Investment Articles

Some ideas on Risk and investing

A friend of mine last week asked about buying some ETF’s. He knew I spent time buying stocks, but as he said, ” I don’t want anything exciting”. His view was buying ETF’s was less risky, and therefore better aligned with his investing goals and interests. I can’t argue with his thinking, but I am not sure it would suit my investing goals and interests. We are two different people.

Risk is often the specific factor that people will cite as to why they will not buy individual stocks but instead look for other avenues for saving and investing. The attraction of vehicles like ETF’s and mutual funds fulfill their need to be invested, but avoids them having to spend the time and worry of picking stocks. The diversification achieved through these vehicles creates the illusion of less risk, and in a steady market that is generally true.

I checked out iGoogle for a definition and it talks about risk as either a source of danger as well as the probability of a negative outcome. It also has two interesting examples that identify a risky investment or losing money. For the purposes specific to investing I would like to call it a measure that specifies the chance of an outcome not matching your expectations. If there is an 80% risk of rain bring an umbrella! If it is just 10% then you might be fine. The difference between investing and rain forecasts is you can have 0% chance of rain, but never 0% investment risk.

An investor gets paid for taking a risk with the general rule being, the more risk you take, the more money you make. The economy is based on this simple concept. If someone else uses your money they pay rent, or interest. The likelihood of you getting your money back determines how much interest you charge. This exact same concept applies to buying stock. If the risk is higher you expect, and demand a higher return for taking that risk.

Let’s start by examining a government Savings Bond. I did some poking around and found one that is paying a huge %0.65. That means a $100 bond held for 1 year pays you 65 cents. With government bonds there is almost no risk. You will absolutely get paid. This particular bond is also flexible. Part way through the year you can get your cash back. No interest, but, no problem either since you are not locked in. For a government bond you have not accepted much risk, so the money you are paid is tiny.

The better question to ask is “did you make money?” With an inflation rate at about 2% you need to make $2 on your hundred-dollar investment, just to stay even. In this case with only 65 cents you actually lost wealth since you can buy less with the money you took out after a year. You actually traded financial risk for inflation risk and lost.

Currency risk is an added factor to consider. Let’s consider an American that buys a Canadian Bond in February 2009 and now it is February 2011. You may be surprised to find you have a bonus gain on the exchange rate. In 2009 the Canadian dollar was trading at $0.80 cents against the American dollar. As of February 2011 they are close to parity. In 24 months you are up 20% due to the exchange rate. However, guess what happens to the Canadian buying an American bond. That is a 20% loss.

As a Canadian investor I was enjoying a subscription to an American investment newsletter a few years back and the authors were great. Every stock they highlighted went up at least 10%. Unfortunately because the Canadian dollar had gone up the value of my account had actually gone down. That was learning currently risk the hard-way.

Taking a look at the stock market, I started by using the stock filter at theglobeandmail.com and on the New York stock market I found 40 companies with a yield of 0.60%. Very close to the savings bond rate. I looked at Eldorado Gold with shares closing at $16.81 and an annual dividend of 10 cents per share. Over the last week this stock has been had a low of about $15.90 and a high of $17.00. If you bought it at the market low you would still be getting the 10 Cent dividends but you have only paid $15.90 per share. That is a slightly better yield of 0.629% so a few days can make a difference. For this stock the 52 Week high was $20.23. If you bought it then the yield was only 0.49%.

As I mentioned with the Savings Bond I used as an example you can get your cash out at any time. This is also true of a stock like Eldorado Gold, but, you may be at the market high of $20.23, or the 52-week market low of 11.39. As an example if you could buy partial shares, let’s say you bought $100 dollars of Eldorado at $16.81 for a holding of 5.949 shares of Eldorado and you sold them at the high of $20.23. That is a sell price of $120.34 or a 20% gain in addition to the 10-cent dividend per share. Clearly you are a genius in the markets. The bad news is you may have needed the money quickly and sold for the market low of $11.29. Now your $100 is only $67.16. Not good.

So the decision to make is, if you can see into the future, are you satisfied with the potential to make a 20% gain with the risk of a 35% loss. You need to follow some rules to limit your losses. Here are some of my best ideas.

1) Be faster to sell than to buy. Back to risk. If the outcome is not matching your expectation don’t be the last guy holding the bag.

2) Diversification. Do not to put all you eggs in one basket. Understand how to invest in different sectors, different types of investments, and for different time frames. But rule #1 still applies. Being diversified does not mean holding a lot of different losers.

3) Diversify your strategies. This includes how to pick stocks, working with options in a variety of ways and also learning about fundamental and technical analysis. You can also do a lot of reading on the difference between growth and income strategies.

4) Get advice. Along with get advice, also be aware of the source. Advice can come from a financial advisor a subscription newsletter or that well dressed guy on the elevator. Do you know their history of success? Are they getting paid for the advice they give you and does that payment affect the advice they give?

5) Have a Plan – Trade the plan. I prefer the notion that you buy a company to go on a journey of discovery. The discovery may be good news, or bad news, but if you know why you started, you will know when the trip is over. A trading plan mitigates risk because if the reason for the journey changes or the navigator gets lost, you can get out of the car.

Try this for yourself. Use the above rules and apply them to each position you currently hold. Why did you buy it and on who’s advice? How long has it been since you checked to see if the advice still applies? What was the purpose of the journey and has the company arrived there yet? For both the market sectors, and strategies you have used are you diversified? You now have a choice. If you don’t have the answers to these questions, then perhaps you should consider some savings bonds. Your portfolio is suffering the one other risk not discussed here – unknown risk. That type of risk is very hard to manage.

Greg is a retail investor with over 25 years of sketchy success in the markets. As penance for not following any rules for most of his investing life he now looks for and writes about simple ways the self directed investor could have more success that he did at Stock Trading Options

When considering investments of any type, the bottom line is of course the most important. But one of the very attractive advantages of alternative investments and overseas retirement is that they are not just digits on a screen. Frequently, they also carry significant fringe benefits that, while not contributing directly to the bottom line, play an important role in the investment itself and in the investor’s longer term strategic planning.

These fringe benefits may be pure fun, or perhaps social status – like inviting friends over to sample the latest vintage from your own winery. But as the traditional financial system remains far from predictable, and the outlook for the rest of 2010 remains gloomy, you might be surprised to learn that savvy investors are turning in droves to alternative Latin-American investments as a conservative ’safe haven’ for serious international asset protection purposes.

Longtime international speculator Doug Casey, who authored The International Man back in 1976, recently wrote that “a wise man… doesn’t allow himself to be limited by an accident of birth.” Casey predicts that we are “heading into a currency crisis for the record books, and I think you can plan your life around some type of foreign exchange controls. If you don’t get significant assets out of your home country now, you may soon find it costly and very difficult to do so.”

Whether you agree with that prediction or not (I do, by the way!), there are several very good reasons to diversify into hard international assets – things like real estate or physical gold bullion.

For a start, there are the tax benefits. If you are managing an investment portfolio today, chances are your geographic location is not really that important. Day-to-day management of your portfolio can be carried out from anywhere there is a laptop and broadband. So more and more investors and managers have realized that they just don’t need to be located in a high tax, high cost country.

The majority of Latin American countries have territorial tax systems – meaning that if you are officially resident there, you are only taxable on your local source income. Anything you do outside the country of residence is tax free as far as they are concerned, so you don’t even need to bother declaring it. This contrasts starkly with North America and Europe where the rule of thumb is that your home country taxes you on your worldwide income.

By living – even part time – in one country while overseeing investments in another, you can therefore legally slash your tax bill at a stroke. Some countries, like Uruguay and Panama, are particularly attractive in this regard, having passed business-friendly legislation designed specifically to attract this kind of international investment management business. They recognize that even though it doesn’t produce tax revenue directly, it stimulates the local economy and provides work for local professionals, banks and businesses.

Other countries like Costa Rica and Belize offer ‘pensionado’ or ‘qualified retired person’ programs that grant specific tax exemptions to retired foreigners taking up residence. If you don’t feel ready to retire yet, bear in mind that some of these ‘retirees’ are much younger than you might expect – qualifying for the programs simply by proving that they have sufficient regular income from abroad to maintain a quality lifestyle. ‘Retirement’ to them might mean waking up to the sound of the ocean in their beautiful beachfront properties, logging on to check how much money they made overnight, working on the internet for a few hours a day, and travelling a few days a month to oversee their investments in person.

Ah, I hear you saying, but there is one big problem with this strategy – if you happen to be a US citizen. The USA is the only country in the world that taxes its non-resident citizens. A Brit or Canadian who moves his official residence to Belize or Uruguay won’t have to worry about home country taxes any more, but his American cousin will.

But it’s not quite as dire as it sounds. There are still substantial benefits to Americans living overseas, that a competent international tax lawyer can help you with. In the end, however, the only way Americans can legally unshackle themselves completely from the IRS is by renouncing US citizenship.

Many are doing just that. But before taking the drastic step of giving up a US passport, another citizenship is required. Millions of US citizens are actually entitled to European or other passports based on ancestry, though the bureaucracy involved can be quite lengthy. That’s why the Caribbean states of Saint Kitts and Nevis and the Commonwealth of Dominica both offer ‘economic citizenship’ programs, effectively ’selling’ citizenships and passports for hundreds of thousands of dollars. Years ago most of the takers were Russians, then came the Chinese, but today most of the buyers are Americans who are renouncing citizenship to become tax exiles.

All this brings me to another big fringe benefit of investing in Latin America: most Latin American countries are relatively liberal when it comes to naturalization – the granting of citizenship based on a period of residence or other ‘connection’ with the country. 2-5 years is the norm. This already short period can often be speeded up even more based, for example, on marriage or on birth of a child in-country. Frequently the processing time on top of the officially-designated residence period can be a year or more – but one has to consider that citizenship via this method is almost free.

Demonstrating some connection with the country is a necessity, but this requirement can be easily fulfilled by owning real estate or investing in a local business. So smart second citizenship seekers should be looking for attractive business opportunities in Latin America rather than investing hundreds of thousands on small, hurricane-prone islands in the Caribbean.

The biggest benefit of going global for me, however, is intangible. If I had to sum it up in a word, it would have to be ‘freedom.’ Difficult economic times generally see governments resorting to patriotic calls to ‘unite’ and ‘pull together’ – something that usually ends up as ‘do as I say not as I do.’ The ’strong leadership’ demanded by the majority in these times is bad news for entrepreneurs, libertarians, classical liberals, and all those who love freedom.

Doug Casey suggests that you should at least consider the possibility of transplanting yourself, or at least start by transplanting some assets. “Don’t look at it as a negative thing,” he says. “The world is your oyster. Make the most of it.”

Although bureaucracy in Latin America can be overwhelming at times, it is relatively easy to cut through. There is less regulation than in the US in particular, and more reliance on common sense and individual responsibility. People don’t sue each other over the least little thing.

Doug is currently involved in developing a community for like-minded individuals in northern Argentina, not too far from Bolivia and Paraguay. The idea being that with the world in constant commotion, it’s good to have a ‘Plan B’ – a place far from the madding crowd that is entirely self-sufficient in terms of food, water and energy – and even wine!

The buyers in such communities, many of whom I have had the pleasure of meeting, are not crazy doomsayers. Most of them are patriotic Americans, serious investors and hard-working entrepreneurs, who hope things will never get that bad – but they sleep sounder at night knowing they have a bolt-hole prepared and assets in place if the worst case scenario plays out. And, lest we forget, they are hoping to pocket a healthy profit on their Latin American real estate investment over the medium to long term.

As with any investment, due diligence in this area is extremely important. But next time you check out an investment, remember to look around for the hidden fringe benefits as well as the cold, hard figures. Treat it not just as a way to increase the number of dollars in your bank account, but as a way to diversify, learn and protect the assets of your family by investing in something with a built-in ‘insurance policy.’

Author Peter Macfarlane is acknowledged as a leading writer and public speaker on expatriation, residence and citizenship planning, offshore banking and asset protection matters. He is joint editor of The Q Wealth Report, a privately-published newsletter based in Switzerland covering freedom, wealth protection and privacy issues for readers he describes as “free + thinking + individuals.” Visit the Q Wealth Report to read more articles like this, sign up for free offshore living news in the weekly ‘Q Bytes’ e-mail newsletter, or read Peter’s five part course on offshore banking and investing, expatriation, asset protection, second citizenships.