Thursday, August 27, 2015

Understanding Investing Risks

The last several years has instilled into investors thinking a couple of major fallacies. One is that when the markets start to go down, it is going to go way, way down. The second is that another 2008 is right around the corner, even though it is a once in 43 year occurrence. Both of these assumptions are wrong. You have to understand that we now live in an instantaneous world. News travels exceedingly fast and reacting to it just as fast, is totally foolish. I do not mean to insult anyone, but it is important to say the truth.

Being invested in hedge funds, alternatives, stocks, bonds, commodities, real estate, annuities, CD's and cash has its risks and rewards. Let's look at these choices since they each have pluses and minuses.

Hedge funds - What is a hedge fund anyway? There are about a dozen different mainstream hedging strategies used today. They all have one thing in common. They strive to reduce the risk in a portfolio. Let's drill down further. Suppose you have a portfolio of 30 stocks. Unhedged, you would be subject to the performance of those 30 stocks for as long as you held them. A hedge fund may hold the same 30 stocks, but put a "hedge" on to protect against a sudden downdraft in the stock market. However, by doing so, it's upside performance is sacrificed. For example, if the hedging was done by buying Put Options, then there is a cost to buy those 30 Put Options. If any of those stocks do not go down as hedged against, then the performance of a 30 stock portfolio with Put Options would significantly under perform. A 30 stock portfolio without the hedge would be better in that situation, than a 30 stock portfolio with Put Options as a hedge. Don't you see? So, what we learn is the risk to a hedge fund is when the market goes up.

Alternatives - Alternatives is kind of a broad term these days, but it can include promissory notes, structured products, limited partnerships, Regulation D offerings, private equity, non-publicly traded investments like REIT's and Business Development Corporations (BDC's), currency funds, physical gold, silver, platinum and other investments. The risk to these can range from a lack of liquidity, inaccurate valuations and or pricing, Ponzi scheme potential, lack of dividends, not to mention significantly more risk. These investments are not appropriate for people with less than $1,000,000 net worth or $200,000 per year in Adjusted Gross Income, in my opinion.

Stocks - Stocks on the other hand benefit when the market goes up, but have the risk of a market sell off. This would include stock mutual funds and ETF's, too. Historically, long term investors have always been rewarded for holding onto stocks for five, ten and certainly twenty years or more. The longer the holding period, the less risk there is to stocks.

Bonds - Bonds are touted as a safe investment by many. However, they are subject to interest rate risk. When interest rates go down, bonds benefit. However, when interest rates go up, they can lose money. It depends on the maturity, the issuer, the rating and other factors, but in most cases bonds will always be affected when interest rates rise.

Commodities - Commodities typically benefit from a booming economy. Commodities need inflation to benefit. It is more sensitive to supply and demand issues. Oil is a perfect example right now. When there is less demand, the price falls. Oil was priced around 100 a barrel not very long ago, but now is down around 60% from that. So, if you bought Oil at 100 a barrel, then you could be down 60% roughly. So, your risk with Commodities is lack of demand and over-supply.

Real Estate - Real Estate Agents always like to tout real estate as one of the best places to put your money. It can be a good place to put your money if you use other people's money to do it. There is no doubt that it can be extraordinarily foolish to pay off your house. Read my book, "Meet Wally Street. The ReasonYou're Stupid" for more on this.

Real estate is subject to supply and demand, also. For example, in the 2008 crisis, there was way too much demand coupled with people who bought homes at the top of the market (over-priced.) When things are over-priced, they eventually correct back to a median or more normal supply price. This was very painful for a lot of people in America and some still have not recovered from it. Real estate is also subject to interest rate risk. If you are invested in real estate via a mutual fund or other investment and rates go up, then you are going to be negatively impacted.

Annuities - Annuities are fully guaranteed by the insurance company who issues them. I am talking about Fixed and Indexed Annuities in particular. Variable Annuities have the same risks as Stocks, so I am not discussing them here. I am only discussing Fixed and Indexed Annuities. Fixed Annuities pay a fixed rate of interest. I received an interest rate update from an insurance company today. A 5 year fixed annuity is paying 2.75%. How does that sound to you? Yes it is guaranteed, but will you be satisfied with a 2.75% growth rate for the next five years?

Indexed Annuities pay interest based on several factors, but in a nutshell they are tied to some kind of index and they return a percentage of that index to policyholders each year. So, if the S&P 500 goes up, then you get a percentage of that upside credited to your annuity policy. If the S&P 500 goes down, then you more than likely make a 1% or 0% return. That may not sound all that great, but it is certainly better than losing 10% in the stock market, is it not? The risk to these is that you will have years of 0% or 1% in some years when the stock market is down.

CD's - CD's are fully insured by the FDIC, but today's CD rates are paltry to say the least. A 3 month CD may pay about 0.25% annualized. Not a lot to write home to momma about. The risk to CD's is little or no income and lack of principal growth.

Cash - Cash or money market funds have some risk to them, but it depends on where you have your money market fund. If it is a FDIC insured bank account, then you are safer than with a mutual fund money market. Rates on money markets are about 0.02% right now. The Federal Reserve has basically stolen from average investors in order to allow the major banks to recapitalize after the 2008 Great Recession. Is this fair? Of course not, but what can we do about it? Not a whole lot, unfortunately.

Where do you invest knowing these risks?

There you have it. Those are your major choices. Which of those is the best place to invest? Should you put all your money into one of these? That might be rather foolish.

Instead, perhaps you may want to be in most or all of those areas, because you never know which one is the right place to be from year to year. This is called being diversified.

This is what we do. We don't react to every piece of frightening news on television, nor to the endless stream of pundits and hucksters who preach doom and gloom. If you are smart, then you will quit watching television and let your diversified portfolio go to work for you. Sure, there will be times when markets pull back, but over the long haul you will be rewarded.

  1. Have we been rewarded because I made the decision in January of this year to eliminate Emerging Markets from our portfolios? Yes we have, but it might have gone unnoticed.
  2. Have we been rewarded for removing High Yield from our portfolios? Yes we have, but again it has probably gone unnoticed.
  3. Have we been rewarded for have about 0.52% of our portfolio in China? Yes we have but again it has most likely gone unnoticed.
  4. Have we been rewarded for getting out of Gold at $250 an ounce higher than where it is trading today? Yes, but this fact too has probably gone unnoticed.

When you wonder why we haven't done anything in the last week perhaps you might consider my four points above. The fifth point is that we are on top of things even if you do not believe that we are. We will make adjustments when we feel they are warranted. As of today, doing nothing in the last week looks to be a pretty good decision in my book.

Stay focused, stay diversified and stay away from emotional decisions based on the television news. Remember this key point. It never feels good to be invested. Something is always going on to affect one or more of the above investments. Always! You must understand that it never feels good to be invested in any market.

The goal is to have a plan, a process and a professional. I call this the three P's. That is what you have if you are a client of ours and you take our advice! I have trademarked a phrase that is apropos. Keep Your Assets. Take My Advice®. Interpreted to mean if you want to keep your assets, then take my advice.

Thank you for being a client and if you are not a client, then perhaps you might want to be.