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Retirement Planning

Retirement FAQ: Should You Buy Apple Stock After The Split?

diversified portfolio

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FAQ: Is now the time to buy Apple stock since it split and is cheap?

Answer: No.

We are getting this one a lot lately. Apple and Tesla are both darlings of the tech world recently and both announced stock splits at the same time. There seem to be two fundamental problems with this question, first is that a split adds any value to a stock or company, and second that the company is cheap because the price is lower.

Problem #1 – A stock split is nothing more than a shake-up of the numbers that dictate a stock. Each company that is traded publicly has a certain number of shares outstanding, called the float. The other relevant metric is the price of each one of these shares. If I own ABC Corp, a cloud-based web services company, they may issue 1 million shares of stock when they incorporate. This means if you own one share, you will own 1/1 millionth of the company. As we learned in elementary school, slicing a pizza pie into more slices does not increase the size of the pie, it merely reduces the size of each slice. If your share of ABC Corp is worth $10, the entire company is worth $10 million. If the company grows and the stock increases in price to $20, the company is now worth $20 million. The Board of Directors of ABC decides a stock split is in order and offers a 2-for-1 split (I will receive 2 shares for each one I own), thus the shares outstanding doubles while the price is cut in half. Again, each slice of pizza is cut in half, but the pie size remains the same. There is no value created from a split. The shares may become cheaper for the average investor to afford, but in a world of fractional share purchases and 401k’s, I don’t think this advantage provides any material value.

Problem #2 – The price of Apple stock may be lower than it was before the split, however, as demonstrated above its value is unchanged. In the case of stocks, value is measured as future earnings per share. Obviously, the idea of measuring anything related to the future is what makes markets. Some people think the earnings will grow at a very quick rate and others think they will grow slowly…or not at all. In the case of Apple, the stock is priced at an extremely unreasonable growth rate based on the last 5 years. Apple is trading at essentially double the market as a whole on an earnings basis. However, Apple has grown its revenue by less than 3% per year on average for the last 5 years. This is far from the growth rates seen by other tech companies such as Google, Amazon, or even Tesla. In fact, this growth rate is slightly less than the average growth rate of the entire S&P 500. The iPhone, which has actually hardly grown at all in the last 3 years is 50% of Apple’s revenue and unless they have something up their sleeve that will change the world in a market that is massive, such as energy, transportation, or health care, it is unlikely that the current valuation is justified.

Sure, as long as there are speculators, the stock may go higher. Nobody can predict the short-term moves of any one investment. Rampant speculation could push the valuation of Apple significantly higher from here. However, speculating is never a good long-term investment strategy. Stay away from Apple until it is unloved by the majority of investors like it was in 2013, and you may be able to buy it at a bargain. Or better yet, take our advice, avoid individual stocks altogether, and stick with a diversified portfolio of low-cost index funds.

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FAQ: Why do bonds, which are supposed to be safe, fluctuate in value?

Answer: Certainly, this is a question that is often asked by those in retirement trying to protect what they have. Let’s discuss this in two ways, individual bonds and bond funds. Although both are essentially bonds, they have slightly different risk characteristics that it is important to understand when investing in bonds.

Let’s start with a simple explanation of what a bond is and how it works. When you purchase a bond, you are lending money to some entity (the government, a public or private company, etc.). In exchange for lending this money, the borrower will pay you interest, typically, each year that the money is lent. At the end of the period, you will receive your last interest payment, as well as the principal, returned to you.

As an example, if I were to purchase a 10-year treasury bond from the Federal Government for $10,000 at a 1% interest rate, I would receive $100 per year and at the end of year ten, my $10,000 would be returned. There are lots of different types of bonds that can have various features, such as converting to stock at some point in the future (convertible bonds), don’t pay any interest until the end of the term (zero-coupon bonds), or any number of variations of interest payment, length of time, and return of principal. For the sake of simplicity in our explanation here, I will limit the scope of our discussion to the 10-year Treasury bond.

Single Bond: In the above example, if I purchase a 10-year treasury bond from the government for $10,000 and the current interest rate is 1%, I will get $100 a year until the end at which time I will get my principal back. This is the agreement we make with the Fed. If we want to hold our bond to maturity, this will not change. However, the face value of that bond ($10,000) will fluctuate during its life. What I mean is that if at some point you want to sell your bond on the open market (yes, you can trade your bond for cash just as if you bought Apple stock and now choose to sell it). The price a buyer is willing to pay will be based on several factors, but in this case, the two important factors are current interest rates and time until the bond matures.

In another example, you purchase a 10-year treasury bond for $10,000 and it will pay a 1% annual rate of return. However, the day after your purchase, interest rates fall and now the treasury is selling its 10-year treasury bonds and only paying .5% annual rate of interest. That means a buyer of a bond today will only get $50 per year, where you purchased it yesterday and are getting $100 for the next 10 years. You can now sell your bond on the open market for a higher price than you paid because the value of your bond is greater as interest rates fall and there is a lot of time left until your bond matures. Who wouldn’t want to get $100 per year instead of $50? Your bond might have a value of $10,322, an increase in value of 3.2% in a day. However, that value can only be locked in if you sold your bond. If you held it for 10 years, you would be stuck with the original agreement you made with the Fed.

The opposite is also true. If, in the same circumstance, rates spike to 2% overnight and you are stuck holding a bond for 10-years that is paying a lousy 1%, while the rest of the world could buy the same bond and get $200 per year, you may want to sell. However, when you contacted a broker to sell your bond, you may be disappointed to learn that overnight, the value of your bond fell from $10,000 to $9,678. You lost more than 3% on the value of your bond simply because nobody wants your lousy 1% bond in a 2% world. Again, if you hold the bond to maturity, you will get the full $10,000.

It is important to remember that time is always a factor. The longer the duration (time remaining on the bond until it matures) the greater the fluctuation in the bond price. Essentially, I would much rather have a bond that pays 1% for 5 years if rates go up to 2% than one that keeps me stuck at 1% for 30 years.

Price fluctuations for individual bonds are only on paper. If you hold the bond to maturity, you will get the full value so the fluctuations could be irrelevant to your portfolio.

Bond Fund: In a bond fund, a manager holds all types and durations of bonds. These bonds are constantly maturing with new money coming in to purchase new bonds. Thus, there is no yield to maturity because the fund never matures. The bonds that are either being sold or mature are being replaced with new bonds. Essentially, the bond funds life span is infinite. Thus, the only way to get your money out of a bond fund is to sell the fund. The bond fund will fluctuate in value in a very similar fashion to the individual bonds that make up the fund (i.e. a long-term treasury bond fund will do very well when there is a financial panic, interest rates collapse, and people run for safe investments). However, the fund will fluctuate based on the duration of the fund, interest rates, and the underlying economic conditions affecting the fund.

As a portfolio manager and financial planner, I prefer to see bond funds in a diversified portfolio versus individual bonds in most cases. The fluctuations of the bond fund are exactly what a well-balanced portfolio needs to offset the fluctuations of the stock (equity) investments in the portfolio. Since bonds tend to have a negative correlation to the stock market (when stocks fall, bonds tend to rise….and vice versa), they provide a fantastic hedge. Especially to retirees.

Although this topic can be a bit technical, it is important to understand at least the fundamentals when investing in bonds. Please understand that when you put your hard-earned money out into the world to work for you, you take risk no matter what you invest in. The key to proper investing is to understand the risk you are choosing to accept in investing that money. Knowledge is powerful!

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FAQ: Now that I’m retired, what do you think if I invest in only high dividend stocks for the income they provide?

Answer: This is a question we get from time to time that can be very concerning. Anytime investors put most or all of their investments in one asset class, they are setting themselves up for problems, however, more than that, the nature of this question typically means that the person asking is unaware of the risks associated with this strategy.

Anytime you put your hard-earned money to work for you to go out into the world and multiply, you are taking risk. Risks that are easy for investors to understand are market risk, the risk that my investment fluctuates in value, and default risk, the risk of whatever I invest in going belly up and losing my entire investment.

However, there are several unseen risks that are not always so apparent to investors. A good example of this is inflation risk. This is the risk that costs to purchase goods are going up quicker than the value of my investment. Thus, even though my investment appears safe and I will get what I invest plus some interest, the money returned to me will be less valuable than when I lent it out (i.e. it can buy fewer goods), even though the absolute value is more. This is a risk that is far less perceptible to investors than market fluctuations, but it can have just as terrible consequences if not properly managed.

In the case of high dividend-paying stocks, there are several less than transparent risks. The one any investor needs to be on the lookout for is a common investing error called a “dividend trap”. A “dividend trap” can occur when a company that pays a sizable dividend begins to see its stock price fall due to a systematic problem in its industry or poor management. As the stock price falls, the dividend yield (which is calculated by dividing the dividend paid in the past year by the stock price) can increase dramatically, making it look like a compelling investment. However, the fundamental problems with the underlying business mean the company will almost certainly cut the dividend in the future and possibly even go out of business.

(For example, General Motors is a $100 stock that pays a $6 (6%) annual dividend. However, the car business is in trouble and the company stock falls from $100 to $20 in three months. That 6% yield is now a whopping 30%. It may look like a fantastic dividend-paying stock, but the company is a shaky investment and will most likely cut this dividend in the near future. In the case of General Motors, they actually filed for bankruptcy in 2009. You would have lost 99% of your invested funds stretching for high dividends).

The most important lesson in investing is understanding the seen and unseen risks of your investments. Reaching for yield through dividend stocks can be a good part of a diversified portfolio, but as with almost all investment strategies, should be diversified. Diversification is the best way to manage all the risks you will face in your investing life.

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