Personal Money Management 101 Blog

Last week saw substantial stock market “corrections” around the world. The Dow Jones index fell by 4.2%, while the UK FTSE 100 fell 5.6%.

The falls have been fuelled by problems in the US housing and sub-prime mortgage markets, combined with fears that the days of cheap credit are coming to an end.

The guiding principle at times like these is “don’t panic”.

All is not doom and gloom. The Dow is still up more than 6% on the year, while the FTSE is only back to where it began 2007.

The companies represented by the lower priced stocks are still the same. They are still performing the same functions for the same profits and still have the same assets.

Markets are not always rational. They are subject to crowd psychology and often over-react to news, good or bad.

Investment is a long-term game. Markets have always suffered drops, and always will. But markets have always recovered from falls (eventually) and delivered healthy returns in the long-term. There is no reason to believe they will not do so again.

In my humble opinion now is DEFINITELY NOT the time to sell. Prices have already taken a hit and will sooner or later recover. If you needed the money tomorrow, then it shouldn’t have been in stocks in any case. Sit tight and weather the storm.

The really brave might consider this to be a good time for bargain hunting. Fine, but with two caveats. Take at least as much (and possibly more care) over stock selection than normal. Look for those stocks least likely to be affected by the causes of the drop and those with which the market has most over-reacted. And don’t get despondent if your acquisitions fall further before they rise. It’s near impossible to hit the exact bottom of the market, and those that do achieve it purely by luck.

In the field of investment risk and reward are a bit like Frank Sinatra’s love and marriage, you can’t have one without the other.

The reward of an investment is pretty obvious, it’s what you make on it and come from either capital appreciation, income, or both.

Risk may not be quite so intuitive to grasp. We may instinctively think of it as being the chance that the investment will fail, ie our capital will be completely lost, or even (in the case of leveraged investments) that we shall end up in debt. More accurately risk describes the volatility of a particular investment, ie the degree to which its value fluctuates. Mathematically this can be measured by a statistic called the “standard deviation”.

In general, the greater the (potential) reward, the higher the risk.

Diagram showing risk and reward. The gray diagonal lines represent investments of equal merit, the choice between two investments on a gray line would depend on the investor’s objectives and risk profile. The best value investments lie to the top-left.

There is no such thing as a risk free investment. If you keep your money under the bed it may be stolen by burglars or eaten by rats, not to mention the inevitable erosion of its value by inflation.

If placed on deposit at a bank you will at least gain interest, but again inflation will erode its buying power, and there’s always the risk – however slight – that the bank will fail.

Probably the lowest risk of all is offered by government issued index linked bonds. But even these have the risk their returns may be outstripped by alternative investments (and the minute possibility the government might default).

Moving up the scale of risk lie corporate bonds. These should offer a known rate of return, but their capital value will fluctuate with interest rates as well as the likelihood of repayment. These encompass a whole spectrum of risk depending on the issuer. An indication of the risk is given by bond ratings such as Moody’s and Standard & Poor’s.

Common stocks also encompass a wide spectrum of risk, with steady but unexciting blue chips at the safe end and aggressive start-ups at the other. One indication of the risk of a stock is its beta value. This indicates its degree of volatility compared to an index (or basket of stocks). A beta of 1 indicates it moves (more or less) in line with the index. A beta of greater than 1 means it is more volatile than the index while a beta lower than 1 means it is less volatile. Of course beta is calculated on past performance which may not continue into the future.

Most risky, but with the greatest reward potential, are derivatives and leveraged investments where you are risking more, sometimes much more, than your initial stake.

Know Thyself

In reality each individual’s portfolio will consist of a mix of investments at varying positions in the risk-reward plane.

Ideally we should all have 2-6 months living costs in a quick access cash deposit account as rainy day money. Beyond this how we allocate the remainder depends on i) our objectives, ii) our circumstances, and iii) our personal risk tolerance.

Our objectives are the reason we are investing. Is it to put a deposit on a house, for kids’ college fees, for retirement…? The further away the objective (circumstances) the greater the risk is acceptable.

But two people with exactly the same objectives and circumstances may plump for different portfolios depending on their unique psychology for risk. Some people are more tolerant of risk than others. As a rule of thumb, if you’re going to lose sleep over it, don’t do it.

Diversification

Modern portfolio theory is a mathematical treatment of the risk-reward issue. It says that risk can be reduced by diversification (ie holding different investments that tend to experience highs and lows at different times). It further says that any risk that can be mitigated by diversification won’t be rewarded by additional returns. That is the market expects investors to allocate their funds as efficiently as possble to reduce risk through diversification and if they don’t, tough, they won’t be rewarded for unnecessary risk.

This means you shouldn’t put all your funds into just one or two stocks. The easiest way to do this is through a tracker fund or ETF (Exchange Traded Fund). I don’t recommend managed mutual funds as management fees tend to  educe the rewards below those offered by passive alternatives (trackers and ETFs).

If you choose to hold individual stocks then hold a sufficient number of different ones. Bearin mind that as you hold more the additional benefits of each reduces. For an individual investor I’d suggest around 8 to 16. Too few and you carry too much risk if one were to suffer a downturn. Too many and they become difficult to manage as well as being subject to higher commission costs.

Bear in mind too the correlation between stocks. If, for instance, you hold 8 supermarkets you won’t have diversified very well because the supermarket sector is often likely to move in the same direction. Instead try to choose stocks that are likely to move independently, or even opposite, to each other. A good example would be an ice cream maker and an umbrella maker for whatever the summer weather one would likely do well.

In the bad old days businesses had the edge over consumers. The price you were quoted was the price you paid. Few people had the time or inclination to get more than a couple of quotes come insurance renewal time etc, and for most plain old loyalty (or is that inertia?) ruled the day.

The Internet changed all that. Now it was possible to get all the quotes you wanted from the comfort of your armchair, in munutes rather than hours or days.

Price comparison sites were an inevitable development in the evolution of Internet business. Essentially these sites are simply computer programs that collect your details once and submit them to multiple sites to find you the best deal – be it on insurance, consumer goods, utilities and just about everything else.

Price comparison sites are great and I unreseervedly recomend them Here’s a couple of tips: 

• It’s always worth trying two or three such sites as not every site polls evry supplier, but between them the top few will cover the vast majority.
• Don’t just accept the cheapest deal you’re offered, be sure to read the small print to find out that it really does meet your demands, for example the cheapest insurance may have too high an excess or too many exclusions.

Rather bizarrely English insurance company Direct Line has chosen to exclude itself from price comparison sites and recently launched an advertising campaign deriding them as “middlemen”. In a manner of speaking that’s true, albeit automated rather than human ones. But who really cares about using a middleman so long as they get the best possible deal. My guess is Direct Line will eventually have to change its policy. Watch this space…

Until recently debt was considered something shameful and to be avoided at all costs. Given the growing levels of consumer debt the return of such an attitude would be a welcome thing. With one exception – mortgage debt.

Without mortgages few of us would ever be able to own the roof above our ahead. But beyond that obvious truth mortgage debt, being secured on a tangible asset, is usually much cheaper than other forms of personal debt such as loans, overdrafts and of course the dreaded credit card.

But the most powerful, and often overlooked, advantage of mortgages is the gearing effect that magnifies the benefits of rising real estate prices. Suppose you buy a house for $100,000, and in a year its price rises to $110,000. A 10% gain in a year isn’t at all bad, and quite realistic with real estate. But suppose you only put $10,000 down and borrowed  $90,000 from the bank. However much your asset increases you only pay back the original debt (plus interest). So in this case your original $10,000 would have DOUBLED to $20,000 after re-paying the initial loan.

We often scrimp and scrape to pay off our mortgage as soon as possible, but before doing so we should see if our money could be earning better returns elsewhere. For example, if you can get 8% on an investment, there’s no point cashing it in to save the 5% you’re paying on your mortgage.

Mortgage lending is competitive business and that’s good news for borrowers. Don’t sign up for the first deal you come across. Shop around, comparing rates and terms. One of the biggest decisions is between fixed and variable rates. This is a hard call as no one can predict what’s going to happen even a few months ahead – not governments, not the best qualified economists – so don’t believe anyone that says they can. Be guided by your own instinct, but be prepared to make a change if a better deal becomes available.

Be sure to read the small print. Often mortgages with the most attractive rates come with expensive up-front charges, exit charges, or both. Or there may be penalties for early repayment. These don’t necessarily invalidate the benefits offered by the lower rates, but make sure you build them into your assessment. If the up-front charge is a fixed amount then it’s usually more beneficial the more you borrow – ie the savings will be more on bigger repayments.

Investment and trading both involve the purchase of assets in the hope that they will appreciate in value. However, there are significant differences in these contrasting approaches with the prime differentiator being the timeframe involved.

Investment is something everyone should be involved in to some extent or another. Many do not consider themselves investors, but if you own (or are purchasing in mortgage) your own home or have a pension plan or insurance policy then you are an investor and your financial well being depends on the performance of stocks and/or real estate.

Trading is a minority activity seeking to derive profit (income) from the short term buying and selling of assets, or put simply selling higher than the buying price.

Investment is a long-term endeavor. It may be for life, as in providing a roof over one’s head, or over many years, as in putting one’s kids through college or providing an income in retirement.

On the other hand trading is relatively short-term, ranging from day-trading where positions are opened and closed within the space of a day up to holding them for a month or longer.

Investments usually consist of holding actual assets, eg stocks, bonds, real estate… Trading can mean holding assets but also consists of devices such as short selling (selling an asset you don’t have in the hope its price will fall), making use of margin (or leverage – ie trading with borrowed money), foreign currency (FOREX) trading, and more sophisticated vehicles such as options, CFDs (Contracts for Difference), spread betting etc.

Investment is concerned with gaining both from an increasing asset price and the income gained from holding the asset (interest, dividends, rent…). Trading is primarily concerned with profiting from movements in the asset price.

Trading is essentially a form of gambling, though hopefully a more informed (and less random) kind than the roll of a dice or the spin of a roulette wheel.

Investors generally rely on fundamentals in choosing investments, ie they look at the global and national economy, what’s happening in a particular sector, and at the prospects for the asset under consideration. Traders do the same, but they also rely on technical analysis (chartism) which attempts to predict future price movements by looking at graphs or charts of historic prices. There’s absolutely no logical reason this should work, but charts do perhaps give a picture of market psychology, and more importantly are followed by many and as such may become a kind of self-fulfilling prophesy. Technical analysis tends to be used most for i) short-term (day) trading and ii) optimizing entry and exit points (timing).

The key point is to know whether you are a trader or an investor. As we’ve said investing is something that should be done by just about everyone, trading certainly is not. If you do decide to become a trader, make sure it is a conscious and informed decision. Study loads, and do lots of paper trading (trading with virtual rather than real cash – there are lots of trading houses out there that will let you set up practice accounts for this purpose). Find a system that works FOR YOU, and stick to it along with disciplined risk and money management.