Posted by: Janet Schlarbaum

Author: Darrell Victor

The conventional advice to retirees is that they should invest in low-risk financial instruments during retirement. Alternatively, the advice of some advisors is that “safe” investments would simply expose your retirement fund to other risks. There is merit in both positions, which is why portfolio diversification can be a great strategy at any life stage. Ultimately, retirees must invest so that they can sleep well at night and protect the real value of their investment. Retirees should base their investment decisions on the following:

1) Risk tolerance- Some people are gamblers, while others are ultra-conservative. Your risk tolerance is primarily influenced by your personality. The main point about investing and risk is that you should be comfortable with the level of risk that you’re taking. No one else can tell you what your comfort-level is. You certainly do not want to invest exclusively in growth options that leave you perpetually worried.

2) Depth of reserves- The level of risk that you can withstand would be dependent on the depth of your reserves as well. Someone who invests 40% of his retirement fund in growth options would find that the nominal amount exposed to loss would be significant. 40% of a $200,000 retirement fund is a significantly higher risk than the same percentage of a $2,000,000.00 retirement fund in terms of the actual dollar value..

3) Inflation risk- Although you’re seeking to provide security for your money, you may inadvertently cause a real loss or substantially lower real returns in the long-run. The good news is that you do not have to put your retirement fund at risk to beat inflation. Use the Consumer Price Index as a guide and seek high-yield CDs or bonds that provide rates of return that outstrip the inflation rate.

4) Understand the risk-return trade-off- The higher the risk associated with a financial instrument, the greater the potential return is. This trade-off is a primary reason that diversification should take place. This is because neither situation is optimal for the retiree. Low risk-low return increases inflation risk while high risk-high return increases the risk of loss. Conservative investing does not necessarily imply investing exclusively in low-risk funds. It suggests that the majority of your investment should be split between cash and income options and a relatively lower percentage assigned to growth instruments.

5) Understand averages- In choosing mutual funds; beware of making selections based on averages alone. Apart from investment fees and charges being a significant aspect of most mutual funds, averages can be misleading. One portfolio may have a better average than another. However if the higher-average fund is volatile, reaching extreme highs and lows, this could be riskier than if you have a moderate-return fund that does not tend to either extremities.

Some retirees leave the bulk of their retirement funds in savings accounts, while their higher-order investments are money-market funds. In economies where the inflation rate is medium to high, this is likely to do nothing for the preservation of your savings. This would mean that your fund would dwindle faster, especially if you didn’t optimise your choice. Even if you are making a low-risk investment, it is incumbent on you to choose the best-performing fixed deposit or money-market fund.

Posted by: Janet Schlarbaum

Author: Richard Stooker

Diworsification is a “clever” term some financial advisors use when they’re pitching you on some company’s stock or their method of beating the market. It’s a red flag for either arrogance or greed, or both.

Diversification is an established method for reducing investment risk. It comes from the work of Harry Markowitz and Modern Portfolio Theory. It’s only common sense that if you have your wealth in only a few investments that you’re facing more risk than somebody who has their money spread out over many different investments.

The usual reply to that is — hey, this company is the greatest thing since Thomas Edison founded General Electric. It’s going to outperform Wal-Mart, Microsoft and IBM put together.

Maybe — but you don’t know the future. No matter how bright a company’s prospects seem, there’s always risk.

The product which you think is a sure-thing fails in the marketplace.

The founder dies of a heart attack.

A terrorist attack destroys the company’s world headquarters.

The Vice President of Marketing could be busted for sale of controlled substances.

A government agency finds the company guilty of law-breaking.

The company is hit with a huge class action lawsuit.

The company’s main plant in Central America is confiscated by a socialist government.

And so on. The possibilities are endless. It’s a virtual certainty that every company you consider investing in — no matter how terrific its long term prospects appear — will face difficulties of one sort or another. You won’t truly know whether it’s the next Wal-Mart or McDonalds until you see how it solves or fails to solve those problems.

The danger you face from investing in one company and depending upon it to survive and thrive despite its problems is called non-systemic or idiosyncratic risk.

So the obvious solution is to invest in two companies. If one fails, the other is still likely to succeed. However, there’s still a high likelihood that both companies will fail. This is especially true if they’re in the same industry. With the introduction of the automobile, all horse buggy companies failed, the well managed as well as the poorly managed.

So the logical answer is to invest in a number of different companies in various industries.

Modern portfolio theory determined that if you invest in 20 different companies in different industries you eliminate about 90% of the non-systemic risk. If you invest in 30 companies, you eliminate all systemic risk.

That means your only risk is what’s called “market” risk — that all 30 companies go down due to macroeconomic factors such as high interest rates or a worldwide depression.

However, there is a flip side to eliminating non-market risk, and that’s eliminating non-market GAIN. That is, when you have 30 or more stocks you won’t lose more than the market as a whole goes down, but your portfolio as a whole won’t go up more than the market either.

Out of your 30 stocks, a few will go up big time, many will do average, and a few will go down. So the average will be pretty close to the market as a whole.

Now think about actively managed mutual funds. Most of them have stocks in from 30 or more companies. Most of them don’t beat the market. They don’t hang on to the stocks they pick. They sell some, making you pay taxes on the winners, and buy some, making you pay transaction costs. Not to mention that you pay the costs of your fund manager’s salary and other administrative expenses which may be relatively cheap (Vanguard, for example) or expensive (most mutual fund families).

The obvious conclusion is that you have a choice between eliminating non-systemic risk by buying and holding a basket of 30 or so stocks in your brokerage account (NOT a mutual fund, where active management will cost you transaction and management fees, plus capital gains taxes) or taking the risk of choosing a few companies you’re sure will take off like a rocket, and keeping your fingers crossed.

(One easy way to do as well as the market is to put your money into an index mutual fund such as Vanguard’s S & P 500 index fund. That way you’ll know you’ll match the market — which is better than 90% of actively managed mutual funds.)

Stock pickers hate this.

That’s anybody who’s trying to sell you their services of telling you what stocks are going to be winners: mutual fund managers, portfolio managers, brokers, newsletter writers, and financial analysts.

They love to look for companies that seem headed to success, and quite often they find them. If you put all your money into one company and it soon doubles or triples in value, you’ve beaten the market.

But remember, if all your investment funds are tied up in one or a few companies, you are faced with that non-systemic risk. If the company doesn’t have the success the advisor thought it would — your portfolio craters.

But surely there are good reasons why some companies succeed and others fail, and if you can isolate those reasons, you can buy the stocks most likely to succeed and avoid those most likely to fail.

This is has been the subject of much study, and in truth, there are proven indicators you can use to isolate companies more likely to be good investments. Two great books on this are: WHAT WORKS ON WALL STREET by James P. O’Shaughnessy and YES, YOU CAN TIME THE MARKET by Ben Stein and Phil DeMuth.

These authors have found long-term value in investing in stocks that have: low P/E ratios, high dividend yields, low price-to-book ratios, low price-to-cash flow ratios, and low price-to-sales ratios.

However, it should be noted that their studies involved groups of companies (O’Shaughnessy used the top 50 stocks in each criteria). None of them claim they’ve found a way to guarantee success in buying individual companies.

Of course, the prices of all stocks in the market can tank a la 1929, which is you should also be diversified across asset classes — called asset allocation. Ideally, everybody should own some stocks, some cash (money markets or certificates of deposit), some real estate (besides your own home), and some bonds.

Ideally, you should own not only investments in your own country, but stocks, cash, real estate and bonds on every continent (except — so far — Antarctica!). This diversifies you across national and regional economies, and across currencies.