Avoiding Risk is Risky Business

Inflation is another doozy – and one that is particularly difficult to guard against in a low-interest rate environment such as the one we have now. With 10-year Treasury bonds yielding less than 2 percent, even a slight uptick in inflation can mean a net inflation-adjusted loss to any portfolio that emphasizes safety of principal to the detriment of all other considerations. Inflation eats away at your spending power over time, and ultimately, your lifestyle. And you cannot deduct losses from inflation. Indeed, under capital gains rules, you get taxed even on gains that have been devoured by inflation. Why? Buy an asset for a dollar, and sell it after 30 years for two dollars, and you still get taxed the same capital gains rate you would had you just held the asset for a year and a day. The tax code doesn’t care that that dollar is now worth just 25 cents, compared to what a dollar bought when you acquired the asset. Inflation is an insidious cancer on investment returns and slowly kills owners of assets just as surely as the termites ate that poor woman’s life savings.

There are some things you can do to mitigate inflation risk, though:

• Buy gold and precious metals
• Buy real estate and/or land
• Buy commodities
• Buy TIPS, or inflation-protected securities. These are treasury bonds that pay a lower yield than garden-variety bonds of the same maturity, but pay out a bit extra if inflation heats up.
• Buy assets that you have a reasonable expectation will outpace inflation. At current levels, I’m not a big fan of long-term low-yield bonds for this reason: They just aren’t yielding enough to cover inflation risk.
• Buy an inflation-protection rider in an annuity. These can be pretty pricey, though. The annuity company isn’t going to take on inflation risk for you without being pretty well compensated for it. Though this is true no matter what asset you’re buying – all markets will adjust for inflation risk, all things being equal.

Even muni bonds are no panacea. The City of Detroit defaulted just this month. Heartland Funds was forced to write down the value of one of its high-yield municipal bond funds by over 50 percent in one night, because they were simply inaccurately priced because the securities in the fund were so thinly traded.

The bottom line – It’s just as the excellent veteran personal finance writer Chuck Jaffe wrote in this column: There is no such thing as a ‘risk-free’ investment.

The smart thing to do is develop a budget for risk. Allocate your risks among several different types – so a negative event in one asset class doesn’t clobber your whole portfolio. Need help developing a risk budget? That’s where we come in. Give us a call and we’ll walk you through it, based on your timeline, your tolerance for uncertainty and your individual financial objectives.

Stocks vs. Mutual Funds. Which is Better For Me?

Why? Simple: You are not Superman. Nobody is. And you aren’t going to get any real market advantage over the professional investors by watching CNBC Squawk Box and Cramer. By the time information gets on TV, the smart traders have already acted on the information, and you’re going to get what’s left over.

You’re going to make your share of investing mistakes – and if you are very, very good, you may well be able to match the returns of the S&P 500 over the course of your investing lifetime.

If you do, bear in mind – even if all you do is break even with the S&P 500, after all your expenses, you are already outperforming the substantial majority of all professional stock mutual fund managers. These with sophisticated computer programs, discounted institutional broker pricing, and full-time staffs of very smart and highly-trained analysts at their disposal.

The problem with the middle-class investor and buying individual stocks is this: Few investors have a portfolio large enough to efficiently buy enough different stocks to adequately diversify their portfolios against the unpredictable and uncontrollable. Buying blocks of under 100 shares (what brokers call “odd lots” is costly, in terms of commissions, and you get tagged with invisible costs, such as bid-ask spreads, that you will never see, but which conspire against your returns.

It’s only when you get to portfolios of $1 million plus, or close to it, that we really have a lot to work with, when it comes to trying to build a single-stock portfolio from scratch.

Does that mean individual stocks have no place in your portfolio? Certainly not! Here’s where individual stock ownership can really play a beneficial role in your portfolio:

• Your employer provides a 401(k) match, profit sharing, ESOP or other equity incentive. If it’s free money, take it!
• You are tax sensitive and want to be able to use ‘tax harvesting’ strategies to control your capital gains exposure. Specificially, if you have several different stocks, and you need cash from your portfolio or you need to make some changes, you can sell some stocks at a loss to offset any taxable profits. This is going to be more important if the capital gains taxes increase from 15 to 20 percent, as they are scheduled to do in 2013.
• You have maxed out your IRA, 401(k) and other tax-deferred or tax-free savings and investment contributions.
• You are participating in a well-designed and constructed DRIP, or Dividend Reinvestment Program, which helps you avoid some of the costs associated with buying individual stocks.
• You want to own stock in a company or industry that tends to do well when your company or industry does poorly. For example, if you worked for a buggy whip company in 1905, it would have been wise to hedge your bets by owning some stock in Ford.
• You have some unique knowledge of a company or industry – legally obtained, of course – that gives you an advantage even over professional Wall Street analysts and sophisticated, professional investors.
• You love the process of investing and you truly enjoy the hunt.
• You can afford to lose 50 percent or more on your entire stock portfolio, and you can afford to watch any one of your investments go completely bust overnight, and not break a sweat.

Do you fall in one or more of the above categories? Then let’s talk about forming a coherent risk management and investment strategy that balances the downside risk against your objectives and your overall portfolio and situation.

Are you in the “none-of-the-above” category? Then let’s stick to funds and index funds, and balance that against your cash savings picture, your insurance plan and your various sources of income – be they from labor, small businesses, passive activities, real estate, or anything else.

Art, Wine and Musical Instruments: Investing in Collectibles

Every once in a while, you’ll hear people arguing for various collectibles as investments. And indeed, there’s at least one mutual fund that actually invests in wine.

I don’t deny that some collectibles have historically held their value reasonably well. In hindsight, some collectibles have certainly made huge profits for their holders. And there is little doubt that this will continue to happen in the future – though not necessarily with the same collectibles.

When we look at an individual stock, let’s say, we look at something called “intrinsic value.” The price of the stock is a totally separate idea from intrinsic value. Intrinsic value is the real value of an investment. Sometimes a stock, like any investment, can sell for more than its intrinsic value, and sometimes for less. If it sells for much less than intrinsic value, we recommend buying. If a stock sells for more than its intrinsic value, we recommend selling and buying something else.

Now, one of the things we look at with a stock is the value of its future earnings. Indeed, a stock price is the market-discounted present value of all the future dividends we reasonably expect – adjusted for risk and liquidity

The same is true of a bond. We know what the future payments are going to be and when the bond will mature and the bond owner can expect repayment of principal. So the bond market takes the sum of those payments, discounts what it thinks inflation will be, and further subtracts something to compensate for the possibility of default.

And that brings us to the problem valuing collectibles – wine, works of art, valuable musical instruments, and the like: There is no stream of income to calculate a discounted present value of future streams of income. The entire equation, in most cases, is purely speculative: These objects have investment value only because of the expectation that someone in the future will pay more for them than today.

They don’t generate any real income whatsoever (not counting licensing fees on art).

But they do generate risk: Your valued collectible is vulnerable to damage, loss, fire, theft, flood damage, vandalism or any other number of hazards.

Yes, you can buy insurance against these hazards, most of the time. But if your collectible has any significant value, you’ll have to add it to your homeowner’s policy – and pay more in insurance premiums as long as you own it.

Later, when you sell a collectible, you have to pay the capital gains rate on collectible income – which is higher than long-term capital gains rates, at 28 percent. It’s lower than a lot of peoples’ income tax rates, but you have a lot of deductions available against income, in most cases.

Special considerations for wine

Wine makes for a strange investment thesis: The value of wine is in the drinking, not in the counting. There is no doubt that there is potential for price appreciation as the wine ages. But ultimately the whole point is to drink it, not count its value. It is a curious investment indeed, that gains value as its destruction draws near. At least bonds and life insurance policies give up a large cash payment when they destruct… er, mature. No matter how good the wine is, ultimately the return is going to be an empty wine bottle… and the memory of a great party.

Art

Art, on the other hand, has a more important value: Its beauty. Which is, at some level, worth paying for for its own sake. But where is its value? Is its value in its beauty?

The enjoyment a potential buyer can get from owning the painting? Or is the value in its scarcity?  These are two different questions – an ugly painting can still be valuable because it’s scarce. There’s nothing like it in the world. The artist only produced one original (and who knows how many prints?)

But tastes change. Art that was once very much in style and demand can fall out of demand very quickly – and prices can fall. And while scarcity has value, it does not have intrinsic value: Its value only exists to the extent others give it value. And they could decide tomorrow that an original from Artist X is no longer worth very much – or even half what you paid for it.

Living artists are always tricky. There’s nothing so good it doesn’t have to be sold, of course… and successful artists are also frequently successful salespeople. You may get a short-term price boost when the artist dies, of course… we know that artist won’t be making any more works! But sometimes art gains in price because the artist is a terrific self-promoter! This is nice for a while – if you buy early. But this is not a lasting thing. Ask yourself if this art is valuable because of its timeless quality? Or because the artist is an effective self-promoter?

The best reason to buy art, in my opinion, isn’t because it’s an investment. It’s because you get tremendous enjoyment out of owning it. If the price goes up, great. If the price goes nowhere, you still win.

Buy like you’ll never sell.

(Unless you’re a dealer, that is!)

Musical Instruments

The nice thing about good quality musical instruments is that while they may gain in value, they usually don’t lose value. If you’re buying solid wood (no plywood), or handcrafted musical instruments, you can usually at least trade up for full value from a reputable dealer. They can usually do this because they know that good instruments don’t lose value, if they are well-maintained. Bad instruments do lose value, though, and become garage sale specials.

If you are looking at starting a youngster on a musical instrument, my advice is to get the best instrument you can afford – usually used. This is defense – not offense. The goal is to ensure you can get back what you paid for it. And sometimes you get lucky and a given instrument gets very valuable over time. Meanwhile, you can get a lot of value out of it by playing it. In some cases, musical instruments can help generate income as well.

As a pure collector’s item, they are as tricky as art, though my sense is that the market for musical instruments is less fickle: Manufacturers of quality instruments don’t fall out of favor for no good reason the way individual artists do. There may not always be a market for a very hot living artist. But there are always markets for good quality Steinways, Martins, Gibsons and all the way up to Stradivarius violins.

Not everything that comes out of these shops is equally good, though… and that’s where your expert knowledge can give you an edge. But if you’re that much of an expert, chances are good you can get a ton of enjoyment just by owning and playing a great instrument.

The bottom line: Buy beauty, and buy quality, and enjoy what you have. Play defense, not offense, with art and musical instruments and similar collectibles. Yes, they can provide a store of value. And yes, they can be the basis of entire businesses that buy and sell them! But very few people are in a position to think of them purely as investments… and thinking of them as an “asset class” and justifying their purchase in the name of “diversifying my portfolio” are surely missing the point.

As the great guitarist, composer and collector Frank Zappa once expressed:

“Shut up n’ play yer guitar.”