FOOL ON THE HILL

Two Extremes of Investors

At the two extremes of investing, we meet one that invests for income and another that buys call options. Most of us are in the middle, giving us more choices.

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By Tom Jacobs (TMF Tom9)
October 31, 2002

[I started a short series on homebuilders last week and asked readers for ideas. The Fool Community response was fantastic. Thanks! I'm holding off for a week so I can incorporate all your helpful analytical insights.]

On Tuesday, I wrote that knowing who you are as an investor can protect you when reading stock analysis -- both good and bad. It helps you pick out what's useful and discard the rest from analyses that often give blanket conclusions without regard to what's appropriate for different investor types. No stock is a "buy," "hold," or "sell" for long or short term for everyone.

To show the range of investing types, here are two kinds of investors and the stocks that might be appropriate for them.

High-Yield Guy
High-Yield Guy is an extraordinarily sophisticated financial mind who has written books, served CEOs, written annual reports, and had just about every personal finance and investing job you can imagine.

He has always invested for income, preferring preferred stocks and bonds. For more than 30 years, he has looked for yields up to about 7%. Anything more than that he sees as a warning sign about the underlying business. It's worked well for him, given the marvelous effects of compound interest, even net of income taxes. Though research presented in Jeremy Siegel's Stocks for the Long Run and elsewhere asserts that stocks have provided better returns than any other asset class (bonds, gold, real estate, etc.) for all 20-year periods since the 1920s, I'll bet High-Yield Guy is quite comfortable.   

And ever since the traditional and Roth IRAs were invented, High-Yield Guy has even more reason to smile. He pays no taxes on dividends from stocks in an IRA. He pays income taxes on withdrawals from his traditional IRA in excess of his contributions, but he never pays a time on withdrawals from his Roth. 

That means if he is not concerned about potential tobacco litigation liability and buys Philip Morris (NYSE: MO) in an IRA paying a 6.15% dividend, he earns 6.15% annually plus any gain in the stock price. In a taxable account, he would pay taxes on that dividend each year at his marginal tax rate. Ditto if he bought a drug maker like Bristol-Myers Squibb (NYSE: BMY), with a 4.8% yield, or Merck (NYSE: MRK) at 2.7%. Or Dow mainstay Caterpillar (NYSE: CAT) at 3.42%. Any dividend-paying stock. 

This table shows the power of tax-free dividends. You can see what yield you would have to get at a given tax rate to equal a given tax-free yield.

2002                Dividend Yield
Tax Rate  7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0%
38.6%    11.4% 9.8% 8.1% 6.5% 4.9% 3.3% 1.6%
35%      10.8  9.2  7.7  6.2  4.6  3.1  1.5       
30%      10.0  8.6  7.1  5.7  4.3  2.9  1.4
27%       9.6  8.2  6.8  5.5  4.1  2.7  1.4
15%       8.2  7.1  5.9  4.7  3.5  2.4  1.2
10%       7.8  6.7  5.6  4.4  3.3  2.2  1.1

How safe is the dividend?
Dividend-paying stocks are not risk free. Some companies produce less and less cash but borrow more to keep paying the dividend and prop up the stock price. Eventually, the debt must be paid, and the dividend might be cut.

If a company has no real potential for growth and just keeps turning out the same cash flow from operations every year, and the company returns it to shareholders in the form of a dividend, the market may essentially value the company as a bond. Bond prices fluctuate inversely to the direction of interest rates. If rates for relatively risk-free investments (like U.S. Treasuries) increase, the price of the high-yield stock may decline, and vice versa. But the investor, holding these stocks for a long time, purchases at a price and yield he likes, and holds them through the many ups and downs of interest rates.

Actually, High-Yield Guy is even more conservative than this. He almost always buys a company's preferred stock rather than its dividend-paying common stock. He would likely find established large companies, such as those in the Dow Jones Industrial Average, inappropriate for his strategy.   

To learn more about preferred stocks, check out The Power of Preferred Stocks, and Why I Don't Use Preferred Stocks -- two very different Foolish views.

To find high-yield common stocks, check out these two classic Drip Portfolio columns: Six High-Yield Stocks and Six More High-Yield Stocks. Be sure to check out current yields of any stocks you find interesting.

Inner gambler
At a farther corner of the investing universe is the investor who told me how he honors his Inner Gambler. He is much younger than High-Yield Guy, has no dependents, doesn't have a lot of money, and devotes an enormous amount of time to investing -- and I don't mean watching stock prices. He reads and reads and practices. He wants to try a more aggressive investing strategy, but is not interested in throwing his money away.

He pursues a conservative approach to a very, very risky strategy -- options. Not employee stock options, but buying call options on stocks. Call options are securities that, for a certain period of time, allow you the right to buy shares of the company at a certain price (the option's strike price). You are betting that the stock will increase and that, before the expiration date, the right to buy at a certain price will be worth more to investors. Before the expiration date, you can exercise your right to buy the shares at the option's strike price, if you want.

This is a very risky strategy only appropriate, if at all, for advanced investors. I'm writing about it only for illustration.

Yet, I called this a conservative approach to a risky strategy because the Inner Gambler invests more than two-thirds of his money in bonds, and a bit less than a third in the riskier options. For the Inner Gambler, even high-yield stocks might be too risky for the bond part of his portfolio, but common stocks would not be risky enough for his options side!

Thinking about options? Take a deep breath and count to 10. We have a handy Fool FAQ to explain everything you want to know about options. If that doesn't scare the bejeesus out of you (what is the bejeesus, anyway?), which it should, then you must be an advanced investor who might enjoy Zeke Ashton's two-part series in this summer's The Motley Fool Select.

Not all you need to know
Each strategy reflects some aspects of an investor's age, reflecting his comfort with risk. Age matters not least because the effects of one's investing mistakes are easier to overcome the longer your investing time frame. (Those close to retirement who dived into the raging bull market with retirement savings know what I mean.) There's a reason that people should become less risk-averse with their money the older they get, though, again, the long-term return from stocks over all other assets classes suggests strongly that even people approaching retirement or in retirement should maintain at least some of their net worth in stocks.

In the middle
I picked two extreme examples on purpose, because most of us are somewhere in the middle. Where are you?

Are you investing a little every paycheck, in the hope of growth over decades? Perhaps Drip investing is for you. Is your 401(k) plan the place for your stock investing? Then the broadest market stock index fund is a good idea. Are you a stock jock, someone who more actively manages a portfolio? Then you may want well-researched stock ideas to subject to your own analysis. There are many stock newsletters, and we publish two -- The Motley Fool Select (30-day free trial) and Motley Fool Stock Advisor -- but no stock in those newsletters is appropriate for every reader.

Chances are, you are a little of each. Study and learn. Take your time. Try different investing approaches. Practice. When you find what fits you, stick to it. Don't let a day, week, month, or year scare you off from what fits you as an investor. And read every article about a stock critically, looking closely for whether it does or doesn't fit your strategy. Especially this one.  

Have a most Foolish weekend!

Tom Jacobs (TMF Tom9) reports that it's been raining for two days here at Fool HQ, and his shoes are soaked. Updates every half hour. At press time, he owned shares of Philip Morris. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.