Scared of Stocks, Young Investors Park Money in Cash

The older, more experienced, and wealthier I am, the more I am convinced that the average person has no business managing their own money.  People are too busy living their lives and getting ahead in their careers to focus on growing their capital.  As a result, they make stupid decisions that cost them enormously in the long-run.

This morning, as I enjoyed a hot cup of black coffee, read the newspapers, and thought about my meeting with the securities lawyers yesterday to discuss regulations for forming a new company, I came across an article called The New Young Investor: Shunning Stocks, distributed through CNNMoney.   The crux of the piece is that younger investors have been so spooked by the volatility in the stock market over the past few years that they are parking everything in cash and bonds, ignoring equities entirely.  In many cases, these were the same people buying stocks during the market boom.

What is responsible for this?  A big reason is something that I call the “Cult of Capital Gains”, which I wrote about in an article at About.com called Don’t Join the Capital Gains Cult – Why You Should Focus on Dividends and Total Return.

A generation or two ago, it was said that companies existed for the sole purpose of paying dividends to the owners.  That is, if you owned a car wash or a bank, it was utterly useless to you unless a check showed up in the mail and you could use it to buy groceries, a nice suit, new furniture, or an education for your children.  What counted was the utility you earned from your investments.

Somewhere along the line, people realized – and there is truth in this – that a good companies is better off reinvesting money for growth rather than distributing cash to owners.  The problem is that inexperienced investors had even more reason to gamble on “the next Microsoft” instead of looking for value.

The 100% Cash Portfolio Ignores the Biggest Threat – Inflation

One of the investors in the CNNMoney story was 18-year-old Robert White.  The twenty-something investor has $35,000 parked in short-term certificates of deposit yielding 4% according to the story.  Yet, we are facing a high probability of large inflationary pressures over the coming years, at least in my opinion.  That means that on an after-tax basis, Mr. White is likely earning a zero percent “real” rate of return.  He isn’t compounding his money for the future, he is merely storing his present purchasing power.

That approach would be good if he needed the money in the next five years.  You should never buy stocks with money you might need within that time frame.  The stock market is too volatile in the short-term.  But the story says that White wanted to “jumpstart his retirement plan”.  This implies that the money we’re dealing with is for long-term planning.

I wouldn’t want to be in White’s position.  The reason is that I look at opportunity cost.  Take a huge blue chip stock like Johnson & Johnson.  Even with the firm’s recent regulatory problems, which may end up costing serious money, the stock currently trades at $62.35 and earns $4.87 in net income per share.  That results in a 12.80 price-to-earnings ratio, or a 7.8125% earnings yield.  Of this, the company distributes $2.16 in cash dividends, which is a 3.5% cash dividend yield.  Under current tax rules, dividends are taxed at lower rates than interest income.

So you have a situation where you could earn almost the same amount as a certificate of deposit in terms of cash, possibly earning higher after-tax returns once adjusting for the different rates applied to each type of investment income.  But the real difference is that a 4% certificate of deposit won’t increase the coupon rate.  Johnson & Johnson, or other companies, have the ability, if they are well-run, to increase earnings per share over time.  They have some natural inflation protection because if costs rise 3%, then it won’t be long before bottles of baby powder and mouthwash rise, too.

If the company’s earnings power is still intact, a drop of 40% on the stock isn’t likely to matter to an intelligent investor.  He or she will look at the business and decide whether they think the problems are temporary or whether there has been an impairment on the cash generating power of the underlying enterprise.  If the company’s long-term prospects are still reasonable, he might use the lower stock price to buy more ownership of the business, increasing the ultimate dividends he expects to collect.

The Five Ways to Know When Falling Stock Prices Can Be To Your Advantage

As long as five important conditions are met, stock price declines can be huge opportunities.

1. The price you paid to buy your ownership in the company is reasonable as viewed from a future-earnings perspective. A business earning a good return on equity with decent growth, a 3% dividend, and a 10x price-to-earnings ratio in a world of 0% or 1% interest rates has the potential to be a very good bargain.
2. The company’s long-term earnings power hasn’t been damaged too heavily or isn’t in danger of obsolesce. It doesn’t matter how cheap the stock price, horse and buggy manufacturers weren’t going to be good long-term holdings once the Model T made it to market.  This requires sound judgment and you won’t always get it right.  That is why, for most people, diversification is prudent.  Even Buffett, who makes concentrated bets with Berkshire Hathaway’s portfolio, is able to do it because the underlying cash generators he owns are excessively diversified – he owns 70 different operating companies selling everything from ice cream to bricks.
3. The firm isn’t facing a situation where liquidity demands could require it to go bankrupt even though it remains profitable or it might have to issue equity to outside investors, diluting existing owners. A business may survive a crisis but if it has to issue so much new stock that the old owners never see the recovery, that is a huge problem for the original investors.  The flip side is true, too.  If a company is healthy and can buy back its own shares during a crash, when things return to normal, it can make stockholders rich.
4. You can afford to make the investment. No matter how cheap something is, if there is even the remote possibility that you might have to sell it to meet your own liquidity needs, you would be best to stay cautious and park the money in cash equivalents that are safe and, preferably, FDIC insured.
5. You aren’t over exposed to the industry or sector. Things don’t always work out how you want or even how they should.  Even with huge bargains in the financial sector during the meltdown, I wouldn’t have wanted 100% of my net worth in bank stocks.  During the depths of the crisis, our shares of Wal-Mart Stores didn’t budge because the firm was benefiting from people taking advantage of the bargains at the discount retailer.  In effect, our Wal-Mart stock served as an anchor to the portfolio, letting us take advantage of other opportunities with our cash flow.