Uncommon Cents

Some people discover their risk tolerance is rather low, or lower than they thought, in stock market times such as these. If that is indeed the case, what options do these people have?

The principle of risk/return does not disappear just because someone can’t deal with somewhat higher risk; rather, it becomes very clearly in effect. If someone wants to take absolutely no chances with their money (or just shy of no chance), they can certainly do that, but the returns their money will gain will be quite low–but they will exist. This is unless it’s someone who would rather bury money in coffee cans in their back yard or stuff it in their mattress, of course–but that’s not investing.

Realistically, everyone needs a safe place to put at least some of the dollars they have. An emergency fund needs to be kept away from stock market risk, because emergencies don’t come on a schedule (some would say the market currently is in a state of emergency!). So “chicken money” is something everyone has at least some of–money we’re too chicken to put at any risk at all.

Savings or Share Accounts: These are your typical accounts at a bank or credit union. Right now the rates of interest on them are anemic–in the case of my mother’s bank account, one fourth of one percent of interest! That’s definitely not keeping up with inflation. However, since the account is FDIC insured and she’s well within the limits of the insurance, it’s as safe as the federal government’s word. If you’re going to use one of these, make sure you have insurance by the FDIC or the NCUA (in the case of a credit union). You won’t make much, but your money will be safe, and it’s really high in liquidity, meaning you can get at your money pretty much anytime (provided the bank’s business hours work for you).

High Yield or Money Market Accounts: These tend to be a lot like savings or share accounts but with a somewhat higher rate of interest and possibly more limits on accessing your money. For instance, I have a Capital One Direct high yield savings account that pays me 3.55% interest and allows check writing and ATM access–but limits how many checks I can write per month. Fortunately, it also allows electronic access, which is a bit more liberal. This is a nice place to stash an emergency fund, since it’s almost as liquid as a savings or share account.

Certificates of Deposit: CDs tend to have rates about the same if not a little higher than high yield or money market accounts. In return for offering a little more interest, you lose liquidity. Still, CDs you may be appropriate for an emergency fund with a little planning (having a CD mature every month with 5/6 of an emergency fund means at most you’d be one month away from access, and having that remaining 1/6 in something like a high yield account could do it) but for simplicity’s sake, you may not want to use these for that purpose. Make sure you are wary of the FDIC limits (which apparently will be increasing, at least for awhile) on how much they’ll insure if you really are concerned about safety!

Treasury Bonds or Notes: In many ways considered the safest of investments, there are lots of different bonds and notes you can get; some may offer tax advantages. I have a bit of my portfolio in I series bonds, for instance. There are also government issued bonds or notes from local or state governments that may be worth looking into as well. Again, the rates are not fantastic, but combined with possible tax advantages as well as safety, this could be a viable option.

Money Market Funds: Not quite the same as the money market accounts, these are mutual funds that invest in short term instruments. They are not backed by FDIC or NCUA insurance as they are mutual funds, although they recently had some temporary insurance offered to them with unusual circumstances that led to a “run” on them as a consequence of the Lehman Brothers bankruptcy. Money Market funds nearly always have a stable net asset value of $1 per share and pay a return based on how their investments do. Of course, since it’s a mutual fund, your initial investment will likely need to be more than you can put into a savings account, money market account, or CD, and you may have commissions to deal with.

Bond Funds: In bond funds, you have a ton of choice just as you do with stock funds. If you’re looking for safety, consider the quality of the bonds in the fund; “junk bonds” may offer higher yields, but more risk. Funds that are based on Government National Mortgage Association bonds–Ginnie Mae funds–tend to be both very safe and pay very nice returns. A fund like the Vanguard Total Bond Market Index has offered similar performance and safety to the Ginnie Mae funds over time. Again, these are funds, but unlike the money market funds which almost never move off the $1 per share net asset value mark, these do fluctuate a bit, but historically, nothing like stock funds.

There are some alternatives–from about as safe as you can get to pretty safe with some amount of risk–to consider for your chicken money, whether that’s just your emergency fund or your whole portfolio. Good luck in selecting one that might meet your needs!

Risk tolerance is a subject that’s discussed a lot in investing. It means how much you can live with in terms of taking a chance with your money, typically meaning that in order to have more potential gain, you have to live with more potential loss, and if you only want to avoid losses, you can, but sacrifice the potential for larger gains. Some people have virtually no risk tolerance in investing–those are folks who need to be in investments like Certificates of Deposit and government issued notes, bills, and bonds or to bury their money in coffee cans welded shut in the back yard. On the other hand some will take huge risks by investing in a single stock with everything they have. If that stock is the next Google, they’ll be incredibly rich! If it becomes the next Pets.com, they’ll lose everything.

The vast majority of people would say their risk tolerance is somewhere in the middle. Where on that continuum you are is easy to overstate when the market is doing well; lots of folks say they’re very comfortable with stock market risk when the market is having the kind of run it did in 2003-2007, with positive returns every year. However, when a year like 2008 happens–with virtually the entire market in a tailspin–those who really have the risk tolerance they state to stay in the market actually do that: stay in the market. Those who don’t start heading for the exits.

You can tell the low tolerance group easily: they’re the ones who are saying that if you stay in, you’re a fool, and proudly declare how they moved everything into cash. They said they have risk tolerance, but they really didn’t. Of course, history shows that cashing out and moving to cash after a market dump tends to be exactly the opposite of the best decisions, but that doesn’t stop them.

Times like this say a lot about how much risk you’re willing to stomach.

As for me? I haven’t sold anything since my usual bit of changes in April of this year. How about you?

One of my friends at work was asking about investing and had an interesting question: “How does Google make money?”

I told him that nearly all Google’s income is ad revenue; they have some paid for products (like their rackmount search appliance) but for the most part everything they do for consumers is free. He was considering investing in Google but aside from search, didn’t know a whole lot about the company.

A different friend of mine loves Ann Taylor. It’s close to the only place she buys clothes from. She has a MBA and knows how to read balance sheets and knows some business basics; she sees the share price and the price per earnings ratio but also believes that the company makes products she loves, uses, and buys.

In this situation, my first friend, while intrigued by Google, needs to learn more about the company before deciding if it’s an investment for him; my second friend would, however, really be a candidate to purchase some Ann Taylor stock.

While understanding things like balance sheets, share prices, and dividends matter, it also matters that you understand the company, what their products are, who their customers are, and believe in what they make or do. If not, the investment is more like speculation. So do your homework and understand what you’re buying; I firmly believe that if a company is profitable and you think they’re the best in the world at what they do–so much so you’re a customer and sold on them yourself–owning them will, over the long run, not hurt your portfolio. Only buy what you know!

[For what it's worth, shares of Ann Taylor (ANN) have outperformed both the S&P 500 and Google (GOOG), even though all are down year to date.]

Short selling, or shorting a stock, is a somewhat speculative investing strategy where you profit from the stock price going down. When you short a stock, you’re selling a stock you don’t yet own–rather, it’s lent to you by a brokerage house for a specific period of time. At some point, you must pay back the lender; if at the point you pay it back the stock price is lower than it was when you sold your unowned stock, you profit because you are paying back the lender with stocks bought at a cheaper price than when you sold them. However, if the stock price rises, you end up with a loss.

Shorting a stock is considered speculative because the general trend of the market is upward. You only make money on a short by a stock price heading downward, which is the minority of the time. Some investors also short to hedge against a market downturn.

Shorting stocks made news recently because in a highly controversial move, the Securities and Exchange Commission temporarily banned short selling a large number of stocks, mostly in the financial sector. Short selling, while somewhat speculative, is a normal part of stock market operations. It seems to me that this is another example of the government trying to limit stock market losses that’s likely doomed to make things worse in the end–my opinion, of course.

One of the folks I follow on Twitter posted this past week:

Stocks just took a smash. Dow closed down 500 points! APPL dropped $8.50 per share. Time to panic yet?

This was on the 15th of September.

Today (the 19th), shows that, as usual, it’s not time to panic.

Today, the most followed of the indices, the Dow Jones Industrial Average, closed at 11388.44. The broader, more significant S&P 500 closed at 1255.08.

The Dow opened the week at 11416.37. The S&P opened the week at 1250.92.

As you can see, the final result for the week was essentially flat. So, even with a very short timeframe, it was definitely not time to panic.

Welcome to your Link Payday for September 20, 2008–fumigation edition! We’re getting the house tented for the first time ever on the 25th, and I’m working every day right up to that point. So in memory of the soon to be deceased termites, roaches, and rodents, here are some of the best posts from around the financial blogosphere over the last couple of weeks:

Moolanomy gives us 5 Surefire Ways to Improve Your Investment Performance. In today’s difficult market, I think this is definitely worth reviewing!

The gang over at Spilling Buckets tackles a huge question with lots of implications in Chivas Regal and a Fine Wine, Why is College Expensive? Having been out of graduate school for more than a decade, it shocks me to see what students are paying today even at a public university that’s known for being a bargain!

Trent at The Simple Dollar takes an interesting approach to dealing with recurring expenses–which I am so not a fan of–when he tries to determine The Least Important Bill. I’m thinking mine is a tossup between my cell phone and cable Internet–but I’m not sure I can successfully do without them!

All Financial Matters gives an important lesson in a basic yet complicated personal finance task when they answer a Reader Question - How to Calculate Personal Rate of Return. This is a tough one to do, and I’m glad they took it on!

Finally, my buddy Ron over at The Wisdom Journal highlights 50 Frugal Things You Aren’t Doing (well, I am doing a lot of them, but surely not all of them!).

And that’s your Link Payday for September 20, 2008!

Actually, yes, there is, although there’s not a lot of it.

The positive parts are:

stocks you were planning to buy are now more of a bargain they were last month–maybe too much of one (see Fannie Mae and Freddie Mac as examples);

high quality bond funds are still doing well;

and oil is still plummeting in price! Right now oil is at a seven month low, about 1/3 off of its all time high price set on July 11, 2008. For an economic recovery to happen, we absolutely need lower energy prices.

So even when things don’t look great, there’s still some things worth cheering about out there!

Up until recently, Ginnie Mae (GNMA), the Government National Mortgage Association, seemed to be just another nickname for a mortgage backer like Fannie Mae and Freddie Mac. Yet with all the disaster around Fannie and Freddie, there’s little talk about trouble at Ginnie Mae. Why is that?

One simple, but world making difference between Ginnie and its siblings: GNMA is a government owned corporation which has the explicit guarantee of the federal government. Fannie and Freddie simply had implied guarantees of the federal government. Where investors have fled from stocks and bonds in Fannie and Freddie (and their prices have reflected this), Ginnie Mae funds, on the other hand, have benefited from a flight to quality and are doing as well as ever.

For what it’s worth, I do own shares in the T. Rowe Price GNMA fund, PRGMX, which has returned 3.54% year to date with a yield of 4.79%. And I’m glad, too!

One of my favorite companies is Apple, Inc.; I’ve used their products since high school and I believe in their business. In the last few months, I’ve backed this in a very significant way: I’ve become a stockholder. Instead of putting a large amount of money into the stock at one time, my holding of AAPL has been one that’s been built monthly, through Sharebuilder. While this seems like dollar cost averaging (and in many ways is identical), it really isn’t dollar cost averaging. Dollar cost averaging would imply I have a large amount of money available at one time and buy into the stock at a fixed dollar amount on a regular basis (monthly, for our purposes). However, I really didn’t have a large amount of money to put in at once, so this is actually an example of regular investment of a set amount of dollars.

I began buying into Apple early this year, in February. I bought a fixed amount each month, and am continuing to do so. When I started, I got the stock at an effective price (includes the commission of $4) for $118.73. As I write this, the stock closed on Friday at $169.53. I could have had a very healthy gain of almost 43% right now had I bought all of my shares that day! However, since I’ve been buying into the stock regularly since then (once a month), I’ve also gotten shares for the effective prices of $141.78, $164.53, $186.57, $176.63, $155.00, and $176.75, so I’ve bought it above the current price three times and below the current price four times. All told, my investment in AAPL is up 8.22% for the year which is tremendously better than the market as a whole but considerably worse than the nearly 43% had I bought everything in February. So does that mean that investing on a regular basis is a bust?

Not necessarily. While many (including myself) are dubious of the risk reduction claims of the dollar cost averaging approach, it appears to have taken hold here. Yes, my returns were far worse than had I bought in February, but had I bought into the company at the start of the year (well, January 2nd, since markets were closed on New Year’s Day), it could have been at the price of $199.27; instead of having that 8.22% gain, I’d have a 14.9% paper loss!

In the end, I think that the lesson behind investing regularly is that doing it helps to assure that you develop a valuable financial habit rather than reducing risk or maximizing gain. Yes, it’s nice to have big gains and reduce risk, but it’s not clear this approach will do either. What it will do, however, is get you to put away money regularly–which is one of the real keys to successful investing.

In addition to my various mutual funds, I have a few individual stocks which in total make up less than 10% of my portfolio. Let’s see how they’ve performed year to date.

Some of these stocks I’ve owned for many years; some I’ve bought this year; at least two of them are the result of dividends or spinoffs. Some of them are decidedly long term holdings and some I’m only thinking I’ll hold onto for a year or so (and those get reviewed at the start of a year to determine whether or not I’ll hold onto them for awhile more). In any case, as you would expect, some have done markedly better than the stock market indices and some have done markedly worse. Proceed with caution on individual stocks, but they can certainly be a part of any portfolio. As a reference, the S&P 500 index is down 12.64% year to date, so even if something is down 10% year to date, it’s doing better than the market as a whole!

In no particular order:

Idearc Inc. (IAR): I got this stock as a dividend from, I believe Verizon. It was too small to do a whole lot with (selling it would have resulted in a cost that was substantial on a percentage basis and I didn’t really want to buy more of it). It’s down an astronomical 90.6% for the year.

American Capital, Ltd. (ACAS): I bought this one because I was impressed by its dividend, which is still quite impressive; it had also had a nicely elevating stock price for a few years prior to my buying it. So much for that: it’s down 34.04% year to date.

Amazon.com, Inc. (AMZN): I’m sure that everyone knows these guys. I bought into Amazon just this year, in fact, just a few months ago, making it my most recent stock purchase. It’s down 12.77% this year.

Apple, Inc. (AAPL): I’m just as sure that people know Apple at least as well as they know Amazon. It’s down 14.41% this year (I am actually buying into this stock every month and found that despite it being down for the year, my investments in it are actually up about 10% year to date).

Altria Group, Inc. (MO): The international tobacco king (that also has many other holdings) has been a long term holding for me. It’s been my most successful stock over time. The performance this year seems dismal but it’s due to a spinoff of Philip Morris International (PM) which is up next. For the year, the stock is down 72.18%, which is due almost exclusively to the PM spinoff.

Philip Morris International (PM): Received as an Altria spinoff, this stock is the first one I’m looking at that’s statistically up year to date, a healthy 6.17%.

Google (GOOG): Another household name. I bought into Google in April. While my holding is definitely down, it’s not quite at the level of the year to date figure, which is a negative 33%.

Merck (MRK): A pharmaceutical giant, I’ve liked Merck’s dividend and had it for awhile. Year to date, it’s not doing so hot, down 38.62%.

Verizon (VZ): I hate all the phone companies, but I own one of them. I’ve had a holding in Verizon for a couple of years, and it’s usually done better than this year, when it’s down 19.62%.

Bank of America Corporation (BAC): Yes, I own a financial stock (two, actually, as you’ll see shortly). Bank of America’s fared better than many (this is one I’ve only owned since this year) but it’s still down 24.53% for the year.

RPM International Inc. (RPM): These are the Rustoleum guys if you can’t figure out what they do. Just as the market has only had a few bright spots this year, this is one of the bright spots in my portfolio of individual stocks. It’s up 6.4% for the year.

Toyota Motor Corporation (TM): You know who these guys are. It’s a long term holding of mine that really hasn’t done well the last couple of years but are not going to be sold out of my portfolio anytime soon. Down 15.62% for the year.

Finally, Wells Fargo & Company (WFC): My other financial that is a long term holding. It’s done very well compared to other bank stocks and the market as a whole and is up for the year, but not much: a positive .26% this year.

It’s a tough market year, as you can see in the performance of these stocks. While individual stocks lack the diversification of a mutual fund, they can certainly be a great part of anyone’s portfolio; just keep their totals to a small part of your total portfolio, buy wisely, and hang on!