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When Risk meant Reward
Ah! The good old days. You could be confused, amateurish, and simply a good listener at a cocktail party and make money. You could plunk down your hard earned cash and magically, the bull market took care of it. The good old days.
A friend of mine, who says he is writing an article about his trip to Manhattan last week to attend the New York Society of Security Analysts mid year meeting wrote me a clipped email, full of very excited tones.
Alan wrote: "we must remember that Wall Street is more than a market- it's a promotion machine run by the exchanges' member firms." and "the small investor had better stop watching TV, stop listening to the "full service firms" and learn how this economic engine runs on his own."
There was more. He went on to say: "Buy and hold is a thing of the past. The financial advisor who relies only on "fundamentals" is a dinosaur. Capital appreciation is not the only game in town.
The built in conflict of interest between a firm's investment banking and asset management operations has been exposed.
We've had an outbreak of banditry in the executive suite. Those men will go to jail. All is not lost.
People need to know this."
Do people whose first foray into the world of investing need to know this? Absolutely.
First things first. We have got to rid ourselves of all this bad feeling about investing. Let's approach it as a wonderful invention.
Stocks are a wonderful invention. With your money, you can become a partner in a company. But as a partner, you must do research, read stuff, learn the jargon. And then it becomes which company, which broker, how will you trade.
This wonderful invention is designed to provide the company with working capital so they can buy what they need. They in turn, operate the company profitably, causing the stock to appreciate. Every one wins. Most of the time.
Individual stocks take a lot of money and time to build true diversity into a portfolio. The only way to do that is with thorough analysis in order to make educated investment decisions. This kind of challenge is not for everyone. Patience and the willingness to learn can reward an investor who choose to buy companies individually.
Or you could hire someone to do it for you. Once again, you are spending money and time before you have made a single investment. And that, to me is counter-productive. Not to mention, counter-profitable.
Mutual funds are a wonderful investment. If you own a 401(k) or some other employer sponsored retirement plan, mutual funds are probably at it's heart. Mutual funds are basically group investments that allow you to purchase large and diverse positions in the stock market without all of the research involved in owning individual equities. In essence, you hire a manager or group of them, and they do the dirty work. Often these funds come with their own in house research teams that are free of much of the intermingling and incestuous relationships that are now coming to the surface.
But once again, these investments are fraught with complications. Fees, performance, and investment stylesmust be taken into account There is a significant amount of self searching involved in determining your risk level. This risk can often lead to greater rewards or in the tale of the recent days, greater losses. Simple rule of thumb when investing in mutual funds is determine your time horizon. Long term investments can withstand some risk and certainly more than short term horizons. If you need the money soon, stay out of the stock market, individually or through mutual funds.
Bonds are wonderful inventions too.
They come in two investment styles. Individual bonds have varying maturity dates and are available in numerous flavors from high risk, junk type bonds to good old government Treasuries. A proven investment style for this type of investment involved what is called "laddering". The principle is simple enough. To keep your money continually invested, you would buy bonds with different maturity dates often in increments of two. When the two year bond matured, it was sold to purchase a ten year, keeping the ladder effect even.
This simple investment style works best when the bond yield curve is high. Yeild moves in the opposite direction of price. There is the consideration of credit risk. Remember, you are, in essence, lending money. There is always the possibility that the company will default on their bond or have call provisions in place that reduce the return. The rate fluctuations present a reinvestment risk. You may not be able to purchase a bond to replace the one you sold on the lowest rung of your ladder. And buying individual bonds does not always net you, the individual invetor, the best price.
Another way to buy bonds is through a fund. They provide diversification but lack the guarantees of a monthly check from coupons and principal. With individual bonds, there is no risk that principal can be lost due to falling NAV, net asset value. Net asset value is the price of a share of a mutual fund. Fees are a consideration here also. You do need to pay for having someone else manage the portfolio. The truly sophisticated investor may turn their noses up at the lack of transparency in the fund's holdings. But the "cons" more or less stop right there.
Professionally managed bond funds are less sophisticated but that is a little to sacrifice for the good they provide individual investors looking for some safe haven. Fund managers are able to not only buy bonds at a better rate than individuals can, but their research into call provisions and creditworthiness far exceeds that of the average investor.
This is, in essence, how fund managers justify their fees. The spread they receive usually offsets any fees. Fund managers often tout their ability to be flexible. Bonds are not stationary investments.
Can you get burnt in a bond fund? Absolutely. The likelihood is marginal unless of course the Fed decides to return to much higher short term rates. But that is a whole story in itself.
REITs are wonderful inventions.
It is probably best if I explain what a REIT is before going any further. REITs or Real Estate Investment Trusts is a company that buys, develops, manages and sells real estate assets. REITs allow participants to invest in a professionally managed portfolio of real estate properties. REITs act as pass through entities, which basically means that they are designed to pass profits on to investors through the purchase of income producing rental properties.
REITs come in three basic flavors: Equity, which invest in and own properties, collecting rents; Mortgage, which act as lenders collecting interest from those loans; Hybrids, which are little of both. These companies are often traded on exchanges, and are a healthy source of income appreciation for not only pensions, but also insurance companies, bank trusts, and mutual funds.
REITs pay dividends, which not only add to their attractiveness, but also allow them to shine in their indexes. REITs paid an average of 7.3% over the last five years of the nineties, which was six times what the Russell 2000 index of small cap stock paid. And therein lies the rub. Many of these companies qualify as small capitalization concerns, and this makes it difficult for mutual funds to purchase.
Many of mutual funds avoided the smallest of the REITs, referring to them as "junk", and because of that, 90% fell below the benchmark.
Gold and precious metals are a wonderful investment. Buying them as jewelry not as part of your portfolio. Much of the current price of gold is the result of a change in the producers practice of hedging, not a result of safe haven purchasing. Hedging is the purchase of future contracts, and canceling the practice, if only temporarily, helped boost the price of gold significantly over the last several months. Its recent prominence has awarded it a small ticker at the corner of the CNBC morning shows.
The small investor has one thing going for them. The ability to determine time. And if you can determine time, you can invest based on that horizon. I am a firm believer in indexing, which is based on the principle that a fund will own companies that fall within a certain market definition. The S&P 500 is the most common of indexes. Bonds have indexes. REITs are indexed. The total market can be indexed. There is an index for every type of investment style, risk and tolerance. Keep in mind, the expenses of an index fund should always be low. The fund should be without a load or a sales commission. A note of caution is necessary here. Some of the cheapest index funds charge a fee for balance limits. Vanguard, the inventor of this type of investing, charges shareholders if their balance falls below $3,000.
Whatever your time horizon, invest evenly (this is called dollar cost averaging) and do not make yourself cash poor in the process. Debt can drain your efforts at an incredibly fast rate. If you need credit to get you through the day to day, then adjust your savings or your lifestyle.
So what if you are in a 401(k) and things aren't going well. In most 401(k) plans, as well as most retirement plans, things aren't going as well as they did three years ago. It may never be as it was. But a plan that is dragging along in tandem with the market, isn't too heavily weighted in your company's stock, might be worth waiting out. Remember the time horizon. It is human nature to want to sell at the bottom. But it isn't always the smartest move to make.
And Alan is right, stay away from the television.
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