth of shares.
Here’s the cool part: You sold $50,000 worth of shares ($50,000 / $500 per share = 100 shares sold), leaving $150,000 of equity to be re-invested by XYZ for future growth. You now have 9,900 shares left. Next year, XYZ will earn $21 per share. Your share of XYZ’s earnings will be (9,900 shares x $21) 207,900.
Did you see that?
While the total number of shares you own decreased, your earnings actually increased. This is perpetual passive income, with free yearly raises thrown in. As long as you withdraw only part of your share of the earnings, this will go on as long as XYZ continues to increase its earnings.
If you lived forever and you continued to follow this policy, you would eventually end up with just a handful of extremely expensive shares. A real world example of this is Berkshire Hathaway. At the time of this writing, a single share of Berkshire costs about $300,000 dollars and (according to their last SEC filing) earns about $35,000 per share per year.
How to Be a Millionaire and Pay No Federal Taxes
Now when you do sell, think of it as a harvest. You planted your investment more than a year before (I explain why we wait a year in just a moment), you have allowed the company time to grow and now, it’s time to harvest.
It’s like copsing a tree. If you harvest just a percentage, it will keep growing back for many years. If you harvest the whole thing, it’s gone for good.
Money doesn’t grow on trees but, following this method, it does grow just like trees.
What’s this have to do with taxes? Following our 3MM plan will set you up for millionaire status. And when that time comes (or whenever your share of the earnings excedes your yearly expenses), you will begin your harvest.
At the time of this writing, the US tax code is extremely amenable to this method, and it doesn’t seem likely to change soon. Harvesting your share of profits in this way will allow you to withdraw $78,000 per year (assuming that you are married, it’s $39,375 if you’re single), without paying a dollar in federal tax, as long as you have held the shares at yeast one year before you sold them. Even if you withdraw more than that, you will only pay 15% on the overages.
Why would the tax code allow millionaires to withdraw so much money and pay so little tax?
The easy answer is that millionaires make the tax code. The long answer has to do with the fact that you already paid income tax on the money you invested, and XYZ has already paid tax on its profits. Don’t worry. The government is still getting more than their fair share. They will be just fine without your tax money.
By the way, this is why some of the richest men in America (Jeff Bezos comes to mind, but don’t quote me on that) only technically, on paper, receive a salary of $80,000 per year. It’s enough to live on, especially when you have billions invested, and it’s the most tax-efficient level of income.
The Only Company that Matters
Ok. So far we have been talking about individual stocks. But all of this applies to a broad-market mutual funds as well. Because mutual funds are collections of businesses, what is true for the business is true for the fund.
We put most of our money into Vanguard’s S&P 500 fund (you should do your own research; this is just what works for us). I want you to think of the S&P 500 (or whatever mutual fund you choose) as a single, very large, business. It’s the only business you care about. Think of it as a mega-monopolizing conglomerate that holds as its subsidiaries the 500 largest companies in the US.
You should be able to find data on the earnings per share of what you choose (we use multpl.com because it aggrigates data from Standard & Poors in easy-to-read tables and charts). Try to find all of the information we talked about above. Namely:
- Share Price
- Earnings per Share
- Dividend
Once you have that information you can keep a mental tally of the how much your investments are earning, and what your share of those earnings are. More importantly, you will have a clear image of much passive income you can buy with each of your hard-earned dollars. AND you will know how much you need to purchase each month to keep up with your goals.
A Practical Example
Let’s say…. in twenty years I want to be able to retire. I want my investments to generate enough passive income that I don’t have to work if I don’t want to.
Let’s also say that the standard of living I want to have will cost me $48,000 per year (or $4,000 per month).
Now, when I’m deciding how many shares to buy each month, I only need to think of that number. I need $4,000 per month in passive income. If I know I that each share of my mutual fund gives me $5 as my share of the earnings, I can begin to set goals and track my progress.
As I buy more shares, I keep the tally in my head. I focus on watching my passive income rate grow. Remember, this is all about psychology, about changing the way we think about money. We are trying to forge a mental framework that allows us to see money as something that works for us, not against us.
With this framework in mind, I see each dollar that comes to me through my day job as a stepping stone to my goal. I use my income to by shares, and my monthly passive income increases. $5 per month, then $10, then $20. In addition to my contributions, the ‘company’ (my mutual fund) is also increasing it’s earnings by reinvesting in its own growth.
Personally, we try to match the long term earnings growth rate. That way, half of our passive income comes from us and half comes from the businesses of the S&P 500 reinvesting in themselves.
Final Thoughts
So why do this? Why think about the shares we purchase this way? Doing so isn’t going to magically make you any richer than anyone else who just let’s their retirement managers do all the thinking, so what’s the point?
The point is to forge a business-oriented psychology. You are not just letting some advisor somewhere buy funds for you. You are a business owner now. You need to think like a business owner.
That means knowing where to invest your capital for the best possible returns. Having a reasonable expectation in mind allows you to choose where your dollars go. Sometimes its better to invest in yourself and your business. Sometimes it’s better to invest in the market. The only way you will ever know is to be able to compare apples to apples.
I have the chance to invest $500 in my side hustle, and I can reasonably expect to earn 5% on that money after a year. This means that after one year my investment would have earned me $25 (maybe $20 after taxes, your rate will vary).
Or
I can invest that $500 dollars in my fund of choice, and I can reasonably expect my share of a year’s worth of earnings to be $30 (tax free).
Once I can compare my share of earnings, the choice becomes clear and I am assured of always investing in the most responsible way possible.