This past month the advisors at Ruedi Wealth Management covered five more “Investing 101” columns that appeared in The News-Gazette’s Business Extra Section. Make sure to look for them every Sunday, but just in case you missed them in February, the columns are below.
What Determines Investor Success?
A lot of people feel they could write the book “Why do investments work for everyone but me?” Others seemingly can do no wrong when it comes to investing without even trying. Why is that? There are only a handful key factors that determine what type of an investment experience that person has, and whether or not they are successful in achieving what they want with their investments. These, in the order of importance, are:
1. Investor Behavior: This is by far the most important factor influencing investor success. Is the investor a patient buy-and-hold investor or someone who was constantly reading news articles and acting on their every emotion? When you consider the irreparable damage panic selling causes when the market is down 40%, the importance of behavior clearly cannot be overstated.
2. Stocks vs. Bonds Allocation: The stock vs. bond allocation determines the vast majority of the risk/return features of your investment portfolio. Successful investors take the time to make sure their stock vs. bond allocation gives them the best chance of achieving their unique goals.
3. Sub-Allocation: The sub-allocation of a portfolio has more to do with splitting the larger asset classes into smaller ones and is where you make decisions like how much to hold in US stocks vs international stocks, large-cap stocks vs small-cap stocks, value stocks vs growth stocks. A lot of investors and advisors get caught up in the minutia of sub-allocation decisions and more or less waste their time. I think the only thing we can say about sub-allocation and investor success has to do with diversification: the more diversified the investment portfolio, the more likely the investor is to be successful.
4. Active vs. Passive Management: We find that investors tend to be more successful using passively managed low-cost index fund investments in their portfolios. Active management by its very nature results in less diversified portfolios and higher expenses.
5. Taxes: Successful investors make sure they take the necessary steps to minimize taxes. However, investors should not let the “tax tail” wag the dog, and have minimizing taxes determine their entire investment strategy.
6. Everything Else: I almost don’t want to give this category its own bullet point, but we’ll go ahead and lump everything that isn’t included in one of the first 5 determinants into one group. Moral of the story, if something doesn’t fall under the first five categories, it doesn’t make a material difference, so don’t worry about it!
Paul R. Ruedi, CFP®
Though investors typically make money when the price of a stock rises, there is a way for people to make money when the price of a stock falls through a process called short selling. This process is very risky and should not be considered a long-term investment strategy, as you are not actually investing in anything, but simply speculating that the price of a stock will drop.
In order to “short sell” a stock and gain from price drops, people actually borrow shares of stock to sell and receive the proceeds of that sale. If the price drops, they are able to buy those shares at a lower price, and the difference between the price when they sold and the price when they buy them back is their profit.
Short selling is extremely risky because the price can rise and force a seller to use their own money to make up the difference. For example, if a stock that was sold short for $100 rises to $150, a person only has $100 from the proceeds and will need to come up with an extra $50 to be able to buy the stock back and get out of their position. Because stocks can rise indefinitely, there is an unlimited amount a short seller can lose.
Since the shares are borrowed, the lending organization (usually a brokerage firm) requires that investors keep a certain percentage of the amount of the short sale in cash as collateral to make sure they can actually pay to buy shares back. Short sellers must meet certain minimum thresholds, and if they fall below them, they must either put up more money as collateral or close out the positions. This means if the price rises high enough, many short sellers have no choice but to buy the stock back, which is called a “short squeeze.”
An army of small investors recently decided to target the stocks that have been most heavily sold short, like GameStop and AMC. This is based on a metric called “short interest,” and is usually calculated as the percentage of shares sold short relative to the total shares available to trade. By bidding up the prices of the most heavily shorted stocks, they forced major hedge funds into a short squeeze, and caused massive losses in those funds. Though I wouldn’t likely recommend investing in the companies that are making headlines for this reason, I think just about everyone was happy to see hedge funds beat at their own game by main street investors. Score one for the little guy!
Ruedi’s Hierarchy of Financial Needs
Paul R. Ruedi, CFP®
If you have ever taken a Psychology 101 class, you probably encountered Maslow’s Hierarchy of Needs. Most often in pyramid form, the hierarchy provides a breakdown of a person’s needs; the needs at the bottom of the pyramid are prerequisites for moving on to the next levels of the pyramid. I feel something like Maslow’s hierarchy could help people clearly organize their financial needs, so I hereby present to you “Ruedi’s Hierarchy of Financial Needs.”
The first layer is the establishment of an emergency fund. The textbook recommendation for an emergency fund is anywhere from 3-6 months of non-discretionary expenses. Having this fund makes sure that any little financial bumps in the road don’t completely knock over your financial pyramid.
With an emergency fund in place, you are free to move on to the next need. This for many people is purchasing insurance to “ensure” that their family’s financial future will not be derailed by the loss of a family member and their income. If you are young, single, or have nobody depending on you – feel free to skip to the next step. For the rest of you, making sure you have adequate insurance is a prerequisite for moving up the pyramid.
With insurance in place you can move on to the next step – paying off high-interest rate debt. When I say high-interest rate debt, I don’t mean to rush to pay off your mortgage debt that accrues interest at 3.5%. I mean the thousands of dollars of credit card debt – the type with interest rates that make it really hard to chip away at that balance.
With high-interest rate debt paid off, a person can finally move on to saving and investing. There are many rules of thumb regarding how much to save, but these shouldn’t be called rules at all since most of them don’t apply to the vast majority of people. The amount a person should save depends on their goals – many people need the help of a financial advisor to determine just how much to save to fund those goals.
With all your most basic financial needs taken care of and your goals funded by a savings plan, you are finally at the top of the pyramid: financial self-actualization. This is where you are able to use your money for the things that truly reflect your values and make you happy. Though it may seem far out of reach right now, if you make the right financial moves along the way and don’t rush ahead, anything is possible!
What Does a Financial Planner Do?
David Ruedi, CFP®
We often talk about financial planning and the importance of having a financial plan. Still, many people wonder, what does a financial planner actually do?
A good planner will first get to know you as a person, learn about what is important to you, and understand your attitude about investing. They need to understand your unique situation to determine the right approach to help you achieve your goals in life.
Once a financial planner understands what you want to accomplish, they have to get a clear picture of your current financial situation. To do this, he or she will gather information about your assets and liabilities, sources of income, and how much you’re currently spending vs. saving. A good planner will also want to know about other financial considerations such as health issues or dependent family members. By looking at these items, they can get a clear understanding of your finances and your means to achieve your financial goals.
Understanding where you are now and what your ideal future looks like, your financial planner will develop a plan to bridge that gap. A financial plan will answer key questions like: How much do I need to save while I’m working? When can I retire? How much can I spend in retirement? What types of insurance do I need? How should I invest my money? When should I claim Social Security?
With the plan completed, a financial planner will review the plan with you, gather your feedback, and potentially modify the initial plan based on your feedback. Many financial planners will include alternative scenarios to illustrate the impact of altering key planning assumptions such as savings rate, retirement age, retirement spending, or portfolio asset allocation. Viewing these alternative scenarios allows you to analyze the tradeoffs involved in financial planning so that you can select the plan that appeals to you the most.
Once you both agree on a plan and finalize the details, a planner will help you determine the steps to get everything set up and begin implementing your plan. This typically involves setting up investment accounts, transferring assets, and managing your investment portfolio to keep it aligned with your plan.
With a financial plan established and implemented, your financial advisor shouldn’t be a stranger. Life will inevitably present you with surprises and challenges that will require you to adapt your initial plans. A good planner will provide ongoing advice, monitor the status of your plan, adjust the plan when necessary, and remain your trusted advisor for decades.
What is a Hedge Fund?
Paul R. Ruedi CFP®
A hedge fund is an investment fund that pools the money of investors to achieve some investment objective. Hedge funds are less regulated than mutual funds and are able to employ much riskier investment strategies. They generally aim to provide high returns for their investors, and they charge very high fees for doing so.
Oddly enough, a “hedge” is actually something an investor does to reduce risk. Though some hedge funds do pursue strategies that work as a hedge to common strategies, more often they are just unconstrained investment vehicles where their operators, called hedge fund managers, take on risk in the hope of reaping higher returns.
Hedge funds are only available to what are called “accredited investors.” To qualify as an accredited investor a person must have income greater than $200,000 ($300,000 for couples) or assets greater than $1 million. Organizations like banks, trusts, insurance companies, and brokers can also be considered accredited investors. The idea is that accredited investors are sophisticated and have a larger financial cushion should they lose their entire investment, and thus do not need the protections that smaller investors need.
Hedge funds take on risk and attempt to achieve high performance numbers in several ways. They may use a lot of “leverage” – borrowing money to invest. They may use complex “derivatives” – securities like options and futures that amplify risk and return. They may also pursue strategies like short selling to gain from a stock market drop or a price drop in a particular stock. Some hedge funds will sell some stocks short while buying different stocks to benefit, in theory, whether the market as a whole goes up or down.
Hedge funds often have two-part fees – commonly referred to as “two and twenty.” Though hedge fund fees have come down slightly in recent years, in the past it was common for hedge funds to charge two percent of the assets they managed for investors no matter how the fund did and twenty percent of any extra performance over a benchmark. Hedge funds are often criticized for charging such high fees.
Hedge funds have a certain mystique about them, but they are often bad investments for typical investors and even sophisticated investors due to their high fees and potential for their risky investment strategies to completely blow up. For the typical investor, it is much better to pursue a boring, diversified, buy-and-hold strategy. It is not as much fun to talk about at parties, but it is a much more reliable way to build wealth.