If you think stock investing is risky, then option investing is even riskier. There is some truth to this but it very much depends on what it is you are trying to do. If you invest in low beta stocks or in Dividend Aristocrats, you can lower your investment risk. Similarly, there are option strategies that are very conservative.
The Risky Option Strategy
The risky way to use options is to buy an option in the expectation of a specific outcome. If that outcome doesn’t occur you lose your money because time runs out on the option. For example, let’s say you think that Ford (F) is going to have a great quarter.
I started investing in dividend stocks in 2006. That’s only six years ago. I could tell you a story about my mothers astronomical gains she got investing in ExxonMobil over 30 years. But, that’s old news, right? Does dividend investing still work?
Let’s look at my results so far for just one position.
I bought Altria (MO) at the end of 2005. At the time, Jim Cramer said that Altria was going to 100 because they were going to break up the company to “unlock” the value of their Philip Morris International stake (Altria was trading at 70 at the time). This argument sounded good to me. So I bought 200 shares.
We live in a low interest rate environment. The U.S. Federal Reserve which has power on setting short term (as well as specific methods to influence long term rates) has made it clear that rates are going to stay low for at least 2 years, perhaps more when you consider that any increases will happen gradually.
This is unfortunate for a few reasons. The most obvious is that low short term rates don’t offer any rate of return. In fact you can make a case that the returns are negative. For example, the 10 year U.S. Treasury bond is yielding about 2% – which after a reasonable assumption of >2% inflation going forward leaves you with a negative real rate of return. How’s that for policy?
A far more damaging aspect of this policy is that it has distorted the relationship between stocks and bonds as a means of valuing the return and risk of investments. Are stocks really cheap now? Well, you can make the case that they are because the 10 year is at 2.0% – but, what would a real market bond rate be right now? Certainly higher than this rate. If it were at a higher rate this would make stocks less attractive.
Before you start investing in stocks, you very likely put your money in cash or cash-like investments. Making the jump to stock investing requires jumping over a chasm because you are putting your principal at risk because that’s how stocks make you money over cash investments.
Investing in stocks over cash equivalent investments requires a very large mindset change. Stocks can both make and lose money. Because equity investments are priced every trading day, your first impression may be that the market is right and knows something that you don’t know when an investment changes in price. When I first started investing in stocks I made the mistake of trusting the wisdom of the market too much. Sometimes the market is right but many times the market is wrong, especially when you shorten the time horizon.
When I started investing for income, my primary goal was to find good companies to invest in. An investment that pays you income is easier to value and much more likely to be an investment that is shareholder friendly. Also, a track record of paying dividends implies that the company manages its finances well.
After investing for a period of time, I have realized that your investment income can be a very powerful tool to increase your spending or supercharge your reinvestment into other companies that are attractively valued. By continuously putting money to work in the market can enable you to get outsized returns by taking advantage of opportunities that develop. Or, you can also just spend the money without selling any shares!
The more investment income you create, the better off your portfolio will be. Here are some tips to increase your investment income.