July 2009

What you need to know about… Investments

Author: Lew Wessel | Photographer: photography by anne

Let me first be clear about what I mean by investments. “Investing,” as opposed to “saving” means putting your hard-earned money at risk, and this is not something you should consider doing until you have put away enough savings, as in cash and cash equivalents, to cover your basic living expenses for six to 12 months. Until you have this “emergency fund” in place, don’t even think about swimming into more dangerous waters.

The investment plan
Once you are ready to invest, as the saying goes: “You need a plan.” Your plan should clearly spell out your goals and what investments you are going to make in order to achieve them; i.e. what EXACTLY you are hoping to do with the money you are hoping to grow through your investments. Is the money ultimately going to be used for your retirement 40 years in the future? For education funding for your kids? For a down payment on a home?

The most important element in these financial goals is TIME. Given enough time, say 20-40 years, returns for different types of investments such as stocks, bonds and real estate, tend to be predictable and intuitive; e.g. over the long run, stocks will have a higher return than bonds. However, the shorter the period of time, the less reliable will be the returns. For example, a portfolio of a mix of 80 percent stocks and 20 percent bonds earned an average of 11.1 percent per year from 1966 to 2005. During that same period, however, this same portfolio earned as high as 34.2 percent one year while losing 17.6 percent in another—a potential swing of over 50 percent. The craziness of the financial markets of the past 18 months highlights the importance of time even more dramatically. For those with short time horizons for their investment, such as those in or near retirement, the drop in the DOW of 53 percent from October of 2007 to March of 2009 was devastating to their financial plans. For those with a long time horizon, that same drop created a fabulous buying opportunity.

Thus, for long-term goals, riskier investment asset classes such as emerging market equity mutual funds can make a lot of sense. When it comes to short-term investments, particularly where the stakes are high, such as in education funding, you have no business dealing with riskier investments unless you’re prepared for a conversation that starts with: “ Oh, sorry Johnny, but about that Ivy League education…”

Another important factor in your plan is your own personality and tolerance for risk. As suggested above, an investment plan that has 40 years to run can legitimately be very aggressive; but if your personality can’t stomach downturns of 30 percent or more from time to time, you’re apt to abandon your plan. Better to recognize your tolerance for financial pain and limit your risk from the very beginning.

Once you have a general plan in place, it’s time to select actual investments. In doing so, it is critical to remember two things:

1) It’s your money—take it very seriously! Don’t lend it, invest it or otherwise put it at risk unless you know what you’re doing and it’s the right thing for YOU.
2) There is no such thing as a free lunch. Investing involves all kinds of risks (see below) and, in order to get a higher return, you have to accept a higher risk. BE VERY SKEPTICAL of any “guaranteed returns” that are higher than what the U.S. Treasury or an FDIC-Insured bank offers.

Risky business
Investing involves risk, specifically the uncertainty that the return you realize will not be the return you expected. These investment risks can be categorized as either unsystematic risk or systematic risk.
Unsystematic risk is basically the risk involved with investing in a specific business (e.g. Microsoft or General Motors) or even a specific country (e.g. a mutual fund specializing in Brazilian companies). Diversification ameliorates unsystematic risk quite effectively and I cannot stress strongly enough that this must be one of the keys in your investing career. Your mother told you not to put all your eggs in one basket, and it is great advice for you as an investor. Personally, I wouldn’t put more than 10 percent of my investment dollars in any one company or specific investment and even five percent makes me nervous. A Bernie Madoff, a WorldCom, an Enron, etc. can happen to anyone; you just shouldn’t lose more than a small piece of your pile if and when it happens to you.

Systematic risk includes a number of factors that can negatively or positively affect many investments at the same time: interest rate risk (which also includes reinvestment risk), inflation or purchasing power risk, exchange rate risk with foreign investments and general market risk. “Event” risk is also a significant factor, particularly since 9/11. Diversification is once again the major defense against these forces as a portfolio of non-correlated assets (i.e. asset classes that do not move in the same direction at the same time) can smooth out the total returns of your investment portfolio. Unfortunately, as has been rudely revealed this past year and a half, asset classes tend to be very correlated in a severe down market. Real estate, bonds and stocks all got hammered since October, 2007, and they all got hammered everywhere on the planet. The lesson here, frankly, is that to mitigate systematic risk, it is critical to NOT be “all in.” As an investor, you must maintain a fair amount of liquidity (“Liquidity” refers to the ability to rapidly and efficiently turn an investment into cash.) in order to weather the storm AND to take advantage of buying opportunities when the financial system crushes virtually every investment.

Investment choices
The spectrum of investment choices is truly infinite, ranging in risk from the Powerball lottery ticket to the 90-day US Treasury bill. Classic investment choices include equities (stocks), fixed income (U.S. government, municipal, corporate (all types) and foreign bonds), real estate, commodities, futures, private equity, and more. Time and space preclude a detailed discussion of each of these, but you do need to be aware of a few basic characteristics of these choices.

Equities.
A share of stock represents a proportional ownership in a company. You buy stocks with the hopes of making a “capital gain” from the increase in share price and/or to collect “dividends” if paid out by the company. There’s money to be made in stocks over the long run, but trying to outsmart or “time the market” in the short run is a fool’s game. If you are going to “day trade” just realize that you are essentially gambling, and limit your stakes accordingly.

Bonds.
As indicated above, there are all sorts of bonds. You buy bonds primarily to collect their promised interest payments, but there can be a capital gain incentive (and risk) as well. Individual bonds are difficult to evaluate and tend to be fairly illiquid; i.e. difficult to trade. In addition, because individual bonds, usually sold in units of $1,000, it can be difficult to adequately diversify unless you have lots to invest. Bond mutual funds are available in all shapes and sizes and are a good option for most investors (see below).

Mutual Funds.
For those just starting out in their investing career, a good choice is to invest in a diversified mutual fund. A mutual fund is simply a basket of individual stocks and/or bonds managed by a professional manager. Taking this a step further, there are now many “target-date funds” where a manager selects and manages your investment in a group of mutual funds with the goal of maximizing your investments in the year you plan to retire (e.g. Fidelity Freedom Fund 2040 and countless others).

Real Estate. A real estate investment can be very alluring, but here is one area where you need to be very careful. Often, investments such as developed lots, rental homes, rehabs, etc. are very easy to get into and unbelievably difficult and expensive to get out of. Don’t jump in to this pool unless you have plenty of staying power (i.e. liquidity).

Other. Investments really do include an infinite number of choices, including commodities, futures, options, private equity deals, limited partnerships, variable annuity contract, hedge funds, etc. etc. Stick to the basic two tenets I mentioned above: Take your money very seriously and remember that there is no return without commensurate risk (i.e. no free lunch), and you should be able to choose wisely.

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