With the stock market tumbling and gyrating again. Some investors want nothing to do with this money-losing business of investing. WSJ’s Michael Pollock offers some pointers to calm your portfolio and your stomach.

October’s surge helped many mutual funds bounce back from recent lows.

It was also a vivid reminder of what has become a fact of life for stock investors: It’s crazy out there. And it seems to be getting crazier all the time.

If the market’s roller-coaster ride has caused you a lot of heartburn, this might be a great time to do something about it, before another slide is just one too many. After all, there are ways to turn down the anxiety without stashing all of your money in the mattress.

With that in mind, here are seven pointers to calm your portfolio and your stomach:

Get real about your tolerance for pain.

When stocks are mostly going up, many investors believe they have the fortitude to tolerate a fair amount of risk. But as soon as prices sink, so does their gumption. They realize they really aren’t willing to ride the roller coaster down as well as up.

If you didn’t learn your lesson before, learn it now: When your current stock exposure makes you queasy, take advantage of rallies to trim it back to a level—perhaps to around a third of your overall holdings—where you won’t be tempted to bail out the next time the Dow Jones Industrial Average plummets 400 points.

But remember that you’ll need to own some stocks in order to increase your assets enough for the future. Otherwise, once you retire, you’ll have to be ultracautious about how much of your savings you can spend without running short of money, says Mark Cortazzo, senior partner of advisory firm Macro Consulting Group in Parsippany, N.J.

Favor funds that cast a wider net.

The narrower the scope of your funds, the greater the risk of outsize losses during market downturns. Consider switching from some of your most narrowly focused funds to funds that hold a wider mix of stocks, or funds that combine stocks with other holdings, such as bonds.

Greg Swenson, co-manager of the Grizzly Short Fund, discusses the challenges that volatile markets have presented for short-sellers lately. But his fund is sticking to its short position on the home-builder sector. MarketWatch’s Jonathan Burton reports.

This year, funds that focus only on financial companies are down 14%, according to Morningstar Inc., which tracks and analyzes fund performance. Those funds that invest in a broad mix of large corporations—so-called large-blend funds—are down only about 1% in the same span.

And “conservative allocation” funds that mix a hefty helping of bonds with stocks are up 2% on average this year. Among these is James Balanced: Golden Rainbow, which usually keeps 40% to 60% of assets in stocks and dials down equities when they seem less attractive.

The James fund so far this year has returned 4.5%, versus a 1.3% return for the Standard Poor’s 500-stock index (including dividends). The fund’s 7.4% annual average return over 10 years ranks it in the top 3% of Morningstar’s conservative-allocation category.

Hire a pilot who charts a smoother ride.

In stock-picking or other strategies, some fund managers try to limit the downside risk. When they succeed, their funds can be easier to keep for the long term. Funds managed with an eye to reducing volatility won’t deliver top-of-the-charts performance when the market is surging. But they can hold their own over time, because it’s easier for a fund to recover from a modest drop than a steep one.

Aiming for steady moderate gains—even 6% a year—reduces the risk that you might need to dip into your portfolio at a point when it has lost a lot of value and thus hamper its recovery prospects, says Michael Lynch, an adviser in Roseville, Calif.

USAA Global Opportunities, which holds U.S. and foreign stocks and bonds, uses derivatives such as options on market indexes to limit downside. But that also caps upside. The fund has a return so far this year of negative 2.4%, but that’s almost seven percentage points less severe than the drop in a benchmark of global stocks, the MSCI EAFE Index.

Another volatility-reducing tack is owning a fund that focuses on blue-chip, dividend-paying companies. Shares of such companies are viewed as safer bets during tough economic times, and they tend to fluctuate less than those of growth-oriented stocks.

Vanguard Dividend Appreciation, an exchange-traded fund, owns big players such as McDonald’s Corp., Chevron Corp. and PepsiCo Inc. and yields about 2.3%. The fund has ultralow expenses of only 0.18% of assets a year. The lower the fees, the more investors get to keep in returns.

Don’t try to wager on where stocks are headed.

Investors have a bad record of calling market tops and market bottoms. But over many years, stock prices will appreciate as the economy grows.

If you’re holding a lot of cash, you are giving up an opportunity to benefit from that long-term appreciation, says Constance Stone, a certified financial planner in Chagrin Falls, Ohio. But if jumping back into the market all at once might fray your nerves, do it gradually, she says.

A way to reduce timing error is to simply rebalance holdings periodically. There is no consensus on how often to rebalance, but some advisers recommend rebalancing whenever the percentage of stocks in your portfolio has risen or fallen by more than about 10 percentage points from your preferred allocation. When stocks drop, shift some of your fixed-income assets into an equities fund. Shift it back after stocks have posted gains.

Fine-tune your cash stash to your family’s needs.

You’ll rest more easily if you know you don’t need to tap your stocks and stock funds when they are down in order to meet expenses. That’s one reason advisers often suggest clients keep on hand cash or readily saleable assets equal to three to nine months of spending. But for greatest peace of mind, your reserve should be tailored to your circumstances.

A dual-income family saving more than around 10% of income a month may need less than six months of cash, while a one-income family should have more, says Marc Vorchheimer, an adviser in Spring Valley, N.Y. If you have a mortgage, he says, keep cash on hand equal to about 20% of your outstanding mortgage principal balance plus whatever you need in the cash kitty.

Don’t assume that a stock-free portfolio is risk-free.

As stocks plummeted this summer, investors shifted a mountain of money from stocks into bank accounts and government bonds.

But returns on those two investments are very low. And you could actually lose money on bonds if interest rates—which move the opposite way as bond prices—were to shoot higher.

Joseph Alfonso, a planner whose practice spans Northern California and Oregon, advises sticking to short bond maturities to lessen that risk.

If you want more risk, have it in the stock section of your portfolio, not the bond bucket, Mr. Alfonso says.

Don’t be ashamed to seek help.

A financial adviser or planner can help you realistically assess your risk tolerance and tailor your investment strategy to it. Some larger advisory firms require clients to have hundreds of thousands of dollars in assets. But many planners don’t set minimums and charge flat fees of as little as $1,000 a year.

Advisers not only aid in creating a strategy, but will help you avoid shooting yourself in the foot by abandoning it at the worst time.

“We’ll try to persuade you not to sell when markets are down,” says Lewis Altfest, principal adviser at New York-based Altfest Personal Wealth Management.

Mr. Pollock is a writer in Ridgewood, N.J. Email him at reports@wsj.com.

Article source: Wall Street Journal

 

In the game of blackjack, you can ‘double down’ on a hand by doubling your bet for one more card from the dealer.  (When playing blackjack, your goal is to create a hand that is as close as possible to 21 without going over)  This action allows you to take additional risk for an immediate payoff.  Within the community of people who enjoy the game of blackjack, most will tell you that it is advantageous to double down on an eleven, or possibly a ten.  The principal reason for this is because cards with a value of ten have a higher concentration than other cards.  Because of this, it is advantageous for players to increase their risk in certain situations because of an increased probability for a higher payoff.

In the world of investing, there are both times to increase your exposure to risk for a higher payoff, and appropriate situations.  The problem which arises is that many people end up taking excessive risk to chase returns.  In this situation, it is rarely the optimal time to take more risk in the hopes of earning a higher return.

Currently, there are many people from the baby boom generation who are currently ‘doubling down’ with their retirement accounts by over-weighting their portfolios in high-risk ventures such as emerging market stocks and speculative real-estate in an attempt to pump-up the value of their nest egg before retirement.  The risk of this strategy is that your nest egg could crack just before it hatches.

The hidden danger of highly volatile investments is that the risk of loss generally stays hidden until market disruptions push the value of multiple asset classes down simultaneously.  In this case, there is not enough time to adjust your portfolio before it has been significantly burned.  These types of situations are especially dangerous, because the market tends to change very abruptly as relevant news and information develop.  For people who are approaching retirement, volatility can be especially dangerous.

This is not to say that investors shouldn’t take risks . . . it is very difficult to generate returns in excess of bond or money market yields without taking risks.  The caution is that you should be aware of the risks that you are taking, and not allow yourself to fall into a false sense of security because the market hasn’t had a significant downward movement lately.  Large returns generally require that you take large risks.  If you are currently earning large returns, chances are that you are at risk for a large adjustment.  It is very important to make sure that a significant downward adjustment in value of your risky investments will not place you in a situation that you can’t recover from.

Thus, when deciding whether to ‘double down’ on your investment strategy, it is critically important to understand whether you are in a situation where such a decision is optimal.  Are your personal emotions constructed in such a way that a dramatic shift in market valuation will cause excessive nervous tension?  In most cases, investors are their own worst enemy … we allow our emotions over the movements of our portfolio value to influence our actions in a way that frequently moves contrary to our rational thoughts.

Thus, investing becomes a battle of reason vs. emotion.  Our reason frequently tells us to make decisions that would appear to be quite smart by most objective standards.  Reason typically evaluates decisions based on their inherent merits.  However, not all of our decisions are made rationally.  Instead of making our investing decisions based simply on the merits of a particular investment, we allow ourselves to be influenced by the other people we have seen being successful in making money.  When the market is going up, our emotions want to double-down on what we have seen as being successful.  When the market is going down, our emotions want to run for the hills and retreat from the perceived danger of the investing world.

As it turns out, the movement in market perception of a particular investment does not necessarily change the underlying fundamentals.  Many investments that are fundamentally sound experience negative market news, and other investments that lack solid fundamentals will experience upward escalations in market valuation that defy reason.  In the former case, it is important to avoid the emotional pull to bail-out on an otherwise solid investment strategy.  In the latter example, it is important to avoid the temptation to increase our investment, simply because the price has gone up and we hope that it will go up some more.

In the end, it is important for each of us to understand the extent to which our emotions compel us to ‘double down’ on what may turn out to be a highly risky strategy.  All of our decision should be made because of what we judge to be best for our well-being.  Achieving our desires will require that we take risks of some manner along the way.  However, it is important to ensure that all of our decisions are being made consciously instead of re-actively … rationally instead of emotionally.  This will help us to make sure that we don’t double-down on risky situations that we are not emotionally prepared to deal with.

 

Every time I turn around there is something new and better on the horizon in digital marketing – new hardware, new software, new tools, new channels, new targeting opportunities, new tracking capabilities, new providers, new pricing models, new ad units, new everything. If consumers are overwhelmed by choice in this fast moving marketplace then marketers are doubly so.

Consumers adopt along a well-documented bell curve, while smart marketers watch and follow that consumer curve. In our current environment, there are many overlapping curves to watch, and placing your bets on which ones have staying power or will achieve the uniqueness or scale that makes them attractive to marketers is extraordinarily difficult – and risky.

The risk to marketers in all this change takes many forms. Jump too fast to trial a new offering, channel, or approach and you may get ahead of the consumer adoption and have inconsequential or too highly segmented, early adopter-only participation. Wait too long, however, and you might lose the opportunity to stand out or capture incremental value. Of course, all things in marketing being relative, your risk and potential reward depend on your business goals, competitive environment, and target audience demographics. Groundbreaking ideas, whether in a category, in the industry, or even just within your own organization may bring some advantages but it also introduces uncertainties.

How to manage marketing risks:

• Work with proven providers. As trusted partners roll out new offerings you can quiz them on the readiness of those offerings and even perhaps participate in beta trials.
• Don’t bet the farm. When trying a new approach or effort make it part of your test budget first with rigorous metrics for success.
• Set expectations. If you don’t know what the impact will be – say so. Inventive marketing requires some stomach for the unknown.
• Watch progress closely. Build in out-clauses and other stop measures that may limit the bleeding on something that isn’t working, but make sure you have the appropriate metrics tracked and have allowed enough time to truly assess results. Look outside of expected results to see if there are unintended impacts either positive or negative from your new efforts.
• Make sure you are doing it for the right reason. If this risk doesn’t have an associated and large enough potential reward, then reconsider.

The internal, operations side of the business is a whole different set of risks. New tools and other first-time efforts exact a hefty toll in training and trialing, whether for an agency or for a corporate marketing department. Processes all down the line may be impacted by a seemingly minor change. Multiply that across all the tools and relationships that have the potential for regular change and you may induce staff fatigue around a constant state of transition.

If you swap out key partners, processes, or tools too often within your organization you risk never really maximizing your expertise in an area. It simply takes time to learn to excel at our complex tasks. On the other hand, if you don’t keep current with the latest tools, knowledge, tactics, and opportunities on behalf of your clients or brands you will be obsolete quickly. So how do you make the right changes, offering enough stasis and stability to your practice to support excellence while staying on top of your game?

• Evaluate whether the incremental benefits offered by the change make the investment worthwhile. Include a time frame, if you can, in which you are likely to be able to benefit from the transfer.
• Don’t be swayed by emotion or competitive pressure. Do an objective evaluation of the features, functionality, costs, and benefits as they relate to your specific situation. Use an outside consultant to help you make the go/no go decision if you can’t detach from the emotion.
• Reach out to your networks for feedback.
• Bring the teams impacted by the proposed change into the conversation. Assess how attached they are to their current state of affairs and if they are likely to resist or embrace adoption efforts.
• Designate a leader for the change process and have them develop a transition plan with associated costs and timetables and report back on them regularly. Track training and adoption time in a separate category from other work so you can really see the cost.
• In early change state, consider creating at least one super user who is responsible for training internally and assumes an overseer role to limit errors.
• Learn to look at the ripples created by change efforts across an organization and prioritize how many you will attempt in any one time period even if they are not directly related. Err on the side of caution. Better to successfully navigate fewer evolutions then to suffer from taking on too much at once.
• Don’t necessarily consider it an either/or situation. You may be able to add incremental capabilities or tool sets and still keep the old for a time period if that does not multiply costs unacceptably. That way you can trial something first with a subset of staff or projects/clients and spread out some of the learning time and the risk.
• Don’t be afraid to change course in the middle. If it truly doesn’t feel right for your team, is not as promised, is overly taxing on the organization, or more costly then you anticipated don’t wed yourself to a disaster. Allow yourself the option to reconsider or postpone.

In the end, “better” is often a very subjective term that needs to be weighed against your organization’s mission and business goals, and carefully balanced with your ability to execute. In this age of newer and better we can easily get caught in a hamster wheel of perpetual change. It is a rare and valuable skill to be able to separate the new and better from the just new.

Article source: ClickZ

 

One of the trends that many people experience in the world of investing is a noted tendency to become ‘gun shy’ when they experience volatility in their investments.  The reason for this is because our psychological makeup is much more afraid of loss than joyful over gains.  This leads many people to either become irrationally risk averse, or to take risks that they are not aware of in a desire to achieve safety.  The problem this creates is that fear of loss can make people blind to the opportunity for gain.

Volatile stock markets are hard to weather out.  Watching your house lose value triggers an impulse to run for safety.  However, safety is an illusion.  Just because the value of something doesn’t fluctuate very much doesn’t mean that it’s safe.  The price that is typically paid for value stability is low rates of return.  These low rates of return can significantly impede your ability to grow long-term wealth.  Acting to avoid losses frequently involves the same actions that avoid gains.  Thus, in attempting to protect your financial future, you may be inadvertently handicapping your financial futures.

You Lose What You Do Not Make

One of the consistent ideas in finance and economics is the notion that you gain what you do not lose, and you lose what you do not make.  Most people are very familiar with the notion of avoided losses, but blind to the idea of lost gains.  The reason for this is because the lost gains are largely invisible.  We are unaware of them because we did not see them.  In this way, many people have allowed themselves to take risks that they didn’t even know are present.  The most insidious of these is the risk of inflation.  Future price increases will erode the purchasing power of dollars that you own.  If your investment capital does not grow at a sufficient rate, it may be worth less (in real terms) when you retire than it is now.

This can be particularly damaging since it is unlikely that the government will be able to finance its entitlement obligations without significantly inflating the currency and eroding the purchasing power of people’s savings, investments, interest income, and annuity payments.  It is likely that most people will need a substantial amount of investment income in addition to whatever is provided by the government in order to avoid a significant decrease in their standard of living during retirement.  In most cases, this can only be accomplished by taking on the risk of losses that accompany exceptional investment opportunities.

Over-Reaction to Recent Trends

In general, people tend to over-emphasize events that have happened recently.  In the current environment, this has led to excessive pessimism about investing.  One example of this phenomenon in practice is a general tendency for people to view the recent real estate collapse in multiple markets across the country as a harbinger of risk with real estate investment.  While this risk looms large in the minds of potential investors, it is accompanied by the opportunity for tremendous gains if investors possess the insight and intelligence to act.  Prices have been significantly depressed in some areas (pushed below the cost of construction in a number of cases), and can present the potential for amazing rates of return.

The opposite side of this phenomenon was the stock market bubble of the late 1990′s and the real estate bubble of the mid 2000′s.  In both cases, people grew to believe that values would constantly go up, and that they could never come down.  A similar sentiment is now being expressed about the price of gold.  In all of these cases, the values do not go up indefinitely.  The same frenzy behavior that drives them up subsequently drives them back down when new buyers disappear, and people rush to cash out before the price crashes.

Fundamentals are Key

The bottom-line for any era of investing is to focus on fundamentals.  The long-term success of any investment strategy is solely dependent on its underlying fundamental value.  Speculation can drive the price above or below its fundamental value for a while, but it cannot keep it there permanently.  All values eventually regress toward their equilibrium value.  Astute investors target investments with an equilibrium value that is likely to grow so that they are not captive to market cycles.  Buying at the “bottom” of a market correction is much harder to do in real life than in hindsight.  It is much better to target exceptional fundamental value and invest for long-term gains.

It can be very difficult to overcome the fear of incurring losses and undertake compelling investment opportunities.  Doing so requires that one muster the courage to act against the grain of popular sentiment.  It can be surprisingly difficult to do, since there is comfort in following the crowd.  However, comfort and profit rarely come at the same time.  If you are seeking profits, it will probably require a departure from your comfort zone, and if you ware seeking comfort, it will probably mean the forfeiture of profitable opportunities.

In the end, each person must find the investment strategy that suits them best.  Some are more comfortable with risk than others, and some are more comfortable with active investment than others.  Regardless of your comfort level, it is important to understand that some risks will always be inherent in capturing gains.  Similarly, risk is inherent in avoiding losses.  All decisions that we make involve some kind of risk.  It is our responsibility to make sure that we are aware of the risks we are taking in the pursuit of gains.  It may well be that these risks are much less dire than the consequences of playing it safe.

 

You’ve heard of black swans—events that are unthinkably rare, immensely important, and as unpredictable in advance as they are inevitable in hindsight. Now, with no one ruling out a default or downgrade of U.S. Treasury debt, investors face a new kind of threat:

what we will call the neon swan, an event that is unthinkably rare, immensely important and blindingly obvious.

The politicians in Washington have a couple weeks to forestall a disaster that has begun to seem like a certainty. Investors everywhere are perfectly aware of the consequences if Congress and the Obama administration can’t strike a deal: The U.S. is likely to lose its privileged triple-A credit rating, and corporate bonds and stocks alike could plummet in response.

As Nassim Nicholas Taleb’s bestseller “The Black Swan” made clear, the human mind is poorly equipped to prepare us for rare, important and unpredictable events. But maybe our minds—and our markets—aren’t very well equipped to protect us against neon swans, either.

Many investors seem to be coping with what seems like an obvious risk simply by closing their eyes.

Theodore Aronson, a partner at Aronson Johnson Ortiz in Philadelphia, oversees $21 billion in stock investments for 90 institutional clients. In roughly 75 conference calls with clients over the past few weeks, says Mr. Aronson, no one has asked whether a different investing approach is needed in light of the risk that a U.S. debt crisis might make the markets go haywire.

“I find it amazing,” he says, “that we have not gotten a single question or comment about it.”

Then again, Mr. Aronson adds, his firm hasn’t done anything to protect against the risk of a crisis in the Treasury market. “We’ve thought about it, but we don’t know what to do,” he says. “As best we can figure it, there isn’t anything we can do.”

Some investors are worried enough to ask questions, but not many have taken any action yet, says Paul LaRock, a principal at Treasury Strategies, a Chicago-based firm that helps large corporations manage their cash. “Companies are pulling out their investment policies and rereading them,” he says. One major firm on the East Coast, Mr. LaRock says, asked this week whether its investment-policy statement, which places “no limit” on its holdings of U.S. Treasurys in the company’s cash balances, needs to be amended to keep the company’s coffers secure.

Mr. LaRock says the client is still mulling that question. And, even with disaster seeming inevitable, many investors may be paralyzed by uncertainty. “U.S. government securities have long been the yardstick for measuring the risk of most other investments,” he says. “One of the most disturbing things that we all have to get our minds around should the unthinkable happen,” he adds, “is that the reference point for pricing securities around the globe could be lost. No one can predict what would happen worldwide.”

Not that Treasurys will necessarily get pounded. If the U.S. defaults or its credit rating is downgraded, says William Bernstein of Efficient Frontier Advisors in Eastford, Conn., Treasury prices would probably “go to 97 or 98,” losing only a few percentage points in value. “You’re not going to wake up one morning over the next couple of weeks and find they’re priced at 50 cents on the dollar,” says Mr. Bernstein.

“It is absolutely inconceivable that we would flat-out default and not pay anything,” he adds. “The worst-case scenario is a very temporary payment problem, and I think the Treasury market knows that.”

But the ripple effects could be considerable. Mr. Bernstein expects corporate and municipal bonds to drop much more drastically if the Treasury market is hit by default or downgrade. And stocks, he says, could be massacred. For investors with cash and courage, a crisis in U.S. Treasurys might well pose a historic buying opportunity. If, instead, it turns out to be “like a giant asteroid hitting the earth, Mr. Bernstein says, “then there isn’t much of anything that’s likely to protect you.”

Thus, keeping a sizable balance in short-term Treasurys—the securities that suddenly feel shaky—is probably a good idea in case stocks and bonds go on sale. You can make a sudden move into gold or cash, but they carry risks of their own, especially if the debt crisis somehow gets averted.

It is important not to be complacent. If you are blindsided by bad news that was staring you in the face for weeks before it came to pass, you will feel like a fool. On the other hand, the forces that do the worst damage to markets “are never the ones that you think are going to get you,” Mr. Bernstein says. Waiting may well be the wisest course this time. You don’t want to ignore a neon swan, but you don’t want to overreact to it only to have it swim quietly away.

—
intelligentinvestor.com; twitter.com/jasonzweigwsj

Article source: Wall Street Journal

 

Most people who have spent any amount of time around college towns or night clubs are familiar with the phrase “beer goggles.”  Simply put, this phrase refers to a general tendency for people who have been drinking alcohol excessively to develop highly distorted perceptions of other people’s attractiveness.  In these situations, many people find themselves making romantic advances toward people whom they would not be interested in if they were sober.

Fortunately, most people mature with age and grow out of the propensity to don “Beer Goggles” when finding their spouse.  As we gain more experience, the importance of intelligent decisions becomes increasingly apparent.  The decisions that we make in regards to our education, career, and spouse all have long-lasting impacts on our life.  Thus, it is not difficult to see why making these decisions with a sober mind is of paramount importance.

Unfortunately, there is a distinctive sector of life where many people bring back the “Beer Goggles” in full force.  This part of life is investing, and many people allow themselves to become inebriated by promises of high returns that lure them into deals that are much less attractive when viewed with sober eyes.

Consider all of the late-night infomercials that you have seen, soliciting you to purchase a system that will teach you to “Buy Real Estate with No Money Down” or “Grow Wealthy with FOREX Currency Trading” or simple exhortations to abandon the dollar and “Buy Gold.”  The interesting thing to consider is that the people selling each of these products earn substantial fees and commissions when you choose to buy.  What these “systems” are banking on is that their promises of fast, easy profits will lure you to send in your money.

This is not limited to inf0-mercials either.  How many people concentrated their 401k portfolios in Technology stocks during the 1990′s, in Energy and Financial stocks during the Real Estate boom, and in Gold now that the spot price has rapid escalated in response to continued government budget deficits.  Each of these represents a “fad” that is generated by investor enthusiasm for quick profits … not for fundamentals, not for cash flow, but for the simple fact that they expect prices to continue rocketing up, just like they have rocketed up in the past.

A common phrase among financial planners is that “Trees don’t grow to the sky,” meaning that abnormally high rates of growth cannot continue indefinitely.  It would be well for many people to remember this wisdom, since the allure of easy profits results in “Beer Goggles” for investors that come on in full force.  When seeking to earn returns from investing, it is critical to understand that there is no such thing as a free lunch.  All investments carry some form of risk:

Default Risk

Some product such as bonds carry a risk of default, where the issuer is no longer able to pay.  Typically, when the default risk is higher, the interest yield also tends to be higher.  This means that bond investors who are earning high yields are running a greater risk of losing their principal.  Most government bond investors are primarily worried about guarding against default with the guaranteed principal value of treasuries.

Market Risk

Products like stocks, mutual funds, and commodities carry a risk that the market value will be lower when they are sold than whey they were purchased.  This risk is even more pronounced when the security does not pay any dividends, because the returns are totally concentrated in capital appreciation.  Volatility of market prices represents one of the main risks for equity or commodity investors.

Inflation Risk

A large risk associated with many investment products is that their performance will either not keep pace with inflation or will have their returns significantly eroded by inflation.  This risk factor is especially dangerous for bond investors, since the interest payments from bonds are fixed.  Because of this, investors who anticipate that inflation will result from current government policy should seek investment vehicles that are more robust in defending against inflation than bonds.

Liquidity Risk

Some investments such as Real Estate produce favorable rates of return from cash flow and leveraged appreciation, but are very difficult to sell quickly without significantly discounting the price.  This means that people investing in these types of assets should only do so with capital that will not be needed for a long period of time. Problems can arise very quickly if your are forced to sell a property and must discount the price lower than your loan balance in order to attract buyers.  In this situation, leveraged gains can turn into leveraged losses very quickly.

In the end, it is critically important for each person to remove the “Beer Goggles” when they are choosing their investment strategy.  Sticking to fundamentals and avoiding the urge to chase after investment fads or pursue quick profits with packaged systems.  By ensuring that your investing activity revolves around creating fundamental value for paying customers with your capital, it will help to avoid chasing the elusive quick buck and keep you on the track to building long-term wealth.

 

One of the concepts that is prevalent in economics is the notion of moral hazard.  Generally speaking, a moral hazard is created when one party in a transaction is shielded from risk because of government protection, or access to information that the other party lacks.  This concept has received a lot of media attention recently, because of the financial crisis involving subprime debt and credit default swaps.

The way that the moral hazard plays out in the financial sector is that the government implicitly shields financial institutions from bankruptcy based on a historical precedent of bailouts for institutions deemed ‘too big to fail’ by the authorities.  When executives and fund managers become aware of the fact that the government will not allow them to go bankrupt, it creates incentives for dramatic risk taking since the gains will generate large bonuses for the company executives and any the company creditors will be made whole by the government in the event of a financial catastrophe.  This phenomenon is frequently referred to as ‘privatizing the gains and socializing the losses.’

The unique irony of our current situation is that government policy has been implemented in such a way as to purposefully manufacture moral hazard by nature of how laws and regulations were written.  The mortgage industry has long been driven by the policies of Fannie Mae, the quasi-governmental agency who purchases mortgages in the open market.  (The reason why I refer to it as quasi-governmental is because of the implicit guarantee provided by the government that Fannie Mae will be insulated from losses by bailouts from the taxpayers)  Since Fannie Mae has an implicit taxpayer guarantee, it is heavily regulated and influenced by Congress and the Senate.

Because of the status that Fannie Mae enjoys as the market leader in purchasing mortgages, its policies have the ability to ‘market make’ throughout the financial sector.  Thus, as political pressures impacted the practices of Fannie Mae in regards to high-risk lending, those practices rippled throughout the mortgage industry.  The extended impact of this ripple effect was that banks could ‘pass the buck’ of risk with subprime mortgages to Fannie Mae by selling them their mortgages.  Thus, the policy of government has been to literally manufacture moral hazard by using the power of Fannie Mae to influence incentives in the financial industry.

Another unique irony of the current situation is the conclusion reached by the political authorities in response to the financial crisis.  Since there was a noted problem of ‘privatized profits and socialized losses’ the solution sought was to socialize the industries instead of privatizing the losses.  This socialization has not taken the form of financial institutions that were forced to accept government capital, and then forced to follow a long list of constantly changing rules and regulations because of the fact that they have government capital on their balance sheet.

In the end, it seems that a much more simple and effective solution would be to simply privatize the losses from this crisis so that investors and fund managers will learn that excessive risk taking is not going to be subsidized by the government.  Most people believe in responsibility and ethical behavior.  However, it seems somewhat foolish to expect responsibility to prevail when excessive risk taking is rewarded by a government that actively manufactures moral hazard.

Running in Circles

An extremely disturbing trend has emerged lately where the Federal Reserve is directly purchasing debt from the Treasury by printing new money.  The danger from this phenomenon comes from the fact that this increase in the supply of money will eventually dilute the purchasing power of dollars currently outstanding, and that the market activities of the Federal Reserve are artificially suppressing interest rates for government debt.  (Much of this is being done to finance the current government budget deficits)

What these factors ultimately add up to is a tremendous risk that current bond holders will be impoverished by rapid price inflation from the increased supply of currency, and devaluation of their bond values when market interest rates eventually increase.  The optimal way for prudent investors to shield themselves from this risk is with fixed-rate debt that is used to finance income producing tangible assets such as rental real estate.  Under this scenario, price inflation will increase the rents and value for your property while the balance of your loan remains flat.

 

The recent financial turmoil in the global economy has caused many people to adopt a dour perspective on the state of financial responsibility in the nation, and across the world.  Much of this cynicism is certainly well deserved, as there were many governments enforcing irresponsible regulations, banks making irresponsible loans, and people taking on an irresponsible amount of debt.

However, it is important to avoid overlooking the fact that there are many people who have remained very fiscally responsible throughout all of this financial silliness that has erupted recently.  The dynamics of the current credit markets are such that risk tolerance has almost completely disappeared, creating a ‘flight to quality’ that has drastically increased the demand for guaranteed treasury notes.  This increase in demand has significantly reduced the interest rate for mortgages that are tied to these treasury notes . . . but only for the people that qualify for loans under the current (more stringent) standards.

Thus, in a strange turn of events there is a ‘responsibility dividend’ that is available to people who have managed their finances prudently.  Since the market appetite for risk has evaporated, there are tremendous opportunities available for low-risk borrowers to make intelligent investments.  This is because the financial crisis has pushed most of the high-risk investors out of the market since they can no longer get capital from lenders that are very timid about taking risk in the current economic environment.

The result of the current situation is that investors who have remained responsible over the past few years will have a brief window of opportunity to make lucrative investments with very minimal competition.  This will result in many fortunes being made over the coming years, just as new fortunes are always created from economic recovery.  Each of us must ask ourselves whether we will be one of the people who create a new fortune.

 

Reading the title of this article probably creates a sense of confusion because of the apparent paradox of being ‘cautiously bold.’  After all, acting with caution and acting with boldness are often contrary to one another.  The cautious person generally seeks to minimize risk for the sake of stability.  The bold person generally seeks to maximize the return that they capture.  So how do we blend these two characteristics into a workable philosophy?

The way to fully understand caution and boldness is by viewing them as a balanced equilibrium, instead of an ‘either-or’ proposition.  This paradigm shift moves the conversation away from concepts like ‘minimizing risk’ and toward ideas like ‘managing risk.’  Similarly, a balanced perspective doesn’t simply seek to maximize returns . . . it seeks to maximize the return for the amount of risk that is being taken.

The importance of this insight lies in the fact that risk and return are positively correlated with one another.  This means that pursuing high returns generally involves taking increased risk, and that minimizing risk involves sacrificing returns.  It is also important to consider that not all risks are created equal.  Thus, the goal of successful investing is to seek the opportunities that produce favorable returns in relation to their risk.

One way that many smart investors seek to implement this strategy is look for opportunities with a limited downside and large upside.  For example, when real estate bubbles deflate there tend to be properties that are available for less than their construction cost.  (These opportunities typically come from distressed sellers and bank-owned foreclosures)  In this case, the downside risk is limited since any new construction in the future will cost more than what you have just purchased this property for, since they will need to purchase land and build a structure on that land.  If the property is rented for income, the owner can frequently cover their property expenses from the tenant cash flows and ‘wait out’ the down market to capture value from future appreciation.

As we have seen, the notion of being ‘cautiously bold’ isn’t a silly paradox, but a statement of desire to maintain balance between minimizing risk and pursuing returns.  Keeping that balance in mind is what drives us to pursue opportunities that limit our downside exposure but maintain significant upside potential.

 

One of the more difficult things that each of us will encounter in our lives is the juxtaposition of what we know against what we think we know.  The reason why this creates difficulty is because our own perception of our own knowledge (i.e. what we think we know) frequently exceeds what we really know by a significant margin.  Furthermore, this phenomenon seems to expand as our knowledge base increases.  This produces the unfortunate effect of creating an intellectual elite that over-estimates the depth and scope of their own knowledge by many orders of magnitude.

This present an extreme amount of danger when decisions for large amounts of resources are controlled by a small number of people through the government, or through a financial institution.  The reason for this is because when people over estimate their knowledge of the market, they under estimate the chances of failure and frequently over expose themselves, their investors, and the taxpayers to catastrophic losses.

While it is pleasing to the vanity of those in power to make claims about how intelligent people should be in charge of everything, it may be better if people were in charge of themselves.  The reason for this is because I can only destroy my own resources if I over estimate my knowledge.  When a small regime in the government is in charge of vast resources, there is a tremendous risk of unfathomable, catastrophic failure if their estimates are incorrect.

Recently, this effect has compounded upon itself many times over.  The unfortunate set of events precipitating this consolidation of power was triggered by the massive financial sector bailout engineered in lieu of allowing the banks to go into liquidation.  This action created two destructive outcomes . . . the first is that it rewarded the irresponsible risk taking of the banks that were bailed out and the second was that it prevented the banks assets from being liquidated to responsible companies that did not engage in high risk lending practices and massively leveraged derivatives.

Furthermore, the financial sector bailout served as a precedent for an automotive sector bailout that still resulted in bankruptcy for two of the ‘big three’ US auto manufacturers.  In the end, the government is now a principal player in the automotive industry and either approves or purchases the overwhelming majority of all home mortgages.  With this amount of power and control, there is tremendous risk of economic damage by even a slight mistake in estimating the cost or effect of a program or decision.

In the end, each of us should be aware of what we ‘really’ know, and seek to maintain perspective when estimating the extent of our abilities.  When we are making decisions and constructing strategies, it is always wise to ask what happens if I am wrong?  By understanding the extent and limits of our knowledge, it will help each of us to minimize the impact if our decisions are wrong and maximize the benefit if our decisions are right.