The countdown to the New Year has begun but before the ball drops, actually before 4 PM EST on that Monday, review your investments and place your sell orders for tax-driven transactions.  For stocks and other securities, make sure your order is placed in time for it to be executed. This is particularly important for thinly traded stock and bonds. Taking a loss will offset gains and you can take an additional $3,000 of losses (on a joint return; $1,500 on a single return) in excess of capital gains as a deduction on your income tax returns. For the maximum advantage, try to offset short-term gains with short-term losses and long-term gains with long-term losses. 

 

For mutual fund investors, even if you haven’t sold any funds this year, you still many have a taxable capital gain. Mutual funds must pass through their net capital gains or losses, and income, to their holders. Give your fund a call if you haven’t heard from it about its 2007 distributions. And, as a general rule, sell a fund before its announced distribution date and buy a fund after that date. This avoids your having to pay taxes on its distributions.

 

If you’re selling your entire position in a fund or security skip to the next paragraph, but if you’re selling a portion of your holding you need to specify the tax lot(s) you’re selling or the First In, First Out (FIFO) rule will apply.  The potential trap here is if you hold a fund or security which you bought at various times, the cost basis of each transaction could be very different. Make sure you specify the most advantageous tax lot to sell.   Mutual fund investors have a third option which is to use the average cost of their holding. Note: Before you make any tax-based decisions you should consult your tax adviser.

 

It’s not too late to make, or maximize, your 2007 IRA and 401-K contributions. Why make them? Because these are tax-deferred accounts. Even if your income is such that you can’t take a deduction for your IRA contribution, once contributed all income and gains are tax deferred.  Then, the power of tax-free compounding works for you. Using these accounts, investors can convert taxable interest and dividend (especially non-qualified) income into tax free (until they begin withdraws at age 70 ½) income. For investors seeking to diversify their portfolios in a tax efficient manner, retirement accounts are a great place for high yielding taxable investments.

 

So before you settle in to watch football or hide from the in-laws review your investments and minimize your tax liability. When the flowers come up in April, you’ll be glad you did.

If you get caught holding in football your team loses yards. If you get caught holding in your portfolio you lose money. There is no such thing as a hold investment. Yes, I know, every day hold recommendations are issued by Wall Street analysts but they’re copouts. Every investment recommendation that is not a buy is a sell, regardless of what label’s put on it. There are only two investment decisions: buy and sell. If you own a stock, bond, mutual fund, ETF, house, or car and don’t sell it, you’re making a buy decision. Why? Because you’re continuing to hold the asset and subjecting yourself to all the risk that comes along with it.

 

The buy/sell decision doesn’t mean you have to keep buying more of an asset but it does mean if you think an asset is fully priced, you should sell it.  It’s okay to hold an investment you’d otherwise buy if you’ve reached your maximum hold size given risk tolerance levels or portfolio diversification considerations. Saying an asset is a good investment but its fully priced is really saying that it’s peaked in value and it’s time to sell.

 

There are two exceptions to the buy/sell rule for taxable investors. If you have a short term gain which will turn into a long term gain if your hold for a few more days – and the operative word is days – then it would be worth considering holding the investment. Holding may also be worth it if you’re approaching the end of one tax year and by holding for a few days you can push the gain into the following year. This one’s particularly relevant right now, since most of us are on a calendar tax year. There’s a knee jerk reaction to make investment decisions based on minimizing taxes. Minimizing taxes is good but what’s even better is maximizing your net worth.  Calculate how much you’ll save in taxes if you’re holding for tax reasons, then calculate hold much – in most cases how little – the investment has to fall in value before you’ll have less money than if you sold it now and paid your taxes. I have no statistical proof, but I believe that most investors end up losing money by holding an investment in an attempt to avoid or minimize taxes.

 

Investors are emotional beings and we become attached to our investments. We don’t like to admit we’re wrong and sell a loser. It’s all too easy to hold an investment where we have a gain, in hopes of even greater profit, for too long. We need to accept that we don’t always pick “winners” and we’re not smart (lucky) enough to sell at the top. Investors also have a tendency to be on the lookout for new investments and become compliance about those they already own, particularly if they have a gain in them. We should place the greatest focus on our existing investments. The questions we need to ask ourselves are: is the investment consistent with my investment objectives and have my objectives changed? How will this investment perform given the current economic outlook? Has anything changed with the investment, the fund manager or the company’s prospects? Lastly, ask yourself if you didn’t own a particular investment, would you buy it today? If the answer is no, you know what you must do.

When the major stock market averages declined by 10% from their 2007 highs on Monday, we were in official market correction. Sentiment is negative owing to the economic back drop of, at best, tepid growth according to the Fed, or a recession.

 

Consumers twenty-five year credit binge fueled by home equity loans, credit cards arriving in the mail, subprime and adjustable rate mortgages and automobile leases, appears to be over. Savings rates has plummeted from 14% to 0% (perhaps to a negative number if home values continue to decline). Pile on top of that the banks debt problems, high energy prices, the homebuilding industry’s woes, weak retail sales and declining consumer sentiment, it’s no wonder that many investors believe a recession is in the offing.

Investors face two challenges right now. If the economy is headed into a recession, where do I put my money? And, if the economy avoids a recession will I be in the right investments? The stock market anticipates the future. It will decline prior to the US entering a recession and it will start going up prior to the end of the recession. Investors who wait for certainty that a recession has begun will be selling stocks at the worst possible time. The same logic holds true if you wait to buy stocks until after the economic recovery, the market will have already moved higher in anticipation. Human psychology is a future complication. We’re most optimistic about the stock market when it’s roaring ahead and most inclined to buy; and most pessimistic and most inclined to sell, when it’s at its bottom. Of course, our investment strategy should be just the opposite.  The moral to this story is that you should invest for the long term and not try to time the market. 

 

If a recession is imminent, the stock market will decline by another 10%. How do you make money? To get technical, buy mutual funds, ETFs and stocks with negative betas or high alphas, such as gold, commodities, real estate and foreign stocks. Gold and commodities already have had good runs, the US commercial real estate market appears to be weakening and foreign economies are increasingly becoming intertwined with ours. Non-investment grade bonds have good yields but are not the place to be given the continuing bank credit problems. High grade bonds and Treasures have relatively unattractive yields, particularly as you go out in maturity.

 

The best performing stocks in a recession are likely to be industry leaders, companies with strong overseas sales, consumer staples and health care. The technology sector is solid and internationally focused, so we’ll add it to our list. Essentially we’re looking at companies whose sales will be strong during a recession. These stocks may not go up in price during a recession but they will perform relatively better than most other equities and are safe investments. The bottom line is it’s hard to make money during a recession.

 

If the Fed is right and we’ll see modest economic growth in 2008, the markets are at their lows and could move 20% higher over the next six months. How do you position your investments for this possibility? By staying in the market and buying the same mutual funds, ETFs and stocks as you did for your recession portfolio. The recession portfolio is a conservative portfolio. Although it will miss some of the dramatic gains made by small cap and more violate stocks, it also protects you from the downside of those stocks while enabling you to participate in any stock market rally.

 

What to do now? Review your long term goals and make sure you’ve got the right asset mix, take losses (up to $3,000 more than your gains, remembering to match short term gains and losses) to minimize your taxes, reposition your equity investments according to our recession scenario, move your bonds into cash and tighten your seatbelt. We’re in for a bumpy ride.

Exchange traded funds are index funds which have advantages over open-end index mutual funds. ETFs trade all day long on the stock exchanges, may be purchased through any broker, have lower fund expenses than mutual funds, and have less likelihood of generating unwanted taxable gains than mutual funds. (See The ABCs of ETFs – Exchange Traded Funds).  

There are a number of reasons, which we’ll discuss, for investing in index funds (ETFs or mutual funds) but let’s start with the fact that the S&P 500 index beats 80% of all actively managed funds. (And, an index fund has lower expenses than an actively managed fund, further enhancing its net return.) If you can invest in an index fund and be in the top 20 percentile of fund returns, that’s a pretty good place to start. 

 

You can construct a well-diversified portfolio entirely out of ETFs.  There are ETFs for almost every type of investment you can imagine.   ETFs enable you to diversify into assets which you may not otherwise feel comfortable owing because of expertise, risk and/or liquidity issues. ETFs are well-suited for investing in exotic areas such as currencies and commodities. Of course, they’re great for sectors such as small cap or international stocks. 

One of the most attractive features of ETFs is their ability to provide you with greater liquidity than if you were to directly own their underlying investments. Take municipal bonds, for example. Most Muni issues trade infrequently and the transaction costs for the individual investor are substantial. Minimum investment size can be another problem. Munis typically have a $1,000 denomination and trade in large blocks. ETFs are the answer to all these issues.  You can buy as little as one share of an ETF (generally less than $100) during market hours and at the same cost as for a stock.   

 

You can hedge an investment and/or lock in gains using ETFs.  Unlike open-end mutual funds, ETFs can be bought on margin and shorted. Investing on margin can magnify your returns and your losses. The ability to short enables you to make money when something goes down in value. Think shorting the dollar or home building stocks. However, to paraphrase TV commercials, these strategies should only be employed by a professional driver on a closed course. It’s also important to note that you don’t have to short an ETF if you think an asset is going to decline in value. You can probably find an ETF which is structured to generate an inverse return to that asset. ProFunds Group has a number of ETFs designed to perform this way. So, for example, if you think the Chinese stock market will decline, you can purchase a ProFund which should increase in value if you’re right. 

All ETFs, even those which track the same index, are not the same. One S&P 500 ETF may weight its stock holdings by market cap, another may weight them all equally. This will result in different returns. Two ETFs which track the technology sector may hold different stocks and/or in different weightings. Since most indexes are not strictly defined, think technology versus S&P 500, there will be a variety of different investment strategies employed. Different strategies to mimic an index are not good or bad, but they may have different risk levels and will produce different returns. Some ETFs  also use leverage to enhance their returns or structure there holdings to magnify any gains (thus, also losses) of an index. You need to know what you’re investing in. To understand how a specific ETF works, visit its website and read its prospectus. Want to learn more about ETFs or take a look at some of the most popular? Go to I shares, Power Shares, or HOLDRs.

 

Within five years most investors will have at least one ETF in their portfolio. Also, within five years, there will be more money invested in ETFs than in open end index mutual funds. The advantages of ETFs – liquidity, transparency and lower expenses, to name a few – will force changes in open end mutual funds.  Happily, the investor will be the winner in the competition between these two investment vehicles.

Every investor should consider Exchange Traded Funds (ETFs).   The younger brother of open-end index mutual funds is growing up fast and showing greater versatility.

 

ETFs are open-end index mutual funds that trade like stocks (and closed-end mutual funds). 

 

There are three legal structures of ETFs: Open-end mutual fund (the difference between the ETF structure and a open-end mutual fund is the ETF is exchange traded, whereas the traditional mutual fund is purchased and redeemed by the fund itself), Unit investment trust and Grantor trust.   The open-end mutual fund structure has a diversification requirement, mandated by the Investment Company Act of 1940, which limit how it mimics some smaller or specialized indices and could result in a tracking error. The other principal difference for the investor is that other than the open-end mutual fund, dividends must be paid out in cash to investors (of course, you could reinvest them if you desired), rather than reinvested by the ETF. These structural differences aren’t significant for most investors. The more important question is whether it’s the right ETF for you in terms of what index it’s designed to follow. The index and dividend payout requirement are disclosed in its prospectus and most ETFs also have websites where you can find this information.

 

Tracking error is the difference between the return on the index the EFT is designed to follow and the actual return on the index. An EFT which holds all 500 stocks in the S&P 500, in the same weighting as the S&P 500, should have exactly the same return as that index, less fund expenses. That’s an easy one. ETFs that are created to track, say, the biotech stock index will have different interpretations of that index. A biotech ETF could weight all stocks equally, weight by market cap, hold big cap or small cap bio stocks, and so on. As a result, the ETFs performance will vary with the success of its strategy. A good illustration of this is in Biotech ETFs: It Pays to Shop Around, in the October 15^th BusinessWeek. The five funds BusineesWeek highlights had year-to-date return ranging from -3.7% to 27.3%.

 

ETFs are required to disclose their holdings every day, unlike mutual funds which only have to disclose once a quarter. However, this should not be a big deal because we’re dealing with index funds and the components of indexes should not change very often.

 

There are two aspects of ETF liquidity for investors to consider: the ETF and its index’s securities. Since ETFs trade like stocks, they can be traded all day long. Open-end mutual funds can be purchased or redeemed only once daily, after the market closes. You have to put your order in prior to 4PM (while the stock market is still open) or wait until the next day. The liquidity of the EFT – the frequency with which it trades and the depth of the market – is similar to a stock and parallels the size of the EFT. But ETFs also have a very unique feature, they can be expanded or contracted depending upon demand, see Share Creation/Redemption, which provides them with even greater liquidity. And, ETFs can be more liquid than the individual shares they hold, thus, providing investors with greater liquidity. This is especially true for an ETF that holds small cap stocks, which are thinly traded, or bonds other than US Treasuries, which trade infrequently.

 

Authorized Participants, think big banks who act as market makers or specialists on an exchange, trade market baskets of the underlying index’s securities to the EFT in exchange for new ETF shares, when the demand for ETF shares increases. The Authorized Participants then sell these newly created ETF shares on the open market. The process is reversed if there are more sellers than buyers of the ETF.  The purpose of this feature is to keep the ETF’s market price as close to its net asset value as possible. (The risk exists that the Authorized Participants would not, or would not be able to, perform this function during a market crisis. The result of this could be an ETF which trades away from its net asset value.)

The price at which the ETF trades is based upon supply and demand. Unlike the share of an open-end mutual fund which is purchased or redeemed at its net asset value (NAV), the price of an ETF share may trade above or below its NAV. By way of comparison, closed-end mutual funds often trade away from their NAV for extended periods of time. Unfortunately, many closed-end mutual funds trade significantly below their NAVs. The Authorized Participants provide vital role, through share creation and redemption, in keeping the price of the ETF close to its NAV.

The structure of ETFs gives the investor a tax advantage over mutual funds. Open-end mutual funds, even index funds, must sell shares of the stock they own to raise cash when redemptions exceed purchases. These sales can result in taxable gains and losses which are passed along to the investor. Thus, you could have a taxable gain on the fund you own, even though you didn’t sell it. The share creation/redemption process for ETFs shifts this liability to the Authorized Participant. If the Authorized Participant trades ETF shares to the EFT, it is responsible for the taxes on any gains if it sells the securities it received from the ETF. Of course, the investor is liable for any taxes when he or she sells an ETF or mutual fund. 

ETFs have lower fund expenses than index mutual funds, although the difference is usually only a few basis points. (Don’t be misled by ETF advertisements which compare their expenses to actively managed open-end mutual funds.) Theoretically, the expenses for an ETF or mutual fund structured to track the same index, assuming they’re roughly the same size fund, should be the same. 

 

Since ETFs are traded like stocks, the commission charged to buy or sell an ETF is similar to the commission on a stock trade. Index funds are no-load, and are commission free, although some charge a back-end fee if you don’t hold it for a certain period of time. The second cost to consider is the bid/ask spread. Even stock and ETF has one, although in most cases they’re very small, i.e., a few cents, unless the ETF is very illiquid. Transaction costs – none vs. some – favor no-load mutual funds over ETFs but the cost differential is slight

 

What are the uses and advantages of ETFs? Come back next week and I’ll tell you.

Alan Greenspan writes extensively about the global economy in The Age of Turbulence. 

He believes there are common dominators to economic success. One is a cultural desire for growth, which includes government integrity, the acceptance of a certain amount of income inequality, incentives to take risk and the willingness to let market forces determine supply and demand. Markets are the antithesis of government decision making. The fall of Russian communism showed the fallacy of central planning. The socialism of Western Europe and the populism of Latin America are lesser forms of substituting the wisdom of government for the marketplace. Western Europe (India and elsewhere) suffers from bureaucracies with extensive approval processes which slowdown change and bureaucrats who substitute their judgment for the market. Restrictive work rules imposed on employers drive up costs and reduce the incentive to take risk, resulting in lower growth and, perversely, higher unemployment.

 

A second factor in economic growth is education. It speaks for itself. A third is a young, or growing, population.  Workers who save money (accumulate capital) and contribute to their heath and retirement plans aid economic growth. Non-workers, such as retirees, who consume these services, which have been promised to them by their government but have not been funded, place a strain on economic growth. As the ratio of workers to retirees shifts, due to the aging of the baby boomers and increases in longevity, the burden of these transfer payments on an economy/society increases.

 

The last determinate of economic prosperity is a strong rule of law, defined as a protection of property rights (and, by extension, individual rights). This is a major theme of Mr. Greenspan’s. Property rights include real estate, intellectual property, goods and, broadly, commercial transactions.  A strong rule of law is not a dictatorship, in fact, it’s just the opposite.  Individuals/companies will take risk, and invest for the future, if they can see a clear and consistent set of rules. As a corollary, risk premiums will be lower in this environment, meaning the cost of capital will be lower, promoting growth.

 

 We can extrapolate from Mr. Greenspan’s thinking as to the best international areas for investment.   So let’s go for an around the world tour. Western Europe has a strong rule of law but their bureaucracies, aging population, restrictive immigration which could otherwise offset an aging population, and expensive social services means their economic growth will be limited. Eastern Europe is on its way to a well developed rule of law and does not suffer from the problems of Western Europe (yet). It’s overcoming its Communist legacy and production costs are low.

 

Russia has inconsistently applied laws which vary with the whim of its rulers. It also has the Western European population demographics. A currency inflated by the high price of oil and gas exports is another limiting factor. However, abundant natural resources, an entrepreneurial spirit, and burgeoning consumer market are positives. Russia has great potential but equally great obstacles to overcome. 

 

Japan has greater population problems than Western Europe in terms of age and immigration and a bureaucracy structured to prevent companies from failing, limiting imports, and preventing foreign companies from operating in Japan. Yes, it has a strong rule of law but it is very Japan-centric. Is it any wonder that the Japanese economy has been stagnant for the last 15 years? Mr. Greenspan says that it will no longer be the world’s second largest economy by 2030. 

 

China is the global wildcard. Its growth has been impressive and it has moved towards a comprehensive rule of law.  But a Western-style rule of law and the personal freedom which it, and economic growth, brings are in conflict with a ruling autocratic party. One or the other will have to give way at some point.   Mr. Greenspan believes that China’s growth will continue, and although he doesn’t come out and say it, China will surpass Japan in GDP by 2030.

 

India has a strong rule of law but a bureaucracy which makes Western Europe’s look like a Ferrari. Its growth has been impressive but it hasn’t kept up with China due to severe infrastructure problems and cultural crosscurrents preventing its markets from freely functioning. Latin America is cursed with populism (take a look at Venezuela), Brazil being the possible exception. Severe income inequality, education and rule of law (government instability and corruption) problems abound.

 

Emerging economies, Mr. Greenspan cites Vietnam, are where the biggest money will be made. Of course, they carry great risk.  Nonetheless it will be exciting to see new economic hotspots emerge as the world looks for low cost production areas and certain counties seize the opportunity. Lastly, the United States looks pretty good by comparison to the rest of the world, despite our problems. Mr. Greenspan predicts we’ll still be the biggest and the best in 2030, although a smaller part of a bigger global pie. 

 

How do you invest globally? Stick with Mr. Greenspan and go with a strong rule of law. Invest in Europe, East over West and, if you can take more risk, invest in China and India. Constantly look for changes in law, or a shift in attitude towards a change, and watch for emerging gems.

 

A current theme among Wall Street wealth managers is for individual investors to have index funds as their core holdings and to focus the remainder of their assets in high alpha investments, which will produce returns not correlated with the market. 

 

A quick digression for those of you who aren’t familiar with alpha and beta. In traditional finance, the return not correlated with a broad market index, such as the S& P 500, is referred to as alpha. The return which is correlated to the market is beta.  An index fund should have the same return (positive or negative) as the index it mimics.  (One of the controversies surrounding some ETFs is their performance has not tracked their underlying index.)

 

The theory behind Alpha and Index Funds is multifold:  1. the major indices are a good place for an investor to be, both from a risk and return perspective;  2. you can’t outperform the major indices, so don’t waste your time;  3. find those investment niches with high alphas to increase your return and reduce the overall risk in your portfolio. Even if you don’t subscribe to this theory, you might find it an interesting exercise to review the alphas -- every investment has one -- of your current holdings. They will tell you something about the correlation and diversification of your portfolio.

 

Where to focus your alpha energy? Investments in real estate, commodities, and energy are less correlated with the stock market (although I’ve never thought commodities were suitable for individual investors).  The Wall Street pros also recommend stock fund mangers who have unique strategies and can demonstrate a high alpha relative to the market (and, of course, positive relative performance). Ask your investment advisor for suggestions.  The alphas for individual mutual funds (and individual stocks) are available from some brokers and online premium services. 

 

Alpha and index fund investing makes a great deal of sense. You know what to expect in terms of risk and return when you invest in an index fund. Having a portion of your portfolio in index funds leaves you free to concentrate your investment time and energy (think alpha waves) on those investments which can make a difference. Picking high alpha investments, which by their nature are less correlated with the stock market, should reduce the risk/volatility of your portfolio and, depending upon the investment, provide above market returns. 

Which of your investments worried you most during the recent market correction?  If it was one of your smaller holdings, you’re not alone. But, we all have only so much time and so many brain cells to devote to investing. If you’re focusing yours on a tiny portion of your investments, the majority of your net worth is going unwatched.

 

Many investors I speak with are focused on only one or two of their investments or, worse, are fixated on the one they sold which has since gone up in price.  Have you ever taken a flyer? Bought a few shares of something on a tip? Stop and ask yourself: suppose this purchase doubles or triples, what impact will it have on your net worth? It will be insignificant. And, any change to your net worth will be dwarfed by the movement of your primary investments.

 

Let’s put some numbers to this. If you have a stock or mutual fund which is 1% of your total portfolio and it doubles in value, it’s now only 2% of your total holdings.  Your net worth has only increased by 1%. And, let’s face it, despite what we think, it’s unlikely that many (or even a few) of our investments will double over the short term.

 

The key to building a strong investment portfolio is to set your goals and diversify, but not have so many investments you can’t follow them all and to avoid investments which are too small to be meaningful.  Here are some rules of thumb: no stock or bond should be less than 2% of your portfolio. No mutual fund should be less than 5%. If you’re uncomfortable holding that much of a particular stock or fund, the investment is too risky for you and you shouldn’t own any of it. Think about the 2% and 5% guidelines for a minute. If you own only stocks, that would be a 50 stock portfolio, a lot of stocks for anyone to follow. It would be 20 mutual funds.  In both cases, more securities than you need to achieve diversification. So the above percentages are only minimums. The maximum holding for a stock should be 5%, that’s 5% of your net worth tied to the fortunes of one company (remember Enron, if you’re wondering why). 

 

For mutual funds, the bigger and safer the fund’s investment focus, the more you can invest in it.   Bigger and safer means, for example, Big Cap stocks for both domestic and foreign funds, investment grade bonds and US Treasuries. To be conservative, you should put no more that 10% of your next worth into any one fund. 

 

This brings us to index funds. If it’s a fund mirroring a big index, i.e., the S&P 500, the Lehman bond index, the Morgan Stanley Japanese stock index, you can invest more than 10% in a single fund. If it is a smaller index, i.e., the technology sector, the 5% rule applies.

 

Diversify, but don’t have so many investments that you can’t follow them all. Avoid investments which are so small they won’t make a difference. Focus on the big picture; don’t let the tail wag the dog.

The recent events in the stock and bond markets drew everyone’s attention. No doubt you took a look at your investments and, perhaps, worried about one or two. Maybe, you made some changes to your portfolio. Let’s take a look at your experience and see if there are some lessons to be learned.

 

Did you lose sleep, literally or figuratively, over any of your investments?   This is the gut check measure of risk tolerance, not quantifiable, but accurate nonetheless. Investing is not an emotional decision, it takes hard work and discipline, but if you worry too much about an investment, it isn’t right for you. One of the hardest parts of investing is keeping your emotions out of it (i.e., taking a loss or selling your “favorite” mutual fund). Emotion will only cause you to buy at the market highs and sell at the lows. But, did your gut tell you to sell anything during the recent market correction? Rule number one of gut check investing is: if you lose sleep over an investment, it’s probably too risky for you. How do you know? This brings me to the second rule of gut check investing.

 

When making a decision to buy or sell a mutual fund, do your research.  Is it a sound fund? Does it meet your investment objectives? How would you feel about this investment if the market were headed in the opposite direction? Write down your reasons, put then in a drawer (or store them on your hard drive) and pull them out when you’re thinking about selling. The purpose of this exercise is to avoid being swept up in the euphoria of a bull market, and making too risky investments, or selling good investments, out of fear, during a market correction. Make your analytical decision, then ask yourself, factoring out the current market emotional climate, does it feel right? If you’re not comfortable, don’t buy the fund, or sell it, if you own it. This is the gut check buy/sell decision making process.  I want to emphasize the sequence.  Do your analytical work first, then sit back and see how you feel about it. The gut check buy/sell decision is a one-way process -- it can stop a buy, but it can’t stop a sell.

 

Sleep well. Sweat dreams.

There’s an old adage in the brokerage community that you should speculate for growth, not for income. Speculation isn’t the right word, but the broker who coined it (pun intended) probably wasn’t an English major (most brokers aren’t). The point is that you should take risk with investments which you expect to increase in value, i.e., stocks, but not with investments made to generate current income, i.e., fixed income securities. This is an essential maxim if you are dependent on that income. 

 

Greater income (return), always entails greater risk. It’s the way the world works. One rule of thumb is to compare your investment to others in the same class.   There’s a reason a money market fund has a higher yield than its peers – it’s taking more risk. The same is true for any bond fund. A second rule of thumb is to stick with quality.  Buy funds which invest in government securities or investment grade bonds. If you invest in long term bond funds, they will fluctuate in price due to changes in interest rates, credit spreads and the yield curve, but you will not run the risk of serious loss of income or principal. Anyone who stuck to investment grade bonds came through the recent/continuing mortgage debacle relatively unscathed. If you owned funds invested in US Treasures, you actually made money.   

 

Funds that invest in bank loans, junk bonds, and other low-rated or unrated debt instruments, or employ leverage to enhance their returns (see Leverage Land Mines) are too risky for the average investor. These investments need to be watched and analyzed similar to your equity investments and are not for investors who need a reliable income stream.

 

The above rules of thumb apply to equities as well as to debt. There are many dividend paying stocks which are relatively safe, and a portfolio of these would be safer than, for example, a portfolio of subprime mortgages.  I’ve been watching a mortgage REIT with a 20% current yield. It doesn’t have subprime exposure, has taken its write-downs and appears to have good liquidity. Good investment? Maybe, but I’d buy it because I thought the stock would appreciate as the mortgage market returns to normal. I wouldn’t buy it for its dividend.  I expect the dividend will be cut because no stock can yield 20% for long. Carry this thought through to the equity income funds you own or are considering and remember: the higher the current income, the greater the risk that it’s unlikely to continue.

 

“Speculate” might not be the right word when talking about reaching for income, but it gets the point across. Take your risks in the stock market and don’t stretch for higher income because you might end up with none.