Let’s move beyond comparisons between lower and higher market prices…
by Steve SelengutMr. Selengut is a private investor and a contributing editor to LIFE&Health Advisor. He is the author of the book ‘The Brainwashing of the American Investor: The book that Wall Street does not want you to read.’ He can be reached at firstname.lastname@example.org
Most investors incorrectly think of “risk” as the possibility that the market value of a financial asset might fall below the amount that has been invested… OMG, how could this be happening!
Wall Street does everything in its power to promulgate such misconceptions.
The ideas that lower market price = loss or bad and that higher prices = profit or good are the greatest risk creators of all. They invariably cause inappropriate actions by individuals and advisors who are less familiar with the ways of the investment gods than they should be.
Risk is the reality of financial assets and markets: the current value of all “marketable” securities will change frequently. If there is no risk of loss, there is no investment. BUT investment portfolios can be designed to minimize risk and render market price volatility much less problematic than you’ve been brainwashed into believing.
This series of articles will deal with the nuts and bolts of risk minimization: Selection Quality, Diversification Rules, Income Requirements, and Profit Taking Disciplines.
The media hype surrounding market volatility, and the hysteria it causes among investors is unwarrented and institutionally self serving. After you study these articles, you’ll welcome both short term market volatility and long term cyclical change… in both investment markets, equity and income.
Financial Impact Cycles
The reality of financial-impact cycles (market, interest rate, economy, industry, etc.) doesn’t fit at all well into Wall Street’s hindsightful, calendar year assessment mechanisms. The amount, cause, frequency, range, and duration of market value change will always vary in an “I-don’t-care-who-you-listen-to” unpredictably certain way — the certainty being that the change in market values of investment assets is inevitable, unpredictable, and (actually) essential to long term investment success.
Without these natural changes, there would be no hope of gain, no chance of buying low and selling higher. No risk, no profits, and no excitement— boring.
The first steps in risk minimization are cerebral, and demand an understanding of the fundamental purpose of the two basic classes of investment securities: growth and income
From the investor’s perspective: equity securities are expected to produce growth in the form of realized capital gains, and income securities are expected to produce dividend, interest, rent, and royalty income. But nothing produces “real” growth until either the gains or the income are realized — even the obscenely ineffective IRC appreciates the insignificance of “unrealized” gains.
Alternative investments are risk creators. These are contracts, gimmicks, commodities, and hedges that college textbooks once called speculations. Until MPT thinking took over, fiduciaries, trustees, and unsophisticated individuals weren’t allowed to use them.
Modern Portfolio Theory Magnifies Risk, Exponentially
Investment products are especially risky for 401 participants, who are unable to differentiate between stocks and bonds from any perspective. Most investors have no clue what is being done inside the investment products they select, and are encouraged to think of these plans as “pension” programs — even scarier is recent DOL regulation that perpetuates the misconceptions.
Wall Street takes advantage of regulatory ignorance mercilessly. In spite of the recent financial crisis, public sector pension plan fiduciaries are falling all over themselves to throw money at the very “alternatives” that crashed the markets in the not so distant past. 401(k) participants are force fed products from providers who make little effort to identify risk, much less to minimize it.
Whatever happened to stocks and bonds, the very building blocks of capitalism? Do investors recognize the financial interest they have in the very corporations their elected officials are encouraged to tax, constrain, and regulate into competitive mediocrity?
Another mental step in risk minimization is education. You just can’t afford to put money into things you don’t understand, or which havn’t been explained simply and clearly. Of course you would prefer to skip this step and jump right into some new product athletic shoes that will hurdle you over the work and directly into the profits. How’s that work out for you during market corrections?
Risk is compounded by ignorance, multiplied by gimmickry, and exacerbated by emotion. It is halved with education, ameliorated with cost-based asset allocation, and managed with disciplined: selection quality, diversification, income, and profit taking rules — the essence of Market Cycle Investment Management.
Real financial risk in equities boils down to: the possibility that a company’s stock (that 30% share of your brother-in-laws’ pizza parlor) will become worthless as management succumbs to economic forces, and/or mandated costs imposed by government regulators, and tort liabilities.
In debt-based securities, risk is: the possibility that the issuer of an interest bearing IOU (the money your spouse loaned her brother at 6% to start flinging pizza) stops or falls behind on its payment obligations and/or declares bankruptcy and wipes out both owner (shareholder) and creditor (bond holder) interests.
Here’s an interesting risk in the securities markets, one that governments cleverly refuse to address for fairly obvious reasons. The “Masters of the Universe” routinely get paid obscene amounts of compensation for risking OPM (other people’s money) perhaps a bit too cavalierly.
Company fails, shareholder interests become valueless, debt obligations are worthless, while the fat cats keep raking it in, even suing to preserve their bonuses. Boardroom corruption, and direct lobbying (another euphemism, for bribery) of elected officials are two additional risks that investors need to be aware of.