It is important to understand all the risk you face as an investor. Risk comes in many forms and some risks are higher than others at different stages of market cycles. Understanding the risks that could hurt you the most and how you can offset or reduce that risk is important to your long term success as an investor.
There is company specific risk. That is the risk that you will own a company like Enron or MCI or Kodak or any other of a myriad of companies that have fallen by the wayside. The cure for market risk is broad diversification. If your portfolio had a 1% exposure to Enron when they imploded it didn’t really hurt, the other 99% of your portfolio likely bailed you out. But if Enron was 20% or more of your portfolio it hurt a lot and took a long time to recover from.
There is interest rate risk. That is the risk that interest rates will rise. This is generally bad for dividend paying stocks, but is really, really bad for bonds, as bond prices fall when interest rates increase. I would venture that interest rate risk is higher in most portfolios today than at any time in the last 25 years.
There is inflation risk. The risk that the falling value of a currency will lead to lower purchasing power per unit of currency. Inflation is really bad for bond holder as they are repaid with currency that purchases less goods and services than the currency they originally loaned out. You can offset inflation risk to a degree by investing in inflation protected bonds or by investing in companies that pay dividends that go up over time.
There is political risk. That is risk that an act of the government could adversely affect an industry. Energy policy can mean millions of dollars of extra business for oil companies or millions of dollars of extra business for renewable energy firms. Tax policy can benefit some industries more than others. Political risk is hard to avoid because it changes so often and is so capricious in its implementation. Here, diversification is once again your friend.
Finally, there is obviously, market risk. Which is will the market prices of the securities you own go down in value over some arbitrary time frame. I say some arbitrary period of time because over the long run this risk has always disappeared. Over the last decade, we have seen markets go down by 50% or so, only to see them rebound by more than double that number. In your lifetime, you will likely see over two dozen times when stocks will retreat by at least 15%. Yet over your lifetime the stock market will almost certainly be a one-way street with the bias to the upside. Maybe we should call this the risk of missing out rather than market risk, because the fear of short term dips could prevent you from profiting from the permanent ups of stock ownership.
Understanding the risks you face and the ways you can offset that risk will help you become a better investor. Invest some time to contemplate the risks you are facing today.
It was about three weeks ago, June 23rd to be exact, that the fears of the Brexit flooded the markets and it seemed as if everything was going down, way down.
Now look at what has come to fruition over the past two weeks. Almost all global markets are trending upwards, especially the US markets, which have seen the Dow Jones and S&P 500 hit record intraday highs over the past 2 days alone.
Throughout all of this chaotic market volatility, we come back to the same recurring theme. Yes, markets will go down, yes, markets will go up. Both sides of this coin are unpredictable, so we look again towards the long run where the markets have continuously trended up over time. When another scare comes around, stand firm, and if you can't, reach out to an advisor who will help you do so.
I turned on CNBC this morning to the news that the Brits had voted to leave the EU. The S&P futures showed a loss of nearly 4%. The British Pound dropping by nearly 8%. The announcers are interviewing anyone that will talk about the doom to come. In other words the sky is falling...again.
Except that it is not.
This is another example of the crisis du jour that causes too many investors to think like day traders. The long term effects may be substantial, but they will not be deadly. The markets will fall today, but they will not go to zero. If anything, this will be a chance to buy some stocks for long term gain.
Remember, the price of the permanent ups of the stock market are these short term downs.
Stole that headline from Twitter. Originated with someone named Allen Kuhn. I don’t know Allen but that is a catchy snippet. One hundred and forty characters doesn’t tell much of a story so I will just guess what Allen was thinking.
These were all on Yahoo finance today.
This could send gold tumbling below $1,000 again, Citi says – Citi doesn’t know which way gold will trade next, but they know you are scared.
Hedge funds dumped Apple, and bought this stock instead – Hmm Apple was a great investment for a long time and now these guys have found a replacement for Apple in my portfolio! Holy iWatch, Batman! Jump on it!
Top 3 American Century Investments Asset Allocation Mutual Funds (TWSAX, TWSMX) – Wait, what? You said three, this is only two and they both have above average fees.
A brutal remark from a high-speed trader tells you everything you need to know about where Wall Street is headed – and my crystal ball says they are all wet.
Wow! Can you believe it? What in the world is going on now? No one understands this, it just makes no sense. Has the world gone mad?
All of these sentences could be uttered every week if you have a conversation about the stock market. It never seems to change, there is always something nutty happening. If it’s not the Fed, it’s congress. If it’s not interest rates, it’s PE ratios. If it’s not earnings, it’s IPOs.
All of this reminds me of an old Saturday Night Live skit that featured Gilda Radner as Roseanne Roseannadanna. After going off on a rambling rant loosely related to some topic, Rosanna would be interrupted by the news anchor played by Jane Curtin and then Roseanna would end the segment with the line, “Well, Jane, it just goes to show you, it's always something — if it ain't one thing, it's another."
And that’s the problem and opportunity with the stock market!
You have heard of the importance of owning a diversified portfolio. For those who do not manage money professionally, the mantra to diversify by investment class is pounded into their heads by the consumer finance media and is rarely questioned.
The reason bonds are included in a balanced portfolio is usually to reduce the overall risk characteristics of a portfolio. For example, if an investor would be panicked by a short term 20% drop in the value of their holdings as reflected in their monthly statement, then we can add maybe 40% to the bond side, making it likely that a 20% drop in stock prices will only result in a 12% drop for that investors statement (.6 allocation to stocks X .2 short term drop in value). It is not that bonds offer superior returns, it is that bonds sometimes provide better returns than stocks with less volatility. The same reduction in risk can be achieved by holding cash and money market funds, but historically bonds have outperformed cash.
Yet when markets enter periods of extreme turmoil like 2008 and 2009 the usual correlations of investment returns fly out the window and bonds can tank at the same time stocks tank. And when interest rates rise bond prices will fall.
So my question to you is: Why do you own bonds? Are you afraid of the temporary drops in stock prices or are you just following the mantra of the popular press? With interest rates poised to rise would you be better off using cash as a buffer?
March Madness is upon us and we have already seen many underdogs coming out of nowhere to upset the perennial powerhouse college basketball programs. If you filled out a bracket, like many of our clients in our annual Oak Street Advisor's Bracket Challenge, then I'm sure you've been somewhat frustrated with this year's tournament, as it has been chaotic and more unpredictable than in many years in recent memory.
Just like this crazy tournament, the stock market can sometimes feel chaotic and unpredictable. Remember in January when some pundits were claiming another global financial meltdown was fast approaching as stocks slid lower and lower almost every day? The S&P 500 has now increased by 13% in the 5 weeks since the year's low on February 11th. Which actually puts the market UP for 2016.
So just as we understand that each year during March Madness there will be chaos and unpredictability, we must keep the same mindset when it comes to our investments. No one can predict what will happen in the future, but we can certainly count on it being unpredictable, and sometimes chaotic.
If you think risk is the chance your investment dollar will go down today, then I challenge you to ask the question “When should I take on risk?”
If you choose to put your money in a CD or savings account, you avoid the risk of any fluctuation of the principle. You do have the risk of interest rates. Will they be higher or lower a year from now? Five years from now? Twenty years from now? Your answer is as good as mine.
If you choose to instead invest in the ownership of great companies who provide great products and services to the world’s population, you have a very real risk that your investment could decline tomorrow. But what about a year from now? Five years from now? Twenty years from now?
You can take risk now, or you can take risk later. The choice is yours.
I saw “The Big Short” this past weekend. It was better than I expected and depicted the madness of crowds and greed run amok.
While most will see the movie as an indictment of bankers and Wall Street, they will be missing one of the most important lessons from yet another financial crisis.
The problem that led to the mortgage meltdown wasn’t just that banks made many, many bad mortgage loans, the ultimate cause was once again leverage. Archimedes is famous for his quote about using a lever to move the earth, "Give me a place to stand on, and I will move the Earth." Leverage in finance speak means borrowing and Wall Street’s version of this quote is “Give me enough leverage and I will ruin any economy”
All economic bubbles and subsequent crashes can be traced at their root to too much leverage in the economic system. The Tulip Mania of the 1860’s resulted from what was futures contracts with no margin requirements. The stock market crash of 1929 was a direct result of too much leverage in the markets where a dime could control a dollars’ worth of stock. The Long Term Capital crisis of the late 1990’s was a result of too much leverage. If you can identify where leverage has gotten out of control you can predict and profit from the next bubble.
So looking around the world today where has borrowing gotten out of hand?
China comes immediately to my mind. Public and private debt (and it is really, really hard to distinguish the two in an economy directed by a central committee) has ballooned to over 28 trillion dollars or about 300% of the nation’s total GDP. China has built shopping malls where no one shops and entire cities where no one lives. In the US these developers would be bankrupt in short order, but in China things just seem to move on as if this is a normal way to do business.
Making matters worse, China is committed to being considered by the world as a stable economic powerhouse. Although a fall in the value of the Renminbi would spur exports and help the Chinese economy, the ruling class is opposed to any move that would make them look to be anything but brilliant. As if they believe they can control everything indefinitely they recently warned investors and George Soros in particular that shorting the Renminbi would result in economic ruin. Ha! Even after spending over $500 billion of their foreign currency reserves to support the currency, outflows continue to pressure the Chinese economy.
Markets are self-correcting and the world economy is big. Do not believe the Chinese can distort the markets indefinitely.
It is always amazing how stock market tops attract so many investor dollars. Just when things are at their riskiest point flows of funds into stocks skyrockets. We convince ourselves that the part will last forever and we hate being left out.
The flip side is the head scratcher of a down market, where no one wants to buy even though prices are marked down 10%, 25% or even 50% on rare occasions. If this were a department store the aisle would be overflowing with bargain hunters. Yet when it comes to investments no one wants to shop the markdown rack.
If you are feeling confident you should stop and think deeply about why. If you are feeling scared, then it is likely time to go shopping.