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Tue. Jun. 2, 2009

All Investing Involves Risk *

If your goal is to accumulate wealth for a comfortable retirement, then there is no risk-free path. Throughout time every angle has been tried and failed. However, some approaches carry less risk than others. Let’s consider some of the popular paths.

Cash/Money Markets/CDs – “Cash Investments”
I have always considered “Cash Investments” an oxymoron. Cash is where some investors park their money when they believe the investment risk is greater than the potential return – their sole focus is capital preservation. Unfortunately, some people consider Cash/Money Markets/CDs et.al. as investments. This is a dangerous assumption. Their slow and predictable growth is generally always below inflation, but since it is growing the “investors” often lulled into a false sense of security and do not notice that they are actually losing ground each year until it is too late.

Land/Real Estate – “They aren’t making anymore land.”
Many investors have discovered the hard way that bubbles can also occur in the real estate sector. What was once seen as a safe place to put your money and forget it is now in the midst on an ugly down-turn. According to S&P, home prices tumbled by 19.1 percent in the first quarter, the most in its 21-year history. Home prices have fallen 32.2 percent since peaking in the second quarter of 2006 and are at levels not seen since the end of 2002. Still, there are no signs home prices have hit bottom. “We see no evidence that a recovery in home prices has begun,” said, David M. Blitzer, chairman of the S&P index committee.

Gold/Precious Metals
If you look at a historical chart of gold prices, you will see a pattern, gold spikes to a new level during a crisis, then comes down to a level above the previous steady state. It then trades sideways until the next crisis. It would be hard to time your retirement to coincide with a crisis/spike.

Professionally Managed Equity Mutual Funds
Every year several professionally managed mutual funds out-perform the market. Unfortunately, it is rarely the same funds each year. It has been well documented that over time, most professionally managed funds under-perform the market.

Treasuries/Bonds
Treasuries and bonds tend to be less risky than equity investments, but have historically under-performed equities. It is important to note that there is risk associated with them. For corporate bonds, the companies could default and not pay them. For all bonds, including those issued by government, there is an interest rate risk – rising interest rates drive the price of bonds down. I do consider bonds an important part of my asset allocation. You can purchase bonds directly in the open market or bundled in funds/ETFs. Below are some low-cost Vanguard bond ETFs:

  • Vanguard Short-Term Bond ETF (BSV) – Yield: 3.38%
    The Fund seeks to track the performance of the Barclays Capital 1-5 Year Government Index. This index includes U.S. Government, investment-grade corporate, and international dollar-denominated bonds, with maturities between 1 and 5 years.
  • Vanguard Intermediate-Term Bond ETF (BIV) – Yield: 4.67%
    The Fund seeks to track the performance of the Barclays Capital 5-10 year Government/Credit Index. This index includes U.S. Government, investment-grade corporate, and international dollar-denominated bonds with maturities between 5 and 10 years.
  • Vanguard Long-Term Bond ETF (BLV) – Yield: 5.60%
    The Fund seeks to match the investment performance of the Barclays Capital Mutual Fund Long Government/Corporate Index.
  • Vanguard Total Bond Market ETF (BND) – Yield: 4.55%
    The Fund seeks to generate returns that track the performance of the Barclays Capital Aggregate Bond Index, and will maintain a dollar-weighted average maturity consistent with that of the index. The Index measures investment-grade, taxable fixed income securities in the U.S.

Also, if you live in the U.S. you can purchase Savings Bonds via TreasuryDirect.gov. However, recent changes in this program have made it less appealing.

Index Funds/ETFs/CEFs
For most people, indexed investments including mutual funds, exchange traded funds (ETFs) and closed end funds (CEFs) should make up the core of their investment allocation.  In effect, you are aligning your investment risk with what the index fund tracks. If you believe that over time that certain index funds, such as the  S&P 500, will outperform the the various approaches listed above, you should have money invested in it.  Index funds allow you to easily track any sector, market cap or index. Here are some varied funds in this category:

  • Vanguard 500 Index Fund Investor (VFINX) – Yield: 2.90%
    The Fund seeks to track the performance of a benchmark index that measures the investment return of large-capitalization stocks. The Fund employs a “passive management” approach designed to track the performance of the Standard & Poor’s 500 Index.
  • IShares MSCI EAFE Index Fund (EFA) – Yield: 3.94%
    The Fund seeks to provide investment results that correspond generally to the price and yield performance, before fees and expenses, of the MSCI EAFE Index.
  • IShares Trust DJ US Basic Mat Sector (IYM) – Yield: 2.58%
    The Fund seeks investment results corresponding to the price and yield performance, before fees and expenses, of the Dow Jones US Basic Materials Sector Index. Component firms are involved in the production of aluminum, chemicals, commodities, chemical specialty products, steel, and other goods and resources.
  • IShares Trust DJ US Real Estate Index (IYR) – Yield: 8.69%
    The Fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the Dow Jones US Real Estate Index. Uses a representative sampling strategy. Component firms include hotel and resort firms and REIT’s.

Individual Stocks
Inherently, individual stocks will carry higher risk due to the lack of diversification when evaluated on a stand-alone basis. You can mitigate this risk to a degree by selecting solid dividend paying companies with a track record of increasing their dividends each year. Some of my personal favorites in this category are:

  • Johnson & Johnson (JNJ) – Yield: 3.58% – Analysis
  • Procter & Gamble Co. (PG) – Yield: 3.32% – Analysis
  • Sysco Corp. (SYY) – Yield: 4.12% – Analysis
  • PepsiCo, Inc. (PEP) – Yield: 3.49% – Analysis

When it comes to investing your money, there is no escaping risk. A good investor will determine the desired outcome and and invest in a way to acheive their goal with minimal risk.

Full Disclosure: Long BLV, VFINX, EFA, IYM, IYR. See a list of all my income holdings here.


7 Responses to “All Investing Involves Risk *”

  1. I don’t agree with you about CDs not being investments, that is longer term ones like FDIC-insured 5-yr CDs with low early withdrawal penalties. By shopping around, I have always been able to find ones with attractive yields. And, with low early withdrawal penalties, like 6 month simple interest, they afford protection against inflation since if interest rates rise a lot it is easy to swap them for higher yielding ones.

    Right now, the best I find is a 5-yr CD yielding 4%. Since we are currently in deflation, I think this an outstanding INVESTMENT, especially since the early withdrawal penalty is only 2%. So, hold it just 6 months and you haven’t lost anything if closing it. If interest rates spike, great, since it is a win-win situation, rarely available with other assets – protection against both deflation and inflation, plus guaranteed by the US government. Such insurance was rare among other countries until recently when this financial mess began.

    Plus, if one holds them in a Roth IRA, one can owe no taxes on the interest.

    I am not saying to only hold CDs, but I do think they have a large place in one’s portfolio, especially since they proved to be risk-free during the last year or so of this financial mess. Even Warren Buffett can’t claim such success.

    There are actually some advantages the little guy has, and CDs are one of the advantages. The big guys with mega cash amounts were forced into all these crazy SIVs, wacky collateralized debt stuff, etc, in search of yields. The little guy didn’t have to do so.

  2. Joseph: You are correct that today CDs are outpacing inflation, but over time they tend to fall behind. My point was that someone in their 20s or 30s couldn’t build an effective retirement solely using cash investments.

    Best Wishes,
    D4L

  3. Super Saver says:

    I prefer individual bonds held to maturities versus bond funds or ETFs. Since I am holding to maturity, I know I will eventually get the face value of the bond. I don’t get the same benefit from bond funds/ETFs.

  4. I prefer individual bonds held to maturities versus bond funds or ETFs. Since I am holding to maturity, I know I will eventually get the face value of the bond. I don’t get the same benefit from bond funds/ETFs.<<<<<

    I agree, though I only consider Treasuries, and currently inflation-protected Treasuries (TIPS) are what I own. By the way, for smaller amounts, US I-Savings Bonds are also pretty good. I think I-Savings Bonds are also good instead of 529 educational accounts.

    My general approach with any investment, is to eliminate the middle man, so to speak, as much as possible. It is easier to avoid crooks that way, not to mention additional fees. There is no way I would trust ETFs. Besides that they are simulated mutual funds, something I don’t like, that they are new raises other uncertainties. Heck, Credit Default Swaps were marketed like insurance products, but they were a scam to avoid insurance regulations. I suspect many ETFs are constructed for the real purpose of avoiding regulations which apply to mutual funds.

    Plus, in my case, I only want to invest in companies which I think are in moral businesses. That is one reason I would ignore Mutual Funds, ETFs, especially index funds/ETFs. So, that is another reason for me to avoid them, though I don’t like the concept anyway like I said above.

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