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Ask The Experts: Investing for a Secure Financial Future

by John S Kiernan on February 18, 2014

investing approachThe recent government shutdown and threat of default shook financial markets and caused many consumers to reassess their financial plans. But has it fundamentally changed the way we should be investing our money?

Probably not, say the experts we consulted. But it certainly has raised new risks that all investors should take into account.

“The recent political issues have given rise to a major new issue that threatens to undermine even the best investment plans,” said Stephen Buser, professor of finance emeritus at Ohio State University.  “The mere notion that the federal government might simply not make certain payments on its debt, even if it continues to have the means to do so, represents a major new risk for investors, not just in the U.S., but literally around the globe.”

The Fundamentals Haven’t Changed

Political uncertainty aside, our experts stress that the basic fundamentals for investing have not changed. Certain tried-and-true axioms still hold true, starting with the value of a dollar saved.

“For most individuals, in any environment, the key is to start saving now,” said David Hobson Myers, a professor of finance at Lehigh University.  “Nothing else will get you to a well-funded retirement account than putting aside money today.  The beauty of compounding (earning interest on interest or return on return) and building from today are the best beginnings.”

Diversification – basically the investor’s version of not putting all of your eggs in one basket – is another fundamental practice that the experts we consulted couldn’t say enough about.

“Diversification should be sought between and across asset classes,” said James DiLellio, assistant professor of decision sciences at Pepperdine University. “This strategy is largely independent of the current economic and political environment.”

Building on that idea, Seddik Meziani, a professor of finance at Montclair State University, says “research from both academics and practitioners alike keeps indicating that 70% of total return comes from proper diversification,” especially when “diversification is combined with good hedging tools.”

This all, of course, begs the question of what constitutes proper diversification.

A Closer Look at Diversification

While going all-in on a particular investment has the potential to produce the most significant returns, it can also lead to a world of pain if your bet doesn’t pan out or the particular segment of the economy you invest in begins to tank.  Spreading out your investments, on the other hand, will reduce the chances of your entire portfolio suffering at the time and will lay the foundation for steady long-term gains.

There are a variety of ways that you can diversify your investments, including across:

  • Asset Classes:  Stocks (also known as equities), bonds, and cash accounts (e.g. money market funds) are considered the three primary asset classes for investors.  Some people also include real estate and commodities in this bucket.
  • Industry Segments:  Companies are grouped into a variety of categories – from consumer staples and communication services to biotech and energy – that indicate the primary industry they operate in.
  • Market Capitalization:  Companies are also considered to be “large-cap,” “mid-cap,” or “small-cap” depending on the dollar value of their outstanding shares of stock.
  • Investment Styles:  Stocks are classified as being either “value” or “growth.”  Value stocks tend to cost less than their earnings would suggest and pay regular dividends.  Growth stocks offer greater potential for significant capital gains.
  • Geographic Areas:  The modern stock market enables us to invest in companies all across the world.  These companies are broken down into regions, which include the U.S., Canada, Europe, Pacific (e.g. Japan and Australia), and Emerging Markets (e.g. China, India, and Brazil).

Spreading out your money in any or all of these ways will add a certain measure of security to your investment portfolio.  The exact manner in which you do so ultimately depends on the money that you have available and your appetite for risk.

Choosing Investment Vehicles

At the end of the day, you’re probably more interested in getting specific investment recommendations than anything else.  While the experts we consulted do mention a few as examples, one should never take action on an investment tip without doing a bit of good old-fashioned independent vetting.

That said, it’s also important to understand the types of investments that you can use to implement your newfound investing approach.   So, what should we be putting our money in these days?

That’s a tough question to answer as it pertains to an imaginary “average consumer,” according to our experts, but there are a few rules of thumb that both minimize risk and maximize returns.

“In the traditional model for personal investment, which most financial economists endorse, an investor should first identify two basic investments,” Buser said.  “The first basic investment would be a diversified portfolio of relatively safe assets.  My personal choice would be a mutual fund that invests in U.S. Treasury securities with maturities between two and five years.   However, many similar alternatives exist as well.”

The second basic type of investment, according to Buser, is a “broadly diversified portfolio of stocks, such as a mutual fund that seeks to match the S&P 500 Index.”

From there, you just need to figure out allocation – that is, how much to put toward stocks vs. bonds. While conceding that a balanced portfolio is still the best strategy for most investors, Charles McNally, chief portfolio strategist at American Independence Financial Services in New York, points out today’s balanced portfolio looks different from that of the past.

“For one thing, while investors still need a conservative allocation to balance their equities and other risky assets, the bond allocation would be smaller, more diversified across bond types and credit ratings, and/or shorter duration than the days when bond yields provided more of a livable yield,” he said.

Arvi recommends allocating your investments relatively evenly across “a few index funds: large cap equity (SP500), small cap equity, international blue chips, bond, real estate and commodity.”

It’s important to emphasize that this type of approach precludes the need to even concern yourself with specific stocks, bonds, etc.  You can simply gain exposure to entire segments of the economy in one fell swoop with a mutual fund or Exchange Traded Fund (ETF).

“You can participate in the market via ETFs, thus minimizing stock-specific risk,” said Marco Avellaneda, a professor of mathematics at New York University who studies investment performance and pricing. “For example, if you think that the U.S. large caps – such as Apple, IBM, and Exxon-Mobile – will do well, buy DIA [SPDR Dow Jones Industrial Average ETF], not the stocks.”

The one thing you should pay close attention to, however, is how much you pay in fees and commissions to whatever broker you decide to use.  And that is why ETFs are becoming so popular (more on them in a bit).

Exchange Traded Funds

Marcus Ingram, chair of the department of finance at the University of Tampa, is among the various other experts we consulted who recommends ETFs. ETFs, as alluded to earlier, are baskets of stocks assembled to replicate certain exchanges and provide exposure to particular segments of the economy or certain geographic areas, thereby reducing the burden on investors who have neither the time nor inclination to do the homework required to identify individual best-in-class stocks across different sectors of the economy.

ETFs are also attractive because they are cheaper than many other types of investments.  Much of this has to do with the fact that most ETFs are not “actively managed,” which means the particular stocks that an ETF holds are based on the holdings of a particular index, rather than what a professional portfolio manager decides to buy and sell.

“You have a ton of great choices in the ETF and mutual fund universe to choose from so why not choose the ones that are cheapest?” Ingram asks.  “I’m definitely a guy who believes that you shouldn’t have very high costs in your portfolio. You should use these fairly inexpensive products to get the exposure to those sectors that you want.”

However, like with any type of investment, there are risks associated with ETFs.  These risks stem not only from what a given ETF may hold, but also from how it is operated.

“Ironically, ETFs, which can support the investment strategy of building a low cost portfolio, can also contribute to overtrading,” DiLellio said.  “They can be traded throughout the day, may carry a trading commission, and in the case of more niche oriented funds, can have significant expense ratios.”

Brokerages list the costs associated with each fund, but Buser recommends Vanguard in particular as being a good source of low-cost options.

“Vanguard was a pioneer in terms of developing these products for retail customers,” he said.  “Hence, as a matter of routine, I often suggest that new investors at least check out the base investments offered by Vanguard and make a note of the exceptional modest servicing fees that Vanguard is able to charge when compared to many of its competitors.”

Your Investment Timeline

How do you see your next five years playing out?  What about the next 25 or even 50 years?  You need to ask yourself such questions when planning an investment strategy because, as mentioned earlier, your timeline should dictate your appetite for risk – at least to a certain extent.

“The extent of risk tolerance can depend on a variety of factors including a general perception about the level of risk to financial assets as well as the current wealth of an investor in relation to long-term goals,” Buser said, adding that people can think of it like a football game.

“To use a football analogy, if a team is ahead by a comfortable margin in the 4th quarter, then relying more on safe running plays and less on risky passing plays might well be optimal,” he said.  “On the other hand, if a long term investment program falls significantly behind its projected path, then even an otherwise conservative investor might be inclined to increase the allocation to the stock portfolio in much the same way that a football team that falls behind in the 4th quarter of a game is more inclined to increase its rate of passing.”

That, in short, means people in their 30s and 40s can take a longer view and perhaps take on more risk, while those nearing retirement have to play it safer.  Stocks are generally considered to be riskier than bonds, so younger people should therefore favor stocks disproportionately before building up their bond and cash positions as they approach major life events such as paying for higher education and, ultimately, retirement.

“To me retirement is a very different issue than, say, saving up to make a large donation or purchase,” Ingram said.  “If you know that down the road you’re going to buy a retirement home and it’s going to be $200,000, a onetime hit, then I think you should make a multi-year plan to start moving money into cash so that you have more like a dollar cost averaging approach.”

However, Ingram also cautions against overdoing things as you approach the standard retirement age, simply becasuse people are living increasingly longer.

“You don’t want to start switching to a bond portfolio where you give up your growth because I’d like to think we’re all going to live to be 100,” he said.  “So I just think when you retire, you need to structure your portfolio so that it continues to have a great deal of growth potential. Maybe just shift to a slightly larger bond component and to more dividend paying stocks. But I would still say even if you’re 65 and you’re now living off your retirement, you’d want to be more than 50% in equities.”

Pitfalls:  Timing the Market, Overtrading & More

For investors, there are plenty of pitfalls. Arvi says the general public has low levels of financial literacy with a herd mentality, which can often lead to big losses.

“Most people buy high when the markets are frothy and sell when markets crash,” he said. “A good example is in 2008 when many people saw their retirement portfolios being halved, panicked and sold out. Had they stayed invested, not only would they have recovered everything they thought they lost but also earned dividends during five year period. Be a value investor and invest for the long term and do not worry about day-to-day fluctuations in the market.”

McNally echoes those sentiments, saying that “people make the same mistakes today as they have always made.”  They remember the most recent crisis for too long and miss the best performance by staying conservatively positioned well past the danger point, and then they shift to a riskier balance once the macro picture is perfect.”

At the end of the day, it seems to all come down to having a conservative, well-thought-out plan that you execute with consistency.

“The biggest mistakes continue to be chasing returns and not having a good exit strategy,” Hobson said.  “When you buy an investment know what your objectives are and what are the indicators that will get you to sell.”

Still hungry for investment advice?  You can find more experts’ insights below.

Ask The Experts

  1. Investment Strategy
  2. Stock Picking vs. ETFs & Mutual Funds
  3. Cash Allocation
  4. Mistakes to Avoid
  5. Tax Prep
  6. Retirement Planning
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Dwayne Barney

Professor of Finance, Boise State University, College of Business and Economics

Stock Picking vs. ETFs & Mutual Funds

When choosing between the purchase of individual stocks or ETFs, my opinion is that the individual investor is generally better off choosing an ETF that tracks the S&P 500 (e.g. SPDR, ticker SPY). Those of us who don’t like a lot of risk can benefit through the diversification provided by an ETF. An ETF that tracks the S&P 500 will provide an expected return that is as high as most individual stocks, but with a lower standard deviation.

Since we are focusing on risk, we should note that bonds are normally thought of as being a low-risk investment. But bond prices fall when rates rise. And the biggest determinant of whether interest rates are high or low is whether expected inflation is high or low. Interest rates will go up if and when inflation heats up. And when interest rates jump bond investors will see the market value of their investments drop.

Presently the Federal Reserve is expanding the monetary base at a rate of $65 billion per month. Continued low inflation in the face of such a flood of new money seems unlikely, which makes an investment in bonds or bond mutual funds rather risky. By way of contrast, when an investor owns an ETF on the S&P 500 she owns a little chunk of our economy’s productive capacity. Rising prices of goods and services will normally result in increased revenues for those companies reflected in the S&P 500, which to some extent protects the investor against unanticipated inflation.
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Ron Christner

Associate Professor, Loyola University New Orleans, College of Business

Investment Strategy

Current environment doesn't matter unless you can predict the future. Nobody can. Any investment decision starts with the same 3 questions and one size doesn't fit all. The questions are:

1. How much do you have to invest, which determines viable choices.

2. For how long?

3. How much risk of loss can you tolerate?

Long term investment outlook of a diversified portfolio of equity and debt securities with little turnover is likely to be a wise though average performance choice. Nobody can time the market. Depending on how much money is available to invest at least 30 stocks and a bond fund, or ETF or index funds for small investment accounts would be appropriate.

Low risk investments are going to yield low return results. There is no choice of a near cash liquid investment that will yield much more than one percent in this low interest rate market depending upon how long you tie up the money and what level of risk you can tolerate. There is no free lunch in competitive markets.
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Thomas W. Miller, Jr.

Professor of Finance & Jack R. Lee Chair in Financial Institutions and Consumer Finance, Department of Finance and Economics, Mississippi State University

Investment Strategy

My best advice is to 1) start saving if you haven't started, 2) increase your savings if you have started, and 3) cut expenses. Cutting expenses is saving money, too. Look at, and then eliminate, ways how you might fritter away money here and there. Look for ten ways to save $20 per month instead of one way to save $200 per month.

Most likely, one would want to defer paying taxes. Take advantage of any retirement savings plan at work that allows you to make pretax contributions--especially ones that match your contributions. If your company matches your contributions dollar for dollar, you are buying a dollar for fifty cents. Plus, in some ways, this savings is 'unseen.' That is, you do not have to take money out of your wallet and save it.

Stock Picking vs. ETFs & Mutual Funds

The benefits of hindsight tell us to pick the *correct* stock and put all our money in it. Dell was the best performing stock of the 1990s. Why not just hold Dell? The problem is: 'Which stock will be the best performing one during the next ten years?' An impossible question to answer.

So, because we invest in a world of uncertainty, investors are much better off diversifying their portfolio by holding mutual funds. Research has shown that small cap value stocks have performed well in the past. (That is, stocks with relatively small market capitalization *and* relatively high book-to-market values.) Will they continue to do so? Time will tell!

Cash Allocation

These days, it seems that people are chasing yield, and I think this strategy is dangerous. That is, it could well be that bonds with high risk are selling at higher prices than they should be. (Higher price implies smaller yield). If they are, then their yield is too low for the inherent risk in these bonds. BTW, these bonds used to be known as 'Junk' Bonds. They are now referred to as "High-Yield" Bonds--presumably to avoid hurting the feelings of Fred Sanford (and son). The average investor should steer clear of 'High-Yield' bonds, in my opinion.

People should try to spread their money across different investments. Perhaps 20% to blue-chip stocks, 30% to small cap value stocks, 30% to global equity, and 20% to high quality corporate bonds. But, this is just one example--there are many online sources that help investors select their asset allocations.
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Craig G. Rennie

Clete and Tammy S. Brewer Professor of Business & Managing Director of the Garrison Financial Institute in the Sam M. Walton College of Business at the University of Arkansas

Investment Strategy

I recommend the average person who is looking to build a portfolio or save for retirement in the current economic and political environment carefully think about their needs and wants, come up with goals (short-, intermediate-, and long-term goals, always written down with dates and dollar amounts), estimate their time horizons (do this differently for short-, intermediate-, and long-term goals) risk tolerance, investment knowledge, assets and liabilities, income, insurance, tax status, etc., to come up with a personal financial plan.

This can be done with the assistance of a financial planner/wealth advisor, or by the individual with tools available on-line. Looking at these factors and the current state of and outlook for the economy, markets, etc., the investor should come up with investment strategies.

Stock Picking vs. ETFs & Mutual Funds

The average investor will typically gravitate towards mutual funds or ETFs. Most mutual funds and ETFs offer diversification at relatively low cost, and professional management and underlying analysis, again at relatively low cost. Excellent fund screeners exist at web sites for major mutual fund companies and discount brokers to help investors identify outstanding mutual funds or ETFs.

Alternatively, a quality wealth advisor can help the average person identify funds to buy (as well as funds to avoid). Some investors who feel overwhelmed but still want to pick funds themselves may simply opt for a life-cycle fund, where the mix between assets such as U.S. and foreign stocks, bonds, and cash, adjusts automatically over time to meet some investment horizon (like a retirement date).

Cash Allocation

Most average people will want a balanced portfolio with some exposure to stocks (volatile but high potential return), including foreign as well as domestic, large-cap, mid-cap, and small-cap, value and growth, bonds or some other kind of fixed income investment (TIPS, government bonds, municipal “tax-free” bonds, corporate bonds, mortgages, etc.), and cash. Some will also hold alternative asset classes such as Real Estate Investment Trusts, Master Limited Partnerships, Business Development Companies, and Royalty Trusts, or, for high net worth individuals, hedge funds.

In the current economic and political environment, I am concerned about near record low interest rates and thus near record high bond prices, so I would only invest in short- to intermediate-bonds, not long bonds, and sacrifice credit quality for higher yields. As long as the Fed continues with Quantitative Easing, asset prices will increase, so the typical investor should avoid long-term U.S. Treasury bonds, for example.

With unprecedented federal borrowing and thus debt, and a constant political drum beat to raise taxes, taxes will probably go up, making municipal bonds a potentially important part of the typical investor’s portfolio. In an inflationary environment, I particularly like real assets, or financial claims on real assets, such as income generating businesses. The average person should therefore probably have significant exposure to stocks, at least for their investment holdings for long-term goals.

Tax Prep

Most important of all, however, the average person looking to build a portfolio/save for retirement or pursue some other financial goal in the current economic and political environment needs to live below their means, save and invest in a diversified portfolio, seek as much investment education and knowledge as possible, and invest in a consistent, disciplined fashion. Such an approach will do well in any economic and political environment over time.
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Marco Avellaneda

Professor of Mathematics in the Courant Institute of Mathematical Sciences at New York University

Investment Strategy

I recommend Country and Sector ETFs. If possible, do this via 401(k) plans or other ways to defer taxes until retirement. In Country ETFs, I recommend a mix of US (via S&P 500 (SPY) and IWM (Russell 2000) and foreign equities, always via ETFs. In the foreign equities, Europe is the most attractive, via a tracker of the Eurostoxx index.

The sectors that I like are Health Care (XLV) and Consumer Staples (XLP), since in our economy, heath care will develop a lot with the Affordable Care Act and with the recovery of basic consumer demand as we enter a slow recovery. A portfolio that has SPY (40%), IWM (15%), IEV (20%), XLV(15%) and XLP (10%) is well positioned for a steady, relatively slow recovery. I have invested in this kind of portfolio and made more than 19% last year. On the other hand, I would stay away from Emerging Markets -- too vulnerable to inflation and world slowdown -- and Asia, which is too overpriced and not really fully functional economies.

Stock Picking vs. ETFs & Mutual Funds

U.S. equities and European equities are the best way to protect against inflation and to participate in the recovery. We are 5 years into the recovery and there are still 5 to go. As long as rates stay low, equities are a good play dividend-wise -- dividends are greater than interest rates -- and there is a lot of buying interest.

Cash Allocation

The advantage of individuals versus institutional investors is that the former can have a long-term horizon. They are not measured by annual or monthly performance. Therefore, ideas for the medium-term matter. What are the ideas that matter? Outlook for inflation, U.S. recovery, Emerging Markets, U.S./Europe economic outlook. If you are right about the U.S., you will be right about everything else.

Make trades that cannot hurt too much. Avoid leverage (trading with borrowed money) in favor of good judgment about the economy. Avoid stock-picking and market-timing. You are not paid for that: money managers are. Think of the stock market as a 'currency' that you exchange for dollars and where you deposit your money. Be excited about Facebook, but don't put your hard-earned money in one Internet stock which no one understands.

Mistakes to Avoid

Stocks are a good play, but you can participate in the market via ETFs, thus minimizing stock-specific risk. Example: if you think that the U.S. large caps (Apple, IBM, XOM) will do well, buy DIA, not the stocks.

Tax Prep

Take advantage of the tax code, which distinguishes between long-term and short term capital gains. Use, if possible tax-deferred schemes such as IRAs.
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Stephen Buser

Professor of Finance, Emeritus & Coordinator of the Student Investment Management program in the Fisher College of Business at Ohio State University

Investment Strategy

I will discuss the traditional recommendation, which is still what I would recommend despite the bizarre political circumstances. However, I must also acknowledge that my lack of an adapted strategy in no way reflects a dismissal of the new political and economic risks. Instead, I am simply not aware of any reasonable adaptations that will effectively address the recent political uncertainty, which I fear will continue even if there is an apparent resolution of the short term crisis.

In the traditional model for personal investment, which most financial economists endorse, an investor should first identify two basic investments. The first basic investment would be a diversified portfolio of relatively safe assets. My personal choice would be a mutual fund that invests in US Treasury securities with maturities between 2 and 5 years. However, many similar alternatives exist as well.

The second basic investment is a broadly diversified portfolio of stocks, such as a mutual fund that seeks to match the S&P 500 Index. Many investment services offer variations of both forms of these basic investments. In particular, Vanguard was a pioneer in terms of developing these products for retail customers. Hence, as a matter of routine, I often suggest that new investors at least check out the base investments offered by Vanguard and make a note of the exceptional modest servicing fees that Vanguard is able to charge when compared to many of its competitors.

The next step is to decide how to distribute funds between the two basic investments. Some firms provide a formula that depends on a number of variables, including the age of the investor. However, I am not aware of any valid support for such formulas. Moreover, in my role as Historian for the American Financed Association I conducted an interview with Harry Markowitz, who won a Nobel Prize for his work on the household portfolio problem. I asked Dr. Markowitz if he was aware of any simple formula for the best allocation between a portfolio of stocks and a portfolio of US Treasury securities, and he too was not aware of any basis for such a rule.

In place of a simple rule, most financial economists agree that the allocation depends on the risk tolerance of a given investor. Moreover, the extent of risk tolerance can depend on a variety of factors including a general perception about the level of risk to financial assets as well as the current wealth of an investor in relation to long term goals. For example, if a particular investor is seeking to achieve a certain level of wealth at a projected age of his or her retirement, then over time, he or she might be inclined to increase the weight for the low risk base portfolio to the extent that progress toward the goal remains on track. To use a football analogy, if a team is ahead by a comfortable margin in the 4th quarter, then relying more on safe running plays and less on risky passing plays might well be optimal. On the other hand, if a long term investment program falls significantly behind its projected path, then even an otherwise conservative investor might be inclined to increase the allocation to the stock portfolio in much the same way that a football team that falls behind in the 4th quarter of a game is more inclined to increase its rate of passing.

For some investors, risk allocation will also depend on the amount and nature of risk at a given time. For example, if the economy appears to be heading into a recession, stock prices in general will fall, and the extent of fluctuations in future stock returns will generally increase as well. Some investors will view such conditions as an opportunity for unusually large potential gains. Unfortunately, it is typically the case that opportunities for large losses also increase. Hence, the issue is not whether stocks are a good bet or a bad bet, per se, but rather how much a given investor is willing to wager in the new environment.

Stock Picking vs. ETFs & Mutual Funds

The concern about low interest rates is valid, and there are actually two problems. First, the current yield on a portfolio of US Treasuries is indeed extremely low. And second, no one knows for sure how much longer interest rates will remain low. If and when interest rates rise, the resale value of the US Treasury securities that are currently in the 'safe' portfolios are certain to fall. Who would pay as much for an old bond with a low rate of interest if new bonds have higher rates of interest and are offered at par?

One alternative is to take part of the funds you would normally keep in a regular US Treasury mutual fund, and reinvest those funds in a mutual fund that holds a special form of US Treasury securities that promise to automatically increase the rate of interest when inflation and interest rates in general increase. Vanguard offers such specialized funds, and I assume other investment houses do so as well.

Cash Allocation

This might seem like a cop out. However, I am not aware of a valid answer to this question. The recent political issues have given rise to a major new issue that threatens to undermine even the best investment plans. For lack of a better description, the issue is sometimes referred to as the prospects for a voluntary default by the US government on the US Treasury securities it has issued.

I do not profess to understand who is to blame or what the ultimate political objective might be. However, the mere notion that the federal government might simply not make certain payments on its debt, even if it continues to have the means to do so, represents a major new risk for investors not just in the US but literally around the globe.

As many have noted, voluntary default would needlessly risk a reversal of the recent economic improvement and would likely induce a corresponding decline in stock values. However, as if this risk were not great enough, there is another an potential even more serious problem for investors. Potential default by the federal government means that we need to reassess the distinction I made above between investments that are traditionally regarded as risky, such as stocks, and investments which are traditionally regarded as at least low risk, if not completely risk free. Moreover, the extended blame game only complicates the issue for investors in the sense that If the risk of potential voluntary default could be restricted to the potential actions of one person, however crazy, then it might be possible in principle to assess the nature of the underlying risk.

Returning to the football analogy, if one or more players for a particular team are injured in a particular game, then bookies might be able to assess the potential impact on a game the following week and simply adjust the point spread accordingly. In contrast, suppose there were no injuries, yet the coaching staff simply announces that it is annoyed for any of a variety of reasons and is considering a voluntary benching of an unspecified number of players. What change in the point spread is reasonable under these conditions, and how should a reasonable bettor behave?

This does not mean that opportunities for substantial gains from stocks, and/or substantial losses in stocks do not exists. It is simply the case that I do not have the slightest idea about how to properly assess the relevant risks. And what is even more scary for me personally, is that it would appear that a new political technology has apparently been developed to allow others in Congress from reaching a similar decision that, for the sake of their personal if bizarre principles, they need to effectively wire themselves with financial bombs and threaten to destroy the financial security of citizens in the US and around the world have enjoyed for generations. Hence even if some type of temporary agreement is reached, what will prevent a repeat episode. Do not forget that even this crisis was supposedly addressed in the form of the sequester legislation that bought Congress time to resolve the longer term issues.

Mistakes to Avoid

There are three common mistakes that investors need to be aware of and avoid if possible. One mistake is to place blind trust in a third party. Even if an overwhelming percentage of investment managers are honest, there are always exceptions. Time and again we hear how even seemingly shred people are taken advantage of. Just ask the former friends and trusting associates of Bernie Madoff, many of whom still insist that Bernie had been a great guy who somehow went bad for no obvious reason.

A second common mistake is personal over confidence when it comes to investing. It never ceases to amaze me that individuals who might very well be exceptional in a given area, including even complicated business ventures, will simply presume that since they are good at one thing, they must also be good when it comes to investments. I thus find it highly ironic they financial economists who have won the Nobel Prize for their work in financial economics and whom I have interviewed for the American Finance Association rarely believe that they have any particular expertise when it comes to investments. On the contrary, most believe the investment market is highly competitive and that for most of the time, most investments are offered at prices that do not provide opportunities for easy profits without significant risk of potential loss.

A third common mistake is specific form of mistake number 2, and that is to simply invest too heavily in a given opportunity. If an investor decided to commit funds to specific investments rather than, or even in addition to, a broadly diversified portfolio, then the investor should not think of that exception as part of the general investment plan. Instead, the investor should think of that action as a hobby, or perhaps a lark just as one might undertake at a gambling casino. Some investors think the odds are better for investments in stocks because on average they provide a positive rate of return. But that logic is in error in so far as an investor can get the positive average return just by investing in a broadly diversified fund. Time and again it has been shown that the odds of doing better on a specialized investment are less than 50-50 after the house, or in this case a collection of stock brokers and managers, gets its cut.
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James DiLellio

Assistant Professor of Decision Sciences in the Graziadio School of Business & Management at Pepperdine University

Investment Strategy

Suggesting an investment strategy for an 'average' person is a tough problem because of the wide range of needs and challenges faced by individuals. Nevertheless, I believe that most individual investors would benefit from a strategy that doesn't create significant costs, such as bid-ask spreads, commissions, or other expenses. Thus, a buy-and-hold or annual re-balance of a diversified index-based portfolio is a good choice. Diversification should be sought between AND across asset classes. This strategy is largely independent of the current economic and political environment.

Stock Picking vs. ETFs & Mutual Funds

This depends on how likely an individual is to need this cash. Assuming they have an investment horizon on the order of years, a diversified bond portfolio (treasuries, corporate, junk, munis, emerging markets, etc.) may make a lot of sense. Of course, given rates are likely to rise in the future, individuals may want to select bonds or bond index funds with shorter maturities.

Cash Allocation

My opinion is that for long-term growth, stocks are absolutely necessary. Also, as rates stay low, corporations will continue to have access to debt markets to finance new or ongoing operations at very low rates. I believe this will continue to enhance profitability, and ultimately help the broad equity markets to continue to grow.

Mistakes to Avoid

I believe the biggest mistake people make is trading too often, attempting to chase returns. I suspect that this behavior is largely due to overconfidence in their own ability to beat the market, which is extremely difficult to do consistently. Ironically, ETFs, which can support the investment strategy of building a low cost portfolio, can also contribute to over trading, because they can be traded throughout the day, may carry a trading commission, and in the case of more niche oriented funds, can have significant expense ratios.

Tax Prep

It may sound morbid, but one of the best ways is to pass on a taxable stock portfolio to an heir, spouse, or charitable organization. I believe in most cases, those receiving the portfolio receive an automatic step up in cost basis. For retirees, and based on an on-going research project I have in this area, this suggests that retirees may be better off consuming from their IRA and Roth accounts before their taxable stock accounts, especially in the later retirement years.

For investors not yet in retirement, I tend to believe this is a good problem to have. If possible, delaying the sales of profitable stocks and stock funds so that gains are (typically) taxed at lower long-term rates is preferred. Seeking stock or equity funds that generate qualified dividends can also help minimize taxes.
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David Hobson Myers

Professor of Practice in the Perella Department of Finance at Lehigh University

Investment Strategy

For most individuals, in any environment, the key is to start saving now. Nothing else will get you to a well-funded retirement account than putting aside money today. The beauty of compounding (earning interest on interest or return on return) and building from today are the best beginnings. The next step is to be well diversified; don’t put all your eggs in one basket.

Stock Picking vs. ETFs & Mutual Funds

No great answer to this question. Search for the best rates you can find.

Cash Allocation

For a retirement that is a long way off, stocks should still be considered. Higher risk-averse individuals or those closer to retirement should have less exposure.

Mistakes to Avoid

The biggest mistakes continue to be chasing returns and not having a good exit strategy. In chasing returns, investors increase turnover and tax exposure and buy at the top. A good exit strategy is typified by having a sell discipline for each investment. When you buy an investment know what your objectives are and what are the indicators that will get you to sell.

Tax Prep

Where possible continue to shelter your retirement assets in IRAs, 401Ks, and other tax beneficial vehicles. In non-sheltered accounts, try to reduce turnover to delay realizing tax exposure.
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Marcus Ingram

Chair of the Department of Finance at the University of Tampa

Investment Strategy

I try to come up with a policy that works well in all macro-environments because I think it’s really incredibly difficult to predict the macro-environment.

What I tend to suggest for people is portfolios that are largely made-up of equity and largely made-up of U.S. equity. I think it’s possible to really create a lot of diversification within a US Equity portfolio. You’d have to just further slice and dice that old universe: small stocks, dividend paying stocks, master limited partnerships that are tied to the energy sector, counter-cyclicals your mining stocks, defensive stocks, obviously growth, technology, etc. You can really look at the US equity market as having maybe 6-8 components. If you pick enough different categories, and got 5-10% in each one, you’ve really effectively diversified.

In every one of those categories, you can pick very low-cost mutual funds or very low-cost ETFs. You have a ton of great choices in the ETF and mutual fund universe to choose from, so why not choose the ones that are cheapest? I’m definitely a guy who believes that you shouldn’t have very high costs in your portfolio. You should use these fairly inexpensive products to get the exposure to those sectors that you want.

Think: What are the areas in which mutual fund managers can do a better job than you can? Early stage companies that don’t have a lot of operative experience, very small companies where’s there’s not a lot of analysts following – those are areas where it makes sense to pay someone to do it. On the other hand, your defensive stocks and your high-dividend stocks, you can probably pick those out yourself.
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Seddik Meziani

Professor of Finance in the Department of Economics & Finance at Montclair State University

Investment Strategy

To answer this question one must first define the current economic and political environment. We have on one hand an economy that doesn’t seem to have fully recovered from the one-two punch of the 2008-2009 fiscal crisis and on the other hand a senate sequester that threatens to derail this still fragile recovery. Add to that a potential taper in the Fed bond buying program that could gradually send interest rates upward. This, of course, spells trouble for bonds, an important asset category in retirement portfolios.

Stock Picking vs. ETFs & Mutual Funds

I would like to say 'stocks' but the latter enjoyed a bull market for the past four years or so and many market strategists are foreseeing a correction. As to real estate, this market might sour if interest rates continue to trend up. Research from both academic and practitioners alike keeps indicating that 70% of total return comes from proper diversification. This is especially true if this diversification is combined with good hedging tools.

Cash Allocation

Again, a well-diversified portfolio that includes both bonds and stocks is never a bad play regardless of market circumstances and direction. People talk about alternatives but these alternatives should mean alternatives capable of hedging these important asset classes regardless of the direction of the market. Hence, allocate some cash to funds that could hedge the bond part of the portfolio such as long/short credit funds that focus on corporate credit exposure rather than on the term structure of interest rates.

The BlackRock Global Long/Short Credit Fund is what comes to mind. It offers both a solid opportunity to improve diversification but also helps protect fixed income portfolios from the risk of rising rates by reducing sensitivity to their movements.

Same could be said and done with long/short equity funds. Rather than keep clear of an important asset class just because some believe that the current bull market is about to run its course, allocate some of the cash instead to funds that take both long and short positions in mid- to large-cap equities. Some examples that come to mind is PowerShares S&P 500 BuyWrite Portfolio or JPMorgan - US Select Long-Short Equity Fund.

Market risk exposure can also be eliminated with the help of a variety of professionally managed market neutral portfolios that implement long/short investment positions. Again, the idea here is not to eschew bonds or equity because of some looming risks that may or may not happen in the short-term but to combine them within a well-diversified portfolio with alternatives that could effectively reduce their risks regardless of the direction of the market.

Mistakes to Avoid

I recommend a tax loss harvesting strategy under the guidance of a tax professional.
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Charles McNally

Chief Portfolio Strategist for American Independence Financial Services LLC

Investment Strategy

The balanced portfolio is still the best strategy for most investors, but today’s balanced portfolio looks different from that of the past. For one thing, while investors still need a conservative allocation to balance their equities and other risky assets, the bond allocation would be smaller, more diversified across bond types and credit ratings, and/or shorter duration than the days when bond yields provided more of a livable yield.

Complementing the bond portfolio is other income portfolios such as REITS, MLPs and dividend equities, plus a whole category of risk managed products that didn’t appear on the landscape until about 5 years ago, namely, managed portfolios of ETFs. Other than 'tilting' the portfolio balance to account for mis-valuations with a multi-year-horizon, such as tilting away from traditional bonds today, the more active aspect of managing the portfolio balance can be left to the managers of tactical ETF portfolios.

Stock Picking vs. ETFs & Mutual Funds

Every category of 'income' investment today carries significant risk today. T-Bills and other money markets are yielding even less than the current depressed inflation rate. Investment-grade bonds are vulnerable to a fall in price if market yields move higher, as this summer’s 'taper tantrum' demonstrated. TIPS prices fluctuate with inflation expectations. High-yield bonds and other income investments with equity characteristics, from REITs and MLPs to equities with high dividend, won’t be protected if the economy weakens and the underlying businesses’ robustness gets called into question.

Most investors will be better served to diversify their cash holdings across these categories so as to balance the risk that growth picks up (which hurts money markets and investment-grade bonds) against the risk that growth falters (which would impact high yield bonds and dividend growth equities), and sprinkle in the other categories such as REITS, MLPs, and TIPS that may do well in one scenario or another. However, as long as developed nations economies are ascendant, especially when growth is led by the US as it is today, it’s hard to make the case for emerging-market debt in either local currency or dollars.

Cash Allocation

People make the same mistakes today as they have always made. They remember the most recent crisis for too long and miss the best performance by staying conservatively positioned well past the danger point, and then they shift to a riskier balance once the macro picture is perfect.

The problem with perfect macro environments is that all the good news is already priced into the market, and it’s not long before a new problem creeps that doesn’t fit the usual historical patterns, but that turns out to be the undoing of the good environment for risky assets. Again, a balanced portfolio approach with infrequent tilts and an element of professional tactical management is all the active management that most portfolios need, or can tolerate.

Tax Prep

The balanced portfolio by its very nature tends to discourage churn, which is the biggest cause of tax inefficiency. But investors should not put the cart before the horse by over-emphasizing tax efficiency. Maintaining a portfolio strategy that the investor will be comfortable with through many market environments is the best bulwark against over- or under-managing the portfolio. Having said that, there are time-honored strategies that can be practiced, such as harvesting losses before year-end, and waiting to realize gains on positions held close to one year, without upsetting the portfolio strategy.
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Leonard Arvi

Assistant Professor of Finance in the Franklin P. Perdue School of Business at Salisbury University

Investment Strategy

Start saving early and start contributing the maximum (if matched by your employer) to 401K. Irrespective of what the market does, keep investing at regular intervals. Contribute the maximum to ROTH-IRA if worry that taxes will increase in the future. Do not worry about short term fluctuations or market volatilities, historically market returns has averaged about 7%. By buying into a low-cost index fund like VTSMX, investors will get decent returns over the long term.

An easy diversification strategy would be to select a few index funds: large cap equity (SP500), small cap equity, international blue chips, bond, real estate and commodity. Focus on picking funds that have the lowest expense ratios. The lower the fees paid, higher will be returns to the investors. We cannot predict what will happen in the future, it is best to be prepared by being financially prudent. If you can save at least 15% of your earnings and keep investing, then you should not have to worry about retirement. Also, invest in yourself by becoming more financially literate so that you can become the best steward of your money.

Stock Picking vs. ETFs & Mutual Funds

Everyone needs to have three to six month rainy day fund which I recommend in a money market fund with your bank. Depending on the risk tolerance, for the young investor I recommend investing in Dividend Appreciation Index fund (VDAIX) or something similar. Every investor needs to be invested in an asset that will yield return higher than inflation.

Cash Allocation

I might be biased in a way that I am for stocks. If you look at history, no other asset class has given good returns over the long term like stocks. We live in a capitalistic society and the only way to build wealth is by staying invested and to partake in the growth of the economy. No matter how gloomy or pessimistic the current conditions might seem to be, there are always better days ahead. We live in an era of rapid technological change and new growth firms will continue to emerge (whether in US or elsewhere).

The best way to capitalize on these fast growing firms that create wealth is by staying invested. By educating yourself and keeping abreast of what is happening in the markets/world economy is the best solution I can recommend.

Mistakes to Avoid

The general public has low levels of financial literacy with herd mentality. Most people buy high when the markets are frothy and sell when markets crash. A good example is in 2008 when many people saw their retirement portfolios being halved, panicked and sold out. Had they stayed invested, not only would they have recovered everything they thought they lost but also earned dividends during five year period.

Be a value investor and invest for the long term and do not worry about day-to-day fluctuations in the market.

Tax Prep

Do not trade often, the more often you trade over the long term you will lose besides incurring higher transaction costs. Also, you cannot humanly compete against high frequency traders so don’t do it. Long term capital gains tax (assets held at least one year or more) is lower than if you buy and sell any asset in less than a year. So make it a conscious choice to become a value investor. Ensure that you also harvest your losses prudently and can carry it over (up to $3000/year).

I am not a tax expert, one simple way is to contribute the annual maximum towards a ROTH-IRA account. Since ROTH contributions are post-tax, you can be certain that higher taxes several years from now will not affect your assets in the ROTH account. Each individual’s tax situation is different and the best recommendation I can make it to consult a fee-based financial advisor to find out what is best strategy that fits your needs.
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Li Cai

Assistant Professor of Finance in the Stuart School of Business at the Illinois Institute of Technology

Investment Strategy

For long-term investment, to save for retirement, I would recommend a well-diversified passive portfolio for the average person, e.g. index portfolio.

Stock Picking vs. ETFs & Mutual Funds

Stocks, and high yield bonds.

Cash Allocation

It depends on the investment horizon. The answer is good it is long term, there are better alternatives if it is short term.

Mistakes to Avoid

My thought is that when people respond to news by rebalancing their portfolios, they are usually impulsive. I would recommend the average person not try to actively time event or news.

Tax Prep

Stay passive, try to avoid excessive turnover.
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Frank Heiland

Associate Professor, School of Public Affairs, Baruch College/CUNY

Retirement Planning

• What is the outlook for retirement planning in 2014?

“Retirement preparedness of average Americans improved markedly in 2013, mainly as a result of significant improvements in labor, housing, and stock markets. I do not expect that to continue in 2014.

Growth in real wages and benefits will be modest at best and further sizable declines in the unemployment rate are unlikely. Housing and stock prices have recovered from their depressed 2008-09 levels and appear to be appropriately valued at this moment, suggesting that future (long-term) returns from here will likely be in line with the historical averages.”

• What retirement planning tips would you give the average person?

“Contribute to your 401(k) and Roth IRA savings accounts (a ‘must do’ if 401(k) has employer-matching; ideally make maximum contributions to both). Consider refinancing a high-interest home mortgage.

Nobody cares about your savings and retirement as much as you do: Become your own financial advisor by investing some of your time to improve your financial literacy!”
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John Kiernan is Senior Writer & Editor at Evolution Finance. He graduated from the University of Maryland with a BA in Journalism, a minor in Sport Commerce & Culture,…
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