The Death of Capital Gains Investing (And What to Replace It With) A free report by Richard Stooker (author of Income Investing Secrets, Master Limited Partnerships, Bring on the Crash, REITs Around the World, and Stock Market Investing for Beginners) SMASHWORDS EDITION Published by Richard Stooker on Smashwords Copyright © 2012 by Richard Stooker and Gold Egg Investing LLC. All rights reserved. Without limiting the rights under copyright reserved above, no part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording, or otherwise) without the prior written permission of both the copyright owner and the above publisher of this book. Smashwords Edition License Notes This ebook is licensed for your personal enjoyment only. This ebook may not be re-sold or given away to other people. If you would like to share this book with another person, please purchase an additional copy for each person you share it with. If you're reading this book and did not purchase it, or it was not purchased for your use only, then you should return to Smashwords.com and purchase your own copy. Thank you for respecting the hard work of this author. Table of Contents Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 1 Any Happy Investors in the House? Look at the bottom line of your 401(K), IRA, Roth IRA or other brokerage account. Like what you see? When was the last time you liked what you saw there? If you're like most people, it was late in 2007, when the Dow Jones Industrial Average broke 14,000. As I write this, on December 3, 2011, over four years later, it's 12,019 and THAT only after a major post-Thanksgiving rally. Not long ago it under 11,000 (and it first reached 11,000 around April 2000). It's down 2,000 points from that 14,000 record. And nobody knows where it's going next. Yet people keep trying to make money this way. When they fail, they're quick to label "Wall Street" a scam or a conspiracy. The stock market itself is not a scam. The trouble comes from how people are brainwashed into trying to make money from the stock market. That is Wall Street's fault. Now it's time to lay bare the truth, so you can position your investments to give you ongoing streams of income to reinvest, to build yourself a fortune by the time you retire. But first, let's define terms. What is Capital Gains Investing? It's what the vast majority of people call simply "investing." It's buying a stock now in the hope you'll be able to sell it for a profit in the future. If you're like most people, you're now confused. That IS investing, you might be thinking. What else? There IS an "else," and I'll get to that in a minute. But first . . . Chapter 2 What's Wrong With Investing to Sell at a Higher Price 1. The simple answer is that, once you sell, you no longer own the stock. You ever hear the old saying, "You can't have your cake and eat it too"? Duh, huh? You can't sell a stock and own it too. And then you no longer benefit from the stock going higher in price. How many times have you heard of somebody selling a stock at its highest price, then happily counting their cash as the stock's price goes down? Not often, I bet. Most of the time, the stock keeps going up in price while you kick yourself. Or it goes down, then goes back up. Look at the long term graph of any great stock, whether it's Wal-Mart or Microsoft. They all trend up in the long term, but have many sharp downward jags, and periods where the price went virtually nowhere. The overall stock market is the same. How many people over the years have bought, then sold such stocks as Wal-Mart and Microsoft, then kicked themselves, because they spent the cash they received, so it's gone, but the stock keeps going up. Sometimes you need cash. Hey, it happens to all of us. But sometimes you sell one stock because it's been going down and you think another company will do better. Sometimes you're right, but often you're not. 2. Finding stocks that go up more than the stock market as a whole is not as easy as brokers, fund managers and stock pickers want you to believe. In fact, it's hard as Hell to succeed in stock picking and market timing on a long-term basis. Hundreds of studies since the Cowles Commission examined why none of the stock pickers and timers of that era predicted the 1929 crash have statistically analyzed the claims of fund managers and stock pundits of all kinds. The universal result? In the long run, almost nobody has successfully picked stocks that beat the market. "Hot" mutual fund managers turn cold or have to invest so much more money that their funds are forced to mirror the market as a whole. Stock pickers edit their records. They tell you about their winners, not their losers. Sure Warren Buffett has done a terrific job, but he's the exception that proves the rule. Besides, you and I can't buy up entire businesses (Berkshire Hathaway owns See's Candys and Geico Car Insurance 100%). If you and I go visit a company's headquarters, we don't get the red carpet treatment. You and I don't get a seat on the Board of Directors. And we can't get the same favorable terms he negotiates. And many of his stock picks pay generous dividends. And his favorite holding time is "forever," indicating he recognizes the perils of selling one company just to buy another company. Besides, this stock market's woes have limited even Berkshire Hathaway's record run. Chapter 3 Trying to Find Undervalued Stocks is Like Trying to Outsmart the World Do you know how many people are trying to find the next Microsoft or Wal-Mart? Are you smarter than all of them? Do you have access to some special knowledge they don't? If not, how do you expect to beat them all? If you do, trading on insider information is illegal, so if you get caught you're still screwed. Don't believe me, just ask Martha Stewart. Around this world there are people mutual fund managers, private management firms, pension fund managers, hedge funds, and others seeking to make trades to beat the market. What do you have that they don't? They have: Banks of powerful computers with real time access to market quotes around the world. And databases of prices going back a century. Proprietary software that finds opportunities and executes the orders automatically. Access to all the financial documents filed by publicly listed companies around the world, along with the programs to screen them. Teams of analysts flying around the world to visit factories and company headquarters of companies on every continent except Antarctica. Not to mention networks of contacts in institutions, businesses and governments around the globe. By the time you see or read the story on Fox, CNN, Reuters or the BBC, it's old news to them. And even THOSE guys fail to beat the market, long term. The "Lost Decade" is Becoming the "Lost Dozen Years" The 1990s bubble bull market peaked in March 2000 with the Dow at 11,700. As I wrote above, it's now just barely over 12,000. So in the past nearly twelve years it's gone up a grand total of 400 points. Wow. Whoopee. Small wonder people who measure their investment results this way are crying. Small wonder people who in 1999 were planning their early retirements are now delaying leaving the workforce. Small wonder many otherwise intelligent people are joining the Occupy Wall Street protests. Stock Indexing is Maximizing a Dysfunctional Strategy Their brokers and the mass media promised them the stock market would go up an average of 10% per year. Where is that? In your dreams? Because stock picking is so risky and liable to fail, according to many intelligent stock market writers, such as Burton Malkiel author of A Random Walk Down Wall Street, the solution is to invest in the market as a whole. Buy into Vanguard's S&P 500 Index mutual fund or Exchange Traded Fund. This eliminates the risk of relying on picking individual companies to invest in. Invest in them all, and profit from the rising wealth of the market. Maybe that 10% per year average will show up soon. After all, responsible investment advisors have always stressed that an average is just an average, and the stock market can have many down years. It's just that after the 25 year bull market from 1982 to 2007, nobody expected to ever see such down years ago. Yet here they are. Chapter 4 Where's the Silver Lining? We're facing a host of major economic problems: 1. The US economy is in a sluggish, minimal "recovery" that shows few signs of strengthening any time soon. Unemployment is still close to 9%. 2. A few months ago S&P downgraded the credit worthiness of the United States government, something which would have been almost unimaginable just a few years ago. This was caused by the huge amount of debt the government took on to prevent a major depression in the wake of the 2008 financial crisis. 3. Democrats and Republicans are at loggerheads over how to reduce this budget deficit. A bipartisan "super committee" failed to agree on how to reduce the budget by $1.1 trillion (to nobody's surprise). This sets the country up for wide, sweeping across the board cuts as of January 2013 (conveniently after the next election is over), which will hurt many and satisfy nobody. Although in theory the government could come up with an alternative budget before then, President Obama has said he won't approve that. As 2012 is an election year, we can expect a lot more rhetoric than action from all sides. 4. Besides the on the books debt, the US government faces the prospect of paying trillions of dollars of unfunded liabilities in the next few years: Social Security, Medicare, Medicaid, and other welfare programs. 5. State and local governments also have to pay millions of dollars of pensions for which they don't have the funds. 6. Many corporations are in the same boat. 7. 80 million baby boomers have started to retire. That's a lot of experience and expertise leaving the workplace. It's also a lot of people who are no longer buying stocks through payroll deduction, but selling them to supplement their inadequate Social Security and pension checks. Less buying and more selling of stocks reduces their price. 8. Leftwing activists have managed to capitalize on the nation's fears and frustration with the economy, to attract thousands of young people to camp out in big cities as a protest against Wall Street. Most Occupy Wall Street participants are well-meaning, naive young people who will be yuppies when they get a job. However, OWS threatens to disrupt law and order, and is draining the coffers of already-desperate cities. 9. Soon the healthcare "reform" law will go into effect, draining more money from the US taxpayers. 10. The Eurozone is threatening to come apart. Greece is close to defaulting on its government bonds. So are Spain, Ireland, Italy and Portugal. There's a lot of pressure on Germany to back up the excess spending of rest of the continent, but German taxpayers have their limits. Pundits around the world are predicting a huge financial disaster if the euro fails. Meanwhile, people around Europe are protesting the budget cutbacks. Like OWS, they're contributing to the financial problems, though without offering any solutions, and often even more violently. 11. In Asia, Japan's recession has entered its third decade, with no relief in sight. The Japanese people are growing older and dying faster than they're reproducing. Thanks to the one family, one child policy decreed sixty years ago, the Chinese people are also getting old. Although it's not well-known, in 2008 China enacted its own version of a stimulus bill, propping up many businesses around the country. They've built several cities which are currently empty. Yes - empty. They're trying not to be so export-dependent, but if Europe falls they'll be in trouble. Inflation in China is on the rise. So is civil disorder. Many experts believe there are many protests throughout the country on a daily basis, but usually not allowed on the news. The government wants to keep dissatisfied citizens from organizing into another Tiananmen Square revolt. Part of their strategy is to keep young people working, so they don't have time to take to the streets. Chapter 5 Financial Experts are Divided About the Future Some believe the huge amounts of debt in the world, together with the slowing of business due to baby boomers retiring (and Europe has its own baby boomers who plan to retire with government pensions and paid health care plans) is going to cause a deflationary spiral which will drag down the market prices of everybody assets (including houses and stocks), raise unemployment and slow down the entire world's economy. If this happens, the Dow Jones Average could plummet to levels we haven't seen in decades. That may not happen, but it's not likely to break that 14,000 record any time soon. Other experts believe the US Federal Reserve's policies of injecting liquidity into the system to prevent a depression are going to overload the world with US dollars. If the Fed doesn't do the job, they argue, one of our major creditors probably China is going to get tired of holding Treasury bonds and sell them. Either way, the world will be flooded with US dollars, causing a hyperinflation that may remind us of Germany in 1924 or even Zimbabwe a few years back. The good news is that your stock portfolio will go up in value. The bad news is that it may not go up as fast as inflation does, and it still won't buy any more than it does now. Perhaps we'll keep muddling through as we are now, though the idea that more of the "same" is the good news, is itself frightening. Maybe everybody is wrong, and the next booming stock market will start up next year. Are you ready to bet your retirement on that? Chapter 6 How Long Can a Stock Market Stay Down? It took over twenty-five years until November 1954 for the Dow Jones to break the record it set in August 1929. Ten years of a Great Depression, four years of world war, four years of a "police action" in Korea, and building a nuclear arsenal to defend the country against the threat of world communism. Japan's stock market reached its peak of 49,000 in 1989. The Nikkei Index is now at 8,643. The country is now in its third decade of slow to no growth and near-zero interest rates. How much longer can the current US bear market last? The truth is, nobody knows. However, someday stocks will go up again, whether it's next year or 2032. When Stocks Go Up, You're Happy, Right? The truth is, capital gains investors have no way of winning the war against their emotions. Many stock and investing writers tell you, don't trade on your emotions. Use your intellect. Unfortunately, our intellects are no better at predicting the future than our emotions. And studies have proven that few people can use their brains (or even their electronic brains computers) to beat the market long term. One thing conventional financial writers tell you that I agree with is stock market investing (for capital gains) is a war between fear and greed. In a bull market, greed prevails. In a bear market, fear rules. But both emotions are present in the individual investor with a decent profit in their stock. A capital gains investor's heart is as volatile as the stock market itself, because they know the market is fickle. Today the market gives you a 5% gain. It may take it away tomorrow. Knowing this, stock investors are tempted to sell before the price goes back down. That's the fear of loss. Old Wall Street maxim: You can't lose money by taking a profit. Ah, but greed plays a part too. Remember, if you sell a stock you don't participate in its later price rises. If your stock went up 5% today, maybe it'll go up 10% tomorrow. Who knows? But you don't want to miss out on that. Another Old Wall Street maxim: Cut your losses short but let your winners run. Here is where responsible mainstream financial writers tell you to invest for the long run. Buy many good stocks, or an index fund, and hang on for 20 to 30 years, and you're guaranteed to be ahead. But when you retire, you're still faced with the sell or hold dilemma. What if a bear market starts up right after you retire? (Ask people who retired in 2007.) So if it's impossible to find the super winning stocks (without the benefit of hindsight, when it's too late) and the prospects for the immediate future seem dim, and even when you have a winner you'll have emotional unrest instead of happiness, what's an investor to do? Abandon the hope of reselling for a profit? Yes. Chapter 7 Invest for Income Buy and hold forever but get a continuous stream of ever-increasing income, starting almost right away. Money you can use to buy new shares with, thus growing your portfolio or if you're retired live on. If the price of the stock goes up, who cares? You don't need to sell it to put cash money back into your pocket, because you're getting quarterly dividends. If the price of the stock goes down, who cares? You're getting your quarterly dividends. If the price of the stock goes nowhere, who cares? You're getting your quarterly dividends. Poof! There goes the conflict between your fear and greed. Suddenly, fear and greed are on the same side. Greed tells you not to sell stocks, because greed wants those quarterly dividends. Fear tells you not to sell stocks, because you're afraid of losing those quarterly dividends. There goes the need to find stocks that go up more than the market, or even as much as the market. You're after dividends. Real Businesses Demand Current Income It always amuses me when I read a mainstream financial writer advise people to buy stocks as though they're buying a business, because shares of stocks are shares of ownership in the business. [...]... probably heard of them, because many of them are well-known consumer brand names, but even the established in their markets business to business companies have secure incomes They make more money than they need, so they reward their investors well In the United States, there are two kinds of companies which are REQUIRED to pay at least 90% of their cash to their investors One of those types of companies... pay the loan back, but you still expect some financial return right away Yet people willingly trade their life's savings for pieces of paper for the sheer joy of seeing the price of those pieces of paper go up (hopefully) year after year Sure, they plan to sell those pieces of paper for a big profit once they retire And if they retire during a bear market like the current one, there's no guarantee they'll... cash to their investors One of those types of companies is regulated by the government, and allowed to raise prices every year by MORE than the rate of inflation And if you're not in the US, you may be in one of the almost forty countries that have a similar version of one of those types of companies And then there are utilities They're allowed to supply customers with electricity, natural gas, water... those dividends, by the end of 1954 your portfolio was worth 40 times more Chapter 10 There are Risks, However In the world of investing for capital gains, "risk" is defined as volatility That is, how much the stock's price goes up or down But if you don't have to sell your stocks to get money back from them, you can ignore that superficial definition of risk and concentrate on the risks that really... nearly the money they hoped for years ago And once they sell, at whatever price, they no longer have them We're back to that fundamental truth Chapter 8 If Dividends are So Great, Why Don't All Companies Pay Them? They can't afford to Critics of investing for income often use that to criticize buying stocks for dividends, but it's actually a good reason to do so See, many companies listed by the stock... relatively new They're not wellestablished in their markets They're fighting hard to compete They need to use all available cash to buy new equipment or to invest in Research and Development They have to keep up, or they'll fall behind and go out of business It would be irresponsible of investors to demand dividends from such companies But aren't such companies the riskiest to invest in? They're the ones... guarantees them a profit they are expected to share with their shareholders You don't have to buy a string of pearls, a grand piano or even an Apple iPod In bad economic times you can cut out such luxuries You do have to turn on the lights, heat your home, and drink water Would you rather base your retirement on one software company trying to compete against five others for fickle consumer loyalty or on the. .. the ones most likely to go out of business, taking your hard-earned money with them Some do go up a lot over the years but, as we've covered, you can't predict the future For every Microsoft, there's a ton of Lotuses For every Wal-Mart, there's a ton of KMarts Stick to Safety With Income Companies that pay dividends are generally well-established They're successful They've been around for years, and... companies generally paid higher dividend yields than they do now On the other hand, she couldn't buy the two types of modern investments which are required to pay out at least 90% of their cash to their owners You can You have another advantage right now You're starting out in a bear market Why's that important? Aren't bear markets a bad thing? They are if you're selling stocks When you're buying... icing off the spoon every three months and have it too The word is spreading Too many senior citizens are currently living restricted lives because they put their money into "safe" certificates of deposit, only to see interest rates slide down to nearly zero Many other retirees and near-retirees are looking at their current portfolios, remembering how fat they once looked, and how skinny they are . The Death of Capital Gains Investing (And What to Replace It With) A free report by Richard Stooker (author of Income Investing Secrets,. sides. 4. Besides the on the books debt, the US government faces the prospect of paying trillions of dollars of unfunded liabilities in the next few years: