Investment Articles

This article focuses primarily on real-asset investments, and this section is designed to highlight some of portfolio planning characteristics of physical assets when considered as part of a well-diversified and balanced portfolio of investments, as well as some of the inherent risks to be considered when allocating investment capital to specific, niche investment sectors or projects.

Whilst real or hard-assets offer a number of significant benefits including reduced volatility, tangible asset values and the potential for superior investment performance that is not reliant on the performance of traditional financial investments, potential investors must give equal consideration to the potential for relative illiquidity, operational or management risks specific to the asset class, and of course counterparty risk exposure when investing in assets that require on-going expert management in order to maximise returns and minimise downside potential.

Portfolio Planning Advantages

Every asset class exhibits different characteristics when considered from the point of view of an Investor or Financial Planner, and Investors invariable choose to invest in specific assets in order to achieve specific goals such as risk mitigation, portfolio insurance, superior returns and a hedge against inflation or some other potential economic impact on the value and performance of their portfolio.

Here we look at some of the broad portfolio planning characteristics associated with a range of physical assets considered as alternative investments.

Capital Values

By their very nature, physical assets retain a disposal value throughout most economic circumstances, and whilst asset values will fluctuate from time to time, Investors allocate capital to hard-assets in order to underwrite the value of their portfolio and insure against the possibility of the values of listed financial assets falling sharply at any given moment. In fact, certain assets such as gold hold a ’safe-haven’ appeal, often rising in value when stock markets falls as Investors sell equities and buy gold.

Non-Correlated Returns

The fundamentals that support value growth and income associated with real-assets are often far removed from the fundamentals that support traditional investments. Often, alternatives share a direct negative correlation with the performance of equities and bonds, affording investors the opportunity to balance their portfolios and make gains when other portfolio components lose value or underperform. This strategy is sometimes referred to as portfolio insurance.

Diversification

Key to risk-mitigation in financial planning, diversification simply means spreading ones investment risk across abroad selection of holdings, reducing the likelihood that too many eggs are held in one proverbial basket. Diversifying an investment portfolio into a range of holding across different sectors and assets reduces the risk that poor performance in any one asset will have too big an impact on the portfolio as a whole.

Inflation Hedge

A number of alternative investment assets share a strong positive correlation with inflation, rising in value faster than the prevailing rate of inflation. This effectively mitigates the impact of inflation on the real value of investment portfolios. Pension funds and university endowments, along with insurance companies and other institutional investors buy into long-term investment assets such as farmland and forestry for this very reason.

Superior Returns

As detailed in the chart overleaf, many alternative investment assets have outperformed traditional investment assets over the long-term by some considerable margin. Whilst all sectors and strategies carry inherent risk, carefully selected and well-managed real-assets have been shown to generate superior investment returns for the Investor capable of tolerating short term price fluctuations and long-term investment horizons. Operational asset like property also generate income useful when other income assets like cash deposits underperform.

David Garner is Partner at DGC Asset Management, an alternative investments boutique specialising in property transactions in the agriculture and renewable energy sectors.

When you think of investment risk, what comes to mind? Is it the recent volatility of the stock markets – up one minute, down the next? How about speculative investment derivatives, such as options or futures contracts, used to bring down Barings Bank in 1995, or the more recent occurrence in September 2011 when the Swiss Bank UBS lost over $2 billion (yes, that’s billion with a “B”!). And who hasn’t heard of Bernie Madoff and his Ponzi scheme, considered to be the largest financial fraud in US history. Makes one want to hide their money in their mattress and forget about it. Or does it?

Yes, these are definite investment risks. But there are others most people don’t know about that should be taken into consideration when choosing your investments. Unfortunately, there is no such thing as a “risk-free” investment, and your individual situation will determine how much risk you can, or should, accept.

Here are some additional risks you should consider and how you may be able to minimize them:

Market Risk

The most obvious, and most talked about these days, is market risk, otherwise known as systematic risk. This is the risk that the value of an investment portfolio will decrease due to a change in factors that determine the entire market. Interest rate changes, recessions, wars, and, more recently, the European debt crisis, affect the entire market and cannot be avoided by diversification. In other words, owning the stocks of several different companies will not eliminate this risk as all stocks will likely move in the same direction in the event of bad news… down!

Company/Industry Risk

Also know as un-systematic risk, company risk can be diversified away as it is the risk to an individual company or industry, not to the market as a whole. For example, by owning the stocks of several different companies in different industries, un-systematic risk will be reduced if factors negatively affect only a few of the companies you own.

Country/Currency Risk

Country risk is the risk of investing in a country which could be adversely affected by its political and economic environment, in addition to exchange rate, sovereign and transfer (the risk of capital being frozen by government action) risks. With emerging markets being popular investment choices these days, keep these risks in mind when deciding where and how to invest. Currency risk is the potential loss arising from the change in one currency relative to another. If you are a Canadian and have stocks in the US, the total return is determined by both the return on the stocks, as well as the change in the exchange rate of the US to the Canadian dollar.

Reinvestment Risk

Normally used in the context of bonds, reinvestment risk is the risk of having to reinvest future proceeds at a lower return. This will usually occur during times of falling interest rates, where interest payments can only be reinvested at rates lower than the original yield to maturity (the expected rate of return if a bond is held to maturity).

Interest Rate Risk

Affecting bonds more than stocks, this is the risk that an investment’s value will change due to a change in interest rates while holding the bond. This is an inverse relationship where, as interest rates rise, bond prices fall, and vice versa. For example, a 10% bond purchased last month will be worth less if interest rates rise because investors could now get a higher return elsewhere in the market.

Liquidity Risk

An investment that cannot be bought or sold quickly in the market without incurring excessive costs faces liquidity risk. Liquidity risk can usually be found in emerging or low-volume markets, where the participants may have trouble finding each other.

Inflation Risk

My grandfather used to say “I remember when these only cost a dollar…” Well, that loss of purchasing power is inflation risk – the very real risk that the value of your money today will be worth less in the future. In other words, if you store your money in a mattress thinking you are avoiding risk, think again. On average, your money is eroding about 2-3% per year. Likewise, any investment that does not yield an after-tax return greater than the rate of inflation each year, such as many savings accounts, money-market funds, bank GICs, and some bonds. And while the stock market may yield negative returns in a given year, over the long-term, returns have historically been higher than the rate of inflation.

As you can see, there is such a thing as a “risk-free” investment. The way to minimize these risks is to be sure you have a well diversified portfolio of different assets classes (stocks, bonds, or their corresponding mutual funds), sectors (for stocks, financials, materials, energy, utilities, industrials are some examples of different sectors that make up the Toronto Stock Exchange), and companies.

The easiest way to achieve this is with a balanced mutual fund, but, as with any investment, don’t put your money into anything you don’t understand, and be sure to read the details of the plan before committing. Be sure you understand the risks and potential returns involved.

Joanne believes that financial independence is the cornerstone to living an empowered and enriched life… and money doesn’t have to be intimidating!

And be sure to join her Facebook page at http://www.facebook.com/FinancialSkillsforWomen

Most investment strategies pitch somewhere upon the continuum between a high risk / high return approach on the one end and a low risk / low return approach on the other. The problem with pursuing high investment returns, is that the capital value of investments may decrease in the short term before they increase again. The problem with conservative low-return investments is that the real value of capital may over time decrease due to inflation.

The art of investing lies in finding the approach that suits you personally best. One should on the one hand try to maximise the return on capital, but at a risk level that is acceptable to you. The question is what is regarded as acceptable risk and, is the acceptability a constant factor that stays the same under any circumstances? The answer is no. More risk is acceptable under certain circumstances, but before these circumstances are discussed, it is necessary to discuss the following terms that will be used, that are often confused:

Saving

Saving is the action of putting money aside. It means that money is not spend, but is kept at the owners disposal.

Investing

Investing means that money is handed over to a third party for purchasing assets with the purpose of long term investment growth. Investors transfer the their funds with the intention that financial assets like shares and bonds or hard assets like diamonds are bought. Investing does not mean to hand money over to dubious schemes.

Gambling

To gamble is normally understood as “to play a game for money or other stakes” like putting money on a roulette wheel or buying a lotto ticket. It can also mean to buy a share that you know nothing about or investing in a scheme you don’t understand.

Marketers of illegal schemes use the word “investing” to lure people to hand their money over to them. Initially, when “investors” receive high payouts, they think the scheme is the best investment thinkable. The fact that it has nothing to do with investment, only dawns on them when they lost all their money and it is to late to recover anything.

Speculation

Speculation means that a calculated risk are taken to make money on a relatively short term. One may for instance buy property with the purpose to sell it in a year or two at a higher price. The price of the property may not rise, but at least you have done sufficient homework to make sure that there is a high probability that it will rise.

Now that we are sure about the terms, we can look at the circumstances under which a higher risk may be appropriate.

Surplus income: The higher your surplus income, the higher the risk you should be able to handle in investing money.
Frequency of investment To invest a certain amount regularly, holds less risk than to invest a single amount at once.
Amount: If the amount you want to invest, is a small percentage of your total capital, you can accept greater risk.
Term: Greater risk can be handled with longer investment terms. Young people can therefore accept greater risk, but if the term of their financial objectives is shorter, investment portfolios should be structured less risky.
Income: If you receive an income from your investment, it should be structured more conservative with less risk. If you are not receiving an income at the moment, but plan to do so in future, you can decide to pursue a higher return till you need the income. When this happens, the investment could be restructured to reflect the new situation.
Investment experience: Investors with little investment experience should be more wary against risk than investors with lots of experience in this regard.
Dependants: Investors with more dependents should be more wary towards risk than those with few dependants.
Health: Healthy investors can handle more risk than unhealthy investors.
Diversification: An investor that already has a well diversified investment portfolio, can accept greater risk with new investments than investors with undiversified portfolios.
Timing: Share investments are normally more risky than some other investments. Investment risk can however be reduced if shares are bought when the economic cycle is on it’s lowest. Risk can also be lowered if investors buy shares of strong well established companies with little debt and healthy balance sheets.
Emotional tolerance:Some people loves the adrenaline rush in going for high returns, with no regard to the risk. They are emotionally capable of doing it this way. For other, it is a nightmare if their investment fall by a single percentage point. One should therefore know how you will respond to sudden capital depreciation.

Summary

One’s view on risk forms an extremely important element in investment planning. It is as irresponsible to take unnecessary risks as it is to be satisfied with a low return on your money. However, to pursue higher return, goes with the responsibility to research the investment opportunity thoroughly before parting with your money.

Dr. Manus J. Moolman is the CEO of My Wealth and has done extensive research on investing strategies. My Wealth is dedicated to advising anyone from average every people to professionals to choose the best investment for their risk profile.

Want to contact us? Visit our website at: http://www.myebroker.info/

If you are like most people, your initial reaction to the question posed by the title to this white paper is “no.” However, for many investors, the answer is “yes.” With all of the investment options available today, many investors are intimidated, confused and frustrated by the investment process. Recent studies also support the suggestion that many investors are perfect targets for investment fraud or already are victims of investment fraud. For instance,

A recent study by Schwab Institutional found that 75% of investor portfolios were unsuitable for investors given their financial situation and goals;

A recent study by CEG Worldwide concluded that over 94% of those holding themselves out as wealth managers were more product salesman than wealth manager;

The 2010 IPT Elder Investor Fraud Survey reported that investment fraud is the number crime against the elderly, affecting an estimated 7.3 million older Americans, or one out of every five senior citizens. Since that number only counts the instances of fraud actually reported, the number of victims is undoubtedly higher.

One of the problems with avoiding investment fraud is the difficulty in detecting some types of fraud due to the subtleness or complexity of the fraud itself. Another problem with detecting fraud is the personal biases and beliefs that each investor has regarding investing. The purpose of this article is to alert investors to some of the more common elements of investment fraud so that investors can prevent unnecessary investment risk and financial loss due to investment fraud.

Fraud and Cognitive Biases

The common response to investment fraud is to call for greater investor education programs. However, a recent law review article in The Elder Law Journal suggests that investor education programs may be largely ineffective due to cognitive issues such as cognitive biases and/or cognitive deficits of investors. Cognitive biases are personal beliefs that impact our decisions. Cognitive deficits are impairments in mental ability, including impairments due to aging.

In the article, “Deception, Decisions and Investor Education,” the author, suggests a model of fraud victimization, which she refers to as the “deception/decision cycle.”1 As investors are provided with investment information, they filter the information through their personal beliefs, beliefs based upon a combination of actual experience, education and first impressions. An Investor’s beliefs, or biases, may or may not be accurate, but they can become so ingrained, or “anchored,” within a person that the person resists any conflicting information.

These biases may be strengthened even further by what are known as “truth” and “authority” biases, a person’s tendency to accept a statement as true, especially when the statement comes from someone with actual or perceived authority or expertise. The individual investor, whether because of issues such as cognitive biases/deficits, the complexity of the investment information of the sheer volume of such information, may fail to recognize the deception involved in the fraud.

Asset Allocation and Cognitive Biases

A perfect example of how cognitive biases can negatively impact investment decisions is a common misperception involving asset allocation. When you mention asset allocation or diversification to most investors, they think in terms of quantity rather than quality. Consequently, a large percentage of investors have portfolios that are diversified in terms of types and numbers of holdings within the portfolio, but the portfolios are not “effectively” diversified due to the high correlation of returns, or overlap, between the investments.

Portfolios that are not “effectively” diversified are sometimes referred to as being “pseudo” diversified since they appear to be diversified, but they do not actually provide an investor with the benefits of a truly diversified portfolio. The high correlation between the investments results in an investor having less downside protection than they would have with a truly diversified portfolio.

As an example, most people would consider a portfolio consisting of a large cap fund (IWB – iShares Russell 100 Index), a small cap fund (IWM – i Shares Russell 2000 Index), an international equity fund (EFA – iShares MSCI EAFE Index) and a bond fund (AGG – iShares Barclay Aggregate Bond Index), to be diversified since it consists of four different types of funds. A review of a correlation of returns matrix for a portfolio of the four exchange traded funds (ETFs) representing the four categories over the time period 8/31/2003 to 8/31/2011 tells a different story.

IWB/IWM – 0.93 IWB/EFA – 0.91 IWB/AGG – 0.05

IWM/EFA – 0.81 IWM/EFA – (0.03) EFA/AGG – 0.11

Analyzing rolling periods of returns often provides a better picture of trends and the persistence of trends. An analysis of rolling five year periods of returns for the referenced ETFs provides the following information:

2010-06

IWB/IWM – 0.966 IWB/EFA – 0.970 IWB/AGG – (0.308)

IWM/EFA – 0.896 IWM/AGG – (0.325) EFA/AGG – (0.432)

2009-05

IWB/IWM – 0.985 IWB/EFA – 0.991 IWB/AGG – (0.282)

IWM/EFA – 0.977 IWM/AGG – (0.338) EFA/AGG – (0.340)

2008-04

IWB/IWM – 0.967 IWB/EFA – 0.999 IWB/AGG – (0.445)

IWM/EFA – 0.973 IWM/AGG – (0.518) EFA/AGG – (0.4650

The higher the matrix number, the higher the correlation of returns and performance. A negative matrix number indicates a negative correlation of returns, which means that the two investments behave differently during various market conditions.

The matrix clearly shows a high correlation of returns between the large cap and the small cap ETF, and a high, albeit varying, correlation of returns between the international ETF and the large and small cap ETFs. The matrix clearly shows a low correlation of returns between the bond ETF and the other three ETFs. An argument can be made that a portfolio consisting only of the large cap ETF (IWB) and the bond ETF (AGG) would produce similar results.

Since fees and expenses are relatively low for most ETFs, cost is not that much an issue with a portfolio of ETFs. Since many financial advisers do not use index funds or ETFs in making recommendations, the negative impact of “pseudo” diversification can be seen in a portfolio of load-based mutual funds, again representing the four asset categories used in the ETF portfolio. The mutual funds represented are American Funds Growth Fund of America (large cap equity), Oppenheimer Discovery (small cap equity), Fidelity Worldwide (international) and PIMCO Total Return (bond).

2010-06

Am/Opp – 0.922 Am/Fid – 0.981 Am/PIMCO – 0.705

Opp/Fid – 0.948 Opp/PIMCO – 0.688 Fid/PIMCO – 0.597

2009-05

Am/Opp – 0.922 Am/Fid – 0.981 Am/PIMCO – 0.519

Opp/Fid – 0.948 Opp/PIMCO – 0.636 Fid/PIMCO – 0.451

2008-04

Am/Opp – 0.893 Am/Fid – 0.989 Am/PIMCO – 0.052

Opp/Fid – 0.935 Opp/PIMCO – 0.482 Fid/PIMCO – 0.148

The data shows the correlation of returns over rolling five-year periods in order to show not only the correlation of returns, but also the trend in correlation of returns. Once again, we see the same high correlation of returns between the equity-based mutual funds, with a lower correlation of returns between the bond fund and the equity-based funds that we saw with the ETF portfolio. The results are consistent with studies that have shown an increase in correlation of returns between equity-based investments over the past decade, especially during periods of increased volatility in the markets.

The correlation of returns matrix exposes the false illusion of diversification created by the bias of assessing diversification on the quantity of funds or types of funds alone. This bias is sometimes difficult to remove, as diversification based on quantity and type seems to make sense. Unfortunately, that is exactly what unscrupulous financial advisers are relying on, as they try to exploit the “truth” and “authority ” biases.

Portfolio Optimization and Cognitive Biases

If you have had an asset allocation plan or portfolio optimization plan prepared by your financial adviser, look at the plan and see if there is anything in the plan that gives you the projected risk, return or correlation of return data on the actual investment portfolio the financial adviser recommended to you. Investors rarely see such an analysis using the investor’s actual investments, primarily because the commercial asset allocation/ portfolio optimization programs used by most financial advisers are not designed to produce such a “real world” analysis. And yet, the calculations can be done using Microsoft Excel.

In many cases this failure to provide a “real world” portfolio analysis results in recommendation-implementation gaps, often leaving investors with portfolios significantly different from the asset allocation/portfolio optimization plan provided to them by their financial adviser, especially with regard to exposure to unnecessary investment risk.

The calculations required to calculate the projected risk, return and correlation of returns statistics for an investor’s actual investment portfolio are complex. Consequently, most investors are unable to calculate the actual portfolio’s statistics themselves or to otherwise detect an investment adviser’s fraudulent behavior.

Too often an investor falls prey to the “trust” bias or the “authority” bias and just accepts the plan given to them without questioning the accuracy of the plan or the failure to provide a “real world” analysis of the actual investment portfolio that their financial adviser recommended. But you should question your financial adviser and ignore any “trust” or “authority” biases, especially since the portfolio optimizers often produce recommendations that are counterintuitive and/or contrary to existing legal standards.

Some examples may help to prove my point. Two of the most important factors in constructing a suitable investment portfolio are the investor’s risk tolerance level and the investor’s investment time horizon. With that in mind, an experiment with two popular online asset allocation calculators provides some interesting results.

The first asset allocation calculator asked about risk tolerance, but did not even ask about investment time horizon. The regulators take the basic position that anyone with an investment time horizon less than five years should generally avoid equity-based investments since they might not have enough time to recover any losses suffered in the market. With the first calculator, we ran the same set of personal investment parameters, with the only exception being that we varied the risk tolerance level in each scenario. The results are shown in Appendix A.

Two clear issues emerge regarding investor protection. First, regardless of the investor’s risk tolerance level, the calculator recommends a portfolio consisting of approximately 60% equities and 40% bonds/cash. Second, the calculator completely ignores the “low” risk tolerance entry, exposing the risk averse investor to an undesired level of investment risk due to recommended equity allocations.

With the second asset allocation calculator, information was requested on both the investor’s risk tolerance level and the investor’s investment time horizon. Once again, the same set of personal investment parameters are used in each analysis, changing only the risk tolerance level and/or the investment time horizon. The results are shown in Appendix B.

If you accept the regulators’ position regarding a minimum five-year investment time horizon for equity investments, then the second calculator’s equity allocation for the 3-5 year time horizon is questionable, as it recommends a 30% allocation to equities for the low risk investor and a 45% allocation to equities for a moderate risk investor.

Expanding the time horizon out to 5-10 years, the low risk investor get the same portfolio recommendations that the 3-5 year time horizon/moderate risk investor got, which obviously raises questions. Strangely, the moderate risk investor with the 5-10 year time horizon receives a recommendation that increases the bond allocation to 65% and lowers the equity allocation to only 45%.

Increasing the investment time horizon to 10-20 years produces basically the same recommendation for both the low risk and moderate risk investor, with the recommended equity allocation only varying by 5 percentage points. The calculator appears to overweight the investment time horizon and basically ignore the low risk investor’s preference to avoid investment risk.

The last example is just further evidence that most asset allocation/portfolio optimization software programs are highly unstable and susceptible to mistakes, so much so that they have been criticized as “estimation-error maximizers” by industry expert Richard Michaud. Investors who wish to protect their financial security would do well to replace any “truth” and/or “authority” biases with a healthy dose of skepticism and a willingness to question their financial advisers.

Investment Fees and Expenses and Cognitive Biases

Investors look to their financial advisers for advice and generally defer to any recommendations provided by their adviser. Again, this is often the results of both the “truth” and the “authority” biases. Many financial advisers limit their investment recommendations to actively managed, commission-based products, which may not be in an investor’s best interests.

The negative impact of biases grows even deeper once the impact of fees and expenses is considered. Fees and expenses on index funds and ETFs are usually low since there is little or no active management of such investments. Fees and expenses on actively managed mutual funds can vary, with some even assessing annual fees and expenses in excess of 1.0% per year. Fees and expenses are important to investors since they reduce an investor’s return.

Assume that we have two funds, Fund A and Fund B, both with relatively similar performance returns. Fund A is an index fund/ETF. Fund B is an actively managed fund that has an R-squared rating of 93, which means that approximately 93% of Fund B’s return can be attributed to the performance of a benchmark index, in this case the index represented by Fund A. However, Fund B’s annual fees and expenses are 1.0% per year, while those of Fund A are 0.25% per year.

Since most of the return of Fund B can be attributed to an index rather than the contributions of active management, why would an investor pay three times more in annual fees and expenses for Fund B? Before investing in Fund B, it is useful to see just how beneficial the active management has been and exactly what the active management is effectively costing the investor.

One commonly used method for making such assessments is known as the active expense ratio. The active expense ratio was introduced by Professor Ross Miller, a finance professor at the State University of New York at Albany. Professor Miller basically compares a fund’s R-squared rating with the excess annual fees charged by the fund to determine a fund’s “effective” annual fees and expenses.

In our example, the active expense ratio calculates to an effective annual active expense ratio fee of 3.02% for the active management of the fund, a little over 200% higher than the stated fees and expenses. For the four mutual funds in our sample portfolio, the active expense ratios were as follows.

American Funds Growth

R-Squared – 98.34

Stated Expense Ratio – 0.69%

Active Expense Ratio – 4.44%

Oppenheimer Discovery

R-Squared – 93.43

Stated Expense Ratio – 1.34%

Active Expense Ratio – 4.63%

Fidelity Worldwide

R-Squared – 97.58

Stated Expense Ratio – 0.71%

Active Expense Ratio – 3.06%

PIMCO Total Return

R-Squared – 68.43

Stated Expense Ratio – 0.56%

Active Expense Ratio – 0.53%

There are those who may argue that the active expense ratio is misleading. However, when an actively managed fund derives most of its performance from an index and an investor can obtain that same index’s performance at a much lower cost, one has to question the wisdom of reducing one’s investment returns by paying “money for nothing” and reducing one’s investment returns. Why pay three times more for essentially the same results?

And yet investors do it every day, impacted by “truth” and “authority” biases they may not even be aware of. Some investors have no choice, as their company’s retirement plan may only offer actively managed, commissioned-based investment options as a result of their plan’s fiduciary being influenced by their own “truth” and “authority” biases. Armed with the knowledge of both these biases and active expense ratios, it would not be surprising to see both plan participants and plan fiduciaries act to provide more meaningful investment options within retirement plans.

Wealth Management and Cognitive Biases

“Anchoring” is one of the strongest cognitive biases and, with regard to investing and wealth management, one of the most potentially destructive influences on wealth preservation. Anchoring can be defined as a reluctance to retreat from existing beliefs and decisions and a resistance to even consider new or opposing information.

The difficulty with addressing anchoring bias can summed up with the observation from noted economist John Maynard Keynes that “the difficulty lies not so much in developing new ideas as in escaping from the old ones” and that “worldly wisdom teaches us that it is better for reputation to fail conventionally than to succeed unconventionally.” Beliefs often become truths, regardless of whether such beliefs are valid, often resulting in unnecessary risk and financial loss.

A perfect example of the potential negative impact of anchoring can be seen in investors that adopt a buy-and-hold approach to wealth management, or, as buy-and-hold critics often refer to the strategy, the “buy, forget and regret” approach. It is interesting to note that the buy-and hold approach to wealth management is apparently derived from an ongoing misinterpretation of a famous financial study.

A 1986 study, commonly known as the Brinson-Hood-Beebower (BHB) study, concluded that approximately 94% of the variability of a portfolio’s returns was attributable to the portfolio’s asset allocation mix. The study made no representations whatsoever regarding the impact of asset allocation on a portfolio’s actual returns, only on the variability of a portfolio’s returns.

Nevertheless, financial advisers and investment companies misrepresent the study’s findings to support their buy-and-hold argument, claiming that all an investor has to do for investment success is to set up an appropriate initial asset allocation and maintain that allocation since the BHB study proved that asset allocation determines 94% of an investor’s returns. The problem is that many investors have read or heard this mantra so often that they have fallen prey to the “truth” and “authority” biases and the misrepresentations are now firmly anchored into their personal beliefs.

It is interesting to note that the buy-and-hold approach is not derived from the works of the early pioneers of wealth management, Nobel laureates Dr. Harry Markowitz, the father of Modern Portfolio Theory, and Dr. William Sharpe. In fact, Dr, Sharpe has recently stated that investors should change their asset allocation in response to changes in market values. A recent study by asset allocation expert Roger Ibbotson has rebuffed the buy-and-hold strategy, stating that active management and asset allocation have about the same impact on a portfolio’s performance.

There are many investment professionals who would argue that the buy-and-hold approach is fundamentally sound and does not constitute investment fraud. These professionals usually claim that anything other than a buy-and-hold approach, with an occasional rebalancing to restore the original asset allocation parameters, constitutes market timing, which is both costly and ineffective.

From a legal perspective, what buy-and-hold advocates fail to realize is that the buy-and-hold approach completely ignores the proven cyclical nature of the market and t the Prudent Investor Act, whose guidelines which are often used by regulatory bodies and the courts in determining questions of fraud and prudent fiduciary conduct. The Prudent Investor Act clearly states that a fiduciary should make changes in an investment portfolio when changes in the market or economy dictate such changes are necessary in order to protect the portfolio against unnecessary risk and losses.

The classic definition of market timing involves having all of one’s assets either in the market or out of the market. The potential tax implications and the difficulty in perfectly timing the stock make such a strategy practically impossible. Reallocating some of one’s resources to reduce risk exposure is not market timing, but smart, defensive investing.

Smart investors would do well to heed the advice of noted investor Ben Graham, who warned that “the essence of investment management is the management of risks, not the management of returns. Well managed portfolios start with this precept.” Various studies support Graham’s postion, with such studies documenting the fact that avoiding losses has a much greater impact than missing potential returns.

Many investors suffered unnecessary investment losses during the recent 2000-2002 and 2008 bear markets due to their cognitive biases regarding the buy-and-hold approach to investing and their refusal to objectively consider other investment approaches. Unfortunately, these same investors will likely continue to suffer unnecessary investment losses unless and until they recognize their cognitive biases and objectively examine their investment strategy. As George Santayana pointed out, those who cannot remember the past are condemned to repeat it.”

Conclusion

Investment fraud is a pervasive problem. While various statistics are often cited as evidence of the problem, the truth is that such numbers are only a small percentage of the actual cases of investment fraud, as many cases go unreported and many victims of investment fraud are unaware that they are victims due to the subtlety or complexity of the fraud itself.

An emerging theory of investment fraud is that investors are susceptible to investment fraud due to cognitive biases and/or cognitive deficits that impair their ability to properly analyze investment situations and the recommendations of their financial advisers. It is imperative that investors become aware of and overcome potentially harmful personal biases, such as “truth” bias, “authority” bias and anchoring, in order to properly analyze investment options and better protect their financial security.

© Copyright 2011, InvestSense, LLC. All rights reserved.

This article is for informational purposes only, and is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional adviser should be sought.

Notes

1. Jayne W. Barnard, “Deceptions, Decisions and Investor Education,” Elder Law Journal, Vol. 17, No. 2 (2010), 201.

APPENDIX A

Low Risk Portfolio

Investment Parameters > Age: 50 > Assets: $250,000 > Risk Tolerance: Low > Tax Bracket: 25% > Economic Outlook: Moderate > Income Needs: 4%

Recommended Allocation > Large Cap Equity – 23%, Midcap Equity – 13%, Small Cap Equity – 9%, Foreign Equity – 14%, Bonds – 23%, Municipal Bonds – 18%, Cash – 13%

Moderate Risk Portfolio

Investment Parameters > Age: 50 > Assets: $250,000 > Risk Tolerance: Moderate > Tax Bracket: 25% > Economic Outlook: Moderate > Income Needs: 4%

Recommended Allocation > Large Cap Equity – 21%, Midcap Equity – 14%, Small Cap Equity – 10%, Foreign Equity – 16%, Bonds – 26%, Municipal Bonds – 18%, Cash – 0%

High Risk Portfolio

Investment Parameters > Age: 50 > Assets: $250,000 > Risk Tolerance: High > Tax Bracket: 25% > Economic Outlook: Moderate > Income Needs: 4%

Recommended Allocation>Large Cap Equity – 20%, Midcap Equity – 16%, Small Cap Equity – 13%, Foreign Equity – 17%, Bonds – 24%, Municipal Bonds – 0%, Cash – 10%

APPENDIX B

3-5 Year Investment Time Horizon

Low Risk Tolerance: Bonds – 70%, Large Cap Equity – 15%, Small Cap Equity – 5%, Foreign Equity – 10%

Moderate Risk Tolerance: Bonds – 50%, Large Cap Equity – 25%, Small Cap Equity – 10%, Foreign Equity – 15%

High Risk Tolerance: Bonds – 60%, Large Cap Equity – 20%, Small Cap Equity – 10%, Foreign Equity – 10%

5-10 Year Investment Time Horizon

Low Risk Tolerance: Bonds – 50%, Large Cap Equity – 25%, Small Cap Equity – 10%, Foreign Equity – 15%

Moderate Risk Tolerance: Bonds – 65%, Large Cap Equity – 20%, Small Cap Equity – 5%, Foreign Equity – 10%

High Risk Tolerance: Bonds – 40%, Large Cap Equity – 30%, Small Cap Equity – ]15%, Foreign Equity – 15%

10-20 Year Investment Time Horizon

Low Risk Tolerance: Bonds – 30%, Large Cap Equity – 30%, Small Cap Equity – 20%, Foreign Equity – 20%

Moderate Risk Tolerance:Bonds – 25%, Large Cap Equity – 35%, Small Cap Equity – 20%, Foreign Equity – 20%

High Risk Tolerance: Bonds – 20%, Large Cap Equity – 40%, Small Cap Equity -20%, Foreign Equity – 20%

James W, Watkins, III is an attorney, a CFP® professional and an Accredited Wealth Management Adviser®. His areas of expertise include wealth preservation, asset protection, investment fraud and fiduciary law. He is CEO of InvestSense, LLC, a registered investment adviser firm located in Atlanta, Georgia. For additional articles and information, visit the company’s website, http://www.investsense.com. Mr. Watkins can be contacted at tawj3@yahoo.com, and followed on LinkedIn and on Twitter @InvestSense.

You’ve finally reached the point where you have a few dollars set aside to invest. You realize that in order to make money, you either have to earn it by working, or derive it from an investment. You also realize that all investments require some form of initial capital. What next?

Investment theory
Investment for beginners merits a certain fundamental question. What constitutes an investment? An investment is anything that you purchase speculatively in the hopes that the value will increase. It’s the age old buy low sell high adage, and whether the investment is a home, stock, bond, vehicle, or other valuable object, the goal of the investment is to generate return for the investor. Some investments, like bonds for example, are a vehicle by which you put down a certain amount of money to buy them (called the initial capital). The investment then grows in value – or at least it’s supposed to – which is called appreciation. Something like a bond will generate interest, called dividends. Some investments can generate both dividends and profits when they are sold. To use the bond example, it generates interest while you hold it, for as long as you hold it, but you can sell it at any time for profit. Other investments, like homes, will only generate a profit when sold.

Investment risks
Most investments carry risks, from remote, to very real – and you should be aware of these risks. Even something like a bond or Treasury bill represents a minute risk. Could a government default on these obligations? It seems unthinkable, but within the last several years, it is a possibility. Bigger items like homes are also not immune to risks. Stocks are also filled with risk that needs to be accounted for in your investment strategy, and are potentially a bad investment for beginners.

How much to invest and when?
Investment is not something to consider when you’re behind on your bills or don’t have an adequate savings. The first rule of investment is to invest with income that you can afford to lose, which is why you need to be current on your obligations and have a comfortable savings in the bank before you begin investing. Investing for beginners means you allow yourself to spend only a designated percentage of your portfolio, say 10% to start out with. Of that 10%, you need to consider what percentage you want to be risky investments versus what percentage you want to be stable, but low yield investment.

Investment is not simply for Wall Street tycoons, it’s for everyone, including investment for beginners. Investment is really the only way to leverage your income into working for you so that you don’t have to work as much, or as hard – and the best time to invest is in your youth as you enter the workforce, which is a time when most people have no debts and lots of disposable income to fuel their investments with. Be prudent, patient, and careful, and you’ll be rewarded with years of profits.

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During the economic crisis of the past decade, markets and industries crashed and hundreds of companies and millions of people were caught with their pants down. This ordeal has taught everyone the value of security during uncertain times. One of the surest ways to buffer yourself from economic crunches is by making sound investments. While there are traditional investment strategies available to first-time investors, alternative investments are rapidly gaining momentum, and for good reason.

Alternative Investments: The Basics

Alternative investments refer to investment strategies that go beyond traditional investments like stocks, bonds, cash, or property. Popular financial assets in the alternative investment category are:

1. Hedge Funds

2. Private Equities

3. Financial Derivatives

4. Venture Capital

5.Commodities

They also include several tangible assets including, but not limited to, the following:

1. Wine

2.Antiques

3. Stamps

4. Art

5. Coins

Characteristics of Alternative Investments

Unlike traditional investment strategies, alternative investments are not direct fixed-income or equity claim on the assets of an issuing body. They are complex in nature, so most of these assets are held by accredited, high net-worth individuals. They also tend to lack liquidity and have a low correlation to traditional financial investments such as shares of stock in a company. This low correlation adds to its appeal, especially with investors who are looking to diversify their investment portfolio (the low correlation coefficient will be discussed in depth in a later section).

Also, compared with more common investments like mutual funds, alternative investments have higher minimum investment requirements and fee structures. The cost of purchase and sale is relatively high. In addition, they are subject to less regulation. While this may be good on one hand, it also has the effect of limiting opportunities to publish verifiable performance data. Hence, historical data on risk and returns may be limited. This data could be useful in promoting an alternative investment to potential investors.

Because current market values of some forms of assets are difficult to determine at the least, it is imperative for investors looking to invest in alternative investments to conduct proper due diligence. This especially applies to tangible assets like artworks and wine.

Some investors consider alternative investments as a good means to diversify their portfolio, thereby reducing overall investment risk. However, this is not the only reason why more and more investors are now looking into expanding their financial prospects via alternative channels.

The Appeal of Alternative Investments: Low Correlation, Absolute Return

Although there are a number of alternative assets presently being offered in the marketplace, a common characteristic among these numerous options is their low correlation coefficients with both fixed income and equities. Low correlation is considered important when choosing assets for inclusion in a portfolio, primarily because assets that are relatively uncorrelated with both bonds and stocks tend to have minimal exposure to systematic market risk factors. Absolute Return Strategies – strategies that seek a low correlation to systematic risks in the market, make it their objective to attain relative independence from the underlying equity or fixed-income market benchmarks’ overall performance.

Absolute return does not come without its challenges, however. There are potential constraints on the upside. To illustrate, when broader stock markets are picking up, investors with low-correlation alternatives may see their portfolios performing weaker in relation to those with traditional assets. This somehow implies that absolute returns can be maximized in negative market climates and tend to underperform during positive economic climates.

The Economic Atmosphere for Alternative Investments

It would not be an understatement to say that alternative investments were, for the longest time, reserved mostly to high net-worth investors. The broader retail market finds the field of alternative investments difficult to penetrate because of reasons mentioned earlier in this article:

- High minimum investment sizes;

- High minimum fee structures; and

- Assets with no liquidity.

Recent years show a change – an evolution – in the economic atmosphere, where alternative investments are concerned. Progress in global financial markets has developed and provided greater opportunities and a wider range of products through which more investors can enrich their portfolios with alternative assets. Directional alternative assets like commodities, real estate and foreign currencies, as well as hedge strategies like buy-write become accessible to more investors through exchange-traded funds (ETFs), exchange-traded notes (ETNs), and mutual funds.

These options were not available until recently. With increasing entry points into alternative investments, investors now find themselves able to participate in innovative investment approaches that promise increased profits. If alternative investments appeal to you, now would be the best time to start investing in alternative assets.

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1) Which single asset class are you most bullish (or bearish) about in the coming year? What ETF position would you choose to best capture that?

If I could own just one stock or ETF, then it would have to be Vanguard’s Total World Stock Index ETF (VT). Perhaps I’m taking the question a little too literally or perhaps I just lack the necessary convictions in my (or anyone’s) market predictions to choose anything more focused. VT is the most diversified ETF capturing the largest percentage of the world stock market capitalization.

I don’t know why I would accept anything less, unless I could tell the future – which I can’t do, no matter how hard I try! Therefore I’ll go with the ETF that gives me the highest probability of achieving a fair return: VT.

2) How does this ETF fit into your overall investment approach?

Investor Solutions has some straightforward investing biases. First, we believe that capital markets and capitalism work. Therefore ownership should produce a fair return for assuming ownership (equity) risk.

Secondly, we believe that capital markets are efficient. Efficient doesn’t mean perfect or 100% correct. Efficient simply means that market prices are the best estimates of value and that future stock prices are unpredictable. Therefore it makes little sense to try and outguess the market. You can try, but the data show that you will probably fail and the act of “trying” will cost you in fees, taxes and underperformance. These two points lead me to select a broad equity ETF. It is best to accept market risk for market returns and to reduce risk by removing as much systematic risk as possible.

Next, Investor Solutions believes that the market should be described as the most diversified global portfolio using public securities. In our firm, we usually target 15 different investment areas using various institutional mutual funds and ETFs to capture the world market capitalization, tilting the portfolio to capture more value and small-cap risk premium. VT is the closest option though it is heavily weighted to large/mega caps, and has no value tilt. Still, VT is the closest option available with 46% in North America, 15% emerging markets and 34% in developed foreign.

Finally, VT offers this global diversification in one simple ETF at the lovely low price of 0.3%, and tax-friendly to boot. So, 100% equity, the most globally diversified, lowest cost, tax-efficient ETF is the clear winner. Many investors would be well advised to give up their sector plays and just build a portfolio solely of VT.

3) Some readers will be expecting a sector pick in Just One ETF, but as you note, it’s about matching return with risk. So my question is: Why settle for market returns? Do you consider yourself highly risk-averse?

I’m certainly not risk-averse nor should anyone mistake VT as a low-risk investment for the risk-averse. After all, VT was down about 40% at the worst of it. So I’m absolutely a risk-taker, though an important distinction should be made as to which risk. I see no reason to take uncompensated risk or unsystematic risk. Sure, you can get lucky with sector bets, but if I can only own one ETF, I don’t see that as a good strategy for real money.

As far as why you should just settle for market returns, I’d say why shouldn’t you? There is this idea that investors should “try” to do something: Try to beat the market. Try to get out before a crash. Try to jump in before a rally. Try to do better. Try if you will, but the empirical data all show that “trying” just increases costs and taxes as well as leading to drastic underperformance compared to the markets.

So if the market returns are acceptable, then why not just accept them? You actually are increasing your risk and decreasing your expected return by not just accepting market returns. Sometimes it doesn’t pay to get complicated and “try.” Let’s use the analogy of driving in heavy traffic on the interstate.

Some drivers sit in their lane staring only at the car directly in front of them, blind to everything else. This makes no sense. But neither does the strategy of darting in and out, constantly changing lanes, honking, trying to guess which lane is best. This strategy only increases the chances of getting into an accident, decreases mpg and increases the aggravation of getting to where you want to be.

Most experienced drivers reach the point where they realize that the best strategy is to stay in one lane unless there is a clear reason to change. On the freeway, this is usually the left lane, so let’s consider this lane equity. The right is usually the slowest, so this will be a mix of stocks and bonds. Then finally we have the exit, which is all bonds.

So a driver can try jumping across lanes or they can pick the appropriate lane for their needs and objectives. Usually that’s the farthest left lane (accumulation phase) until they get close to their exit (death) at which time they move to the right lane (distribution phase) and then finally exiting (to the great unknown). Few rational prudent drivers stay to the far left lane and then quickly swerve to the exit. This type of jumping back and forth only increases the chances of a wreck in driving as well as investing.

4) What about fixed income? Do you expect record-low yields for bonds to have any effect on the global equities that you’re counting on for a steady return?

I never said anything about a steady return. Quite the opposite, I think you should count on unsteady returns from global equities moving forward just as there has always been. There is a real misconception today that markets used to be stable, which is completely ridiculous. Secondly, record-low yields are not the same as record-real yields. But I’m guessing your question is geared to the idea that low bond yields are an incentive for investors to take more risk in stocks.

Obviously, there is some effect here but we could see low yields for a long time. But remember, low yields in the U.S. is different from low global yields. VT is a global investment. The developed markets have low real yields, but VT has about 15% in emerging markets which still have relatively high yields. Trying to use a yield ratio to time equity is a mistake. Better to own the appropriate amount of bonds according to your desire, need and capability to handle investment risk.

5) Tell us more about global equities, and what makes that asset class your top pick.

Investing in VT is the lowest risk to my future, meaning the lowest risk of not achieving my return objective. The lowest risk of missing the market returns. The highest probability of success. Let’s say you decide to place all your capital in a commodity producer ETF or a Gold ETF – what happens if this very narrow slice of the market does nothing? What if it isn’t its time to shine?

I hate to use a gambling analogy, but let’s take roulette. Picking one gold stock is like placing all your chips on the number 13. Picking one gold ETF is like picking 4 numbers. Picking an S&P 500 ETF is like picking red. Some people think VT is essentially placing your chips on all the roulette options, but it isn’t, not even close.

Buying the total global stock market, VT in our example, and not trying to jump in and out, is like owning the roulette table. The casino might not win every time, but over time, the casino is the only winner in Vegas. And that is what we are trying to accomplish in the capital markets. We are trying to extract a premium over the risk-free rate on our investment by accepting ownership risk.

6) Are there alternative ETFs that could be used to capture the same theme? What makes VT your first choice?

The only other global ETF is iShares MSCI ACWI Index Fund (ACWI). If I couldn’t choose VT, I’d be happy with ACWI. For all practical purposes the difference is marginal and both would achieve my goal if utilized prudently. With that said, VT has a lower fee and a slightly more diversified index, and Vanguard is well known as a master at managing index funds.

7) How does your view differ from the consensus sentiment?

Investors today have too much data- er, I mean noise. One day the experts are predicting the second depression while simultaneously other experts are predicting deflation or inflation or something catastrophic. Most people don’t understand that the media is in the ad business. Extreme sells. Polarization of opinions gets air time, not level-headed common sense strategies.

So what is the sentiment in the industry about VT? VT is boring. It is hard for anyone in the investment industry to make a living talking about VT. It is easier to talk about some sexy sector selling the hopes of something new and improved. A vote for VT is a vote for common sense.

If you could only have one investment, a lot of people in the financial services industry would pick VT, but they wouldn’t tell you. Their salary is often dependent on creating an aura of mystique, of being an expert, of knowing something no one else does. Essentially what they promote at work isn’t necessarily the same thing they do with their own investment portfolios.
Do you still believe in the efficient market and modern portfolio theory? Some say that both failed in 2008?

How did the efficient market hypothesis (EMH) fail in 2008? EMH basically states that current market values are the best estimates and that future market price are unpredictable. EMH does not state that the market prices are correct.

I’m not sure why some people feel EMH or modern portfolio theory (MPT) failed in 2008. No one should infer that the validity or application of EMH & MPT will insure positive returns. Rather, the application increases the probability of a positive return. There is a difference between possibilities and probabilities. EMH and MPT help increase the desired probability but cannot remove the possibility of a negative outcome.

The alternative would be market timing and there simply is no empirical data that supports market timing. Are there successful money managers timing the market? And, will these same money managers successfully time the markets moving forward? All the data would lead any rational, prudent investor to abandon market timing

9) What catalysts, near-term or long-term, could move the sector significantly?

I’m sorry, but it seems like a futile exercise and detrimental to investor performance to try and guess. A simple question: Do you believe in a return on equity ownership and are you willing to accept the risk of equity ownership? If yes to both, just buy the appropriate amount of the global markets, in this case using VT. If you can’t answer yes to both, then don’t get involved.

10) What could go wrong with your pick?

By wrong, I’m guessing you mean a negative return. But that’s a mistake. The real thing that could go wrong in my mind would be that VT produces a significant tracking error to the FTSE All-World Index. Given the breadth and liquidity of the index, as well as Vanguard’s management experience, I’m not worried.

11) Fair enough, but another global stock pullback would be considered “wrong” for those who would rather be taking even low bond yields (and of course, that kind of “going wrong” is “going right” for those on the other trade, shorting the broader equity market). What do you think the odds are of a big macro event hurting global equities, like the eurozone debt crisis?

Of course we would rather be in low-yielding bonds or short stocks right before another global stock pullback and then move long global stocks right before another global stock rally, but the chances of getting both right are pretty slim to none. Even being more or less “right” in your timing still wouldn’t mean a better return than just sticking to your investment plan.

When we consider what can go wrong, investors essentially should be trying to gauge how much downside they can handle. You ask about the odds of another big macro event hurting global equities and I’d say you should expect it to happen. The questions are really when and how bad, and the answer to both are just guesses and speculation. As an investor, you should expect there will be years with negative returns and you should not expect anyone to be able to successfully get you out right before. Try as they might, the net result is usually worse than just staying the course.

Also, let’s put this in perspective. You reference the eurozone debt crisis. I’d like to point out that last year everyone loved Europe and the euro. The broader European stock markets were up about 35% in 2009, compared to about 25% for the broader American stock markets. So how did investors in VT do? They enjoyed a return of about 30%. Now in 2010, the eurozone debt crisis has punished the euro and European markets. Yet for all of the concern, the VT is about flat for the year after being down at worst 10% in June. For most investors, the investing experience generates a far worse mental account than the actual return.

This is exactly why I would pick VT if I could only own one security. You can expect big macro events, both positive and negative, to occur at some time, yet still be confident that you will be OK. If you aren’t comfortable with that, you should either hold less VT or just be happy with cash or low bond yields.

Thanks, Jason, for sharing your choice with us.

A. Jason Whitby CFA, CFP AIFA http://www.investorsolutions.com/about-us/our-team/jason-whitby/

Investor Solutions is a fee-only registered investment advisor, which means that we do not accept or receive any type of compensation other than what our clients pay for the management of their portfolios. We do not create, sell or recommend commission-based products allowing us to have the freedom to focus on what is right for each and every one of our clients. http://www.investorsolutions.com

U.S. Treasuries are considered one of the safest investments in the world. Why? Just take a look at the yield on the 10 year bond; despite the deadlock in Washington and the media induced fear that the U.S. may default on its debts, the world still believes that the U.S. will not renege on its debt. As a matter of fact, while the stock market declined recently because of inaction in Washington, the yield on the 10-year bond actually dipped below 3 percent (when investors buy Treasuries, the yield goes down). Because U.S. Treasuries are perceived to be risk-free, they are used as a bellwether for other bonds as well. Corporate and municipal bonds are compared to U.S. Treasuries to assess their risk; when the interest rate between a non-Treasury bond and a Treasury bond is wide (also known as spread), the Treasury bond is considered riskier, and vise versa. But just because the U.S. Treasury is assumed to be default proof, it does not necessarily mean that it is risk free. While default risk is important to consider, investors must also recognize that bonds exhibit other risks beyond default risk. Below is a list of the different types of bond risks investors should be aware of.

Default risk – is the risk the borrower (U.S. government, municipality, or a corporation) will not make interest payments as promised. Investors perceive U.S. Treasuries to be default proof because they believe the U.S. will always pay its obligations. Many investors falsely believe that municipalities are also default proof, but in 1994, Orange County, California defaulted on its debts.

Interest rate risk – is the risk that interest rates will change after issuance. For example, assume an investor buys a 10 year bond for $1,000 paying 4 percent annually, which means the investor will receive $40 per year for 10 years. The investor is exposed to interest rate risk because if interest rates increase, the investor will still receive $40, but the price of the bond will decline because no one would want to pay $1,000 for a bond paying 4 percent when the market interest rate is higher than 4 percent; the reverse is true if interest rates decline. The change in the price of the bond given a change in interest rates is measured using a term called duration.

Reinvestment risk – Continuing with the same example from above, as the investor receives $40 in interest payments every year, it is assumed that he/she will reinvest that interest payment at prevailing market rates. If prevailing market interest rates are below 4 percent, the investor is exposed to reinvestment risk because they will reinvest those payments at lower rates.

Liquidity risk – Liquidity is the ability to buy or sell an investment quickly without difficulty. Bonds do not trade the same way as do stocks. Whereas stocks are easily traded throughout the day on an exchange where there are usually thousands, if not millions of shares traded in a single day, bonds (except for U.S. Treasuries) are traded through bond dealers where trades occur much less frequently. This infrequency of trading within the bond market leads to stale prices and liquidity risk.

Spread risk – As mentioned in the opening, U.S. Treasuries are used as a bellwether for other bonds, and a bond’s riskiness is measured by the spread between its yield and that of a comparable Treasury. Hence, spread risk is the risk that the bond’s yield will widen against that of a comparable Treasury; the wider the spread, the greater the risk of the bond.

Downgrade risk – Bonds are rated by major credit rating agencies, despite whether investors still trust the rating agencies given the Mortgage Backed Security debacle. Nevertheless, bond ratings are important for many investors, especially institutional investors such as banks, endowments, pensions, etc. Such institutions have policies that prohibit them from owning low grade bonds, so they rely on the ratings to screen bonds. Downgrade risk is the risk that a bond will be downgraded by one or more of the credit rating agencies and lead to a sell off among those bonds.

I identified six risks of investing in bonds. However, there are additional risks that apply to complex bonds as well. When bonds have more unique features such as calls, puts, zero coupons, etc., the risks multiply. Many investors wrongly assume that if they invest in a bond and hold it to maturity, that they are not taking any risk. But as you can see from the various risks identified above, investors must be aware of the complexities associated with investing in bonds, and learn how to manage those risks.

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With high inflation, we need to take control of our finance and plan for our futures nowadays. Living within one means reduce the risk of debt but is it sufficient to secure your future? Why do we need to be financially free and have financial control?

We need to invest to build up a source of income, which will continue to grow and be able to provide a secure future for ourselves and possibly our next generation.

The reasons to invest include:

1. Let your money work for you: Learn to save money and invest the rest so that it grows even when you are sleeping.
2. Cope with inflation: If you have wise investment that surpasses the inflation rate, you have a sound future finances. You have no worries of the prices of dairy expenses.
3. Business owner: Business needs to invest, whether small or big small sized business. Investing not only grow the capital and expand the business but also teaches one to become a successful businessman.
4. Dependents: Money generated from investment can help to pay bills, buy accessories and pay expenses for holidays.
5. Education: Education fee is increasing with inflation. Investing in an education plan helps to support someone’s studies.
6. Assurance: By making long term investment, you can be assured of sufficient money if you plan to retire. Start investing young and you can have a higher return before you retire.
7. Attaining things you want: The returns from investment can be used to get those things that you dream off, such as cars, houses, etc.

Investment return has to be a source of money unrelated to our regular wages, but money from income producing assets. We have to invest in income producing assets so that they will grow and we can be financially independent.

The investment risk level that you take depends on your needs. If you are interested to make fast money, you would be interested in investment which involves high risk. If your plan is for retirement, you would prefer something that is safer and can grow over time.

The main objective in investing is to create wealth and security with time. It is always impossible to earn an income as one will want to retire. Hence, smart investment helps to insure your financial future. The earlier you gain the investment knowledge, the more successful you will be. Longer time in investment means higher return and you can retire earlier.

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American investors lost trillions of dollars as a result of the bear markets of 2000-2002 and 2008. As a result of such losses, mutual funds companies are beginning to offer so-called absolute return mutual funds. The goal of an absolute returns strategy is to achieve, positive, more consistent returns under all market conditions. While the power of consistent returns has long been recognized, investors should be aware that the new absolute return funds often use different approaches in trying to achieve such results, some more questionable than others.

The focus on absolute returns has been long overdue. While many investors and investment advisers focus primarily on returns, smart investors realize that the true secret to successful investing is managing investment risk. Legendary investor Benjamin Graham first advanced this concept decades ago. Investors would be well advised to read Charles Ellis’ classic, “Investment Policy-Winning the Loser’s Game” (the more recent edition simply goes under the title of “Winning the Loser’s Game”) for a simple explanation of the concept. Simply put, the concept of absolute returns simply follows the Wall Street axiom of “don’t tell how much you made, tell how much you were able to keep.”

Many investors lost money in the recent bear markets because they adopted the popular static buy-and-hold approach to investing. But the recent bear markets offered further proof that the buy-and-hold approach is fatally flawed in that it fails to recognize the cyclical nature of the stock market. What most investors do not realize is that the buy-and-hold approach is based largely on a famous study known as the BHB report and a misrepresentation of the study’s findings.

Some financial advisors will mislead investors and tell them that there is no reason to make adjustments in one’s portfolio since the BHB study found that asset allocation, not individual investments, accounted for 93.6% of investment returns. What the BHB study actually found was that asset allocation accounted for 93.6% of the variability of investment returns, not the returns themselves,

Looking at only three types of investments, stocks, bonds and cash, the BHB study concluded that the variability of a portfolio’s investment returns increased as more money was allocated to the more volatile investments. In retrospect, this seems to simply be common sense. The key takeaway for investors is that the BHB study, however, did not study the determinants of actual investment returns, did not claim to do so, and made no representations regarding same.

Advocates of the buy-and-hold approach to investing often offer numbers regarding the cost of missing the “best” days of the stock market. As a trial attorney, I am always interested in the other side of the story, what is not being said. In this case, what is not being said is that recent research indicates that the benefits of avoiding the “worst” days of the market far outweigh the cost of missing the “best” days of the market.

A recent study by Javier Estrada of the IESE Business School found that missing the “best” 10, 20 and 100 days of the stock market (defined as the Dow Jones Industrial Average) during the period 1990-2006 reduced an investor’s returns by 38%, 56.8%% and 93.8%, respectively. On the other hand, Estrada found that avoiding the “worst” 10, 20 and 100 days of the stock market improved an investor’s returns by 70.1%, 140.6% and 1,691%, respectively. The study found similar results for the period 1900-2006. The difference in the numbers is due in large part to the fact that investors have to earn more, sometimes significantly more, than they lost just to break even and the time spent in making up for such losses constitutes an opportunity cost for an investor.

So what does this mean for investors? Does this mean that investors should engage in short-term market timing to avoid market corrections? Not at all, as trying to time the short-term swings in the stock market would be both costly and virtually impossible.

Absolute return investing simply acknowledges the cyclical nature of the market and then takes advantage of such nature to maximize potential performance. Those familiar with the classic book,”The Art of War,” will recognize this strategy of using the nature of things to one’s advantage as a cornerstone of General SunTzu’s strategies, but it is equally applicable to investing.

The truth is that most investment portfolios fail to take advantage of the nature of the market, as they contain too many investments with a high correlation of returns, meaning that the investments react in like manner to market conditions and therefore fail to provide an investor with adequate protection against downside risk. A 2007 study by Schwab Institutional reported that 75% of investor portfolios studied were inappropriate for the investor in light of the investor’s goals and/or financial situation. This unfortunate situation is often due to the shortcomings of the commercial asset allocation/portfolio optimization software often used by financial planners and investment advisers.

Fortunately, investors wishing to implement an absolute returns strategy can do so on their own and save the costs and expenses involved with mutual funds. There are a number of investment products currently on the market that can greatly simplify the process of constructing an absolute returns portfolio. By heeding the advice of General Tzu and focusing on investment alternatives that have varying levels of correlation of returns and monitoring the stock market to decide when portfolio reallocation or substitutions may be appropriate, an investor can effectively manage investment risk and improve their potential for investment success.

James W, Watkins, III is an attorney, a CFP professional and an Accredited Wealth Management Adviser. His areas of expertise include wealth preservation, wealth protection and fiduciary law. He is CEO of InvestSense, LLC, a registered investment adviser firm located in Atlanta, Georgia. For additional articles and information, visit http://www.investsense.com. Mr. Watkins can be contacted at tawj3@yahoo.com.