The types of investment risk
Before anyone begins investing it is critical that they understand what the risks are so they can manage their investments effectively. One type of risk is obvious while another is much more insidious. There is still another risk that I will explain later, but structuring your investments properly can help you avoid this particular type of risk.
Risk of loss of principal
This is pretty obvious. You plop down $5,000 of your own money in a stock or on an investment property and the price of that asset goes down. Now your $5,000 investment is only worth $2,500. Why does this happen? There are a lot of reasons for it, but the underlying reason is the investor didn’t understand the actual value of the underlying asset that he or she was purchasing in many instances.
I will use an example from my own life as a lesson on this. When I made one of my first stock purchases I bought Life Partners Holdings, Inc. (LPHI). This company engages in the secondary market for life insurance policies of high net-worth individuals. Looking at the financial statements for the company the stock was selling at about 20% below book value per share and also had a pretty healthy dividend yield of 10%. I also thought I understood the business model pretty well and thought with the baby boomers hitting into the 60′s it might have some rather steady business and revenue for the next 20-30 years.
However, I didn’t dig far enough. What I should have done was look more at the news surrounding the company and what it does. There had been a note in one of the annual reports regarding litigation over life expectancy valuations performed by the company’s contracted physician. The Wall Street Journal had uncovered that several life insurance policy investors had discovered that the life expectancy valuations were off by more than a few years and in a higher percentage of cases.
After this came to light the SEC (that’s Securities and Exchange Commission not the collegiate football conference) launched an investigation into the company. Two days after I had purchased the stock the SEC staff had completed its investigation and issued a Wells Notice, which is a formal recommendation by the staff to the Commission to issue enforcement and also pursue civil penalties.
The day the Wells Notice was issued the stock price plummeted 20% in a single day. I considered several things about the business and looked into the news more thoroughly surrounding LPHI before making the decision to sell. I came to several conclusions as a result of that:
1. I didn’t really understand the secondary market life insurance market well enough to make a judgment about how well LPHI was doing in it.
2. Looking at the nature of the press releases I didn’t get the feeling that the management was very forthcoming about what was going on and keeping the shareholders and potential investors apprised of the situation in the company. LPHI doesn’t engage in any other business. The secondary life insurance policy market is its “one-trick pony”. This is a business that is built almost entirely on reputation, with a reputation badly stained it would be an uphill battle to restore business back to nominal levels if that was even achievable.
3. There was evidence of accounting shenanigans going on as evidenced when the company’s auditor, Ernst & Young, LLP, resigned as auditor over a disagreement with management over the content of the 2010 Annual Report. Additionally, the company quietly filed a form NT 10-K/A with the SEC which is a notice that it will delay the filing of its Annual Report. This filing isn’t necessarily anything to worry about, but one of the statements it contained was that they anticipated taking significant impairment charges based on policy valuations from previous years and that the delay was due to significant changes that needed to be made to the annual report. No press release regarding this fact was made.
In other words, looking at the new information I had gathered I learned that I didn’t feel I could trust the management. Since they are the ones driving the company then I had no way to fairly value the company. Without an accurate way to value the company then it was best to just walk away. So I did.
* If you are going to invest in a stock or a bond that is being backed by a company then you need to understand the underlying value of the company that backs that security. While the economics side of valuation can be found in a number of places here are some other things you need to consider:
* Do you understand how the business works and what it does to make its money?
* Is there pending litigation or other possible impairments on the company that has driven the price of the company down now or may in the future? This can work for or against you, depending on your investment time horizon with the stock.
* Is the management inherently trustworthy? Who are they? How did they get there? Are they a hired jockey? The founder of the company with a unique vision? A corporate “gun-for-hire” who only works for the highest bidder with the best stock option package? If they don’t seem trustworthy or they just seem to be “in it for the money”. Then this is probably a company best left alone.
Risk of inflation
OK, so your principal is safe, but is your return outpacing the rising costs associated with living in a world where resources are increasingly scarce as the population continues to rise? Here in the US inflation goes up at an average of three to five percent each year. If you are investing at a compounded rate of two percent per year surprise your money is now worth less than when you started investing for the long-haul.
That is why it is important to also look for high-quality investments that provide great returns over the long-term. If you merely look for safety, such as treasury bonds or life insurance annuities that pay low-interest rates, you may start your retirement fundamentally further behind from a cost of living amount than what your entire principal was worth initially.
As I implied in the introduction, this is a far more insidious form of risk. Because you actually have more dollars than when you started investing, but if you haven’t made an adequate return on your investment to outpace inflation your purchasing power is actually decreased. Your investing is really nothing more than saving and has done nothing but give you something to live on a little longer.
I have talked about taxes in one of my other posts, but this is such an important matter that it needs emphasis. Before I launch into this topic let me emphasize that I am not a tax professional and that you should consult an accountant or tax attorney to help you make the right decisions for your individual situation, but a lot of what I write here should be applicable to many U.S. citizens that are considering investing in stocks.
First of all you need to know that you will pay capital gains taxes on money that you actually realize from your investment. As I write this the current capital gains tax is 15% in the USA. What that means is if you buy an investment for $1,000 and sell it for $2,000 you will only pay taxes on the realized gains of that investment: $1,000. Remember, this only happens when you actually lock in your gain. If you don’t sell your investment then you don’t pay taxes on it. It’s that simple.
Also, if the stock you own pays a dividend you also owe capital gains taxes on the dividends as well. Even if you use a dividend reinvestment program to reinvest those dividends at a later time, you still pay capital gains taxes on that amount when a dividend is paid.
Additionally, there are ways you can legally defer taxes or avoid paying them altogether which will help your investment returns dramatically.
The first way to do this is with a 401(k) contribution. There are some pretty big advantages to contributing to your 401(k) if you have the option to do this. First, is that the money in the 401(k) is tax sheltered while you are contributing and working. This means that you pay no taxes on the gains year to year. This may not seem like a lot, but over a 20-30 year investment timeframe the difference between paying taxes each year on these investments and paying taxes when you withdraw 30 years into the future are HUGE. I’m talking literally thousands or tens of thousands of dollars in tax savings. Additionally, a lot of companies and organizations pay matching contributions on your 401 (k) up to a certain percentage of your pay (typically 5% but there are variations). This is literally free money for your retirement, but if you don’t contribute you can’t get it. The other great thing is that the money you contribute to your 401 (k) comes from your pre-tax income (at least here in the USA). So this reduces your tax burden putting more money in your pocket. I will talk about a little trick I do with my own finances that allows me to grow some of my investments tax-free forever in just a moment.
The major disadvantage of a 401 (k) is that most employers only allow you to choose from a limited selection of mutual funds or exchange traded funds (ETF’s) rather than directing your investments yourself.
Even if you are contributing to a 401 (k) at work you can also add contributions to a traditional tax-sheltered IRA or a Roth IRA. As I have mentioned in other posts the difference between a traditional IRA and a Roth IRA is when you pay taxes. If you have a traditional IRA your taxes will be deferred to when you withdraw your IRA contributions after you retire. For a Roth IRA those taxes are already paid before you contribute to your IRA. Thus, with a Roth IRA you can withdraw your money and never pay taxes on it again.
If you can not contribute to a 401 (k), then I recommend using the traditional IRA as your method of tax sheltering. This will best protect your IRA contributions from the corrosive effects of taxes over time until you can withdraw them.
If, on the other hand, you have a 401 (k) or similar type of structure that you can contribute to at work, I recommend contributing the maximum amount you can to this first, then using the tax savings from your pre-tax contributions to add to your Roth IRA.
Here is an example of how this works. Suppose you get paid $5,000 every month. You can contribute up to 5% of your pay every month with matching contributions from your employer to your 401 (k). So you can contribute $250 every month without paying taxes on it and your employer kicks in another $250 also. If your tax rate is 25% this means you will have a tax savings of $62.50 every month from your 401 (k) contributions ($250 x 25% = $62.50). This represents $62.50 of your money that the government hasn’t touched now and can’t touch in the future if you place this in your Roth IRA. You can then grow this in your Roth IRA tax-free for 20 to 30 years or more (depending on your age).
$62.50 each month may not sound like much, but grow this at 15% every year for 25 years without worrying about being taxed on it ever, and this grows to $205,307.11 from a principal investment of only $18,812.50.