Investing–The New Rules: The Lily Tomlin Approach

Lily Tomlin on How to Read Your Portfolio Statement

Examining with a cynical eye is a good thing–at least when it comes to your investments. Rob Bennet explains why you should adopt the Lily Tomlin view in this week’s ‘Investing–The New Rules.’

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Investing — The New Rules
Lily Tomlin on How to Read Your Portfolio Statement

#15–August 9, 2010

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Comedian Lily Tomlin once pointed out that, “no matter how cynical you’ve become, it’s impossible to keep up.” It wouldn’t surprise me to learn that she came up with that one after paying a visit to InvestoWorld. You cannot trust anyone in InvestoWorld. Even your portfolio statement lies to you!

You are trying to figure out where you stand financially. You open your portfolio statement and you see a line near the bottom of the last page marked “Portfolio Value” and you think to yourself “This is it!” The number next to those words is “$30,000.” You’ve solved the puzzle. You own stocks worth $30,000.

No?

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Um — actually, no.

Depending on the circumstances that may not even be close to being the truth.

There’s one sense in which that number is accurate. If you were to sell all of your stocks today, you would get $30,000 in return for them. That much is at least so.

However, if you are like most middle-class workers, you have no intention of selling all your stocks today. You are in it for the long haul, trying to finance a retirement that you won’t be enjoying for many years to come. The amount that your stocks would sell for if you sold them today is not the number you need to identify to know where you stand financially. You need to know the true value of your stocks, the value that they will hold not just for today but for tomorrow and for next week and for next month and for next year and for ten years down the road. That’s a different number.

Figuring out the true and lasting value of your portfolio is a two-step process. You first need to identify the number that your portfolio would sell for if you sold it all today (the portfolio statement number). Then you need to add to it or subtract from it the necessary amount to adjust for overvaluation or undervaluation.

It’s our friend P/E10 (discussed in an earlier column) that tells you how big an adjustment is required. The fair-value P/E10 value is 14. Say that the current P/E10 value is 28. That means that you need to divide your portfolio amount by two to identify its true value. If the portfolio amount is $30,000, the real value of your stock portfolio is $15,000.

Conversely, if the current P/E10 value is 7 (half of fair value), you need to multiply by two to identify the true portfolio value. In that case, the true value of a portfolio priced nominally at $30,000 would be $60,000.

There’s a big difference between having a portfolio with a true value of $15,000 and having a portfolio with a true value of $60,000. It’s a huge mistake to go by the number reported on the portfolio statement. You must perform the valuation-adjustment step to be able to engage in any meaningful financial planning.

Say that you are trying to figure out whether your retirement plan is on track. It is impossible to make a good assessment if you are thinking that your portfolio is worth $30,000 and it is really worth either $15,000 or $60,000. Fail to perform the valuation-adjustment step and you have little idea whether your retirement plan is on track or not.

Actually, it’s worse than that. Use the nominal number and you have a mistaken idea of whether you plan is on track. The portfolio number is misleading. It would be better to have no idea what your portfolio is worth than to have confidence in a number that is wildly off the mark. Bad information prompts bad decisions. Bad information sets you back.

Or say that you were an investor of the late 1990s trying to figure out whether stocks were paying off for you or not. Nominal stock prices were going up by 20 percent or 30 percent per year in those days. Many investors were fooled into thinking that their own portfolio values had increased by that much. Falling for that one can cause big trouble down the road.

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ALSO at DBKP:
* Investing–The New Rules: Young Investors Taking Hardest Hit
* Planning for Retirement: Retirement Riddle
* Investing–The New Rules: The Godfather Visits InvestoWorld
* Investing–The New Rules: Determining Stock Value Using P/E10
* Investing–The New Rules: The Monster That Ate the U.S. Economy
* Investing–The New Rules: Stocks Are Not Worth Buying Today
* Investing–The New Rules: Sarah Palin Will End Economic Crisis
* Investing–The New Rules: Dollar-Cost Averaging is a Loser
* Investing–The New Rules: John Bogle’s Evil Twin?
* Investing–The New Rules: Stock Return Predictor Not a Case of ‘Too Good to be True’
* Investing–The New Rules: The Stock Investor’s Weather Report
* Investing–The New Rules: Harness the Power of The Stock Return Predictor
* Investing–The New Rules: Get the Odds on Your Side
* Stock Investing: Much of Today’s Understanding is Primitive

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We have for the last 10 years been paying back the money we borrowed from future investors to temporarily push stock values up to the insane prices that temporarily applied in the late 1990s. Think how disappointed you would feel in seeing where your portfolio value stands today if you were thinking back in 2000 that the numbers you saw on your portfolio statement at that time were accurate and that you could realistically expect to see even more gains over the following ten years. Now you have some sense why many of today’s investors are feeling panic!

Now take it the other way. Say that you understood back in the late 1990s that the number on your portfolio statement was fictitious and that the true and lasting value of your portfolio was only one-third as large a number (stocks were overvalued by a factor of three at the top of the bull). Knowing that would have told you that stock prices would be coming down hard for the next 10 years. Wouldn’t it be nice to be able to see into the future? Those who make the necessary adjustments to their portfolio statement numbers are able to do so, at least in regard to stock prices.

There’s a huge strategic implication that follows from all this. If the nominal portfolio value is accurate in the sense that you really can obtain that amount if you cash in your stocks immediately but fictitious for real and lasting purposes, what are smart investors doing when stock valuations go to two or three times fair value? They’re selling stocks! Why not? So long as there are other investors willing to pay you the fictitious portfolio value for your stocks, why not take advantage of their willingness to do so?

Sometimes it pays to be a little cynical. Lily Tomlin nailed it.

by Rob Bennett
images: sdnn;dbkp file

Rob Bennett writes about safe investing strategies at www.PassionSaving.com. His bio is here. And please don’t even think about not reading these Important Cautionary Words.

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