Avoiding the Stock Market Can be a Risky

Jane Young, CFP, EA

Jane Young, CFP, EA

You may be hesitant to invest in the stock market because it feels too risky.  However, consider the risk you are taking with your financial future by avoiding the stock market.  The primary reason to invest in the stock market is the potential for a much higher return, especially in low interest rate environments.  Most of us need the potential for long term growth provided by the stock market to meet our retirement needs.  If you invest all of your money in fixed income you may struggle just to keep up with inflation and you run the risk of outliving your money.

Historically, stock market returns have been almost double those earned by bonds.  According to the Ibbotson SBBI (stock, bonds, bills and inflation) report, between 1926 and 2014 the average annual return on Small Stock was 12.3%, Large Stock was 10.1%, Government Bonds was 5.5%, Treasury Bills was 3.5% and Inflation was 3%.  This illustrates that investing at least some of your portfolio in stock can provide a much greater opportunity than fixed income to meet your financial goals.

Investing in the stock market is not without risk.  As with all investments, we must take on greater risk to earn a greater return.  However, there are many ways to help manage the volatility of the stock market.  Before investing in stocks make sure your financial affairs are in order.  Pay off your credit cards, establish an emergency fund and put money that will be needed over the next five years into less volatile fixed income investments.  The stock market is for long term investing.  It can provide the opportunity to earn higher long term returns but you can count on some volatility along the way.  By creating a buffer to cover short term needs you will be less likely overreact to fluctuations in the market and sell when the market is down.

You can also buffer stock market risk by creating a well-diversified portfolio comprised of mutual funds invested in stocks or bonds from a variety of different size companies, different industries and a variety of different geographies.  Investing in a single company can be very risky but investment in mutual funds can reduce this risk.  When investing in mutual funds your money is combined with that of other investors and invested, by a professional manager, into a large number of stocks or bonds.  Investing in a large number of companies enables you to spread out your risk.

Dollar cost averaging, where you automatically invest a set amount on a regular basis – usually monthly or quarterly, can also reduce risk.  Rather than investing a large amount all at once, when the market may be high, you gradually invest over time.  With dollar cost averaging you buy more shares when the market is low and fewer shares when the market is high.

Selecting the Right Asset Allocation

Jane Young, CFP, EA

Jane Young, CFP, EA

When investing money, one of the first decisions to be made is your asset allocation.  Asset allocation is the division of your assets into different types of investments such as stock mutual funds, bonds, real estate or cash.  In order to maximize the return on your portfolio it’s crucial to maintain a well-diversified asset allocation.  According to many financial experts, asset allocation may be your single most important investment decision, more important than the specific investments or funds that you select.

There is no one size fits all; the right asset allocation is based on your unique situation which may change as your circumstances or perspective changes.  Some major factors to consider include investment time horizon, the need for liquidity, risk tolerance, risks taken in other areas of your life and how much risk is required to achieve your goals.

Arriving at the appropriate asset allocation is largely a balance between risk and return.  If you want or need a higher return you will have to assume a higher level of risk.  If you have a long investment time horizon, you can take on more risk because you don’t need your money right away and you can ride out fluctuations in the market.  However, if you have a short time horizon you should minimize your risk so your money will be readily available.

If you want to minimize risk, invest in fixed income investments such as money market accounts, certificate of deposits, high quality bonds or short term bond funds.   If you are willing to take on more risk, with the expectation of getting higher returns, consider stock mutual funds.  Generally, avoid investing money needed in the next five years into the stock market.   However, the stock market is an excellent option for long term money.

Regardless of your situation, the best allocation is usually a combination of fixed income and stock mutual funds.  With a diversified portfolio you can take advantage of higher returns found in the stock market while buffering your risk and meeting short term needs with fixed income investments.

Once your target asset allocation is set, rebalance on annual basis to stay on target.   Rebalancing will automatically result in selling investments that are high and buying investments that are low.  Avoid changing your target allocation based on emotional reactions to short term market fluctuations.    Stick to your plan unless there are major changes in your circumstances.

If you are unsure where to start, a good rule of thumb is to subtract your age from 120 to arrive at the percentage you should invest in stock market.  In the past it was customary to subtract from 100 but this has increased as life expectancies and the time one spends in retirement have increased.   In the final analysis, select an asset allocation that meets your specific needs and gives you peace of mind.

Mutual Funds Probably Better Option Than Individual Stocks

 

Jane Young, CFP, EA

Jane Young, CFP, EA

Mutual funds are a better option than individual stocks for most investors.  The decision to invest in mutual funds or individual stocks depends on the size of your portfolio, your investment knowledge, your level of time and involvement, your risk tolerance, your ability to make objective investment decisions and your tax situation.

Many investors don’t have enough money to adequately diversify their portfolio across a wide range of individual stocks.   To gain true stock diversification, you need to invest in companies of different sizes, in a wide range of different industry sectors and in a variety of different geographies. Mutual funds enable you to gain this broad diversification by pooling your money with a large number of other investors.

Additionally, mutual funds are professionally managed, making them ideal for individuals with limited investment knowledge or a limited amount of time to research and monitor individual stocks.  Most mutual fund companies have a large staff of managers and research analysts who analyze financial reports, visit companies and keep tabs on the economic and political climate.  It is very difficult for most     investors to devote the time and commitment needed to create and maintain a well-diversified portfolio of individual stocks.

Professional managers also have access to more timely information.  Many investors are tempted to buy and sell individual stock based on current events.  However, the market is relatively efficient which means it quickly responds to new information.  What seems like breaking news has probably already been factored into the price of the stock.

Unfortunately, diversification and professional management does not come without a cost.  Most mutual funds charge an annual management fee of between .25 and 1.25%.

Additionally, when investing your own money it is hard to stay objective.  We have a natural inclination to emotionally react to changes in the market and to become emotionally attached to specific stocks.  It is easier for mutual fund managers to make objective decisions.  Performance is usually better when we stay on course and history shows us that investors in individual stocks trade more frequently than mutual fund investors.

Mutual funds can also be a better option for investors who are risk adverse. By investing in a broadly diversified portfolio of mutual funds, most of your risk will come from fluctuations in the market.  A portfolio comprised of several individual stocks is generally more volatile.  It also carries a higher risk of losing money if a company, whose stock you own, has financial problems or goes out of business.

A disadvantage to owning mutual funds, instead of individual stocks can be a lack of control on when you pay capital gains. This is especially true if you are in a high tax bracket and a lot of your money is invested outside of retirement accounts.  When fund managers sell stock, gains must flow through to the investors as they are earned, not when the fund is sole.

Asset Allocation – the Foundation of Your Portfolio

Jane Young, CFP, EA

Jane Young, CFP, EA

Your asset allocation serves as a foundation from which to build your investment portfolio.  An asset allocation identifies the types of investments and the proportion of each you plan to hold in your portfolio.  At a very general level most investments are broken into three categories: stocks, interest earning, and real estate.  Each of these broad categories can be broken down further into hundreds of different options.   The two factors that usually drive an asset allocation are the timeframe in which you will need your money and your personal risk tolerance.  Generally, we strive for a diversified portfolio that provides the highest rate of return for the level of risk we are willing to take.

The first step in developing an asset allocation is to evaluate your current situation and determine when the money you are investing will be used.  Money that is needed in the short term should be placed in interest earning investments, not in real estate or the stock market.  Interest earning investments, such as money market accounts and CDs, are secure but usually provide a rate of return below the rate of inflation.  While it’s important to keep your short term money safe, too much in interest earning investments will stifle the long term growth potential of your portfolio.

Once your short term money has been secured, you can create a diversified portfolio that supports your investment timeframe and risk tolerance.   A great way to diversify is through the use of low cost mutual funds.  Mutual funds enable groups of individuals to pool their money to buy a large number of different companies or government entities.  Mutual funds enable you to maintain a diversified asset allocation by investing in funds with different objectives.  Consider selecting funds that invest in a variety of stocks and bonds in large, medium, and small companies within different industries and different geographical regions.  Your goal is to maintain diversification so that when one category is doing poorly it may be offset by another category that is performing well.   A diversified asset allocation allows you to spread out your risk so you don’t have dramatic losses if a given company or asset class performs poorly.   Additionally, by spreading your asset allocation over a broad range of investments, you may have opportunities that would have been too risky in an undiversified portfolio.

Your asset allocation is the framework of your portfolio – establish a plan that meets your objectives and stick with it!  Avoid making changes to your asset allocation based on emotional reactions to short term changes in the market.   Over time, your portfolio will get out of balance due to fluctuations in the market.   I recommend adjusting your portfolio by rebalancing on an annual basis.  In addition to keeping your asset allocation on target, the need for rebalancing will result in selling stock when it is high and buying when it is low.

Investment Risk Comes in Many Forms

Jane Young, CFP, EA

Jane Young, CFP, EA

One of the first steps when investing money is evaluating your tolerance for risk.  The amount of return you can earn is heavily dependent on how much risk you are willing to take.   We generally associate investment risk with market risk, or the possibility of losing money due to fluctuations in the stock market.   The stock market is volatile and can be a high risk investment if you have a short time horizon.  However, over long periods of time, the stock market has trended upward.  It’s important to consider your tolerance for stock market risk when building your portfolio.  However, the risk of losing money due to a drop in the stock market is only one of many risks that can adversely impact your financial security.

Although fixed income investments are generally considered safer than the stock market, they are not without risk.  Fixed income investments can include CD’s, bonds, bond funds and cash accounts such as money market or savings accounts.  The most common types of risk associated with fixed income investments are interest rate risk and default risk.

Interest rate risk is the possibility of your bonds dropping in value when interest rates increase.  When interest rates increase, the value of an existing bond decreases to compensate for higher interest rates available on the market.  Generally, if you buy and hold an individual bond till maturity, you will get back the full face value plus any interest that was earned.   However, when you own a bond fund,  you don’t have control over when bonds within the fund are sold.  When interest rates rise, bond managers may be forced to sell bonds at inopportune times due to the large number of withdrawals.

Individual bonds have less interest rate risk than bond funds, but they have a higher degree of default risk.  Default risk is the possibility of losing your principal if the bond issuer becomes insolvent.  Bond funds are able to reduce the default risk by pooling your money with others and investing in a large number of different companies or municipalities.

 Treasury bonds and FDIC insured CD’s provide what is generally considered a risk free rate.  If held to maturity, there is very little chance of losing principal.  Your investment is insured by the Federal government against default risk, and you have control over when you sell.  The primary downfall with this type of investment is the extremely low rate of return.

Investing too much in extremely safe, low earning investments often results in inflation risk.  Money placed in “safe” investments with a low rate of return can’t keep up with inflation, resulting in a negative real return.   You also lose the opportunity to earn a reasonable rate of return needed to grow your retirement account.   It’s all about balance; you need to take some market risk to build and maintain your retirement account and stay ahead of inflation.

How ETFs Differ from Mutual Funds

 

Jane Young, CFP, EA

Jane Young, CFP, EA

ETFs (Exchange-Traded Funds) and mutual funds are investment vehicles that enable investors to pool their money to buy a collection of stocks or bonds.   This makes it practical for the average investor to diversify their holdings across a large number of companies or entities.   Mutual funds can be actively or passively managed.   Generally, ETFs are passively managed and are designed to represent a specific index or category of securities, similar to an index mutual fund.   ETFs are especially useful in focusing on narrow sectors of the market that frequently aren’t offered by mutual funds.   ETFs can be especially useful to invest in a specific country or industry sector.

Mutual funds and ETFs differ in how they are traded.  Mutual funds are bought and sold through a mutual fund company.   ETFs are bought and sold on the market, between investors. Shares in a mutual fund are traded based on the price at the close of the day.   ETFs can be traded throughout the day, anytime the market is open.  This is similar to the manner in which individual stocks are traded.  

Generally, ETFs have lower fees than mutual funds because of lower overhead costs.  This is especially true when comparing ETFs to actively managed mutual funds.  However, when you purchase an ETF you must pay a brokerage fee every time a transaction is made.  Mutual funds may be more efficient if you are planning to dollar cost average, or buy shares over a period of time.

Due to structural differences, ETFs can provide greater tax efficiencies than mutual funds.  ETFs are traded on the market between investors, much like individual stocks.   When investors buy and sell shares of ETFs, shares are exchanged between one another; there is no taxable sale of stocks or bonds within the ETF.  On the other hand, mutual funds are traded within a mutual fund company.  If several investors decide to sell, the manager may be forced to sell stock or bonds within the fund to cover the redemption.  This is a taxable event that may result in capital gains that must be passed on to the shareholders.

Additionally, the structure of an ETF allows for the creation and redemption of shares with in-kind transactions.   Capital gains taxes are avoided because there is no taxable sale of stocks or bonds within the ETF when an in-kind redemption is done.

Finally, ETFs are generally tax efficient because they are passively managed, similar to an index fund.  Passively managed investments track to an index and don’t do a lot of trading.  With less trading, the investor should incur less capital gains while holding the ETF.   Mutual fund investors can also minimize their exposure to capital gains by purchasing index funds and tax efficient funds that do minimal trading.  Both Mutual Funds and ETFs that invest in bonds or dividend paying stocks must pass interest and dividend income on to shareholders.

The Pitfalls of Market Timing

Jane Young, CFP, EA

Jane Young, CFP, EA

Market timing is one of the most detrimental ways an investor can negatively impact his stock market returns. History shows that investors do not effectively time the market. For the last nine years, DALBAR, Inc., a market research firm, has conducted an annual study on market returns called the Quantitative Analysis of Investor Behavior (QAIB). This study has consistently found that returns earned by the individual investor are significantly below that of the stock market indices. The 2013 QAIB report found that during the 20 year period between 1998 and 2012, the average mutual fund investor lagged the stock market indices by 3.96%. This is a significant improvement over the period between 1991 and 2010, in which the average investor lagged the mutual fund indices by 5.1%. According to Dalbar, “No matter what the state of the mutual fund industry, boom or bust: Investment results are more dependent on investor behavior than on fund performance. Mutual fund investors who hold on to their investments are more successful than those who time the market.”
The stock market is counterintuitive in that the best time to sell is usually when the market seems to be doing well, and the best time to buy is usually when the market is doing poorly. As investors, our decisions are frequently driven by emotion rather than cognitive reasoning. We frequently overreact to emotions of fear and greed which throws numberswiki.com

us onto an investment roller coaster. When the stock market goes up we start to feel more and more optimistic, and as the market rises higher we get caught up in a state of euphoria. Our sense of greed kicks in and we don’t want to miss the opportunity to make money, so we buy when the market is high. The market may stay up for a while but eventually the economic cycle changes and stock prices start to drop. Initially we rationalize that this is temporary, or just a minor correction. As the market continues to drop we become more and more concerned. Soon our sense of fear kicks in, we start to panic and we sell at the wrong time. If we don’t recognize the dangers of this emotion driven cycle we are deemed to repeat it.
In addition to our intrinsic emotional response, we are bombarded by sensationalized news and advertising campaigns to influence us to change the course of our investment strategy. Don’t get caught up in the hype about the next big investment craze. Your best course of action is to develop and follow an investment strategy that supports your tolerance for risk and investment timeframe. The stock market is volatile and is best suited for long term investing. Time is needed to absorb fluctuations in the market. Keep short term money in fixed income investments. You will be less tempted to time the market in a well-diversified portfolio specifically designed for your investment time horizon.

Understanding Mutual Fund Fees

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Jane M. Young, CFP, EA

When investing in mutual funds it is important to be aware of the associated fees.  High fees can significantly impact your total investment return.   All mutual funds have operating expenses and some have sales fees, commonly known as a load. When you invest in mutual funds you have a choice between load and no-load funds.   A mutual fund load is basically a commission charged to the investor to compensate the broker or sales person.   As the name implies, no-load funds do not charge a sales fee.

The first type of load fund is an A share fund, where you pay a front end sales charge plus a small annual 12b-1 fee.   A 12b-1 fee is a distribution fee that covers marketing, advertising and distribution costs.  The typical front-end load is around 5%, but can go as high as 8.5%.  Class A shares offer breakpoints that provide you with a discount on the sales load when you purchase larger quantities or commit to making regular purchases.  The 12b-1 fee associated with most A shares is generally about .25% annually.

The second type of load fund is a B share, where you pay an annual fee of around 1% plus a contingent deferred sales charge (CDSC), if you sell before a specified date. The CDSC usually begins with a fee of 5% that gradually decreases over five years.  After five years or so the fund converts to an A share fund.  The actual percentages and timeframes may vary between fund families.  Most mutual fund companies have stopped offering B share funds because they are usually the most expensive option for the investor and the least profitable option for the mutual fund company.

The third type of load fund is a C share that charges a level annual load, usually around 1%.  This is on-going fee that is deducted from the mutual fund assets on an annual basis.

Generally, any given mutual fund can offer more than one share class to investors.  There is no difference in the underlying fund.  The only difference is in the fees and expenses that the investor pays.

All load and no-load mutual funds charge fees associated with the operation of the fund.  The most significant of these expenses is usually the management fee which pays for the actual management of the portfolio.  Other operations related fees may include administrative expenses, transaction fees, custody expenses, legal expenses, transfer agent fees, and 12b-1 fees.

These annual fees are combined and calculated as a percentage of fund assets to arrive at the fund’s expense ratio.  The expense ratio is an annualized fee charged to all shareholders.  The expense ratio includes the fund’s operating expenses, management fees, on-going asset based loads(C shares) and 12b-1 fees.  The expense ratio does not include front-end loads and CDSCs.   According to Morningstar the average mutual fund expense ratio is .75%.

 

 

Mutual Funds May be Your Best Option

 

 

 

 

 

 

Jane M. Young

Generally the typical investor is better off investing in stock mutual funds than in individual stocks. A mutual fund is an investment vehicle where money from a large number of investors is pooled together and invested by a professional manager or management team.  Mutual fund managers invest this pool of money in accordance with a predefined set of goals and guidelines.

One of the primary benefits of investing in stock mutual funds is the ability to diversify across a large number of different stocks.  With mutual funds, you don’t need a fortune to invest in a broad spectrum of stocks issued by large and small companies from a variety of different industries and geographies.  Diversification with mutual funds reduces risk by providing a buffer against extreme swings in the prices of individual stocks.   You are less likely to lose a lot of money if an individual stock plummets. Unfortunately, you are also less likely to experience a huge gain if an individual stock skyrockets.

Another benefit of stock mutual funds over individual stocks is that less time and knowledge is required to create and monitor a portfolio.  Most individual investors do not have the time, expertise, or resources to select and monitor individual stocks.  Mutual funds hire hundreds of analysts to research and monitor companies, industries and market trends.   It is very difficult for an individual to achieve this level of knowledge and understanding across a broad spectrum of companies.  Mutual fund managers have the resources to easily move in and out of companies and industries as investment factors change.

Most individual investors appreciate the convenience of selecting and monitoring a diversified portfolio of mutual funds over the arduous task of selecting a large number of individual stocks.   Stock mutual funds are a good option for your serious money.  However, if you really want to play the market and invest in individual stocks, use money that you can afford to lose.

For diehard stock investors, there are some advantages to investing in individual stocks.  Many stock mutual funds charge an annual management fee of between .50% and 1% (.25% for index funds).  With individual stocks, there is a cost to buy and sell the stock but there is no annual management fee associated with holding stock.

Another advantage of individual stocks is greater control over when capital gains are recognized within a non- retirement account.  When you own an individual stock, capital gains are not recognized until the stock is sold.   In a high income year, you can delay selling your stock, and recognizing the gain, to a year when it would be more tax efficient.   On the other hand, when you invest in a stock mutual fund you have no control over capital gains on stock sold within the fund.  Capital gains must be paid on sales within the mutual fund, before you actually sell the fund.  Mutual funds are not taxable entities, therefore all gains flow through to the end investor.

What You Should Be Doing Now!

Jane M. Young CFP, EA

1. Start by re-evaluating your monthly expenses to determine how much money you need for necessary expenses. Then determine how much you have remaining after you cover these expenses.

2. During difficult economic times, like the present, most people should maintain an emergency fund of at least 6 months of expenses. If you have an exceptionally secure job you may be able to drop it down to 3 months. Always be sure to sure to maintain an adequate emergency fund.

3. Once your emergency fund is established pay off any high interest credit cards.

4. Put aside money for special one time expenses such as a new roof, a new car or a down payment on a house. If you don’t own your own home give some serious consideration to saving up to buy one. Decide how much you want to save on a monthly basis and start a systematic savings plan.

5. Now you can start investing! Determine how much you can afford to invest on a monthly basis. Most people should start by investing in their company retirement plan up to the level that the company will match. If you can afford to invest beyond the level of your company match, invest up to the maximum allowed in a Roth IRA. This should be done on a monthly basis to take advantage of dollar cost averaging – investing the same amount every month. The 2009 contribution limit for a Roth IRA is $5,000 if you are under 50 and $6000 if you are over 50. There is an income limit on your eligibility to contribute to a Roth IRA based on your adjusted gross income. For 2009, your eligibility to contribute begins to phase-out at $166,000, if you are married filing jointly and $105,000 if you are single.

If you still have money to invest after maximizing your Roth IRA, resume contributing to your company retirement plan up to the maximum amount. The maximum contribution limit for a 401k in 2009 is $16,500 if you are under 50 and $22,000 if you are over 50.

Invest your money in a diversified set of mutual funds. Establish an asset allocation consistent with your timeframe and risk tolerance. For most individuals this will vary from 50% to 80% in stock mutual funds, with the balance in fixed income investments. The market is still priced very low and it is a great time to buy stock mutual funds. However, the market will be very volatile over the next 6 – 9 months. Dollar cost averaging into your retirement plans will help you take advantage of this volatility.

This is very general advice and everyone’s situation is unique. Treat this advice as a general guideline and adapt it to your own situation or consult a Certified Financial Planner for guidance.