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August 2006 - Posts
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From the perspective of an investor, buying and selling stocks seems pretty simple. If you use a full-service broker, just call him or her up on the phone and place an order for 100 shares of Coca-Cola. Within a few minutes, you'll receive a confirmation that your order has been completed, and you'll be the proud new owner of Coca-Cola's stock.
Behind the scenes, however, there's a lot of action that takes place between your order and the confirmation. Here's what has to happen:
1. You place the order with your broker to buy 100 shares of the Coca-Cola Company.
2. The broker sends the order to the firm's order department.
3. The order department sends the order to the firm's clerk who works on the floor of the exchange where shares of Coca-Cola are traded (the New York Stock Exchange).
4. The clerk gives the order to the firm's floor trader, who also works on the exchange floor.
5. The floor trader goes to the specialist's post for Coca-Cola and finds another floor trader who is willing to sell shares of Coca-Cola.
6. The traders agree on a price.
7. The order is executed.
8. The floor trader reports the trade to the clerk and the order department.
9. The order department confirms the order with the broker.
10. The broker confirms the trade with you.
That's how a traditional stock exchange works, but much of the action that takes place when you buy or sell a stock is being handled with the assistance of computers. Even if you bought a stock that trades on a stock exchange, your order may be executed with little or no intervention by humans. You can log on to a brokerage firm's Website, enter an order, have the trade be executed, and receive a confirmation all within sixty seconds or less.
And of course, as an Internet-proficient investor, you already know that you don’t need a broker to execute a trade. In our next blog, we'll take a look at the major stock market indexes - the barometers of investment performance.
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How does a stock trade work? To understand that, you have to understand how the financial trading system, i.e. the "stock market" works. Several markets make up what is known as the stock market. Many stocks are traded on the New York Stock Exchange (NYSE), the National Association of Securities Dealers Automated Quotations (NASDAQ), and the American Stock Exchange (Amex). In addition, such cities as Boston, Chicago, Philadelphia, Denver, San Francisco, and Los Angeles have exchanges, as do major international cities like London and Tokyo. The NYSE Also known as “The Big Board,” the New York Stock Exchange (NYSE) is home to the most prominent players like IBM, Google, and Disney. The Big Board is not for little league players. Among other requirements, a company must have at least 1.1 million public shares of stock outstanding, must show pretax income of at least $6.5 million over the three most recent fiscal years (each year has to be equal to or more than the previous year), and the company’s market value of public shares must be at least $40 million to be on board. In addition, the company’s most recent year’s pretax income must be at least $2.5 million, and its net tangible assets must be a minimum of $40 million. The NYSE is a 36,000-square-foot facility located in the heart of the city’s financial district, which is wedged eastward between lower Broadway and the South Street Seaport, and extends all the way down to the southern tip of Manhattan. The oldest stock exchange in the United States uses an agency auction market system designed to allow the public to experience the actual trading as much as possible. Open bids and offers are relayed by NYSE members acting on behalf of institutions and individual investors. Buy and sell orders for each listed security meet directly on the trading floor in assigned locations. Every listed security is traded in a unique location, at one of the floor’s 17 trading posts. The Specialist – a dying art? Specialists (or specs) are members of the NYSE or American Stock Exchange (AMEX) who perform a unique function by acting as the focal point for trading the stocks assigned to them. Specialists play a significant but perhaps diminishing role on the NYSE. Whether they specialize in the shares of blue chips or of small growth companies, the job of the specialist is to help maintain fair and orderly markets in those stocks. Each stock on the NYSE is allocated to a specialist, who trades only in specific stocks at a trading post. All buying and selling of stock occurs at that location. Buyers and sellers – represented on the floor by brokers meet openly at the trading post to find the best price for a security. The people who gather around the specialist’s post are referred to as the trading crowd. Bids to buy and offers to sell are made by open outcry (thus the perceived chaos on the floor!). When the highest bid meets the lowest offer, a trade is executed. While the majority of volume (approx 88%) on the NYSE occurs with no intervention from the dealer, to a large degree, the specialist is responsible for maintaining the market’s fairness, competitiveness and efficiency. Although specialists cannot control the price of a stock, they are responsible for ensuring that changes in price are gradual, and that all customers have had a chance to participate at a given price. Behind the frenzied spectacle that many outsiders picture when they think of the NYSE trading floor, however, is a methodical and organized system of trading in which the price of any stock is set purely by rule of supply and demand in an auction setting. Specialists help match buyers and sellers, but shares are always sold to the highest bidder. The NASDAQ and the AMEX The National Association of Security Dealers Automated Quotations (NASDAQ) and the American Stock Exchange (Amex) united in October 1998, creating the NASDAQ/Amex Market Group. The American Stock Exchange is now a subsidiary of the National Association of Securities Dealers, Inc. (NASD). By joining two of the world’s top securities markets, there is now an alliance creating an even more globally competitive market. However, the NASDAQ and the Amex are still currently operating as separate entities. The NASDAQ is an over-the-counter (OTC) market, which is the term used to describe securities that are traded through telephone and computer networks as opposed to through an auction exchange (such as the American Stock Exchange). The NASDAQ began operating in February of 1971, with 250 companies, as the world’s first electronic stock market. It has since evolved into a full-fledged stock market with over 7,000 companies listed. Trading volume broke the 500 million shares-per-day barrier back in 1996. Today, more initial public offerings (IPOs) are listed on NASDAQ than on any other U.S. stock market. The NASDAQ market is an inter-dealer market represented by over 600 securities dealers trading more than 20,000 different issues. These dealers are called market makers (MMs). Unlike the NYSE, the NASDAQ market does not operate as an auction market. Instead, market makers are expected to compete against each other to post the best quotes (best bid/ask prices). The NASDAQ has no single specialist through whom transactions pass. NASDAQ’s market structure allows multiple market participants to trade stock through a sophisticated computer network linking buyers and sellers from around the world. Together, these participants help ensure transparency ad liquidity for a company’s stock while maintaining an orderly market functioning under tight regulatory controls. Two separate markets comprise the NASDAQ Stock Market: the NASDAQ National Market, which includes the NASDAQ’s largest and most actively traded securities; and the NASDAQ SmallCap Market for emerging growth companies. The AMEX lists over 700 companies and is the world’s second largest auction marketplace. Like the NYSE, the AMEX uses an agency auction market system designed to allow the public as much access to public shares as possible. In our next blog, we'll track the trading process -- so you'll know just what happens when you place your own stock trade.
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Even if you’ve never set foot in Manhattan, everyone has an idea of what it means to work on Wall Street with all its frenetic energy and activity. Images of traders in brightly colored jackets jumping up and down on the floor of the stock exchange, voices straining to be heard over each other as deals are made, bells ringing to signal the start and finish of each trading day. These perceptions, while still very much a reality, are becoming less representative of today’s investment world. Today, more trading is being done in cyberspace, specialists are beginning to become obsolete, and trading floors now exist in the ether more than on hardwood. Nonetheless, it’s important for any investor to understand the various entities that comprise the investment market and how they work. The next few blogs will prepare you to enter the walk down Wall Street confidently. How Wall Street Works In 1792, a handful of businessmen opened the New York Stock Exchange under a buttonwood tree near a quiet avenue called Wall Street. That exchange and “The Street” were known as hard-nosed places where great fortunes could be made – but at great risk. Most investments were for a very short term, and traders on the exchange tended to deal for themselves first, and for their clients if anything as left over. For years, Wall Street insiders had the markets virtually to themselves. A lopsided playing field gave brokers, market makers, traders, and specialists a big advantage over small-account investors. Typically, insiders were in at the start of a stock’s run-up and bowed out long before the stock tanked. Individual investors were left holding the bag. Information was peddled to the highest bidder, and investment advice was often provided by “tipsters,” a breed of information merchant who delighted in spreading inside information. After many decades as a functioning exchange, the fastest form of information became the ticker tape, which reported only prices. Without adequate information, the investor was at the mercy of the market. After the crash of 1929, financial reformers made substantial gains in cleaning up the markets, and investors eventually benefited. Much improved methods for analyzing risk were developed, along with efforts to introduce what is now called “transparency.” For years, the term investor meant institutional investor. Pension funds, insurance funds and mutual funds dominated the markets, acting on behalf of individuals but exercising their own special brand of institutional influence. Institutional investors remained in the driver’s seat until the NYSE introduced negotiated commissions in 1975. This scheme opened the door for individual investors by allowing discount brokers to begin offering bare-bones brokerage services to retail investors. Another 20 years and unforeseen new advances in technology – particularly the advent of the World Wide Web – were needed before the full implications of this power shift from institutional to individual investor would be felt. By the onset of the 1990s, it was clear that individual investors were serious players in the Wall Street World. It’s true that there are no guarantees when it comes to investing. But with the creation of online investing, and an aggressive play for smaller investors by the two leading stock markets - the New York Stock Exchange and the NASDAQ – buying and selling investments that interest you will only get easier and, as important, less expensive. Competition, both domestic and global, will continue to make stock transactions more transparent and more accessible for all investors. By understanding how the different stock markets work and compete for your business, you’ll be better equipped to benefit from your own investing knowledge.
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As I've pointed out in the last few blogs, ideas and property are great investments and wealth creators, but they have historically left a void for investors. To fill that void, Western society created another financial vehicle – stock, or equity ownership. When an investor purchases a share of stock, the individual takes on the position of owner. A piece of paper called a stock certificate is issued to represent ownership, but that piece of paper has no intrinsic value of its own, nor does it guarantee any future value. The issuer of the stock does not guarantee you any return, but they will transfer to an equal portion of the risk in exchange for a chance to secure an equal portion of the profit or loss the company may realize from its business operations. Whatever money is left over after the company deducts its expenses from its revenues is the profit or loss that is then shared with the investor through dividends or appreciation in the value of the company’s stock. It is the expectation of future results that causes the original investor to increase or decrease the price he is willing to accept to exchange his share of company stock for cash from another investor. One important attribute of stock ownership is that it is the only investment that can be held in multiple formats (a retirement account for example) while retaining the single truly capitalist fundamental – ownership. As I’ve pointed above, there are three different ways you can choose to invest your money. You will build more or less wealth, depending on your choices. One option is simply to spend that dollar, which we all know how to do. A second option is to do what “lenders” do (but should not do) – lending your dollars in the hopes that this will build wealth. Most people think they are building wealth when they are lending their money to a bank via a CD, when they buy bonds or insurance products. But nobody I know and nobody you know has ever built or maintained wealth by lending his or her money. Between taxes, inflation, and time this is a guaranteed loss. After all, nobody builds wealth simply by lending their money. Only through the third option – ownership – can you truly build wealth. By “ownership” I mean purchasing stocks in solid companies that operate under good, principled management. When you act as an owner with your capital, you can choose to own pieces of American industry, real estate, or even your own business. The more dollars you place in ownership, the more wealth you will build. Ownership is the real key to building wealth in our society, and this has held true through the pages of history. This does not mean that you should go out and snap up the latest hot stocks. You’re better off ‘investing’ in a weekend in Las Vegas. Your ultimate goal should be to diversify your ownership – which means building a balanced portfolio in terms of company size, sector, and geographic location. Historical market data tell us that the next twenty years will more than likely resemble the last twenty years, which that means the highest total returns after taxes and inflation will come from owning a fully diversified portfolio of strong, solid companies. Hiatory also shows that two to three times per decade investors can expect to lose money - and once in a while there may be a big dip - but the stock market is a bit like a yo-yo climbing a flight of stairs. The key is to focus on long-term results. The media - among other so-called advisors – has a tendency to shift investors’ focus to the near term, by reporting on hot trends or ‘panics’ that naturally have an effect on people’s emotions. But emotions should never guide your financial decisions; instead common sense and intellect should rule. Remember, we live in a democracy that has embraced, among other worthwhile things, democracy. But under the terms of accepting capitalism in a democracy, we are responsible for our own decisions. So it’s best to make the right decisions – the more often the better. We’ll delve more deeply into that in the next few chapters. The Ten Truths of Wealth Creation • The key to wealth is through ownership, not financial products. • The more money moves, the more wealth is created. • Everything in life requires payment. • The biggest cost to wealth creation is through interest lost, interest paid, or taxes. • Average rates of return and total rates of return are meaningless financial planning tools. • Not all debt is bad. When determining whether to pay cash or finance a purchase, remember that you should not finance anything beyond its useful life. • The obstacles to building wealth are the approaches we take, the economic system we live in, and the market information available. • There is no such thing as financial goals; financial results are achieved through personal and professional goals. • The key to wealth is understanding your options and minimizing your future decisions. • Index investing is a flawed measurement tool. Risk is not about losing money.
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One of the great benefits of most Western economies is the long-held right to own property. Contrast this mostly-Western right with Egypt’s current situation: 92 percent of all Egyptian buildings and land are owned outside the legal property system (without recognized title deeds) and that 88 percent of businesses were in the same situation. Egyptians, then, are not benefiting financially from ownership of most of their land and businesses – a fact which has played havoc with their economy for decades. Property title is the key to wealth creation. Look at the African continent as a whole. Very few African countries grant citizens property titles – instead, property remains in the hands of the state or corrupt leaders. The absence of legal property titles in African countries has stunted development and economic growth. Legal ownership of property spearheads development and is the "staircase to social growth". Property ownership is the genesis of the market economy as it provides legal identity, basis for credit, and a real asset base. That's been proven time and time again here in the U.S. I met a woman last week at a real estate seminar in Orlando named Dianne who got a sudden reality check when the corporate division where she worked as a computer programmer was sold to another company. "I knew then that I couldn't rely on large corporations for job security and financial stability and that I needed other ways to produce income and create wealth," recalled Dianne. She decided to "build my assets with real estate." She had already bought a town house in Tampa to live in, using $8,000 from her savings for the down payment. Next, through a program for first-time investors, she got 100-percent financing on the purchase of a two-bedroom condominium to rent out. Just recently she bought another rental condo near the Walt Disney Resort in Orlando, using $7,000 from her savings for the down payment. Like other investment-savvy property owners, Dianne knows that wealth comes from the accumulation of assets that increase in value. So many people don't understand the difference between income and wealth - they think a large salary means they're wealthy. But, of course, it doesn’t. But with real estate, your home is your salary -- and it grows in value much faster and farther than your annual paycheck. As they say, land is so valuable because God ain't making any more of it. Words to live -- and invest -- by.
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You may have heard of the "ownership" society. It's a government initiative to encourage people to own -- stocks, homes, property, etc. -- and stop renting and leasing things that wind up costing more money. I tend to stay out of politics, but there is plenty of value in owning as opposed to renting. That's especially true of investing. While it’s true that you can own a car, or a membership in an expensive golf club, or a great wardrobe, at the end of the day, the creation of wealth is driven by three types of ownership – ideas, real estate and stocks. In the next three blogs, I'll delve into the benefitd of each. Let's get started. Ideas Last year, in a South African courtroom, global pharmaceutical firms challenged a law that permitted the manufacture and importation of generic aids drugs. The companies quickly dropped this claim, however, when the defense of their patent rights became a public relations fiasco. Indeed, just prior to last year's World Trade Organization meeting in Doha, Qatar, South Africa's health minister called the high prices for lifesaving medicines a "crime against humanity." Ten thousand miles away in San Francisco, the music industry tried to take down Napster, a service that allowed users to swap digital music files over the Internet. In this case, the courts agreed that Napster's file-sharing technology violated music copyrights. And across the Atlantic, advocates of "software libre" are introducing legislation in several European parliaments to give preferences in government procurement to software that can be freely copied and distributed. The Eurolinux Alliance argues that only free software "preserves privacy, individual liberties, and the right for every citizen to access public information." Battles such as these are erupting all over the globe. At stake are decisions about how society can best encourage the creation of ideas, when someone can stake a claim to intellectual property, and how far copyright- and patent-holders can go in preventing others from taking their property. The scope of the controversy is vast. It might encompass debates about ownership of the formula for an aids vaccine, a Miles Davis riff, a software algorithm, or a new way of uncorking a wine bottle. Each of these is an idea embodied in physical forms: formulas, notes, code, or drawings are turned into capsules, records, CD-ROMs, or corkscrews. The economic consequences of the dispute are also immense. The resolution of who gets to own what, where, and for how long will determine how much corporations and entrepreneurs invest in creating intellectual property, where they will sell products based on intellectual property protection, and how much they will be able to charge for these products. The current explosion in controversy over the protection of ideas has three main causes. First, brainpower drives the modern economy: there are more demands to own ideas and more demands for cheaper access to ideas. Second, technological change has made it harder to protect ideas. More people want to use technology to get access to intellectual property. The owners of this property want to stop or at least limit these attempts. Third, globalization has made it easier for intellectual property to spread to parts of the world with weaker protection of ideas. In a variant of Gresham's Law, the one nation that does not protect patents within its borders can drive down global standards, making it harder to enforce ownership rights everywhere. On top of these trends, the output of the "idea industry" has grown exponentially. More books, movies, drugs, music, software, and video games exist today than at any time in history. Still, the basic tension over intellectual property remains the same. The originators of innovative ideas are trying to stop people from using the fruit of these ideas for free. Why? Because ideas are a root source of wealth creation. If I own an idea, I can use that idea to create a business and drive a revenue stream. Protecting that idea is central to personal wealth creation. Next blog -- real estate.
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One big benefit in being a U.S. investor is the home field advantage we have in simply being Americans. In short, we are the most economically competitive country in world history. By almost any measure, America is the most innovative nation on earth.
• We generate the most patents per capita. According to Harvard Business School professor Juan Enriquez, it takes about 3,000 Americans to generate one U.S. patent, compared to 4,000 Japanese, 6,000 Taiwanese, 1.2 million Mexicans, 1.8 million Brazilians, 10 million Chinese and 21 million Indonesians.
• We conduct more research and development than any other nation. The United States funds 44% of the total worldwide investment in R & D - equal to the combined total of Japan, the United Kingdom, Canada, France, Germany and Italy (National Science Board's 2002 S&E indicators).
• American scientific output is greater, as measured by scientific publications per million population, than the EU and Japan (708 to 613 and 498 respectively) (1999 data compiled by the EU).
• Our labs and universities remain a more attractive destination for the best and brightest young minds in the world. 85% of the PhDs who come here from China remain in the U.S. because it's a better place to live and do business. By contrast, many European Union nations remain challenged when trying to attract top scientists and students from places such as India and China.
• Our culture rewards risk, encourages entrepreneurship, celebrates success and upholds the rule of law more than any other.
• And of most significance to us today, Americans have enjoyed the most rational, predictable and transparent framework for intellectual property rights in the world, encouraging investment and incenting innovation. I bring this up in today's blog not as a flag-waving patriot, although there is certainly nothing wrong with that, but as a Wall Street realist. To make money in the investment world, you need good industries and good companies to choose from. As the evidence shows, the U.S has those in abundance.
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Although you won’t hear it mentioned in the same context as “risk” or “diversify,” good old “patience” is a major factor in investing—one that generally works in your favor. Take a guy who invested $1,000 in a stock on Monday. It dropped 5 points by Wednesday. He sold it and took a loss on Thursday. On Friday it went up 7 points. Suffice to say, a week isn’t a great deal of time when it comes to investing. It has been proven repeatedly that just as retail prices go up over time, so does the stock market. Patience is not easily found on Wall Street, but it is a valuable asset if you can find it. Being patient and letting time take its course is part of wise investment planning. Just as retirement funds succeed and grow over time, so will other investments. Playing the market on the short-term basis may work for shrewd investors who follow the details of the market and the financial updates very closely, but for others it’s essentially gambling. World events over the course of a few days can send the market soaring or dropping and your investment along with it. Time is one of the best allies of most investors. Bond holders, because there is a set maturity date, are more often aware of the idea of a “time frame.” Unless a high-grade bond holder is looking to sell, he or she, because of the nature of a bond, should be comfortable with the element of time. The principal will be returned in time and that is comforting. There is no such comfort (no time table) when you own a stock or stock fund. Therefore, you need to make your own. Shrewd investors who work hard at following the market (stocks or bonds) and have a more calculated idea of when to buy and sell can play the investing game on a short-term basis. It is riskier, and one needs to stay very much on top of the business world to be successful. You need to look ahead at what is forthcoming in an industry, in a company, or in the market as a whole. Chasing after last year’s hot stock or mutual fund generally does not work because the path of investing is to move forward and think ahead. While looking toward the future, you need to understand that the road to your goal will not always be a smooth trip, just as you’ll hit a bump or two while driving or some turbulence when flying. A company, even a solid, long-standing blue-chip company, will have an occasional quarter where their earnings are off. Perhaps they issued a new product that didn’t take off as they had hoped, such as “The New Coca-Cola.” 15 years ago. Some investors will jump ship; others will note the long history of success of a company and resolve that they will bounce right back with something else. Good investors will also see that many industries will have higher and lower periods. Beyond being patient, it’s often to your advantage to pick up more shares of a solid company that you believe in when the stock price drops. Tips for maintaining your PATIENCE include: 1. Avoid impulsive reactions. The opposite of being patient is being impulsive. You need to give yourself “stop orders” at times to ride out the volatility associated with most investments. Don’t impulsively bail out. You also should stop yourself from buying impulsively without checking up on the stock first. 2. Stick to your goals. If you have set up goals for yourself, to have X amount of money in X number of years, remind yourself that these goals will not be reachable without patience. 3. Smile at advice. Everyone under the sun will always have a new and better way to spend or invest YOUR money. If you follow everyone’s advice you’ll be moving your money all over the place and never reach your goals. You can add new investments, but be patient with the ones you have (unless you know the company you’re invested in is going out of business). Take advice with a grain of salt, smile, and listen to most well-intentioned friends, neighbors, relatives, and so on. Even the myriad of “experts” out there will have new-and-improved ways for you to invest. There’s nothing wrong with investigating some advice that sounds feasible to your goals and needs, and even making some adjustments as you go along (in fact, managing your asset allocation can be important), but you should maintain and be patient with the core of investments in your portfolio. Don’t be easily swayed.
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Now that you’re ready to get into the pool are you going slowly, step by step; jumping into the shallow end; or diving in off the high board? New investors will commonly start off small and build as they feel more comfortable. There’s nothing wrong with this approach. If your initial investment doesn’t perform as you hoped, it may give you a “real” indication of your risk tolerance level. One investor will lose $1,000 in a good investment gone bad and shrug it off, saying, “I’d take the same chance again in a similar investment,” while another might say, “I’ll try something a little safer.” Dollar-cost averaging is popular with new investors, particularly in mutual funds. This has you investing consistently by putting in steady amounts. It allows you to maximize your number of shares when the price is low while also still investing when the price is high. By automatic withdrawal from a bank or money market account, the money is invested steadily for you, taking away the responsibility and decision of when to add more money into your investment. Here are some more tips for getting in: 1. Set realistic expectations for your investments. Unless you play the lottery or hit a “jackpot” you won’t score big instantly. Investing is a way of watching your money grow, and growing takes time. 2. Start sooner than later. No, you can’t turn time back and start young, but remember that money builds over time. If you are able to start investing regularly at age thirty-five, by the time you’re sixty-five your money will have had thirty years of appreciation. This doesn’t mean you can’t do very well investing in your forties or even fifties, but it’s always to your advantage to give your money time to grow. 3. Prepare to be proactive. The day you invest is not the day to stop doing your homework. Managing your assets is also not solely the job of a mutual fund manager, broker, financial consultant, or anyone else. Many people who are invested in 401(k) plans or other long-term retirement plans forget that they have the flexibility to move their investments around within the plan. Start off by being aware and ready to follow your investment. 4. Just Do It! This is not by any means saying that you should not do your homework, and is not contradictory to the previous advice. However, it means that there is a ton of information available and at some point you have to stop investigating and (once you feel you can make an informed decision) as Nike says, “Just Do It!” Too many people are at the starting line with a stock or mutual fund, only to wait just one more week . . . okay, just one more week . . . and so on and so forth. You need to reach a point where you are simply ready to get into the pool. 5. Diversify. The idea that diversification means you need to have large sums of money invested and/or be a more savvy investor is incorrect. Mutual funds can immediately, for even $500, have your money diversified. You too can take your initial investment and spread it around to some degree. You could, for example, take $2,500 and invest $1,000 in a bond, and $500 in a mutual fund, and $1000 in three different stocks. It’s easy to diversify within an asset class and allocate your assets accordingly. 6. Manage your risk. Look at investments that best combat the risk you are concerned about, be it inflation, taxation, liquidity, or all of the above. Allocate your assets across different asset classes and try to cover the various types of risk associated with investing. 7. Pay yourself first. You’ve heard it said before, but it’s true in investing as well. Once you’ve paid your monthly bills and made sure your expenses have been covered, you should then add to your investment. Having direct deposit from your paycheck makes this easier, but if it’s up to you, make adding to your investment(s) a regular part of the process. 8. Reinvest your earnings. Many investments, including mutual funds, will do this for you, but it’s to your advantage to keep your income working for you unless you need it for a specific purpose.
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Yesterday I introduced the topic of risk, and how managing your expectations and your comfort level is a big deal when investing your money. Today I'm bringing to the table three more types of risk. Let's have a look: Inflation Risk Inflation risk is the risk that inflation will rise faster than your investment and that your dollars will be worth less in the future than they are today. In an effort to manage away inflation risk, or purchasing power risk, you need to look at stocks, real estate, and investments that will, over time, beat the inflation rate. During periods of moderate or low inflation the stock market performs well. During periods of high inflation the market can fall dramatically. It’s hard to beat high inflation risk, but you can ride it out with investments that have a tendency to stay ahead of the projected inflation rate. An investment such as a CD that sits at a low rate would be your worst bet because often the CD is paying less than the inflation rate. For instance, if you put $10,000 into an investment vehicle yielding a 4 percent return and earned $400, after paying tax at 28 percent (or $112.00) you would be left with $288. Then factor in the inflation rate of 3 percent on the entire investment, or $300, and you are actually ending up with a total of $9988, or coming out at –$12. For this reason, it’s also important to gauge appropriately when looking ahead in retirement accounts. Many people do not factor in inflation. There’s no way to know what the inflation rate will be in twenty years, but always remember to include it along with taxes (in investments that are taxed) to see if you are coming out ahead. Liquidity Risk Liquidity risk is technically not considered an investment risk; it is not a risk based on the investment itself but on how much you need to be liquid. It is the risk that we will need our capital at a time other than we planned for. It deals with the risk of being able to rapidly convert our assets into cash. The full definition says that liquidity risk is how quickly your assets are convertible into cash at full value. Getting back a few cents on the dollar does not make you rest assured that you are not at risk. Forced liquidations and auctions are the results of not taking liquidity risk into account. Liquidity risk is also based on, or balanced by, your need for the money in hand. You want to have a certain amount of your portfolio easily transferable to cash in the event that you need the money for an emergency. You also do not want to find yourself with no liquid assets for day-to-day needs. Beyond that, it is to some extent a state of mind or a level of comfort. Many people will prefer to have their money in stocks knowing that they can take out what they need for an emergency and not worrying about getting 79 cents or a full 100 cents back on the dollar if it’s a matter of covering medical bills for a “real world” crisis. This takes us back to the various meanings of liquidity. Money back should I need it, versus full principal back, are two responses to different levels of risk and from different personality types. Money market funds are the low end of liquidity risk, and actual real-estate investments along with locking money into retirement plans such as IRAs and 401(k)s are on the high end of liquidity risk. The best way to manage against the potential problem is simply to determine how much money you need in your budget for a certain time period, be it weekly or monthly, and make sure you always have that money available to you plus some reserve. NOTE: People often comment that if their stock or bond falls they haven’t lost the money unless they sell it. Actually, for the most part this is not true. If you’ve seen your stock drop from $90 to $72, when you do a new balance sheet those $18 per share will not show up on your list of assets. In this case, and with this type of investment, you are not liquid to the full value that you invested and there is no guarantee that you will be. This is a liquidity risk, in regard to full value—but by holding onto the stock you can get back to full liquid value. Tax Risk Tax risk is also not considered an investment risk; like liquidity risk, it isn’t a risk to the actual investment, but more to the investor. You know ahead of time which investments are taxable and which are not. It is important to determine where you will land in the “tax bracket” game, and try to determine accordingly if some (and there aren’t many) tax-free investment vehicles are a plus for your portfolio. As more singles and couples hit the higher tax brackets in a time of higher wages and low inflation, municipal bonds and municipal bond funds have appeared more attractive to many baby boomers. Most of the investment tax management, however, does not come from the investment itself, but rather from the vehicle in which the investments are made. IRAs, 401(k)s or 403(b)s, and variable life insurance are vehicles in which you make investments. The structure provides you tax-exemption or deferral to an extent dictated by the vehicle as well as by state tax laws. Often a tax-exempt or deferred vehicle directed at retirement also falls under the “not very liquid” heading. Nonetheless, from a portfolio-building standpoint, it is also important to address tax risk. All types of risk need to be on the table when deciding how you are going to invest. One rule of thumb: if any one of these risk factors is causing you to lose sleep at night, it's usually best to err on the side of caution and ratchet down your investment exposure to such risk factors.
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Before jumping into the water as an active investor, it’s a good idea to know how to swim. Likewise, as an investor, it’s important to lay the groundwork before diving into the investment pool. In future blogs we will examine key investment areas such as asset allocation, diversification, liquidity, and risk/tolerance. But as we approach the “ins and outs” of actually investing, it’s important to see how these areas tie together and how “risk” (very often used as a broad term to explain a fundamental risk) can be broken down into various types of risks while building your portfolio. A good investment strategy begins with managing away, as best you can, several types of risk; three types of risk we'll cover today and three we'll cover tomorrow. Fundamental Risk Fundamental risk, or business risk, is often (combined with technical risk) the primary risk referred to when risk is discussed. Fundamental risk applies to bonds, stocks, real estate, and all investments. It is the risk inherent within a particular business enterprise that relates to the company’s financial strains, their position in the marketplace, their reputation, how they fare against their competition, and so on. It is more than the risk graded in the bond market, known as credit risk, which is more “black and white,” determining the likelihood of the company defaulting or not. The fundamental risk is affected by how well-managed the company is and how they fare in their market. The best way to manage your portfolio to minimize the effects of fundamental risk is to diversify. This is where you are investing in different companies in different industries within the same asset class. Technical Risk Technical risk involves measuring things such as unemployment, interest rates, the budget deficit, and various other economic and market indicators. All of these external factors play a part in the success or failure of your investment. Technical risk, also known as market risk, is how well the market of your investment fares in regard to these factors. The affects on the overall market will affect your investment—which brings us back to the all ships rise or sink with the tide analogy. Managing technical risk means having a balanced portfolio. This is another way of diversifying across asset groups by having your dollars allocated into stocks, bonds, real estate, money market funds, CDs, and so on. Different asset classes also exist within the same market. Beyond that, there are numerous markets and they will react differently to the economic indicators listed here. Even in the bond market, there are different classes of fixed asset investments including long-term bonds, short-term bonds, high yield or junk bonds, municipal bonds, government bonds, global bonds, and so on. Investors can work on the 93 percent of the investment puzzle by focusing on the area of asset allocation and then look at the “7 percent solution” by focusing on the specific investments. In other words, if you plan to spread your money across various markets and asset classes, you can lessen technical or market risk before focusing on the specific investments within each group. Interest Rate Risk Interest rate risk, which I'll also discuss in future blogs on bonds, is how your investment is responding to the direction in which the interest rate is heading and how fast the rate is going. Often people assume that this only affects the bond market. Not true. There actually is a strong correlation between interest rate risk and the stock market. While stocks have various other factors that directly affect them, they will frequently follow suit with bonds and react in the same inverse manner to the direction in which the interest rate moves. You can manage away interest rate risk by having part of your portfolio in fixed principal investments (bonds) with a guaranteed interest rate. Also, having a portion of your portfolio leaning toward short-term bonds (rather than long-term bonds, which will fluctuate more) will help you better avoid interest rate risk. We'll take a further look at investment risk tomorrow.
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