Ask an Ex-Banker About The Big MO: What Are Returns?

A version of this appeared in the San Antonio Express News

Dear Michael,
I own a little of MO, purchased some time back with an average cost of $27.37. As you know it pays $2.08 dividend, and when I tell my friend my return is 8%, he says my return is what the stock presently pays, 3.8% or so.

I figure my return on my cost, not present price. Who is correct?

George, in Boerne, TX

Marlboro_man
The Marlboro Man, before dying a horrible death

Dear George,
Thanks for your question, which hinges on what we mean by ‘returns’ when we talk about an investment. And I can tell you who is right.
I will also use your question to discuss the unending debate between returns on stocks and returns on bonds.

Dividend Yield
Your friend’s definition of return at 3.8% posits a very particular number known as ‘dividend yield.’ We figure dividend yield mathematically by dividing the annual dividend of a stock by the current price of that stock.

Since the stock MO (slightly more commonly known as Altria, more likely known as Phillip Morris, and best known as a massive purveyor of cigarettes such as the iconic Marlboro brand) pays $2.08 per share per year in dividends and currently trades around $55 per share, the dividend yield is roughly 3.8% – which is $2.08 divided by $55.
I know precisely zero people (like your friend) who would call 3.8% the ‘return’ on owning MO stock.
So he’s wrong.

Instead, the return of MO stock ownership is the calm satisfaction you get from funding a delicious and refreshing tobacco-smoking experience for millions of satisfied customers.

Haha just kidding, lolz, smoking is disgusting.

altria_stock_chartAnnual vs. Overall Returns
What I actually mean is the real return of MO stock ownership is calculated, as you already indicated, by figuring out your average purchase price, the current market price, and any dividends you may have received in the interim. Since your MO shares have doubled in price since you bought them, your overall return is something north of 100%, so far.

And so far, so good, for you.

However, we frequently talk about ‘annual return’ on an investment rather than ‘overall return’. If you made this purchase nine or ten years ago, your annual return might be something like the 8% you stated.
But I don’t know. It depends partly on when you bought, and also how you did or did not reinvest dividends.

If you know your way around an Excel spreadsheet, I could use the ‘IRR’ function to input your various annual purchases, plus any interim dividend cashflows, and then the proceeds you would collect when you sell, in order to calculate your annual return.

Then you can tell your friend to put that number in his pipe and smoke it, so to speak.
It’s well above 3.8%.

Knowable vs. Unknowable returns
But since you haven’t sold MO, you don’t actually know yet what your total, or annual, returns will be on the stock. You have to sell the shares to know your return on any stock investment.

And that leads me to a thought on the psychological problem of investing in stocks, especially when compared to bonds.
Since you have to sell to know your return, and since the correct holding period for stocks is roughly ‘forever,’ stock returns are less knowable than bond returns.
Stock returns, unlike the returns on bonds, are unknowable ahead of time. You basically have to leap into the unknown with stocks, which you don’t have to do with bonds.
Unlike stocks, traditional bonds simply ‘mature’ after a set number of years and ‘return’ your money back to you in the fullest sense of the word. Because your money ‘returns’ to you with a bond at a set date, calculating bond returns is knowable.

Donald_rumsfeld
As goofy as he sounded, Rumsfeld was right. About investing, at least

Bond yields are, however, a bit mathematically complicated.
For simplicity’s sake, traditional bonds have a known ‘Coupon Yield’ which tracks the income an investor can reasonably expect just by holding the bond. This would be analogous to your ‘Dividend Yield’ that I described for stocks above.
The Coupon Yield is the ratio of the annual bond payments to the bond price, so a bond issued with a 3% annual coupon starts off with a Coupon Yield of 3%.
Sophisticated bond investors do not consider ‘Coupon Yield’ an accurate enough measure of bond returns, however.

Calculating bond yields
After a bond has been issued, the ‘annual return’ or ‘yield’ you get holding a bond depends on whether you paid more or less than face value for the bond. If you paid less you will make a higher return than the coupon, and if you paid more, you will earn a lower return than the coupon. A precise yield or return calculation would require applying a special ‘discounted cash flow’ math formula to all remaining bond payments.
Confused yet? That’s the way we finance people want to keep it!

Haha just kidding, lolz. Finance is disgusting.

Ok, no, it’s not disgusting, but I’d have to direct you to some math to learn more about calculating bond yields and ‘returns.’ Don’t worry though, because a main point is this: The final ‘returns’ of a traditional bond held to maturity are knowable, making bonds psychologically comfortable for some folks.

Final ‘returns’ on a stock depends on an average purchase price and average sale price. So until you sell the stock, you have unknown returns. This partly explains why stocks are psychologically uncomfortable for some folks.

Stocks v. bonds
So which one should you own in your investment portfolio?
Well, let’s see, that’s a complicated question with many answers.
Let me tap out the tobacco in my pipe, my young friend, clear my throat heartily, and tell you in a deep voice that it depends on your time horizon, your risk appetite, your savings rate, plus a sophisticated calculation regarding the number of years until your retirement.

Haha just kidding, lolz.

You should own stocks.

 

Please see related posts:

Stocks vs. Bonds

Discounted Cash-Flow formula

Another discounted cash flow example

 

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Driving In Traffic – A Metaphor For Fund Fees And Performance

Editor’s Note: A version of this post appeared in the San Antonio Express News in my brand spanking new “So…Money” column.

 

My morning commute this summer means driving the two young lovelies to their respective kid camps. I like driving in heavy traffic as much as I enjoy hauling over-heated kitchen garbage out to the brown bin in the garage in August. Which is to say, I often have my crinkled-nose sad face on when commuting.

One benefit of being stuck in 8 a.m. traffic headed north on U.S. 281, however, is the chance to reflect on my favorite analogy about investment fund fees and risky markets.

Picture me in traffic, in my dark red — although for my own pretentious reasons I insist friends refer to the color of my car as “Crimson” — Hyundai Elantra. This hot number accelerates from O to 60 in just under 4.3 minutes.

[By the way, please open and press play on this YouTube link in another browser, as it constitutes the preferred musical accompaniment to this entire post. This is meant to be a multi-media experience. Thank you.]

hyundai_elantra_like_an_index_fund
Hyundai: The “Index Fund” of the Car World

So we’re crawling along around 3 miles per hour, and I glance over my left shoulder at the electric blue Corvette next to me.

A key fact to know, which hardly needs spelling out, is that the owner of that pretty blue Corvette paid approximately three and a half times what I paid for my Hyundai.

I exchange a “Whaddyaknow?” grimace in solidarity with the middle-aged man behind the wheel of his sports car, since we’re both stuck behind a few miles of bumper-to-bumper commuters.

My investment fund fees analogy hinges on the key fact that my crimson Hyundai and my buddy-in-traffic’s electric blue Corvette are in the process of accomplishing exactly the same thing, despite an obvious difference in price — and an obvious difference in status.

blue_corvette
Shiny, fast, and expensive!

Because both of us are moving nowhere fast.

Now, here’s my great traffic and investment fund analogy in full:

With your investments, your primary goal is to get from point A to point B. Specifically, to turn some amount of money you have today into some larger amount of money in the future.

The speed at which traffic flows is the market returns of any given year.

Sometimes you’ll flow along nicely up 281 at 65 miles an hour with not much traffic. That’s like earning a cool 12 percent from the stock market for the year without breaking a sweat.

On other occasions you’ll ease onto the nearly empty Pickle Parkway — also known as State Highway 130 — and legally cruise at 85 miles an hour. That’s what it feels like to earn 20 percent or more from the stock market.

And then, in the worst times, you’re stuck behind a four-car pileup, sweating and swearing and unable to move or even get off the highway. We had that kind of year in 2008, when everyone in stocks lost about 35 percent.

Here’s where my analogy really kicks in, though. For the vast majority of driving situations, like the vast majority of investing situations, we get what everybody else gets and there’s not much we can do about it.

As my daughters’ pre-school teachers like to remind them: The best (investing) attitude is ‘You get what you get and you don’t get upset.’ Maybe you already know this idea, and you set it to good use when you buy an investment fund. But I know most of us don’t act like we know it.

Practically the entire personal investing industry is built on the false conceit that you, the consumer, can buy a financial vehicle that can go faster than someone else’s vehicle — essentially to “beat the market.” In reality, that’s incredibly rare.

Without breaking the law, heading onto the shoulder lane or driving recklessly at an elevated risk of hurting yourself or others, you cannot generally beat the rate of traffic, whether you drive an electric blue Corvette or a crimson Hyundai Elantra.

And the same goes for investment funds. You can pay more for a mutual fund or hedge fund, but almost none of them reliably “beat the market.” Every rigorous academic study of financial funds ever done concludes this way: The difference in market returns between high-cost and low-cost funds is, in aggregate, the cost of the funds’ management fee. The difference in market returns, in aggregate, favors the low-cost fund.

Traditional mutual funds charge between 0.75 percent and 1.5 percent management fees, or between $750 and $1,500 per $100,000 investment per year. If you buy an index fund — the Hyundai Elantras of the investment world — you will pay between 0.1 percent and 0.5 percent management fees, or $100 to $500 per $100,000 in the account.

ridin_dirty_hyundai_elantra

The entire financial industry would like you to think that the extra cost buys you something, but I’m here to tell you the straight fact that you’re paying three and a half times more to get exactly the same investment performance.

Whaddayaknow?

 

Please see related Posts:

On Cars Part I – On Avoiding Excessive Fleecing

On Cars Part II – Acceptable Price of a Car

 

 

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