Keeping Track

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A reader asks: How to keep track of all the accounts, taxes due; how to measure progress in meeting financial objectives. I hate administrative tasks myself, so I sympathize with this correspondent’s anxieties.  Here is a walk through a typical year with my advice on what to do when, and what information to have on hand when you are obligated to undertake certain actions.  Some dates on what follows are dictated by federal, state, and local governments. Other dates are arbitrary.  For instance, I suggest calculating your net worth every January.  You could do it at any time, but do it at least once a year.

January

  • Calculate a personal statement of your net worth. By the third week of January you should have obtained statements from the financial institutions holding any of your savings and investment accounts.  Add the value of these to the value of your other assets, large pre-paid items such as college tuition and the value of your house and car, if you own them.  The total figure is your assets.  Do the same for your liabilities — large expected bills, the amount remaining on the house’s mortgage, and other outstanding debts, including credit card debt.  The difference between your assets and your liabilities is your “net worth.”
  • Review your financial goals. Revisit the plan described in this post.  Write down how your efforts in the previous year have advanced it and then how you will advance it further in the coming year.
  • Create folders for all the financial and tax information you will receive over the coming year so that you will have easy access to this material when you need it, especially at tax time. In particular, you will want to file receipts for business expenses to write off against your taxes. The Internal Revenue Service (IRS) website provides guidance on what expenses do and do not qualify as deductions. irs.gov.
  • Pay off as much credit card debt from the holidays as you can, starting with the card that charges the highest interest rate. You should do this even if it means delaying other purchases, and even if it means interrupting your saving schedule, because no investment offers a rate of gain equal to the interest cost on a credit card.
  • January 15 is a tax date, the last of four for estimated taxes due on income from the previous year. If your employer withholds taxes from your paycheck, you will not need to do much.  But if you run your own business or do freelance employment, you will need to make a payment to avoid an IRS penalty.  Consult an accountant on how much you must pay.
  • Take advantage of post-holiday sales to shop for next year. 

February

  • Contact any bank or financial institution that has failed to send you statements, because you will need them to file your taxes based on the previous year’s income.
  • Make an appointment with your accountant.  Taxes are due April 15, but having this conversation in February will avoid scrambling at the last minute for needed material.
  • If you expect a tax refund, file early and use the money to pay down credit card or other debt, or put it to work in your savings and investment accounts.
  • February 15 is a tax date. If your child works but will not earn enough to owe any tax, this is the latest date when you can file an IRS form W-4 with his or her employer token that employer from withholding taxes.

March

  • Finish preparing your tax return (if you did not file in February).
  • Confirm that all colleges and other schools have received your financial aid forms. The deadline for federal student aid varies from school to school, but earlier is always better.
  • Review your property tax bill. Deadlines to challenge it vary depending on where you live, but most allow appeals in early spring.  About half those who appeal win reductions –– on average some 10 percent.  The National Taxpayers Union website, ntu.org, offers guidance here.

April

  • April 15 is a tax date. Filing on income for the previous year is due to the IRS and to those states that impose state income taxes.
  • April 15 is also when you have to pay the first installment of your quarterly estimated taxes if you are self-employed or if your employer is not withholding at all or is not withholding enough. You should pay these estimated taxes equal to at least 90 percent of what you will eventually owe.  Your February conversation with your accountant should inform this calculation.
  • The 15th of April is also the last date on which you can take care of some previous tax-related business (of which more in an upcoming post) from the year before, for example:
    • funding your Individual Retirement Account (IRA);
    • funding your Keogh or Simplified Employee’s Pension (SEP) plan, if you have self-employment income;
    • paying your IRA fees. (Use a separate check, since this expense is tax deductible.);
    • filing for an extension. (If you and your accountant have failed to get your return in order on time, you are entitled to a six-month extension, which brings you to October 15th.  That is an extension for filing, not for the payment of tax.  You will have to pay estimated taxes together with an extension for filing your return.)
  • If you’re planning to move, try to do so in April.  Moving costs are some 50 percent higher between May and October than between November and April.  Save all receipts if the move is job related.  Many moving expenses are deductible.  For guidance, visit the IRS website, irs.gov.

May

  • Contact the IRS if by month’s end you have not received any refund due you. Use the refund to pay down credit cards or to invest.
  • Book your summer vacation. This is usually the last month to get reduced rates for early reservations.
  • Because this is otherwise a light month for financial tasks, May might be a good time to take an inventory of your household items and check your insurance coverage.Take pictures of any valuable items.

June

  • June 15 is a tax date.  If you are self-employed or your employer is not withholding enough, the second installment of your quarterly estimated taxes will be due.
  • June 30 is a filing date.  It marks the deadline to file with the U.S. Treasury if you have a bank or other financial account in a foreign country worth more than $10,000.
  • Meet with your financial advisor to review your investments.  Beginning investors will have little need for such meetings, but for others, this is a good time to review.
  • Have a yard sale to raise more investable cash.  Donate to charity whatever you fail to sell.  Get a receipt from the charity to use as a write-off on your taxes. Guidance on what applies is available on the IRS website, irs.gov.
  • Pay off your credit card so it has room for you to charge items on summer vacation.

July

  • This is a good month to sell your old car.  Seasonal pricing patterns show that now is a likely time to get a better price.
  • Enjoy a month of financial leisure.

August

  • Provide children and grandchildren who are going off to college with information on managing their checking account, credit cards, and budgeting.
  • Travel that combines with work may have tax-deductible elements. Keep receipts.  Check with your accountant and/or consult the IRS website, irs.gov.

September

  • September 15 is a tax date.  It marks the due date for the third installment of your quarterly estimated taxesif you are self-employed or if your employer is not withholding enough.
  • Calculate what your child earned on a summer job and ask your accountant whether your offspring needs to file a return. Again, you can get guidance from the IRS website, irs.gov.

October

  • October 15 is a filing date for your previous year’s tax return if you received an extension the previous April.
  • October 15 also is the last day to make a Keogh or SEP contribution, if you received an extension last April.
  • With little else pending, this is a good month to review your will.

November

  • A good month to buy a car.  Dealers have to clear their lots for next year’s models and are inclined to offer good deals.
  • If you have a flexible spending account with your employer, plan to use it now, before the end of the year, because if you don’t use it, it will revert to your employer.
  • Check your credit score and correct any irregularities. You are entitled to do so free once a year.

December 

  • December 31 marks the last day you can set up a Keogh plan for the following year. You have until April 15 to fund it, but you must do the paperwork by Dec. 31.
  • Though you can wait until January 15 to make estimated income tax payments to state governments, you can deduct all or a portion of them from this year’s federal tax if you pay by December 31.
  • You can make cash gifts to individuals, up to $15,000 each without them having to pay a gift tax or suffer any complications on your future estate taxes.
  • Make all charitable contributions before December’s end to receive write-offs on the current year’s taxes. For gifts over $500, the IRS recommends that you receive a letter of acknowledgment from the charity.
  • Arrange, if possible, to push income and bonuses into January to keep them off the current year’s tax liability. You will eventually have to pay taxes on the income, but this way you get the earning power in your investment account for a whole year before you have to pay the tax.

 

Going Abroad

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So far, these posts have focused largely on American investments and institutions.  But overseas investing offers opportunities that are frequently well worth the risk, although not for everyone.

Why Go Abroad? 

At least half the world’s stocks and bonds are issued outside the U.S.  These offer different opportunities than those in the U.S., and when it comes to diversification, they have unbeatable advantages.  Three points make the case:

  1. Because foreign economies frequently show strength when the U.S. economy shows weakness, investment positions abroad offer diversification that can give your portfolio buoyancy even when U.S. business hits one of its recurring rough patches. Foreign investing, in other words, offers other baskets for your investment eggs.

Note: Though many American firms have considerable overseas exposure, they are not a substitute for holding foreign bonds and stocks.  The stocks of American firms, even those that earn more revenues abroad than at home, such as Coca-Cola, Proctor and Gamble, and Exxon Mobil, still respond mainly to conditions in the U.S.

  1. Often, overseas investments offer the only effective means to gain exposure in certain industries.  If, for instance, you wanted to buy the stock of a large, global engineering firm for your portfolio, you would have to go overseas.  There are publiclly traded engineering firms based in the United States, but only a few do much overseas business and most of those that do are privately owned.
  2. Investing in foreign instruments is sometimes the only way to capture the main competition to American firms. Boeing, for instance, has as its chief competition the European consortium, Airbus. When one of them bests the other for a big contract — say from China Airlines — the loser’s stock drops while the winner’s rises.  Having exposure to both companies eases concerns over which firm will win the next contact and focuses your investments on the far more secure prospect that the world’s airlines will both grow and upgrade their fleets.

What Are Your Options?

Investment professionals classify foreign stocks and bonds into three basic groups:

  • Developed Europe: This includes the United Kingdom, France, Germany, Scandinavia, Italy, Spain, etc.  These economies, because they do a lot of trading with each other, frequently move in concert.  Generally, European countries that have relatively recently emerged from communist rule –– Poland, Hungary, the Czech Republic, and others –– are classified as emerging markets.
  • Developed Asia: Here the classifiers face real ambiguity.  Japan, of course, counts as a developed market.  South Korea, Hong Kong, Taiwan, and Singapore have many well-established financial and economic structures, such as a developed market economy, but many analysts still view them as “emerging,” if well along the way to full development. China, too, is sometimes included in this group, as is India.  What is more, these Asian economies, fully developed or not, depend less on each other than do their European counterparts and thus move less in concert than does developed Europe.
  • Emerging Markets: These include a diverse group, ranging from just about all of Latin America to, among others, Vietnam and Indonesia in Asia; Kuwait, Abu Dhabi, and others in the Middle East; Egypt, Nigeria, and South Africa in Africa, though some consider South Africa as developed. Some analysts make distinctions within this category, referring to the better-established members as emerging and less established members as frontier markets.
  • You may think it strange that the classification system makes geographic distinctions for developed markets but not for emerging markets.  Certainly, some emerging economies have clear geographic biases.  Latin America, for instance, has a particular orientation toward the United States, while the ex-communist countries in Europe share an orientation toward Western Europe.  Some professionals make geographic distinctions on the basis of such orientations. But two critical aspects common to all emerging markets override such geographic distinctions:

1. They are all at an early stage of development, giving each of them the potential for more rapid growth than developed markets.

2. All emerging markets depend for growth and profitability on the developed world’s demand for their products and its willingness to invest in them directly.  As a consequence, all emerging markets, regardless of their location, are subject, often in exaggerated ways, to the positive and negative shifts in the developed economies.

Currency Risk

This is probably the biggest single risk in foreign investing.  Because stocks and bonds bought abroad are almost always denominated in currencies other than the U.S. dollar, an American investor can lose (or gain) simply from fluctuations in currencies.  Take, for example, investments in Germany, where stocks and most bonds are denominated in euros.  Should the euro lose value against the U.S. dollar, your euro-dominated investments, even if they rose sharply, would be worth less in dollars.  Conversely, were the euro to gain against the dollar, those investments would gain dollar value even if they otherwise performed badly. The same risk and potential applies to almost all foreign investments.

For some, this risk is reason enough to avoid foreign investing, and that is understandable: Currency values can swing wildly from one month or year to the next, and they can do so in seemingly unpredictable ways.  However, before giving in to such fears consider these facts:

  1. Investors can hedge currency risk. (More on this in a coming post.)
  2. Currency moves can sometimes cut two ways. Take the earlier example of German investments. If the euro were to fall against the dollar, it is true that the dollar value of euro-dominated investments would fall with it.  But at the same time, a drop in the euro would also give German exports an advantage on global markets by reducing their price in terms of other currencies.  This boost to German business prospects might well raise German stocks sufficiently to offset much or all of the loss due to currency shifts.
  3. A purely domestic portfolio hardly avoids currency risk. To understand why, move the German example just given to the United States.  If the dollar were to rise against the world’s currencies, the holder of a purely domestic portfolio might be pleased for having avoided the currency loss implicit in foreign investments.  But that same investor might face a setback because the rising dollar means an increase in the global price of American products and so puts American producers at a competitive disadvantage. The currency move would also make foreign imports cheaper in the United States and thus put even purely domestic American producers at a competitive disadvantage.

How Much Is Enough?

 Some business school academics have said that because half the world’s assets lie outside the U.S., half your assets should, too.  This would be a mistake.  As with so much else in investing, the right answer depends on your individual circumstances and plans.  Are you investing in order to buy a home in a few years? That relatively short time horizon might preclude you from taking the risk of overseas investments.  But if you are investing for a retirement that is decades into the future, price volatility would present less of a problem compared to the investment’s long-term potential.  Your decision would also hinge on where you want to retire.  If you are thinking of Bali, or Paris, you may want more of your portfolio in those respective markets than if you plan on living your retirement years in Utica, NY.

Because most readers contemplate their future liabilities in dollars, and because of the other risks of investing abroad, few should even consider putting half their wealth overseas.  Generally, the longer time you have before you need the money, the more risk you can afford to take advantage of overseas investment opportunities, and so the more you will place abroad.  As I have said, in the end it will come down to your personal tradeoff between the risks you are willing to take, your circumstances, and your goals.  This is something you may well want to discuss with your broker or financial advisor.

How to Do It

 It is no more difficult to invest abroad than in the United States.  Full service brokers can recommend investments and also buy and sell foreign securities for you.  They will report to you with values stated in the currencies of those countries and also in dollars, using a recent exchange rate.  You can also open a brokerage account overseas.  None of this is very complex––though tax reporting can become cumbersome.  Many foreign companies also are listed on U.S. exchanges in what are called American Drawing Rights (ADRs) or Global Drawing Rights (GDRs).  These actually quote the stock in dollars and give the appearance of trading just like U.S.-based companies.  A box below lists just a few of the many foreign companies trading this way.

Note: Because these ADRs and GDRs quote prices in dollars and seem to trade just like U.S. companies, many investors mistakenly believe that such trades avoid currency risk.  But be aware that their American listing simply converts the price quoted in their currency of origin into dollars at a recent exchange rate. If the dollar’s foreign exchange value rises (or falls), the dollar quote of an ADR or GDR listing will fall (or rise) just as if you held the asset in the foreign country.

Because it is more difficult to obtain research on foreign companies and keep up with overseas events, it is usually wise to delegate the management of these investments to professionals.  Mutual funds can serve this purpose. You can buy into a number of no-load mutual funds with a focus on foreign stocks, just as with domestic investing.  Brokers will not buy you these funds, because they make no commission on the purchase, but they can buy you other mutual funds (of the load variety) and ETFs that specialize in foreign stocks.  Some mutual funds, either the load or no-load variety, tout their security-picking abilities.  As with domestic investing, make sure that you have done a complete review of these funds’ performance record to see if they’re worth their fees.  The marketplace has any number of mutual funds that make no pretense of such abilities, and for a relatively low fee, they will invest your finds in a broad index of stocks in a specific market or region.

 

 

Markets and the Shutdown

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With the government shutdown on pause, I received this interesting question last week:

“I’m a young investor, and I’ve never experienced anything like this shutdown before.  And there may be another in 3 weeks!  I see that the stock market seems not to care.  How can this be?  How should I, a thirty-something, think about it?

I can certainly understand this young person’s confusion and concern. During the shutdown and even still, everyone seems very worried about its impact.  Politicians have decried it and bureaucrats have described it as a threat to national security, to law enforcement, and to the nation’s general well being.  Some economists –– though not all –– have predicted that the economy would stall, but the February 1 job reports indicates they were wrong.  The media have run stories non-stop on who was right, who was wrong, and what evils would befall the country if it did not end soon.  But the stock market, as our young questioner points out, seemed little bothered.  The broad-based S&P 500 Stock Index did fall on the first day of trading after the shutdown started on December 22, by about 2.7 percent.  But on balance, it climbed after that.  By the end of 2018, it was up 10.7 percent from its level just before the shutdown began and held those gains right up to the time that the “pause” was announced.

The market’s shrug would seem to have at least four drivers:

  1. Most investors had confidence it would not last.  They have seen quite a few of these over the years, and for all the wringing of hands, the shutdowns all ended without much economic or financial incident.  And even as this one went on longer than the others, investors retained their common sense of the matter.
  2. The impact of the shutdown, its scale, didn’t threaten the economy as much as the media said it would. According to government estimates, some 450,000 workers were either furloughed or had to work without pay.  That is less than 0.3 percent of the country’s workforce.  The economy produced more jobs than that in the last three months of 2018.  Of course, government contractors also missed payments.  Those who depend on government workers and contractors for their business also suffered — victims of what economists call multiplier effects.  Perhaps the 800,000 workers referred to frequently in the media took all these effects into account.  That would have had an economic effect, if the shutdown had continued, but still not the disaster that common rhetoric implied.
  3. However severe or understated the problem was, investors knew that government workers would get their back pay (and contractors would have their invoices honored) when the shutdown ended. What is more, contracted work that was put on hold for the shutdown would resume. All would help the economy spring back.
  4. Investors understood that no issue of real economic or financial significance hung on the outcome. Donald Trump wanted funding for his “wall,” while Nancy Pelosi wanted to thwart Trump.  As much as the country really needs to revisit its immigration laws, that was not likely to occur, no matter how the shutdown was resolved.  Investors understood that no new significant policy would emerge.

If the sides fail to compromise and the shutdown returns, this same analysis will likely prevail again.  There is a possibility that another such event, because it would have no precedent in the memories of most investors, could make them feel that this time things would be different, but the odds do not favor such a reaction. What might change matters is if the dispute takes on more substance than a cynical battle between political heavyweights to see who can pin on the other the blame they both deserve.

And even if something more substantive develops, young people investing in stocks for the long term should have every reason to look beyond this episode and continue their bet on the U.S. economy’s basic growth and its tendency to lift stock prices over time, no matter the fear or distraction of the moment.

 

 

More Detail On REITs

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A public official responded to this recent post on real estate investment trusts (REITs) with two pertinent questions: 1) Is it better to buy a specific, open-ended, actively managed REIT or a broad-based REIT index? 2) Is it true that actively managed REIT funds do not track all that closely to the stock market and are less volatile than broad-based REIT indexes?

On the first question, the answer depends entirely on the track record of the actively managed REIT and its performance prospects going forward.  If it has a good track record, if it has consistently outperformed its benchmark index and shows evidence it will continue to do so––for instance, the stability of its staff––then it is generally a better bet than a broad-based REIT index.  But there are two other important considerations:

  1. Actively managed REITs generally charge higher management fees than broad-based index products. Make sure that the better performance more than compensates for the additional fees.
  2. Many actively managed REITs concentrate on particular regions of the country and/or on particular sorts of real estate investments –– shopping malls, for example, or office buildings. If those concentrations are not part of your strategy, then the investment is not for you, however strong it may appear.  If the focus fits, but you also want a broad diversification within real estate, then you might need to buy into several other actively managed funds. Or you could combine a particularly good actively managed REIT with holdings of a broad index product, the one for its outperformance, the other to broaden your exposure.

This second consideration brings us to the public official’s second question.  Yes, actively managed REITs tend correlate less with the stock market than do broad-based REIT index products.  This is because both the stock market and broad-based REIT investments have national exposures, and thus both reflect the health of the U.S. economy.  The same comparison applies to broad-based and narrowly based stock funds.  With a more narrowly based investment, you are implicitly betting on that narrow area over the broader economy.  There is nothing wrong with that strategy, of course, but know what you are doing when you seek to avoid correlation to the broader market in this way.

Investing with an emphasis on stability can offer less volatility even when narrowly focused.  Selecting such an approach or choosing a broad-based portfolio (similar to an index) to dampen volatility will depend on your particular objectives and preferences.  If you’re tempted to go with the narrower, actively managed alternative, be sure to compare its historic volatility record to the stock market or any other relevant comparison point.  And be sure that the calculations show lower amounts of volatility year-by-year over a long period of time, and not just over an unusually favorable period.

 

 

Mortgage-Backed Bonds

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Mortgage-backed bonds got a bad name during the 2008-09 financial crisis.  They were a large part of how bad mortgages made by banks infected the entire financial system, threatening the stability and well being of all of us.  Nevertheless, there is nothing particularly dangerous or devious about these instruments.

Essentially, these bonds are a way for investors large and small to participate in the usually superior interest rate returns available to mortgage lenders.  These bonds are created when banks and other mortgage lenders package the mortgages on their books into securities and sell them to investors in the broad bond marketMost of these bonds are divided into subgroups, called tranches.  Each tranche reflects a level of credit risk for that subset of mortgages in the bundle. Whether their underlying mortgages are risky or secure, these bonds effectively pass the payments made by the borrowers who take out the mortgages through to the holders of these mortgage-backed bonds.

You can buy mortgage-backed bonds directly through brokers or through mutual funds.  Some mutual funds specialize in these bonds, while others include them in a broader selection of offerings.  Although such bonds are similar to those described in this earlier post, they can have a special appeal for three reasons:

  1. Because mortgage borrowers usually pay higher interest rates than corporate borrowers, mortgage-backed bonds tend to pay higher yields than other bonds of comparable maturity and quality.
  2. The pass-through arrangements (mentioned above) pay out monthly, providing a more regular flow of income than conventional bonds, which usually pay semi-annually.
  3. Because mortgages pay down the principal on the loan in stages, bond owners also get part of their principal back with each payment, thus enriching the regular cash flow. (Most conventional bonds pay the principal back only when the bonds reach maturity.)  The drawback with mortgage-backed bonds is that there is no further payment of principal at maturity.

These bonds do have one unique risk.  When interest rates fall, many mortgage borrowers will take advantage and refinance.  Just as with bonds that have “call provisions.” Bondholders get paid in full, but they miss the benefit falling rates have on bond prices.  (For a discussion of call provisions and the price effects on bonds from falling interest rates, see this earlier post.)  But even recognizing this drawback, the other advantages of mortgage-backed bonds give them a distinct appeal to many investors.

If you want to hold mortgaged-backed bonds in your portfolio but remain wary because of memories of the 2008-09 financial crisis, you might consider buying Ginnie Mae bonds.  These mortgage-backed bonds are issued by the Government National Mortgage Association on behalf of the Federal Housing Authority (FHA) and the Veterans Administration (VA).  The US government backs them, making them as safe from default as possible, and they pay a slightly higher yield than Treasury bonds.  You can buy them directly from the US Treasury or through a broker in units of $25,000. Alternatively, you can buy into mutual funds that specialize in Ginnie Maes.

 

Options and Futures: A Consideration

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These instruments have a mixed reputation –– as something only for the very sophisticated investor, as dangerous, and in some circles as devices that can defy economic and financial laws.  There’s an element of truth in each description except the last.  I will not pretend that options and futures are simple, that they are for everybody or easy to use.  But they do not require a genius mind, and, even if you never use them, it pays to have a notion of how they work.

Basically, options or futures offer you the right to buy or sell a stock, bond, or commodity at a specific price under certain conditions on a specific date or during a specific period of time.  Options and futures are called derivatives because they “derive” their value from the underlying security or commodity they entitle you to buy or sell.

Futures

 Futures contracts are possibly the oldest financial instruments in the world. There is evidence that they existed in ancient Mesopotamia, thousands of years before the birth of Christ.  There they dealt with wheat, the ancient staple crop.  Farmers planting their fields would naturally worry they would not get a good price at harvest time. Speculators would contract to pay an agreed-upon price when the wheat was harvested –– regardless of the market price at harvest time.  The speculators effectively took on the risk of a loss should future market prices fall below the price they contracted to pay the farmers.  That risk was worth it, however, because the arrangement gave speculators a potential profit if market prices for wheat rose above the price they paid the farmer. Thus futures allowed speculators to bet on the future price of wheat while allowing farmers to use speculators to hedge the risk of falling prices, happy to exchange the chance of extra profit should wheat prices rise high for the surety of the guaranteed price offered by the speculators.

Futures retain this basic character today, but over time they have come to include minerals, copper, coal, gold, oil, etc., as well as crops and livestock.  There are futures tied to currencies and stock market indices.  In every instance, the principle of the ancient wheat farmer remains the same: One party wants to hedge market risk by securing a price in the future, and the other party is willing to promise that price and take on the risk of loss in the hope of getting a higher price at that future date.

Today, futures are sold on organized exchanges for specific “volumes” of a product –– bushels of wheat, tons of copper, and the like –– with set dates when they must settle.  These exchanges have rules on how much money speculators must put up to participate. Futures are bought and sold for a fraction of the amounts due when the time comes to buy or sell the underlying securities or commodities.  Because the ultimate commitment in dollar terms is huge, the average individual investor seldom uses futures directly.  However, many mutual funds participate in them on behalf of their investors.

Sometimes the standardized amounts and dates of expiration used on organized exchanges don’t meet the needs of large players who have in mind both different amounts and dates for settlement.  They have the alternative of tailoring what are called forward contracts.  Forwards work just like futures, but are organized around these different specifics.  They are most heavily used in currencies, typically timed to a point where for business reasons one of the parties to the contract needs to make a payment in a currency other than their own. 

Options 

Used mostly with stocks, options are more complex than futures and forwards. They come in two types:

  1. Calls: An investor sells another the right to buy a stock – to “call it” – at a certain price, called the strike price, within a certain period of time.
  2. Puts: An investor, in return for a received fee, gives another investor the right to force humor her to buy a stock at a certain strike price within a certain period of time.  In financial jargon, the first investor sells to the other investor the right to “put” the stock to him.

These options are bought and sold on organized exchanges for standardized periods of time.  They can vary in price, though they usually trade between 3 and 5 percent of the value of the underlying security.  The financial community has worked out many strategies for them to meet specific needs or expectations.  Here are two of the most common:

  • Covered calls: If you own a stock whose price is almost where you want to sell it, you could sell a call, “write” in financial jargon, on that stock at a strike price a little above the current market.  If the stock’s price then rises, you are just as happy to let the option holder call it, because you had already planned to sell at that higher price.  In the meantime, you capture the fee on the call you sold.  And if the price fails to rise, you keep the stock and the fee.
  • Put escape: (This is what I call it.) If you own a stock that might become very volatile, for instance a retailer heavily dependent on holiday spending, you may want to hold it for the upside generated by a good selling season. But because you fear the downside from a bad season, you can buy a put on the stock.  If the stock’s price falls, you have the option to put it to someone else at the strike price.  Rather than sustain a big loss, you lose just the fee you paid for the put option.  If the stock’s price rises, you can then enjoy the upside and forego the use of the put, happy to have paid the small fee on that put for the insurance against a big loss it offered in the interim.

It should be apparent that both futures and options have specific purposes for specific strategies.  For that reason alone, it is mostly professional investors who use them.  Because these instruments also generally involve larger amounts of money than most of us generally invest, they are far from a daily investment concern.  Still, everyone should have a notion of how they work, if only to avoid feeling intimidated when they come up in conversation, and to avoid getting involved when doing so would be unwise.

Real Estate Investment Trusts (REITs)

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Until now, my posts have focused almost exclusively on stocks, bonds, and bank accounts.  This is only reasonable, as most Americans, apart from the value of their homes, keep the bulk of their assets in these financial instruments.  But there are other investment vehicles: options, futures, currencies, and foreign investments of all sorts.  Future posts will look into each; this one focuses on real estate investment trusts (REITs).

REITs, though seemingly exotic, are actually straightforward investment vehicles.  They very much resemble stock and bond mutual funds except that instead of buying stocks or bonds on the investor’s behalf, REITs buy commercial real estate. Before 1960, when Congress passed legislation enabling REITs, the only way to invest in real estate was to buy properties directly, which presented considerable risk because few investors had enough money to diversify their holdings adequately among different sorts of properties and geographic locations.  Now, through the many REITs trading on major stock exchanges, investors have a way to buy into commercial real estate in smaller amounts and with greater diversification.

But diversification remains a critical consideration.  Because most REITs specialize in specific regions of the country, investors often have to consider investing in several to insure geographic diversification.  In addition, many REITs specialize in one type of property, such as shopping centers, commercial buildings, self-storage units, healthcare facilities, office buildings, and the like.  Here, too, you should consider investing in several to assure thorough diversification. Some REITs take on a lot of risk, while others are more cautious.  Before choosing, consider your own objectives and your tolerance for risk.

In addition to offering a way to bring real estate into your portfolio, the other major attraction of REITs is that they pay higher dividends than most common stocks –– often two or three times as much.  This is the outgrowth of the law that excuses REITs from taxes as long as they pay out, in dividends to shareholders, 90 percent of their annual income.  Because this generates a lot of annual income, many investors –– retirees especially –– are attracted to REITs.  Within reason, putting them in your portfolio is probably a good idea.  But investors must take care lest their desire for income seduces them to distort the diversification of their overall portfolio with too large an exposure to real estate.

As with any mutual fund, research any REIT you plan to buy.  Examine the prospectus to see how it approaches investing, what kinds of properties it buys, and their geographic distribution.  And look at its historic returns to determine whether the performance is worth the fees.

 

Should You Have an Active or Passive Portfolio

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Investors have debated seemingly forever the merits of active vs. passive management.  Passive investing aims to duplicate the movements of a major index, like the Dow Jones Industrial Average or, more likely, the S&P 500 stock index or sectors of an index or the European index or a composite of emerging markets indices. Active management attempts to improve on the performance of one or another of these indices. Active approaches can emphasize stock selection, timing market swings, rotating through sectors, or any one of hundreds of other techniques that aim to “outperform the benchmark index,” as the professionals say. A nearby box outlines the pros and cons of the two approaches.

Despite the endless argument, you must decide for yourself which approach best suits your objectives, inclinations, temperament, and tolerance for risk. Many investors mix the two approaches, using one for part of their portfolio and another elsewhere. (Full disclosure: This is the approach I use.)  For instance, you might use an S&P 500 index for the large capitalization U.S. stock holdings in your portfolio but use a more active approach for the small capitalization part, where specialized knowledge might have a bigger payoff than with large, well-known companies. The same sort of tradeoff might appeal in the divide between developed markets, where information is plentiful and widely disseminated, and emerging markets, where information and insights are harder to gather.

Once you decide, the financial community offers a variety of ways to proceed. Here are three primary alternatives:

  • You can buy individual securities and build a portfolio for yourself. Unless you have immense assets, any such effort will by nature have an active component.  Few people have the resources to run a passive portfolio for themselves, which would involve buying every security in an index in proportion to its weight in the index or employing elaborate, computer-based algorithms that can otherwise construct an index-tracking portfolio.
  • You can hire professional help dedicated to you: This route can be very expensive, whether you want a passive or an active approach. You could only justify the expense if you have immense wealth and very particular needs as well.
  • You can use mutual funds and ETFs: Mutual fund companies, both load and no-load varieties (as described in this earlier post) offer a wide array of active and passive portfolio strategies.  Should you want a passive approach, load funds become pointless, since the only justification for the extra fee is superior performance.  Many no-load mutual funds offer a variety of passive portfolios at remarkably low fees.  Since brokers have a hard time buying no-load mutual funds for their clients, you would have to approach these mutual funds directly to channel your portfolio in that direction.  Alternatively, many ETFs offer passive approaches that your broker would happily buy on your behalf.

 

Passive vs. Active

Passive

§  They almost always have lower fees and lower trading costs as well.

§  You always know how well your investments are doing.

§  Most active managers fail to beat the indices.  In the past 15 years, some 90 percent of active managers have actually lost to their benchmarks.  In other time periods more have done better, but seldom do more than 50 percent beat their benchmark.

§  Passive management offers reliability.  They track the index at all times and run none of the risk involved with losing key staff and so suffering performance setbacks.

 

 

Active

§  Some active managers do outperform their benchmarks.

§  Active outperformance tends to do best relatively in down markets, which can have a special importance to many investors.

§  Active management, whether you manage for yourself or hire professionals, can offer a greater sense of involvement.

§  Many active managers claim that there really is no such thing as a passive portfolio, since the indices they track are themselves something or an arbitrary assemblage of securities, though the index makers argue that they are representative of the broader market.

 

 


 

Computerized Trading and the Individual Investor

 

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I’ve been asked about computerized trading.  Sometimes called “program trading,” it was blamed for the market’s extreme movements late last month.  It is not the whole story, as I wrote in my post  at the time, but it was a factor.  My questioners ask if they should account for it in their trading.  The simple answer is: NO.  Here are four reasons:

  1. For all its high-tech associations,computer-based trading is really just a high-tech, algorithm example of herd behavior of the sort that has, in various forms, always typified financial markets. Investing in response to computerized trading only makes the investor one of a herd – never a way to make money in any financial area but especially so in stocks. Trying to anticipate the turn is akin to standing in front of a cattle stampede betting your life that you know when, and which way, it will turn.  You could get lucky, of course, but more likely you’ll be trampled.
  2. Program trading increases market volatility, exaggerating its moves up and down, but in general it has little impact on prices over time. To the fundamental investor seeking to meet the basic objectives described in this post and this one, it is an irritation, but should not be considered anything more.  The market in the closing weeks of 2018 demonstrates this: Computerized trading pushed the downdraft in stock prices much further than it otherwise might have gone, and then exaggerated the upswing the following day.
  3. Individual investors who buy into and out of stocks ahead of such swings are as likely to lose as to win.  Traders buying and selling algorithmically make money because computerized trading enables them to move blindingly fast––faster than most professional investors and certainly faster than any retail investor.  (In fact most of these operations have their computers physically near the exchange, because a profit opportunity can be missed in the time it takes to get an electronic order to the exchange from, say, an office in Connecticut.)  And even at such speed, they can only make money by squeezing pennies or less out of a single transaction; it is only worthwhile for them because they deal in inordinately large volumes of stock.
  4. Computerized trading violates a fundamental rule for the retail stock investor: Even without the added volatility of computerized trading, stocks exhibit considerable volatility. This fundamental aspect should warn investors off stock investing if there is any chance they will need their invested money in a hurry.  If you cannot wait for the ups and downs to cancel each other out and give you the long-term positive gain of stocks, then you should not be in them in the first place.  Go into bonds or savings accounts; look at this post for more detail.

 

This Is Not The Time to Panic

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Stocks have been having a rough ride.  In the last few weeks, prices have fallen into negative territory for the year. Last week, the media tells us, market indices have had their worst week in a decade.  But before panicking or accepting the media’s parallels to the financial crisis of 2008-09, investors should keep these  considerations in mind:

  1. Unlike 2008, financial markets today function well.  Back then, people were afraid to trade with each other, much less engage in deal-making.  Today, trading in stocks and bonds happens smoothly.  Investment banks continue to underwrite new issues of stocks and bonds, and a variety of financial institutions are lending to individuals and businesses.
  2. The economy is growing. And it’s growing well, in fact, and faster than at any point in the last ten years.  In 2008-09, the economy was entering what came to be known as the “great recession”: unemployment skyrocketed and businesses failed.  There are no signs of a downturn today.  Indeed, the gross domestic product (GDP) for the third quarter (the most recent period for which we have data) grew in real terms at an annual rate of 3.4 percent.  Yes, housing sales and construction have slowed, but nothing like the 2008-09 collapse. On the contrary, the present slowdown reflects a well-ordered and reasonable response to the rising costs of property and mortgage financing.  While it is also true that, with unemployment at new lows and productive capacity utilization in industry on the high side, growth prospects face limits, but no constraints are imminent.

Against this background, the market would seem more likely to rise in the new year than fall.  To see why, consider four factors that have brought it down during these last few weeks:

  1. First is the Federal Reserve (Fed), which has been raising interest rates gradually for years and continued to do so through December. Late last month, policy makers indicated that they were nearly done with this project, but when they raised rates again in December, investors were disappointed. They were further concerned that the Fed indicated further moderate interest rate increases in the new year. Because these recent market losses have already discounted these future rate-hikes, it is unlikely that prices will suffer much, or at all, when the actual rate increases happen.
  2. Fears for the future of the US economy have emerged.  To some extent, they reflect the constraints on productive capacity just mentioned.  But these fears are premature––the effects of capacity restraints will take time before they begin to substantially affect the economy.
  3. Economic fears reflect the prospect of a trade war between the United States and China.  A trade war would indeed be grave and it would threaten markets, but it is unlikely to happen.  China especially needs a trade agreement.  Nor does the Trump administration, despite its bravado, really want a trade war.  The likelihood then is a mutual accommodation within the next few months that will soothe market concerns.
  4. Because prices are down, seasoned investors are harvesting losses in these last few weeks of the year order to write them off against longer-term gains on their taxes.  For the moment, such selling exaggerates the downward pressure on stock prices.  But because these investors will put their money back to work in the market in the new year (called the January effect by financial professionals), markets should see an immediate lift in the opening weeks of the new year or by February at the latest.

Of course, there are risks.  Efforts to avoid an unwanted (by both sides) trade war with China could nonetheless fail. The Fed could change its monetary policy.  Some new fear might emerge among emerging economies — or in Europe, where everything seems to be in flux.  But interpreting today’s picture, investor panic seems ill advised.  Panic selling would lock in losses and make it difficult for these sellers to buy stocks in time to catch the market’s likely future gains.  Even if the rebound fails to develop, little on the horizon suggests a continuation of recent steep declines.