How much would you pay for a money machine?

Let’s say you could buy a machine that could legally spit you out money on a regular basis. For simplicity sake, lets say annually. How much would you pay it? Would it depend on how much money the machine could spit out? Well the machine gives you $100 per year. Let’s say you could buy a treasury bond (the lowest risk bond) and get a 4% return. In other words, the U.S. treasury would give me $100 dollars per year for a $2,500 investment. Let’s say you are fairly certain this machine will pay you on time every time but you still want a better return than you could get from treasury bonds. So you offer $2,000 for the machine or a 5% interest rate and the seller agrees. But here’s the kicker: after 10 years you can return the machine and get all your money back and keep the profits. Why would you not do this? Suddenly, just as you get home and you look on the news and you see that the stock market just crashed and the Fed had to lower interest rates by 100 basis points this time to save all the poor hedge funds. At first you’re mad because your stocks are worth half of what you bought them for but then you’re glad that you have the safe and reliable money machine. Then, there is a knock on your door. Someone wants to buy your money machine. How much should we sell the money machine for? Treasuries are now paying 3% and the money machine is still chugging along paying out $100 per year. He will probably want more than a 3% yield so you sell it to him for $2,500 so he can have a 4% yield (1% above treasuries). Meanwhile, you just made a $500 profit. The market just crashed and you have $2,500 in your pocket; lets go and buy some stocks while they’re cheap!

That was a very extreme and simplistic example but it illustrates how the bond and stock markets can be inversely related. It also illustrates how, when used together, the investor can benefit from short-term market movements. This technique also works when yields increase because a fund with automatic dividend reinvestment (a very common free feature) will be buying, or reinvesting more when the fund is under performing, magnifying the returns for when the market corrects. In a bear market common stock portfolio alone won’t be clicking on all cylinders. Just something to think about.

(image via profitmax)