Category: Investments

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3 Risks of Investing in the Stock Market – Volatility, Timing & Overconfidence

dice invest-918x516Risk and reward are inextricably intertwined, and therefore, risk is inherent in all financial instruments. As a consequence, wise investors seek to minimize risk as much as possible without diluting the potential rewards. Warren Buffett, a recognized stock market investor, reportedly explained his investment philosophy to a group of Wharton Business School students in 2003: “I like to go for cinches. I like to shoot fish in a barrel. But I like to do it after the water has run out.”
 
Reducing all of the variables affecting a stock investment is difficult, especially the following hidden risks.

1. Volatility

Sometimes called “market risk” or “involuntary risk,” volatility refers to fluctuations in price of a security or portfolio over a year period. All securities are subject to market risks that include events beyond an investor’s control. These events affect the overall market, not just a single company or industry.
 
They include the following:
 
Geopolitical Events. World economies are connected in a global world, so a recession in China can have dire effects on the economy of the United States. The withdrawal of Great Britain from the European Union or a repudiation of NAFTA by a new U.S. Administration could ignite a trade war among countries with devastating effects on individual economies around the globe.
Economic Events. Monetary policies, unforeseen regulations or deregulation, tax revisions, changes in interest rates, or weather affect the gross domestic product (GDP) of countries, as well as the relations between countries. Businesses and industries are also affected.
Inflation. Also called “purchasing power risk,” the future value of assets or income may be reduced due to rising costs of goods and services or deliberate government action. Effectively, each unit of currency – $1 in the U.S. – buys less as time passes.
 
Volatility does not indicate the direction of a price move (up or down), just the range of price fluctuations over the period. It is expressed as “beta” and is intended to reflect the correlation between a security’s price and the market as a whole, usually the S&P 500:
 

  • A beta of 1 (low volatility) suggests a stock’s price will move in concert with the market. For example, if the S&P 500 moves 10%, the stock will move 10%.
  • Betas less than 1 (very low volatility) means that the security price fluctuates less than the market – a beta of 0.5 suggests that a 10% move in the market will produce only a 5% move in the security price.
  • A beta greater than 1 (high volatility) means the stock is more volatile than the market as a whole. Theoretically, a security with a beta of 1.3 would be 30% more volatile than the market.

 
According to Ted Noon, senior vice president of Acadian Asset Management, implementing low-volatility strategies – for example, choosing investments with low beta – can retain full exposure to equity markets while avoiding painful downside outcomes. However, Joseph Flaherty, chief investment-risk officer of MFS Investment Management, cautions that reducing risk is “less about concentrating on low volatility and more about avoiding high volatility.”

Strategies to Manage Volatility

Strategies to reduce the impact of volatility include:
 
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How to Fix the United States’ Debt Problems & Reduce Federal Deficits

federal-debt-18 trillionAccording to projections by the Congressional Budget Office (CBO), America will continue to spend more than it receives in revenues from 2016 to 2026, and perhaps beyond. The budget deficit is projected to be slightly below 3% of gross domestic product (GDP) through 2018, then rise to 4.9% by 2026.
 
If the CBO projections are accurate, the federal debt will grow another $9.4 trillion by the end of the 10-year period, with potentially dire consequences for the country. According to the authors of the report, “The likelihood of a fiscal crisis in the United States would increase. There would be a greater risk that investors would be unwilling to finance the government’s borrowing needs unless they were compensated with very high interest rates; if that happened, interest rates on the federal debt would rise suddenly and sharply.”
 
Higher interest rates—averaging 2.3% in 2014 and 2015, as reported by TreasuryDirect—on an increasing amount of debt are likely to cause a “crowding out” effect, according to the Federal Reserve Bank of St. Louis. As the Federal Government borrows more money to pay its bills, there is less capital available for the private sector.
 
Many believe that the CBO’s concern is understated. In his testimony before the United States Senate Budget Committee February 25, 2015, economist Dr. Laurence J. Kotlikoff of Boston University bluntly stated, “Our country is broke. It’s not broke in 75 years or 50 years or 25 years or 10 years. It’s broke today. Indeed, it may well be in worse fiscal shape than any developed country, including Greece.” Kotlikoff claims that Congress has “cooked the books” for years, and that the difference between the present value of all projected future government expenditures less the present value of all projected future receipts was actually $210 trillion in 2014, more than 16 times the actual reported debt.
 
Whether or not economists agree on the appropriate level of the federal debt, there is agreement that the only way to reduce annual deficits and pay down the debt is for the government to Collect more than it spends – an unlikely (if not impossible) result in today’s political atmosphere. Only six times between 1960 and 2015 has the Federal Government spent less than it collected, according to the Office of Management and Budget. Most recently, in 2015, the Federal Government collected $3.25 trillion in taxes, almost 60% from income taxes, while spending $3.69 trillion. As a result, the budget deficit of $439 billion—the lowest deficit since 2008—was added to the federal debt.
 

The Myth of Economic Growth as a Solution

Politicians regularly suggest that the deficit problem can be resolved as the economy improves because revenues through taxes naturally increase as incomes rise through stronger growth. Such thinking encourages postponing actions that are politically unpopular, such as raising taxes or cutting popular programs.
 
Hoping that economic growth can solve America’s problems is likely futile for the following reasons:
 
GDP Growth Is Projected to Be Lower Than in the Past. According to the CBO’s Budget and Economic Data, annual growth averaged 3.2% to 3.3% from 1974 to 2001, 2.7% from 2002 to 2007, and 1.4% from 2008 to 2015. While the economy is recovering, the CBO projects average annual growth from 2016 to 2025 at 2.0%, well below the average prior to 2008.
 
Widening Income Disparity Threatens Economic Growth. The trickle-down theory was discredited by a 2015 International Monetary Fund report, which indicated that when the rich get richer, no others benefit and growth slows. The data from more than 150 nations suggests that when the richest 20% of a society increases their income by 1%, the annual rate of GDP growth shrinks by nearly 0.1% within five years.
 
Costs for the Major Entitlement Programs Will Rise Sharply. The aging population, rising healthcare costs per person, and increased costs of the Affordable Care Act are likely to boost federal spending for Social Security, Medicare, and Medicaid if current laws remain unchanged. As Kotlikoff testified, the estimated 76 million members of the Baby Boomer generation are already entering a period where each recipient will Collect “$40,000 in Social Security, Medicare, and Medicaid benefits each year.” As a consequence, the largest group of people to put money into the system – the Boomers – will begin taking it out. Left unchanged, Social Security will begin using its surplus funds to pay benefits in 2017 and deplete reserves by 2034.
 
Interest Costs on Federal Debt Will Triple in the Next 10 Years. According to CBO projections, net interest costs for the federal debt are projected to more than triple from $223 billion in 2015 to $772 billion in 2025.
Projections Do Not Include the Costs of New Wars for Defense Against Terrorism. The Watson Institute of Brown University estimates the costs to date of the wars in Afghanistan, Pakistan, and Iraq at $4.4 trillion, all of which were funded by borrowing. Some analysts estimate the costs of the three wars even higher. The cost of future defense is unknown, but likely to be as high as – if not higher than – past wars.
 
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Everything You Wanted to Know About Preferred Stock

preferred-stock-business-918x516Once upon a time, preferred stocks were a popular investment with companies and investors. Combining elements of debt and equity, preferred stock was an ideal issue for businesses that lacked the physical assets to collateralize debt or could not attract common stock buyers.
 
In order to appeal to new investors, companies sweetened the pot by issuing a new security – preferred stock – that had less risk and a greater certainty of income than common stock. If a company falters and requires liquidation, the debt holders are paid in full first, followed by payment to the preferred stock holders in an amount equal to the liquidation value of the preferred stock (established at the time of the initial offering). Common stock shareholders then receive any cash remaining. Preferred shareholders receive full payment of their investment before common shareholders receive any payment. Similarly, preferred shareholders receive dividends before any common stock dividends are paid.
 
The first preferred stocks were issued by railroad companies and canals in the mid-1800s. Today, preferred stocks are more often issued by entrepreneurial startup companies, organizations in dire financial circumstances that are precluded from traditional debt and equity, or financial companies and utilities. In recent years, preferred stocks have fallen out of favor as investors have turned to common stocks or bonds – but there are a few notable exceptions.
 
Billionaire investor Warren Buffett is especially active in preferred stocks, usually in combination with attached stock warrants – a legal right to purchase common stock from the company for a defined price. In other words, a share of preferred stock might have a warrant giving the preferred shareholder the right to purchase a share of common stock for a fixed price for a specific term of time. In 2008, Buffett publicly invested $5 billion in a private Goldman Sachs preferred issue with a 10% dividend and warrants to buy $5 billion of stock at $115 per share (43.4 million shares). Other notable preferred stock purchases by Buffett include the holding company that owns H.J.Heinz, Bank of America, General Electric, and Burger King.
 
Investment grade preferred stocks with current yields between 5.2% and 6.5% have particular appeal to investors seeking high income, especially with current rates from high-quality bonds averaging yields between 1.7% and 3.0%. However, preferred stocks can be complicated, depending upon their composition, and are not for everyone.

Key Features of Preferred Stock

A Hybrid Security

Preferred stocks combine features of equity and debt:
 
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Turning Point – Free Trade or Protectionism

free tradeThe debate about free trade versus protective tariffs (taxes) has raged for centuries. However, it has become especially virulent as industrialized countries lose an increasing amount of jobs to emerging nations. Free traders, worried about the possibility of new tariffs to protect native industries, predict a trade apocalypse. Reported by TIME, Robert Zoellick, president of the World Bank, claimed, “If we start to trigger a round of protectionism, as you saw in the 1930s, it could deepen the world crisis.”
 
Proponents of free trade – including many economists – claim that the benefits of lower prices far outweigh the costs of lower incomes and displaced workers. Professor of Economics Alan Binder, writing in the Library of Economics and Liberty, claims that a country’s wage level depends not upon its trade policy, but its productivity: “As long as American workers remain more skilled and better educated, work with more capital, and use superior technology, they will continue to earn higher wages than their Chinese counterparts.”
 
Opponents of free trade disagree. Senator Bernie Sanders of Vermont has consistently voted against trade agreements, including the North American Free Trade Agreement (NAFTA). He argues that trade agreements have encouraged corporations that seek low-income labor and fewer regulations to close factories and ship jobs overseas. According to the senator on Fox News, “Over the years, we [America] have lost millions of decent-paying jobs. These trade agreements have forced wages down in America so the average worker in America today is working longer hours for lower wages.”
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Understanding the history of tariffs and free trade, especially in the United States, is necessary to evaluate the effects of NAFTA and the proposed Trans-Pacific Partnership (TPP). Two other major trade agreements are also being discussed – The Transatlantic Trade and Investment Partnership (TTIP) and the China Bilateral Investment Treaty (BIT) – which could have global ramifications as well.

Tariffs and Free Trade in the 20th Century

By the end of World War I, advocates of high tariffs recognized that tariffs weren’t the most important source of government revenues and so adopted an alternative argument. There was the widespread belief that tariffs benefited the wealthy while raising the cost of goods for other Americans. As a consequence, protectionists justified tariffs primarily as a way to promote employment for citizens of their country. This argument coincided with a growing concern that inexpensive foreign goods would destroy domestic manufacturers and lead to widespread unemployment.
 
After World War I, economic nationalism and protectionism dominated world trade with countries creating new taxes on foreign goods to protect native industries and maintain full employment of their citizens. As the global economy shrank, countries retreated behind the new tariffs and trade blocks to protect native industries until after World War II.
 
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