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.

A Closer Look at the Facebook IPO

Well, that didn’t take long. Facebook had a nice opening day for its initial public offering (minus some execution glitches when the matching engine computer that runs the Nasdaq started to overheat). But the stock required some massive investment bank intervention to avoid fizzling out on Friday, Facebook’s first trading day.

The stock then flamed out on Monday, closing down 11 percent from the opening price. Yay.

It seems that the investment bankers pricing the shares substantially overvalued the company. Zuckerberg and the existing shareholders managed to make out just fine – selling out a big chunk of the company at a very good price (just days, incidentally, before GM announced its Facebook ads weren’t profitable).

Well, why do companies go public? Given the substantial expenses in going public and keeping your stock in circulation on a major exchange, there have to be some very good reasons. The best reason is this: The company needs to raise capital to expand. Its management believes they can invest the capital at greater than market rates of return, even after paying 7 percent off the top to the investment bankers selling the shares. And that this 7 percent commission is more efficient and reliable than borrowing the money.

Well, borrowing money is cheap these days – and Facebook has such great prospects, it shouldn’t have much trouble raising debt financing at, say, 6 percent. (That 6 percent interest payment, incidentally, is tax deductible. Dividends it may eventually pay to shareholders are not tax deductible.)

The nice thing about equity financing, though, is that debt free companies are unlikely to ever declare bankruptcy.

If you’re an insider, and you’re young (Zuckerberg isn’t hitting retirement age very soon), and you’re supremely confident about the prospects of the company, though, you don’t go public. You keep it private, and raise what you need to expand via the bond markets. Your investments pay off, you pay back the bonds and interest and keep everything else free and clear.

If you feel your prospects getting shaky, that’s when you sell off a bunch of equity to strangers and cash out.

Another tell: Facebook’s opening was on a Friday. That’s the day companies and governments release bad news – hoping that events over the weekend will distract the news commentators before the public comes back from the beaches and fishing trips.

I’m distrustful of IPOs generally, because of the natural temptation of management to dilute its holdings just as things get difficult. But I’m especially distrustful of Friday IPOs.

And I’m distrustful of stockbrokers and their managers. Here’s why: The investment bankers did everything they could to whip up demand among small accounts, offering “teaser shares” and allotments. They created an artificial shortage, and then they had brokers calling their small clients, offering a very small number of shares. Here’s the trick: Small orders are very expensive and inefficient to process for the customer. They are a gold mine for the broker dealer firm, which charges high commissions on small orders, on a percentage basis, compared to large ones.

The whole operation was designed to shear sheep.

This, indeed, was the most shameless shearing I’ve seen since the collapse of the Internet bubble in 2000.

IPOs, historically, have been a disaster for the small investor.

This isn’t new: A 1992 study from the University Illinois found that the 18 out of 21 cases, IPOs trailed the Nasdaq’s returns. The vast majority of the IPOs in the late 1990s proved to be disasters when the dot-com bubble burst. And lots of companies pointedly didn’t go public for years after that point, because of broad public disaffection with the stock market (and the atrocious behavior of stock promoters and the terrible performance by the financial media during that period of time.)

If IPOs were really priced fairly, you would expect them to roughly track the performance of the stock market over time. But look at the following chart:

This chart compares the performance of the Bloomberg IPO index against the S&P 500 index over the last year. The Bloomberg IPO index – represented by the blue line – replicates the performance of a portfolio of IPOs for 1 year after they begin trading. The S&P has been relatively flat; IPOs lost 26 percent over the last 12 months. (The Bloomberg website doesn’t allow for longer comparisons)

What’s that, you say? It’s not fair to compare IPOs against the S&P, which is all small caps? Ok. The Russell 2000 index of small cap U.S. stocks lost 6 percent over the last 12 months. IPOs, as the famous Gordon Gekko character from Wall Street would say, have been dogs with fleas.

That’s not saying IPOs are bad things, at all. Public companies have to go public somehow. But IPOs are clearly a game for experienced, professional investors with gimlet eyes and access to detailed information from vendors, competitors, industry data, and who have been able to question the fund management in considerable detail. They can then make a large buy, and do so efficiently. They frequently negotiate a discount for themselves and their direct investors – as opposed to their stock purchasing customers. There’s a difference. Just because you have an account with Morgan Stanley – the underwriter of the Facebook IPO – that doesn’t doesn’t mean you’re a part owner of Morgan Stanley.

Some IPOs work out great for everyone, no doubt. Some IPOs will struggle for a year or two or five before hitting their stride. They won’t show up in the Bloomberg IPO index.

But IPOs are not a game for the small retail investor. The company management is selling shares for a reason – and it is just too hard for the retail trader to separate the marketing and promotional froth from the real value of the company.  

Small Cap Stocks are Rockin’ – But Steady the Course

The gains come on the heels of a huge move in October of 2011, when the Russell 2000 rocketed up 15 percent. Things bumped around in November and December, then took off again in January (+7 percent) and February (+2 percent), for a total change of 15 percent in the last six months.

Traditionally, small cap stocks have been extremely sensitive to economic cycles. They take the biggest bruising when the economy slows down – but they also tend to come back strong when the economy begins to recover.

Investors are beginning to notice: Net inflows to small-cap funds and ETFs were north of $1.8 billion in February.

Does that mean we’re backing up the truck to buy all the small-cap shares in the Russel 2000 index?

No. We don’t quite work that way. If anything, the opposite is true: If you bought a bunch of small cap stocks back at the beginning of October, when the Russell 2000 Index was taking a bruising, your portfolio may have been thrown out of whack by the rise in small cap stocks.

If the rally continues, it may be prudent to balance things out a bit. After all, economic cycles come and go. Just as the great Pete Seeger song “Turn, Turn, Turn” implies, there is a time for bulls and a time for bears, a time you may purchase small caps, and a time to gather bonds together.

We’re still pretty early in the economic recovery, so we’re not too concerned about small-caps taking it on the chin just yet. Although they’re not exactly cheap at current valuations (the average P/E is about 17) have room to run. But no one knows the future for certain. We don’t like our clients to make gambles they can’t afford to lose.

Strategy Trumps Tactics

Batters keep their eye on the ball; hitters keep their eyes on the game. Take a look at your portfolio as a whole. If you are willing to accept risk at all (and that’s not a given!), then you should probably maintain a healthy split between small caps and large cap stocks – as well as U.S. and overseas stocks. You should also maintain a healthy diversification across industries, as well.

What does that mean? It’s a little different for everyone.

The easiest way to do that for most people is to use index funds, or their close cousins, ETFs.

The execution: Keep things balanced. Investing is like flying a multi-engine airplane: You want to keep an eye on all the dials. You want to keep engine output as balanced as possible. When one engine begins to overheat, or is pulling too much of the load, it will begin to become inefficient – and at an elevated risk of a flame out. So you back off the throttle a bit, and distribute the workload among the remaining engines.

The same with investing: At some point, you’re going to want to back off of small-caps, or back off of gold and precious metals. You start with a target allocation, and when any one asset category takes up too much of your portfolio, back it off some.

In our view, the time is long past to back off long-term bonds, including long-term treasury bonds. Those yields have gotten miniscule, compared to the risk you incur when a long bond collides with a rise in interest rates. It’s not pretty.