Currencies are unlike other assets.  For instance, currencies are used for monetary exchange across the globe.  People don’t buy groceries with gold coins or mutual funds in France – they use Euros.  That’s the way we usually think about currencies.  But currencies can do more than buy groceries.  If you’re a US-based investor, your investment account can gain value when holding a currency that appreciates against the US dollar.  Your account can also profit while a currency is going down if you sell-short in that currency.

All of the major world currency values float against each other, though some float less than others (ex. Chinese Yuan).  Investment managers use these major currencies to diversify investment accounts.  The major currencies ranked by trading volume are:

1. US Dollar (USD)
2. Euro (EUR)
3. Japanese Yen (JPY)
4. British Pound Sterling (GBP)
5. Swiss Franc (CHF)
6. Australian Dollar (AUD)
7. Canadian Dollar (CAD)

Investment managers buy or sell currencies in various ways.  The easiest and most cost-effective way to hold currencies is through ETFs.  The most popular are CurrencyShares from Rydex.  There are several competitors, but none have the trading volume that Rydex has garnered.

For example, an investment manager could use a currency ETF when he sees weakness in the US market.  If he observes a stronger Japanese market in the intermediate-term, he could buy CurrencyShares Japanese Yen Trust (FXY).  If he’s right, the investment would appreciate as the US Dollar fell versus the Japanese Yen. FXY would go up since the ETF is priced in Dollars.

Another way investment managers use currencies is through non-US dollar savings accounts.  Like any bank account, you deposit money in a bank and receive a rate of return.  But unlike other bank accounts, the funds are counted in a different currency.  Your deposit will fluctuate in value if that country’s currency fluctuates while your cash is on deposit.  There are various risks associated with this strategy, so make sure your investment manager is doing his homework.  If you want to make international savings deposits yourself, check out Everbank.

By the way, if you’re curious about how the Dollar matches up with other currencies, check out these exchange rates.

Funds aren’t an asset in themselves; they are vehicles that help you invest in various asset classes.  Traditional mutual funds are a collection of securities that are actively managed by an investment manager and his team.  They often compare themselves with investment indexes of similar asset classes.  Mutual funds have evolved over time, and now some invest in a multitude of assets, some buy other mutual funds, and others simply track an investment index.  Mutual funds are typically bought for the benefits of diversification, professional management, and low capital outlay.  Many kinds of mutual funds can be expensive to own and cumbersome to sell.

Here are some of the fees mutual funds can charge:

• Management Fees – (normally 0.5%-2.0%) this is how mutual fund companies pay their fund investment managers and staffs.
• 12b-1 Distribution Fees – (0.25% and 1.0%) for marketing to new prospects.
• Administrative Fees – (0.20% – 0.40%) to keep the lights on at the office, paper in the copier, etc.
• Sales Loads – (3.0% – 5.75%) Also known as sales commissions, they are used to pay the sales force who sell the funds.
• Exchange Fees – Additional fees you can incur if you decide a mutual fund no longer matches your investment objectives.

If you buy a mutual fund with a sales load, your investment has to dig itself out of a hole before you can make a penny.  That sort of expense is a big drain on your rate of return.  Ensure that you evaluate the cost against the value you’ll be receiving when considering a purchase of fund.  You can also purchase mutual funds that have no sales charge (load).

An alternative that has been making tremendous strides to mutual funds in the last decade are ETFs.  ETFs, short for Exchange Traded Funds, are collections of stocks, bonds, or other assets. They can track a number of different underlying indexes such as the S&P 500.  The increasing popularity of ETFs has provided a large menu to choose from.  Whatever kind of investment pool you’re looking for, there’s a good chance at least one ETF tracks it.

ETFs are similar to mutual funds in being pooled investments, but have some enormous advantages.  Often, the expenses are fractional in comparison to funds, so you don’t have to waste your hard-earned savings on fees every year.  The average ETF charges 0.1% – 0.65% annually.  This can mean enormous savings over time.

An added benefit is that ETFs provide up-to-the minute pricing while the market is open.  You don’t have to wait for end of day pricing, common with most mutual funds. You can buy and sell an ETF knowing the price you’ll pay.  ETFs also tend to be more tax-efficient.  The passive management of index investing coupled with the lack of pass-through taxes, inherent in most active mutual funds, can reduce your tax headaches.

ETFs still have their challenges.  Light trading volume or shallow markets can affect the pricing of some ETFs.  In addition, transaction costs can add up if you’re a high frequency trader, although there are ways to reduce these expenses.  Some other features such as automatic dividend and capital gain reinvestment that are available in funds, are not generally possible in ETFs.

Pooled investments are an important tool for a majority of investors.  The uniqueness and benefits of mutual funds and ETFs are stark compared to individual securities.  If you’re constructing a portfolio and you want to buy a diversified block of assets, mutual funds and ETFs are great options.  The benefits they provide can be paramount to a successful portfolio.

Client Objectives

Every investor is different. While many may have similar goals, all have unique circumstances. Some might be looking forward to a retirement full of international travel and posh leisure activities. Other investors’ objectives may be more modest in nature, but no less important. Whatever the goal, good investment managers start by understanding their client’s objectives. Then, they put together an investment plan that will seek to meet these objectives while minimizing the risks associated.

Portfolio Construction

A big part of the investment plan is asset allocation, which is using different asset classes to construct a portfolio designed to meet client objectives. These asset classes are varied. They include cash, stocks, bonds, commodities, real estate, insurance, and more. Experienced investment managers use many or all of these asset classes in varying degrees to build portfolios for their clients.

Hypothetical Asset Allocation

To illustrate how asset allocation can work, we have a very simple, hypothetical case: Sam and Sally. Sam, 40 years old, is married to Sally, also 40, and they have no children.

They enjoy what they do, but both want to retire when they are 65. They plan to travel extensively and prefer to relocate to the beach upon retirement. That gives them roughly 25 years to make their world traveling, beach living retirement a reality. Both are comfortable with taking on higher-risk for the potential of more growth in their investments, so they are okay with greater volatility.

Understanding Sam and Sally’s objectives and risk tolerance is crucial for determining how to deploy assets in their portfolio, and typically there’s a lot to work that goes into determining the proper asset allocation. Let’s go forward with the understanding that this extensive planning process had been completed because the point is to illustrate the difference in asset allocation models at different stages in life. A reasonable asset allocation mix over time for Sam and Sally may be:

Phase 1: Age 40-55

• Allocate 60% in stocks, 15% in commodities/real estate, 20% in bonds, 5% in cash.
• Continue to work, receive average raises in relation to inflation, and save 15% of their income per year before taxes.
• Monitor and rebalance portfolio every year for the best in class assets, but do not adjust overall strategy unless investment goals change.

Phase 2: Age 55-60

• Start re-allocating to a 50% stocks, 30% bonds, 10% commodity/real estate investments, and 10% cash portfolio.
• Monitor and rebalance portfolio every year for the best in class assets, but do not adjust overall strategy unless investment goals change.

Phase 3: Age 65+

• Start re-allocating 30% in stocks, 50% in bonds, 10% in cash, and 10% in commodities/real estate investments.
• Monitor and rebalance portfolio every year for the best in class assets, but do not adjust overall strategy unless investment goals change.

As this couple gets closer to generating income from their portfolio, their investment approach transforms from a growth portfolio to an income portfolio and you can see how their portfolio is restructured over time to reflect this. Still, at no time is their plan one of extremes. There is always a growth component and conservative component, just of differing degrees to reflect their needs in life.

Real retirement plans should never be all in one asset class, whether in growth mode or income mode. You need the proper balance to protect your plan from the multitude of risks out there. Additionally, you’ll notice this asset allocation schedule roughly follows the Three Phases of Retirement Investing. Asset allocation is fundamental to investment planning, and although there are different ways to be successful in managing your investments, it remains a staple of how to reduce risk.

If you direct your own investments, asset allocation is one of the first things you should consider.  Some people learn this the hard way.  In an effort to get rich quick, they fall into investing all their money into one asset – often stocks or real estate.  Sometimes it works out.  Most of the time, it works against you.  Without proper asset allocation, you could lose your entire investment portfolio on a risky bet.

Even if you want to live on the interest from a million dollars, it’s important to consider wise asset allocation as soon as you start investing.  But before you do that, it’s good to define the components of asset allocation.  Investment managers use these categories to construct portfolios.  The snapshots below explain what they are and what sort of risk to expect from each:

1) Cash or Cash Equivalents

The most common asset class is cash.  Cash generally includes any cash saved above what you need from a transactional basis.  This can include your savings account, your money market account, and even the physical savings bonds kept in your dresser (Note: You should always keep anywhere from 6-12 mo cash aside for emergency basis).  Foreign currency is also considered a type of cash, although it’s often distinguished in asset allocation.  Cash is a low-risk, low-return asset, typically used to offset some of the riskier parts of your portfolio.

2) Stocks or Equities

Stocks are shares of ownership in a company.  Stocks can be subdivided in numerous ways including small-cap vs. mid-cap vs. large-cap relating to the size of the company.  Sometimes they are categorized by their growth-orientation (value vs. growth).  A distinction between domestic stock and international or emerging market stocks is also common.  Most of the financial press is focused on stocks.  Stocks historically have offered greater return opportunities but also great risk and volatility.

3) Bonds

Bonds are debt securities.  They are formal contracts that governments or companies issue to borrow money that will be repaid with interest at fixed intervals.  If you’re a bondholder, you have lent your money to someone because you expect to get a stream of interest with your principal back at a later date.  Bonds have traditionally offered less return than stocks over time, but also less risk and volatility.

4) Commodities

Commodities are physical assets that are traded on the capital markets.  These include corn, soybeans, gold, platinum, cotton, oil, natural gas, pork barrels, etc.  Commodities are usually higher risk assets, but are especially high-risk in the leveraged futures markets.  Although volatility can be very high with commodities, they are useful as an asset class that is less correlated with stocks.

5) Insurance Contracts

Insurance contracts include any annuities or life insurance.  They can be considered a growth or income asset, but are generally used for eventual income planning purposes.  Both kinds of contracts can be invested in fixed return or use market instruments to fuel growth.  Insurance contracts also have an additional risk, since they depend on the solvency of the issuer.

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There are three other types of assets that qualified investment managers can invest in: Real Estate, private businesses, and special collections.  Each of these requires a different skill-set and knowledge base, but they are still legitimate assets to be considered in asset allocation.

The year was 1974.  I came from a blue-collar neighborhood where typical incomes were in the $10,000 to $15,000 range.  Anyone making $20,000 was well above-average.  I believed my plan would overcome inflation, and it was based on an extremely conservative income assumption – living off the interest while never touching the principal.

It was a simple plan, but at least I had a plan.  Many people never stop and think about their retirement income until much later in life.  My plan has evolved over the years:  I am no longer content with a $50,000 retirement income, and I am not relying on interest.

Unfortunately for millions of Americans, their plan is similar to my first one:  accumulate a large amount of money and live off the interest.  They worked hard all their life, perhaps paid off their mortgage, grew a sizable nest egg, and are now counting on it to generate income.  Again, this sounds like a reasonable plan, but let’s look at how it is doing.

The two largest retail money market mutual funds are Fidelity Cash Reserves (FDRXX) with assets of $127 billion and Vanguard Prime (VMMXX) with more than $109 billion.  Funds like these are what thousands of investors and savers count on to generate “risk-free” income.

Just three years ago, in 2007, the plan seemed to be working.  These two funds were yielding 5% and kicking out $50,000 a year for every $1,000,000 (one million dollars) invested.  Today the story is different.  According to iMoneyNet, the current yield (as of 3/2/10) on FDRXX is 0.02% and for VMMXX it’s just 0.01%.  Instead of $50,000 in annual income, these two funds are only providing an average of $150 per year.  That is not a typo, and there are no zeroes missing.

What seems at first like a risk-free plan has at least two enormous risks.  The first is interest-rate risk.  The plan assumed 5% and didn’t take into account that interest rates could drop to nearly zero.  A 99.7% decline in interest income is not only possible, it has happened.

The second unmanaged risk is inflation.  If you think it’s hard to live on $150 a year today, just think what it will be like when oil gets back above $100 and health care costs climb even higher than today.  Lower prices for housing, education, and consumer goods are of limited value to retirees, whose expense patterns do not necessarily match the official inflation rates.

The fact is that money market funds are enormously risky if you count on them for income over long periods of time.  Stocks and bonds are risky, too, but in different ways.  That’s why investment management is a key ingredient for long-term success.

You can’t put all your eggs in one basket and then ignore them, even if that basket is cash,   If your plan is still based on living off the interest, or if it has been a while since you last updated your plan, perhaps now is a good time to review the assumptions and see if they are still reasonable.

Disclosure covering writer, editor, and publisher: FDRXX is used by our affiliate, Capital Cities Asset Management, as the cash-sweep fund for many non-taxable accounts.  No positions in any of the companies or ETF sponsors mentioned.  No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.

The problem is that investor buying has begotten more buying, and the tape is not matching the fundamentals.  If the only reason you are buying is that the herd is telling you the market leads the economy, then why was the S&P 500 at 1575 in October 2007?  That’s where the debate should begin and end.

The question is: how well was the market discounting the next 6-12 months back in Q4 2007?  Not so well!  The same may be true today.  The next question is: What about market efficiency?  The previous example proves the point.

Take any market…traders like to cite China and the Shanghai Index breathlessly these days, especially on the heels of a 100% surge this year alone.  But look farther back.  The Shanghai Composite Index traded to 6100 in late 2007.  It crated below 1700 last year.  Today it is around 2900, after nearly reaching 3500 two weeks ago!  Hello discounting market, hello efficiencies!!

The point of my rant is that the panic chase to buy stocks since mid-July and the level of bullishness are good reasons to fret.  The next time someone tells you how the market reflects future information, I’d caution you as to the reliability of such a notion.  Stocks move on perception as well as reality.

Sometimes perception is all that matters, until reality takes hold.  Right now the spin-doctors hope you rely on perception, in the sense that you must own stocks because the economy is getting better and the great recession ended three weeks ago!  How many times have you heard that in the past seven days?!

The recession may have indeed ended last month, but what happens if or when the economy pulls a W rather than a V?  The market is as much a casino as ever before, and you better not rely on certain viewpoints without thinking through the pros and cons before taking a position.

Frankly, the manic tendencies our market has faced these past two years (and likely well into the future) will dictate attention to a mixed type of portfolio.  It would contain loads of cash, a few targeted equity and fixed income securities, and a whole lot of patience.  Perception may not be reality, but as Warren Buffett likes to say, the market votes in the short run and weighs in the long run.  I plan to thrive in the long run and will manage accordingly.

Good luck out there.

We’ve recommended larger-than-normal cash balances this year, and have discussed being exposed to traditionally defensive sectors such as healthcare and consumer staples. However, being all-in or all-out has repercussions, and probably negative ones. How can anyone manage in an environment where the market can move five percent one way or the other in a single day?

What about today’s sudden DOW plunge of -270 points (from high to close) in the last ten minutes of trade, on the mere mention that General Electric’s CEO, speaking at a dinner reception in Europe, lowered their 2009 forecast?! There wasn’t even a press release from the company, just rumor and innuendo, moving the market in seconds.  This sort of volatility is more common than you may think.

Cash is Risky

One key component of managing risk, however, is to not move too far away from the benchmark, as you can increase the risk that the benchmark moves one way and you move in the exact opposite direction. Therefore, most growth oriented investors forget how risky it is to be completely out of the market! Many investors think of risk in terms of loss. However, risk can also be defined as missing an opportunity. At the end of bear markets, those sitting entirely in cash significantly under-perform a market that shoots higher. It is a careful process in times like these to manage both sides of the equation.

Market Whipsaw

The headlines today suggest the economy is a mess. Wouldn’t investors be better off completely out of the market? If you sell everything now, you raise the specter of a whipsaw. Getting whipsawed increases the likelihood of losing out to the benchmark as you lose the resulting gain of the next move up. The whipsaw takes place when you have maintained some long equity positions despite the decline, and you throw in the towel close to the bottom. Days or weeks later, the market moves appreciably higher. Now that you sold the positions you’ve doubled your pain as you are no longer well positioned to benefit from a bounce or a new bull market. This is not prudent money management.

Maintaining a long-term discipline is critical during periods like the one we are in. Reacting to the news of the day won’t fulfill your long-term financial objectives. Maintain your allocation and to stick with your strategies.

History as a Guide

History has shown that recessions, corrections, and bear markets occur regularly. Although they are painful, the stock market has shown the ability to recover. We also know that the stock market typically leads the economy by six to nine months, so drastically altering your investment game plan in the middle of the game could be a dreadful mistake. With change comes opportunity, and we at IWAE will seek to adroitly manage through this period and position ourselves with proper care, always mindful of the risks associated with each asset class.

Good Luck

Stocks = Risk

It’s hard to admit, but even experienced investment publishers go through drawdowns. Despite our best efforts to keep investors in the black, we sometimes dip negative. It’s very difficult NOT to experience the effects of a down market. Just as a ‘rising tide lifts all ships’, so also a falling tide (or market) lowers all ships. To spin this into another metaphor, if you have skin in the game, you will get burned…it’s just a matter of time.

If you invest in stocks, you will suffer risk, volatility, and yes, even loss of capital. You may not realize these losses until you actually sell, but the effects are still psychologically damaging. Stocks don’t move in a straight line. There are times of exploding growth, sideways meandering, and yes, even gut-wrenching declines. Such is life on the exchanges.

Unfortunately, many investors don’t take this into account when stock investing. Blinded by historical returns of the S&P or implied 20% returns that some managers discuss, investors jump into various funds, hire managers, or follow strategies, without appropriately weighing the risk. Every decision involving stocks should properly consider loss of capital.

Warren Buffett vs. Bill Gross

The chart above demonstrates the stocks’ relationship to typical return and risk, or loss of capital. As you can see, ‘Shares’ or Stocks have a higher potential for return, but also a higher implied risk. In other words, the more you own, the more you can lose OR gain. To drive home the point, let’s contrast a couple of investors…

1. Warren Buffet is the perennial stock investor. At last count, Buffett had a net worth around $62 billion. Still, Buffett has lost big during his climb to the top. In 1993, he bought Dexter Shoes for $433 million. When the value vanished, Buffett’s Berkshire was left holding the bag. Buffett’s stock investing carried with it significant risk, yet he’s still a billionaire many times over.

2. Bill Gross, aka The Bond King, is probably the best bond investor in the world. As you can see from the chart, bonds have lower risk and lower returns compared to stocks. As good as Bill Gross is at trading bonds, he’s hardly in the same league as Warren Buffett — Gross has an estimated net worth of $1.3 billion. Not to minimize Bill Gross, but his returns are somewhat limited because of his choice of careers: bond investing.

Stocks: Who Needs ‘Em?

If you like the 10%+ returns possible in stock-investing, then stock investing may be a great thing for you. But understand something whenever you buy stocks, ETFs or mutual funds. You can’t have those attractive returns without temporary losses. Extremely risk-averse investors should probably steer clear of equities in general.

But if you’re looking for index-or-better returns, then stocks are your best bet for delivering the goods. Keep your eye on the long-term prize when buying equity-based investments. Rewards tend to be higher with stocks than with any other investment. Over the long haul, you could be looking more like Buffett than Gross.

On the other hand, I wouldn’t mind a piece of Gross’s bond portfolio.

That’s why I was particularly interested when I read about former lead-off batter for the Phillies, Lenny Dykstra, spouting off the benefits of annuities. June’s issue of Kiplinger’s highlights Dykstra’s investment business. I’m not much of a baseball fan, but I had heard of Dykstra. Batting a respectable .285 with 1,298 hits, Dykstra played in the late-80’s, early-90’s. From all accounts, he was a hard-charging player with an off-the-field reputation to prove it. Once retired, he invested in options and real estate making a few more bucks. Dykstra now writes for Phillies-fan, Jim Cramer, at theStreet.com.

As for Dykstra’s annuities…they are typically avoided in the investment management world. Think overweight, dark-suited, slicked-back hair, life insurance salesman, working out of the car, sitting at your kitchen table – who just won’t leave until you sign that contract – that’s the image I got when I heard about Dykstra’s new-found obsession: annuities.

My impression of Dykstra’s logic goes something like this: “I sell annuities to professional ball players because it makes sense. When these guys make all that money, most of them are too stupid to know what to do with it. That’s why it’s best to lock in guaranteed income. That way they won’t be broke when they retire from the league.”

Maybe most NFL, NBA, MLB and other 3-letter leagues are filled with players who understand sports physics better than finance. But I disagree that annuities are the best solution for these players. Annuities lock in principle, unlike any other vehicle. The withdrawal tax penalties can be punishing and the fees are outrageous. Not to mention, people who purchase annuities can lose everything if the insurance company goes under. At least a mutual fund’s risk is spread over many companies. Unless you fall into these categories, you should think carefully about purchasing these types of contracts.

Here’s a final comment from Dykstra in a Philadelphia Enquirer interview..

Host Bernard Goldberg:
“Is it true you once said you don’t read books because they might hurt your batting eye?”

Lenny Dykstra:
“Yeah. You got to rest your eyes, man, plus it makes you think too much.”

Goldberg:
“Reading?”

Dykstra:
“Too confusing.”

Goldberg:
“Reading?”

Dykstra:
“Yeah, I still don’t like to read.”

Goldberg:
“And I’m supposed to follow your investing advice?”