Selection of Individual Investments 

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Selection of Individual Investments

In order to match your objectives with specific investments, you need to identify the characteristics of the different investments and their risks. Funds for immediate needs and emergency purposes should be liquid, in other words, able to be converted easily into cash without incurring a loss of principal. Such investments are money market mutual funds, checking accounts, and savings accounts. These are readily convertible into cash. By increasing the time horizon from immediate needs to short-term needs, investors could increase marginally their rates of return by investing in certificates of deposit (CDs), Treasury bills, and commercial paper. However, of these, only Treasury bills are marketable, meaning that they can be sold on the secondary market before maturity. Savings accounts, CDs, money market mutual funds, Treasury bills, and commercial paper provide some taxable income, are liquid, but do not offer the possibilities of capital gains or losses. Although investors might not lose any of their principal by investing in this group of investments, there is a risk that the returns from these investments may not keep up with inflation.

The financing of intermediate-term objectives that stretch several years into the future—such as the purchase of a car, a house, or an appliance or the funding of a child’s education— requires investments that generate income and the return of principal. These investments need to produce a greater rate of return than a savings account or short-term money market securities. Short- to intermediate-term bonds offer increased rates of return over money market securities as well as the possibility of capital gains or losses if the investor needs the money before maturity. Although investors receive increased rates of return from intermediate- term securities over money market securities, investors need to be aware that their principal invested in intermediate-term bonds is not as liquid as short-term securities.

An investment plan to finance a child’s education in five years requires a relatively safe investment, which would not include investing in stocks. Most people would not gamble with the money earmarked for their children’s education in the event of a declining stock market when the money would be needed.

Long-term objectives such as saving for retirement or for an infant’s college education in 18 years require investments that offer long-term growth prospects as well as greater long-term returns. Stocks provide larger long-term returns than bonds or money market securities, but stock prices are more volatile. The level of risk that can be withstood on stock investments depends on the individual investor’s circumstances.

Amore conservative long-term portfolio might consist of longterm bonds, blue-chip stocks, and conservative-growth stocks. The emphasis of this strategy is to invest in good-quality bonds and the stocks of established companies that pay dividends and offer the prospect of steady growth over a long period of time. Securities offering capital growth are important even for conservative portfolios in order to provide some cover against any potential erosion in future purchasing power from inflation.

A growth-oriented part of a portfolio seeks the generation of long-term capital gains and the monetary growth in value of the stocks in the portfolio. A more speculative portfolio, where an investor can absorb greater levels of risk to strive for greater growth and returns, would include growth stocks, stocks of emerging companies, foreign stocks, emerging market stocks, convertible bonds, junk bonds, real estate, options, commodities, and futures. Bear in mind that including the last three types of investments— options, commodities, and futures—is not an endorsement that these securities should play a major role in a portfolio. For a speculative investor who understands the nuances of these investments, these securities could account for no more than 5 percent of the total portfolio. The other assets mentioned offer investors the opportunity for large gains, but the risks of loss are also greater. Foreign bonds and stocks also should be considered, but investors should do their homework first so that they understand the risks fully. International mutual funds might be more helpful to spread some of the risk, although in the short term there is always currency risk when investing in off-shore investments. Over the long term, however, exchange-rate fluctuations tend to even out and are not a significant factor.

Investors who are not comfortable buying individual bonds and stocks could choose mutual funds, exchange-traded funds, or closedend funds. Investors willing to make their own investment decisions on individual securities can eliminate the fees and expenses charged by mutual funds and closed-end funds. When considering the different types of securities to choose for a portfolio, investors should weigh the characteristics of the type of investment along with the risks. (See Table 18–3 for a summary of the strategies to reduce the different types of risk.)

Table 18-3
Summary of Strategies to Manage Risk
Investment Risk Strategy
Common stock Market risk Invest for a long period of time.
Financial risk Diversification: invest in companies with low leverage.
Interest-rate risk Active or passive strategy, depending on the investor’s time horizon
Declining market rates of interest Increase the percentage of the portfolio allocated to stocks.
Increasing market rates Decrease the percentage of the portfolio allocated to stocks.
Credit risk Invest in good-quality stocks.
Purchasing power risk Requires active portfolio management; invest in stocks that (when inflation increases) will weather the effects of inflation better, such as gold stocks, oil, and commodity stocks.

As mentioned throughout this book, diversification reduces risk without decreasing returns. A portfolio should include at least 12 to 15 stocks in order to lessen the risk of loss. In other words, an investment in one company should not account for more than 10 percent of your portfolio. If that investment declines significantly, you would be limiting the total amount of your loss to at most 10 percent of your portfolio. One method of building a portfolio is to invest equal amounts in different stocks. For example, if you want to invest in 20 stocks, the amount invested in each stock would be 5 percent of your total capital. However, you might identify some of the 20 stocks that have the potential to perform better with lower risk, and you would want to allocate greater amounts to those stocks and lesser amounts to stocks that might not be as attractive.

Investors who assume that the stock markets are efficient strive to build portfolios that are well diversified with risks and returns that match those of the market. In order to earn returns that are greater than those of the market, investors would need to invest in securities with higher risks than the market indexes. Passive investment strategies of matching market returns involve indexing and long-term buy-and-hold investing strategies.

Investors who think that they can beat the market averages are more likely to choose their own stocks and are also likely to have shorter holding periods for their stocks. Market timers buy and sell stocks as market trends and economic factors change. Some industries are more sensitive to the economy than others. Industries that move in the same direction as the economy are referred to as cyclical industries. The sales and earnings of these companies generally are aligned with the economic cycle. The stage in the business cycle of the economy becomes important to the timing of the investments in these cyclical companies. For example, you would not want to invest in the stocks of automobile companies at the peak of an economic expansion because their stock prices would be at their upper limits, and they would face a downturn in earnings when the economy slows down. During a period of economic expansion, the stock prices of cyclical companies traditionally increase; during an economic recession, the prices decline. Cyclical companies are in industries such as automobiles, building and construction, aluminum, steel, chemicals, and lumber. Because these stocks are sensitive to changes in economic activity, investors should time their purchases of cyclical stocks to the early phases of an expansionary period. Figure 18–8 illustrates the timing of the different industries in the business cycles of the economy.

Figure 18-8. Industry Selections
Industry Selections

Coming out of a recession, financial stocks tend to do well because of lower interest rates, whereas at the expansionary phase, stocks of consumer durable goods companies are the ones to buy. During a recession, consumers delay purchases of automobiles, large appliances, and houses. Cyclical stocks fluctuate with the state of the economy and are always hit hard by rising interest rates. Into an expansionary cycle, capital goods companies benefit from increased sales in the business sector, which result in an increase in the demand for raw materials and commodities. Stable industries include health care stocks, beverage stocks, food retailers, food companies, consumer services, and household nondurables.

This pattern is typical in most business cycles, but exceptions always exist. During the recession of 2000–2002, for example, auto companies saw sales of cars rise significantly because of sales and marketing incentive programs, such as zero-percent financing and considerable price discounts. This increase improved auto companies’ sales but did not improve their profits. By timing stock purchases in these different industries, investors might be able to improve their returns.

Anticipating changes in interest rates could prompt investors to reallocate the types of investments in their portfolios. If higher rates of interest are anticipated, an investor has a number of different options. Profits may be taken by selling stocks that have appreciated, or the investor may decide to sell stocks in the interest-sensitive industries, such as financial stocks, cyclical sector stocks in the automotive and home-building industries, and utility stocks. Some investors might buy stocks in the pharmaceutical and food industries, which tend to weather the effects of higher market interest rates better than other sectors of the economy. Other investors might decide to hold their existing stocks but not invest any new money in the stock market until interest rates start to level off. True market timers might liquidate their entire stock positions and wait on the sidelines for more favorable conditions.

Purchasing power risk, or inflation, hurts all financial investments to some degree or another. However, traditionally, returns on stocks tend to outperform those of bonds and money market securities during low to moderate rates of inflation. Mining stocks, such as gold and platinum, and aluminum stocks have been good hedges against inflation.

Even a passively managed portfolio should be examined at various intervals with regard to returns on different investments as well as the changing economic conditions. Not all investments achieve their anticipated returns, and if they turn out to be poor performers, they might need to be liquidated.

Investors who do not have the knowledge and skills to manage their portfolios might turn to professional advisors. Financial planners and accountants offer advice on the planning and management of portfolios. For investors who do not wish to be involved in the management of their assets, there are professional money managers and trust departments of various institutions. Their fees are often a stated percentage of the total dollar amount of the portfolio, which often requires that the portfolio be substantial in dollar terms.

The key to long-term successful investing is to allocate investments into bonds, stocks, and money market securities suited to the investor’s particular objectives and circumstances.

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