Information conveyed in this article is of general nature and not to be construed as investment advice. Readers need to consult their own advisors for investment advice.
I plan to write two or three more articles on this important subject.
In the past century US markets have lost around 40%, seven times, causing devastation, heart aches and attacks. When we say average loss of 40%, that means some lost in excess of 40% up to 100% of their portfolio and some from zero to 40%. Those who lost not a dime in any down turns, have been and are doing something right. I will cover that in another article.
"GET RICH QUICK STORY" TOLD BY JOHN JANE DOE
John and Jane have a portfolio worth $500,000. Both are Eager to see it grows to that magic number $1,000,000. John has been searching the net, watching ADs and reading news papers looking for good GET RICH QUICK money managers. John identified a couple and forces Jane to go with him to meet them in down town. Jane reluctantly obliges her husband (character like Frank, father of Ray Romano in the series I Love Raymond!). Jane murmurs to herself, I cannot believe, John keeps falling for all kinds of ponzi schemes. When he is going to learn?
They are in the office of C. Swindler financial services. John is very impressed with the lavish office settings, with young flashy receptionist (turning Jane off and John on) gourmet coffee and cookies. Three big signs framed with gold borders reads "WE LOVE RICH CLIENTS". "GET RICH QUICK SCHEMES EXPERTS", "SHORT CUT TO MILLIONS". John reads them loudly and says to Jane, Hey Jane, do you see those signs? finally we are at the right place. You never trust me. Do you?
Mr. Swindler comes out to greet the couple with a big smile on his face.
C S.: Hello Mr. Mrs. Doe I am Con Swindler. Welcome to the world of the riches. Come on in. Have a seat.
JJ: Thank you.
(John is all pumped up and restless and Jane keeps kicking him in his foot trying to control his excitement)
CS: Folks, feel free to call me Con. What can I do for you?
John: Hey Connie, how much of a starting capital do we need to get to one million dollars soon?
CS: That is very simple to answer TWO. We can do that. We are the best game in town.
John: Wow! Just two dollars?
(Kick in the foot. John leans back)
CS: No, two million.
John: Oh, that is not bad either, it is still better than the other guy.
(kick in the foot)
CS: Who is the other guy?
John: Your competitor, Ronnie Ranoff financial services. He said he needs 4 million dollars. OUCH!!!
(Powerful kicks )
Jane: Let us go. Thanks Mr. Swindler.
Money Management at its best or what?
Well, realistically it is not that bad. There are COMPETENT money managers out there serving the public well. Needless to mention, you need to do your due diligence to find a good fit for you.
Destruction has always been easy and momentary. Construction takes a life time and more. Our focus is going to be on construction. I am going to share with you some ideas towards that goal.
It is fair to say that today's money management is an art and science. Extensive, time tested education is available. There are several state of the art investment management software programs available at a reasonable cost to the professionals who manage money as well as to the public and to the do it yourselfers out there.
Therefore exposure to unwanted and suicidal risk are unnecessary. Risk can be controlled and managed.
The first step in trying managing your portfolio and your risk is to clearly understand and define your risk/reward profile. In plain English, how much are you willing to lose in a given year for a desired reward (portfolio returns)?. Generally investors are so carried away by the brighter side of the markets and their profit goals, they do not recognize that markets do go down and they could lose big time. That negative thinking, understandably, does not appeal to any investor.
Investors would love to see 20%, 30%, 50%, 100%+ returns. When you mention to them, they should be willing accept a loss of 20% or more in any given year for an annual return of 10%, the answer would be, fist bang on the desk and an angry NO, NO. Investors who are well informed and conditioned to accept this reality, understand, risk and reward go together and dealing with the inevitable market volatility is a way of, the investing life.
These are not issues for those who do not want anything to do with equity or other speculative markets as they have reconciled to work with principal protected investments, offering lesser returns.
There are a number of world class money managers out there who consistently do well, managing money in any market conditions. The criteria to call some one a good money manager is, he/she outperforms the benchmarks during market upturns and loses much less than the bench marks during downturns. Modern technology has innovated mind boggling management tools to accomplish optimal results.
The kind of extensive micro research that is available today with lightning speed delivered to the computer screen, combined with the advanced analytical tools, makes the job of any one who manages money for themselves or others, challenging, filling, fun as well as a little easier.
What to consider in designing a portfolio:
1. Risk/Reward criteria. This is the basis for creating a well balanced portfolio. Quantify the risk tolerance.
2. Time Horizon (short-term, mid -term and long-term goals)
3. Liquidity needs
5. Choice of domestic and global investments, such as money market funds, fixed annuities, life insurance, Government securities, mutual funds, exchange traded funds, stocks, bonds, real estate, sectors, industries, precious metals, futures, commodities, options and others.
6. Negatively Correlated Asset Allocation to diversify and minimize the risk
7. Active or passive management
8. Trading or investing
10. Re-Balancing and frequency
11. Portfolio turnover
and a host of other considerations.
SOME ASSET CLASS CHOICES FOR ASSET ASSET ALLOCATION
Large Cap Growth
Large Cap Value
Mid Cap Growth
Mid Cap Value
Small Cap Growth
Small Cap Value
Cash Value Life Insurance
Domestic Real Estate
Foreign Real Estate
High Yield Debt
Emerging Market Debt
You have access to these asset classes with several individual securities within these asset classes to choose from, for asset allocation and diversification. Sky is your limit with modern technology at your command. Specialists on every asset class are also available around the country to manage money for a reasonable fee.
I like to touch upon, Exchange Traded Funds (ETFs), considered by many experts as the versatile investments of the 21st century. You need to know a little bit about this fascinating breed of investments. Some of the wisest investors and money managers in the US and around the world have abandoned mutual funds and migrated to ETFs for good reasons. They consider mutual funds are investments of the past.
It is important to understand the difference between value style and growth style investing, whether you choose large cap, mid cap or small cap. There are money managers whose focus is either growth or value. A brief explanation would be, in growth style investing the manager continues to invest in stocks that have a strong upward momentum due to strong earnings and other factors. In value style investing the manager buys depressed, undervalued stocks at the beginning of their recovery. It is worth looking into the track record of these managers from both sides of the aisle before making a decision whether to go with value or growth or a combination.
In either style investing it is a scary initial reaction for an investor. For example growth manager keeps buying when a particular stock has already moved, may be 200% from its low. The manager has her/his own valid reasons for doing this. Stocks with a strong upward momentum, for any number of reasons, could move from $30 to $60 to $100 and to $200 in a short time. When the manager buys that stock at $100, an investor could get very nervous until the stock moves to $200 proving the wisdom of the manager. Well the manager could be proven wrong also. There is an inherent risk in either style of investing that comes with the territory.
In the value style of managing, the manager could be buying an undervalued, out of favor stock when it has dropped down, for example, from $100 to $20. Chances are that the manager has identified, using fundamental and technical analysis, this stock has met its support criteria and is at the reversal point and is ready to bounce back. Again a scary initial reaction.
DEFINITION OF EXCHANGE TRADED FUNDS
They are a collection of securities that trade like an individual stock on an exchange. For example a bunch of the stocks of a particular sector such as oil, will be one ETF. This diversifies the risk. Assuming there are 50 oil stocks in this ETF, the chances of all the 50 going down the tube at the same time is unlikely, whereas individual stocks could go down to zero fast. Stocks within an ETF balance themselves for most part. Obviously when the whole oil industry is suffering due to any number of reasons most of the stocks in this industry will react negatively in concert.
ETFs enable investors to hold a portion of all the securities an index tracks, in one individual share, with the flexibility to trade the shares throughout the trading day.
ETFs vs MUTUAL FUNDS
This is a very brief comparison to give you a taste of the ETFs.
1. MUCH LOWER COST. Lower cost investing in ETFs compared to mutual funds. ETFs have lower internal trading costs due to their low portfolio turnover.
2. TAX EFFICIENCY. ETFs have a unique way of creating and redeeming shares. Unlike mutual funds, ETFs are not subject to pooled capital gains distributions. With mutual funds your taxes are out of control. Embedded capital gains and short-term traders are likely forcing you to pay taxes, even when you have no gains, a frustrating experience indeed. Investors in mutual funds commingle their money by putting it all in one account. There are other problems with taxation in mutual funds.
3. TRANSPARENCY. ETFs disclose and publish their full portfolio holdings daily, as well as any changes to their holdings, allow investors, to know precisely know what they own at all times. ETFs holdings are priced every 13 seconds throughout the day, unlike mutual funds which are not required to continually disclose their holdings.
4. LIQUIDITY. ETFs are continually priced and repriced to coincide with the underlying basket of securities, thus creating intraday liquidity.
5. TRADING FLEXIBILITY. ETFs are bought and sold throughout the day at intraday prices, unlike mutual funds which receives end of day pricing.
6. LONG OR SHORT SELLING.
SHORT selling is a controversial topic. Some money managers do not like it as they feel it is unpatriotic. They have a valid point in that short selling could drive a stock lower and even wipe the company out. While managers on the opposite camp argue that they have a fiduciary responsibility for their clients and should do not give room to sentiments and emotions and do what is good for their clients.
SHORT selling managers also argue, rightly so, when the price of a stock keeps going down and down, there are genuine reasons why that is happening. May be bad management, falsified records, irregularities, or obsolete product or services and a host of other valid reasons and do not deserve to be in business. Markets are generally very smart and alert and will punish the stock of such a company. Short sale managers will jump on the band wagon and exploit the opportunity for (huge?) profits.
What are LONG and SHORT selling?
When an investor feels a particular stock is expected to do well and the price will go up he/she will buy the stock and take a LONG position. When an investor is suspecting that a stock will go down he/she SHORTs (sells) the stock. In this case he/she does not own the stock. The investor borrows it from the broker. If the stock indeed goes down the investor will buy the stock back at a lower price and give the borrowed stock back to the broker and pockets the gains.
Historically selling short has been more profitable than the long side of the trades. But short selling is more risky. Good skills are needed in the shorting area. But it cannot be ignored. To understand the profit potential behind shorting if you check the performance of short and ultra short ETFs for year 2008 you will be surprised. The markets lost close to 40% in 2008 whereas the top 20 short and ultra short ETFs made 8% to 77% in profits!!! Did some catch these profits? Perhaps a few who were smart and studied the markets correctly did.
There are world class money managers who use advanced hedging strategies using options to minimize risk and maximize returns. Primarily they use ETFs. Their investment philosophy is to protect the downside with options and let the profits run.
Money managers use several option strategies to hedge and effectively enhance portfolio performance. That would be a topic for another article.
PORTFOLIO CONSTRUCTION PROCESS
Once the investor answered the profile questionnaire, state of the art investment management software takes over. The program identifies the investor's individual profile and quantifies the risk . The program then graphically recommends the asset allocation to be used. The manager then uses extensive research and selects individual securities falling within those asset classes. It has been proven that diversification of asset classes are far more important than the selection of the individual securities. The program performs Monte Carlo simulations, which graphically shows the high and low end of probability of the performance of the portfolio for a given period for a given asset mix. The mix could be modified and fine tuned.
While diversifying, it is important to negatively correlate the asset classes as much as possible to accomplish true diversification. For example choosing large cap stocks and buying 20 of them does not offer proper diversification. This selection increases the risk. Stocks and bonds are negatively correlated and so are a variety of other assets. Historically when the stocks go down the bonds go up and vice versa. When a portfolio is well balanced with a mix of negatively correlated assets, desired balance and optimal results are accomplished, with minimal risks.
These management software programs are so sophisticated that they will also analyze and compare an investor's existing portfolio to the recommended one after establishing the risk/reward profile, which generally would be superior. Graphically the investor will be able to see the danger zones where asset classes are over weighted which affects the performance. Managers also use use efficient frontier graphs where they can visually see the risk/return numbers of various securities. This helps the managers to pick those securities which offer the maximum return for minimum risk.
The software helps in monitoring the performance as often as needed and re-balancing the portfolio as frequently as desired. Internal rate of returns net of all the expenses will be available at anytime. These programs take into account additional deposits and withdrawals while calculating the rates of returns.
If you imagine a pyramid, wide at the bottom and narrow at the top like a triangle, then we can place assets in that pyramid based on their levels of risk. The assets in the bottom layer is least risky, close to zero risk and the top layer is the most risky where the investor could lose the principal.
For asset allocation purposes the profile of an investor is identified from one of the following five categories. If an investor is willing to accept certain level of risk for proportionate reward he/she can split between these five any way they want.
1. AGGRESSIVE GROWTH: Art, Rare Coins, Precious Metals (Gold, Silver etc), Futures, Commodities and Currencies, sale of Uncovered Options, Purchase of Call and Put Options.
2. CAPITAL GROWTH: Speculative and other Stocks, Oil Gas exploration, Raw Land, Commercial and Residential Real Estate for investment purposes.
3. GROWTH INCOME: Oil Gas income programs, Mutual Funds, Managed Accounts, Blue Chip stocks, sale of Covered Call Options.
4. INCOME: EH Bonds, Municipal Bonds, Corporate Bonds, Fixed Annuities, Variable Annuities, Treasury Bills Notes, Indexed Universal Life Insurance.
5. CAPITAL PRESERVATION: Cash, US Treasuries, bank CD, Money Markets, Annuities, Cash Value Life Insurance
I mentioned earlier that some wise investors lost zero in any and all of the down periods. They all used the investments from this bottom layer. We all know that US Treasuries are the safest investment in the world. Money Markets and Bank CDs are all pretty straightforward and safe investments.
On this subject, in my next article, I will discuss in detail about two of the best, safe and tax advantaged investments namely, INDEXED ANNUITIES INDEXED UNIVERSAL LIFE INSURANCE. These are gaining popularity in the past few years with investors, young and old alike. If you knew the unbiased facts about these investments with character you may be inclined to use more of these in your Asset Allocation.
Good Luck with your investing,
Ranga Chary, MBA, CFP
Certified Financial Planner
Member in good standing with National Ethics Bureau &
Certified Financial Planner Board of Standards INC.
About the Author
Mr. Chary has been in comprehensive financial planning practice since 1977. Has been serving clients and their three generations, living in different parts of the US and abroad.
For more information, please visit: High Yield Money Market