Financial Literacy

Financial professionals have mathematical formulas for investment portfolio diversification. However, we’ve all heard the simple phrase about investing, “Don’t put all of your eggs in one basket.” In my opinion, an options-trading expert (Don Kaufman) offers the most illustrative analogy, “You don’t want all of your soldiers in one spot when the bombs start dropping.” This is very important to know because, sooner or later, there is always an unexpected bomb strafe. You, alone, are the Field Commander responsible for the survival of your army on the battlefield.

Let’s examine how to apply this strategy to your potential investments:

• Are all of your retirement accounts invested in the same stock index or fund – or are they spread among several asset classes and types of investments?
• Are all of your rental properties in one city – or are you geographically diversified?
• Are you only positioned long the stock market – or do you have some short positions?
• Are all of your investments in your home country and currency – or do you have several?
• Are all of your options expiring at the same time – or do you have multiple expirations and multiple strike prices?
• Are all of your assets subject to lawsuit – or are some held in entities or investments that are protected from any creditor?
• Are all of your personal valuables hidden in one location – or do you have them in several locations and some secured offsite?

Whatever investment risk you can conceive, there is some way to minimize it with diversification or hedging. Take some time to look at all of the savings and investments that you have and consider, “If unexpected bombs start falling and one fell on this, would I be totally wiped out and have to start from scratch?” If so, then you need to make some immediate strategic and tactical investment moves.

It is simple and common to open a brokerage account to buy a mutual fund or stock. But there is a universe of alternative investments categories that most people ignore because they do not know how to find them. I have owned a small part of a race horse, some cattle in Nebraska, a silver certificate held in Austria, and am looking for a producing oil well. You do not come across these easily or by accident, nor should you consider buying any of them without doing a lot of self-education.

This week, I came across a webpage with a large number of investing platforms for investments in: real estate, loans, startup businesses, profitable online businesses, private equity and hedge funds, along with robo-stock trading; http://www.sidehustlenation.com/alternative-investment-platforms

There are many ways to actively invest, here are a few examples:

• Buy an apartment solely for the purpose of renting it on AirBnB.com.
• Buy a car solely for the purpose of renting it out on Turo.com.
• Buy a tool, like a chainsaw, solely to rent it out on the many rental websites; such as loanables.com, anyhire.com, or toolzdo.com.
• Buy a boat solely to rent on Boatbound.com.
• Want to start tiny? Rent out a textbook on CampusBookRentals.com.

Plus, there are books and videos on how to make a living or profitable side business from renting items out as well. The more popular the platform, the more information there is about how to best make money from it.

The less you know about any investment, the greater the certainty that you’ll lose money. So spend plenty of time, effort, and some education expense to understand the investments you’re attracted to before you put your hard-earned money at risk.

The U.S. stock market has been tearing upward for over 8 years. The last 8 months, the stock market has been climbing at an even steeper rate. Meanwhile, interest rates have been trending downward for over 8 years, pushing bond prices ever higher.

Have you been riding these trends upward to grow your investment accounts, or sitting on the sidelines? Have you been scaling back, taking some profits, and re-adjusting because you know it cannot go on forever?

There will be a day in the future when these bull markets will stall or fall. Will you know exactly what action to take, or will you be like a deer in headlights when the stock market falls 5% in one day; or falls 20% over a few weeks. Or if interest rates will jump up to a higher level within a week, will you know what to do? Or like many, will you ride this trend up and then helplessly ride it all the way back down?

This moment, right now, is the time to prepare your mind and emotions for what are logical and prudent actions regarding your investment portfolio. Think about them, write them out, and get expert advice from different sources that are aligned with your risk tolerance. Do this so you will be fully prepared for however the financial markets unfold. When the day arrives and stocks and bonds are falling, you will know exactly what to do while most everyone else panics.

What are a few possibilities?

• Sell some now to have cash available to buy cheaper later on.
• Place stop-loss orders to prevent catastrophic losses.
• Have some candidates ready that will increase in value as the markets move down.

There are more sophisticated tactics for defensive positions, however they must fit your capability, interest, and investment goals. The critical element is to have an investing plan for whatever the financial markets may do. Even if you are a buy-and-hold investor, is there a pain point where you stop the losses – say -25% before it becomes a -40% loss like in 2008? Have an investing plan and be ready to execute it; whether markets are moving calmly or swinging violently.

It is misleading to use the term ‘average returns’ instead of actual returns. Many financial planners and investment advisors use average returns to make an investment appear far better than it is. Let’s start with a simple example.

Let’s say that the stock market went up 30% one year and then declined 30% the following year.

Wall Street will claim that your ‘average return’ was zero (+0.30-0.30 = 0.00).

Really? Let’s examine what would have occurred with a $10,000 investment.

Year 1: $10,000 X 30% gain = $13,000 account balance at the end of year 1, a net gain of $3,000.

Year 2: $13,000 X -30% loss = $9,100 account balance at the end of year 2, a net loss of $900 or -9%.

So you actually LOST 9% of your money while financial planners using ‘average returns’ would tell you that you broke even.

The financial term is called the ‘sequence of returns’ and it makes a great difference in ACTUAL investment returns. Are large losses incurred with larger account balances or are large gains incurred with smaller account balances – then your actual returns will be far below the ‘average return.’

Here is a short sequence of actual stock market returns:

2004 +10.9%

2005 + 4.9%

2006 +15.8%

2007 + 5.5%

2008 -37.0%

The average return over this period was -0.10%, or about break even.

What would your actual return have been? -10.50%. So Wall Street, using ‘average returns,’ will claim that you just about broke even over 5 years but you actually suffered a loss of over 10%. This is because the 37% loss was incurred on a larger number than the first-year return of 10.9%.

An investment that offers a lower actual return, which is more consistently positive, will usually beat a more variable-return investment, even if they are periodically far higher returns. In the race between the tortoise and the hare, the tortoise’s returns are more robust and far more likely to win any race. When evaluating returns, it is best to ignore ‘average returns’ and use actual returns to determine whether or not it the risk/return provides a favorable location for your money.

European junk bonds now yield 2.77%. Yes, the worst-rated bond trash in Europe has a yield that is only a speck higher than the U.S. government 10-year treasury bonds, considered among the safest investments in the world, at 2.33%.

So how can the best and worst bonds have nearly identical yields??

If you were a European bond manager, you have a puzzle to solve. Central Banks are buying all of the sovereign bonds and much of the corporate bonds, pushing yields on them negative. So there is only one place left to get any positive yield (theoretically at least) and that is corporate junk bonds. These are bonds highly likely to default, they are non-investment grade (meaning fiduciaries cannot buy them), and their yield is so tiny, a portfolio of them is a guaranteed loss. Buying these bonds is an exact fit for the Wall Street risk/reward saying, “like picking up pennies in front of a steamroller.”

Negative interest-rates are imperiling pension funds, insurance companies, and other institutions who must purchase bonds. Even though junk bonds in the U.S. are very low (3.9%), U.S. companies are now racing to sell their junk bonds in Europe because their rates are so much lower. These bonds are nick-named “Reverse Yankee Bonds” in the industry but in my opinion, they are a failures looking for a sucker.

What all of this points to is: colossal systemic risk in the European bond market. When this bubble pops, there will be tears for any investors with European bond exposure.

Every asset and investment is inherently fraught with risks. These include price risk, theft, fraud, damage, obsolescence, bankruptcy, hyper-inflation, taxes, mismanagement, stock market crash, new regulations, interest-rate risk, and many others. There is no single location for money where it is prudent to place all of it and expect it to earn money, free from all risks. Not gold, not cash under your mattress, not even stock in the legendary company, Berkshire Hathaway.

Why is a single location for money such an imprudent action to take? Because a single unfavorable event can wipe you out, take you out of the investor game, and destroy all that you’ve worked to accumulate. It is similar to gambling all your money by putting it on the color red and spinning the roulette wheel. Although any particular investment may play out over a longer time-frame, the concept is identical – your gamble either wins or loses based upon the outcome of a single item. Going all in is the opposite of your most important assignment as a money manager: to safeguard your savings and investments.

When a Ponzi scheme inevitably collapses, there will be victims revealed who had put their entire life savings into the fraudulent investment. When a stock goes bankrupt, some reporter will find an investor who had placed all of their retirement money into it. When a string of homes is leveled by a tornado, anyone who held cash in a secret hiding spot in their home lost it all.

This week, there is a story on bitcoin news sites of someone with a terminal illness who just borrowed $325,000 on his home in order to put it all into bitcoin. He did this based upon the hope that bitcoin will launch from its current $1,800 price to beyond $10,000; whereupon he would sell the bitcoin. I do not know if this story is true, but there are likely to be people who have done this.

The prudent way to hold your savings and investments is to place them in several different types of assets, and additionally, diversify among those assets. The term “asset type” refers to items such as: real estate, stocks, bonds, precious metals, cash, cash equivalents like savings accounts or Treasury bills, private placements, or specialty ETFs or mutual funds (such as commodities or unique investment strategies). There are many alternative asset classes as well: hedge funds, options, currencies, futures, and collectibles from stamps to wine, art, and watches. I probably have 6 different asset types where I place money so that a catastrophe in one or two of them will not permanently impair my net worth. There is no single asset or investment that is so attractive and risk-free that anyone should “go all-in,” let alone leverage up by borrowing money to purchase even more of that investment. Wall Street doesn’t go a few years without a collapsed hedge funds because it went all in on a single investment idea: Greek economy turnaround, a sovereign bailout that didn’t materialize, a technology that failed, a sector that ‘should’ have gone up/down but didn’t, and many more. Do not follow their folly, going all in is the path to going broke.

Since 2008, central banks around the world have set their shortest-term interest rates at, or below, zero. In order to provide savers or investors with a higher return, money managers have slowly crept further out in time on the investment-yield curve. For example, while a bond fund previously invested in 2-year bonds , they may now be investing in 5-year bonds to keep their dividend rate competitive. The risk of a 5-year bond is significantly greater than a 2-year bond, and if you’re not paying attention, you may not know that your money manager has been putting your money at far greater interest-rate risk.

The mathematical bond term for time is, “duration.” This refers to the number of years to recover the cost of a current bond purchase. (Calculated by the net-present value of all the bond coupon and principal payments.) This way, the length of bond-like investments can be compared with a single number, their duration. As you can see in the chart, bond fund duration has been continually getting longer since 2009. This longer duration adds enormous risk to any money in funds that are buying longer-dated bonds to increase their yield.

To avoid this duration creep, you can either purchase individual short-term bonds and hold them until maturity, or buy a fund to do this for you. To make it easy for investors, there are now bond funds that target a particular date. Another bond-fund candidate that you may want to consider is RiverPark Strategic Income Fund, ticker symbol, “RSIVX.” This is a 4-year-old bond fund run by an expert on short-term high-yield bonds which currently has a yield over 6%. The fund has minimal exposure to rising rates because of short duration, pays out monthly dividends, and a long track record of buying bonds that always payout in full.  You can learn more about this fund at http://www.riverparkfunds.com/Funds/StrategicIncome/Overview.aspx

As always, you must perform your own due diligence to determine if these may be an appropriate fit for your portfolio. If you decide that they are something to invest in, never invest more than 5% of your portfolio into any one alternative strategy; such as this fund.

For a couple decades, demographic experts have been pointing out a potential stock market risk from the Baby Boomer generation. The theory goes, beginning in the year 2017, the first of the Baby Boomers will be turning age 70 ½. Anyone with an IRA must begin withdrawing money from their account once they reach this age, or pay a stiff penalty. For the next 15 years, the selling pressure of Baby Boomers liquidating some of their IRA investment holdings will be larger than the buying pressure from the next demographic-age bracket. Could this trigger a stock market crash, a downtrend, or prevent the markets from advancing any further?

Since the stock market is already at a high valuation, below are a couple conservative investment candidates that you may want to consider.

1. Ticker symbol, “TAIL.” This is a brand new Exchange Traded Fund (ETF) by Cambria Research that will profit from a stock market decline. Most of the fund’s assets are earning interest in U.S. Treasury debt. But a portion of the fund will purchase out-of-the-money put-options on the U.S. stock market, the S&P 500 index. The fund expects to lose a little money each year that the stock market is flat or up, but profit greatly from the put options in the event of a sharp stock-market selloff. You can learn more about this at http://www.cambriafunds.com/tail.aspx

2. Ticker symbol, “DIVY.” This is a 2-year old ETF that uses options to scalp dividend growth out of the stock market with close to no price risk. This fund distributes a large special dividend at the end of the year. When this option-model is back tested over 10 years, the financial result triples the return of the S&P 500 with less volatility. You can learn more about this fund at http://www.realityshares.com/funds/divy

As always, you must perform your own due diligence to determine if these may be an appropriate fit for your portfolio. If you decide that they are something to invest in, never invest more than 5% of your portfolio into any one alternative strategy; such as these funds.

Investors who have heard about academic studies on investing returns may know that: up to 90% of your long-term investing return is dependent upon your portfolio’s asset allocation. Asset allocation refers to the proportion of money you have in categories of investments: equities, fixed-income, commodities – and a few of their sub-components.

There are several websites that track asset allocation returns. This is an up-to-date one that you can examine: https://novelinvestor.com/asset-class-returns

It shows 15 years of annual returns for 9 asset classes. Some active investors use tables like this to make minor adjustments to their allocations. For example, if a particular asset has performed well for 3 years, then it is less likely to perform well in the immediate future. Contrarily, if a particular sector has been performing poorly for a number of years, then it may be time to expect it to perform better. These are both contrarian investment ideas; the opposite of which is momentum investing – adding more money to last year’s best asset class. This momentum-asset investing idea has consistently proven to be a losing investment method.

There are many models of asset allocation. If you don’t have one, a couple excellent models for you to consider are:

1. The Yale University Endowment Asset Allocation described by its Chief Investment Officer, David F. Swensen, in his book, “Unconventional Success: A fundamental approach to personal investment.”

2. Money manager, Mebane Faber’s asset allocation described in his book, “The Ivy Portfolio: How to invest like the top endowments and avoid bear markets.”

3. There are many asset allocation models that can be found online, plus there is one in my book as well, “Financial Literacy: timeless concepts to turn financial chaos into clarity.”

Recent financial market headlines include: “30-year bond bull market is over,” “The bottom is in for bond yields,” “London Interbank Rate Highest in 8 Years,” and “The Great Rotation from Bonds to Stocks Has Begun.” By looking at long-term charts and recent bond prices, it is possible that a 30-year run in bonds has hit its peak price, at least in the short term. As proof, bond investors are selling bonds at the fastest rate in 3 years, mortgage rates are above 4%, and many investors are expecting an interest-rate increase by the Federal Reserve next month. Looking at a 20-year price chart you can see that bond prices have a very, very long way to fall if this is a price peak. How should you react with the bonds or bond funds that you own?

Most people hold some bond mutual funds or bonds as part of their portfolio allocation in retirement accounts. There are also many securities highly correlated with bonds such as REITs, utility stocks, and others known for historically paying a decent interest rate or dividend yield.

If today marks a medium or long-term top in bond prices, there are some actions you can take to minimize downside risk. The first and easiest is to sell some or all of your bonds. But then you have another problem – deciding where to place this money instead of bonds funds?

For most casual investors, the best approach to hold bonds is to own individual bonds until they mature and are fully paid off. This way, no matter what the price gyrations do, it is irrelevant to your interest payments and final payback of your principal. Rather than research individual bonds, there are bond funds that do for you called, “Target Date Bond Funds.” There are two large sponsors of these funds, Guggenheim Bulletshares and iSharesBond. They have many offerings so you can choose among several types of bonds that will mature anywhere from 1-7 years. You can choose maturities to time your income needs, or “ladder” by purchasing bond funds that mature in a variety of time frames.

Another way to manage your bonds is to use some money to hedge them. This requires some homework. Let me briefly explain:

First, the bond market is a complex terrain of many types of bond issuers – U.S. Treasuries, Corporate, High-yield Junk, and many different maturity dates. There are also country specific bond funds, and today, Emerging Market Bonds are collapsing in price. You may want to sell all you have of these. Since a falling price pushes yields up, these countries will likely find it more difficult going forward to roll-over debts at more expensive rates. Another factor to consider is that when interest rates rise in a country, then that country’s currency becomes more valuable. So if the Federal Reserve raises interest rates, then the U.S. dollar will likely strengthen as well. This is yet another dimension to analyze for your investments: will a rising dollar help or hurt your specific investments?

Second, because there are so many types of bonds, your hedge needs to match your specific holdings as much as possible. There are many inverse bond ETFs that you can purchase to hedge your bonds, they move in the opposite direction of a particular class of bonds. There are over 30 of them, but the top 20 in trading volume can be found here: http://etfdb.com/etfdb-category/inverse-bonds

Third, you need to decide if you own enough bond investments for the cost of hedging. If you have less than $100,000 in bonds, it probably isn’t worth the cost to hedge. It takes money (and opportunity cost) to purchase $100,000 worth of the appropriate inverse ETF (it moves in the opposite direction of your bonds). But you don’t have to hedge all of it; you could also hedge 25%, 50%, or 75% of your holdings, depending on how much interest-rate risk you’re willing to accept. If you don’t want to learn and manage hedging, just sell your bond funds and look for something to re-invest the money in that will profit from rising interest rates. For example, an industry that performs well with rising interest rates is insurance companies. They will buy bonds paying a higher interest and have portfolio teams that manage hedging and other portfolio risks.

Whatever your level of interest in managing your money, you or your money manager must have a plan of action when the economy or financial markets change. There is growing evidence that there is a big change happening right now: the ever-lowering interest rates in the U.S. is pausing and may be starting to move the other way. How are you adjusting to this new condition – to defend yourself from losses in bonds or profiting from rising interest rates?