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Aug 25

Is Your Portfolio Diversified?

By Chris Chen CFP | Financial Planning , Investment Planning

Is Your Portfolio Really Diversified?

Diversification is simple to understand. In the context of managing your portfolio, diversification is (simply) about investing in diverse securities so as to lower the risk of the portfolio. Ever since markowitzNobel Prize winner Harry Markowitz wrote his seminal paper “Portfolio Selection” in 1952, finance professionals (and increasingly lay people) have understood that the true risk of an asset is its contribution to the risk of a portfolio.

In a recent survey run by Insight Financial Strategists, according to 41% of respondents a single mutual fund is sufficient diversification . After all, even the most concentrated mutual fund typically has several dozen stocks. However, many mutual funds diversify within a single asset class in a single country, such as, large-company stocks in the U.S.

Others will concentrate their portfolio on a few securities, sometimes with very unfortunate results. For instance, between September 1, 2015, until November 17, 2015, the Sequoia fund (symbol SEQUX) lost 26.3% of its value largely due to its high concentration in a single stock, Valeant (VRX). Looking at the price evolution of VRX below (source: Google), and knowing that SEQUX had more than 30% invested in VRX, it is not surprising that the mutual fund tumbled.

Stock price of VRX from 9/1/2015 to 12/1/2015

Price of VRX from 9/1/2015 12/31/2015

In practice, diversification is hard to implement. There are many levels of diversification. Some of them are:

  • by individual securities
  • by asset manager;
  • by asset class; and
  • by geography.

Ideally, an investor will want to diversify so that the various investments are not correlated with one another, have low correlation or even have negative correlation. For instance, according to data from portfolio analytics firm Kwanti, Goldman Sachs (GS) and JP Morgan (JPM) have an 89% correlation based on monthly returns. In other words, buying GS and JPM in the same portfolio only provides a low diversification value.

diversification is about investing in diverse securities so as to lower the risk of the portfolio

In another example, based on monthly returns, JPM and Walmart have a negative correlation of -0.14%, according to data from Kwanti . I don’t know that I would necessarily want to buy either JPM or WMT. However, this pair provides good diversification from one another.

Most of us end up investing in mutual funds and exchange-traded funds, not in individual securities. The same principle applies there. Having a single large cap mutual fund that tracks Standard & Poor’s 500-stock index may not be sufficient diversification.

Sure, the S&P 500 ETF provides more than one security and is, therefore, diversified. But in general, most of the securities within a single asset class will be highly correlated with one another (such as with JPM and GS). With that, you would be protecting yourself against the risk inherent in any given company in the portfolio, but not against risks inherent to the asset class or other factors.

Ideally, you would want to be diversified across asset classes, across regions of the world and across asset managers. The following jelly bean chart from Schwab demonstrates the benefits of a wide diversification program: the ranking of the assets by performance changes seemingly randomly from year to year. A fully diversified portfolio (the orange boxes in the chart) is intended to avoid the peaks and valleys of individuals asset classes while providing a more middle-of-the-road return experience.

Jelly Bean chart

Is your portfolio diversified? A detailed analysis from a fee-only Certified Financial Planner can give you the full scoop on your portfolio and provide suggestions to mitigate the risks that you are exposed to. Like any other sound advice, apply it now, not later.

Check out some of our other blog posts on investing:

Market Correction? Hold On To Your Socks!   

3 Mistakes of DIY Investors 

5 Symptoms of Fake Portfolio Diversification   

4 Counter-Intuitive Steps to Make Your 401(k) Rock   

Sustainable Investing: Doing Good While Doing Well   

 

A previous version of this post was published in Kiplinger.

Sep 09

Stock Market Blues

By Chris Chen CFP | Financial Planning , Investment Planning

Stock Market Blues

Stock Market BluesAs the stock market plunged almost 10% on Monday August 24, following similar plunges in China and Europe, it is natural to ask whether one should be invested in the stock market at all. After all a 10% drop is significant, and the media makes sure that we know that.  

the average equity fund investor made on average 5.19% a year

And it is not just the US stock market. We have heard rumblings since June now about economic malaise in China, including a similar drop of 8% in the Shanghai stock market on August 24 as well. We have fretted about Grexit, the potential Greek exit from the Eurozone. We have seen gas going down at the pump, and we cannot even feel good about that!

So then, is it time now to get out of the stock market? Or if you have cash on the sidelines, is it time to get in?

It is worth pondering that from 1900 to 2010, 10% corrections have happened on average three times a year. 20% corrections have happened on average every 3.5 years. In other words, stock market corrections happen “all the time”. Based on statistical evidence, the only thing that your Financial Planner can tell you with regard to future stock market directions is that it will go up and it will go down!

I know, it’s not very reassuring. Your adviser or financial planner has probably told you that you need to be invested for the long term. That requires us to be committed, and to be invested. (If we have needs that are not long term, say college tuition for the next term, that money should not be in the stock market).

When, then, should we get in or out? The fact is that no one, not even the smarty pants who run your mutual funds, are able to time the market with any reliability. That is one of the reasons why mutual funds are consistently invested; they don’t get in and out of the market based on short term fluctuations.

In a recent study, Dalbar found that from January 1995 to December 2014, the average equity fund investor made on average 5.19% a year, while the equity markets went up on average 9.85% annually. One of the key contributing factor to this huge disparity is that individual investors have a tendency to get out when the stock market is low, and to get in after it has recovered.

Yet, it is natural to be scared. If you feel scared about the financial markets, today may be a good time to call your Financial Planner. If you manage your own money, today may be the time to set an appointment with one!

A previous version of this article appeared in the Boston Globe on August 24, 2015

Jul 17

Should you buy stocks now?

By Chris Chen CFP | Financial Planning , Retirement Planning

Should you buy stocks now?

buy stocks now or follow your long term financial plan?If you are like many investors, you may have a large chunk of your brokerage account or IRAs in money market or short term treasury, and your 401(k) in a Stable Value Fund. The DJIA and S&P500 have been reaching new highs in the past few weeks, and, naturally, investors are wondering: is it time to get back into the market, is it time to buy stocks now or stock mutual funds?
A recent Dalbar study has shown that the average investor in US stocks and stock mutual funds earned an average return of 4.25% per year over the past 20 years, while the S&P500 stock index generated an average 8.21% return over the same period. In other words the average equity investor underperforms the financial markets by almost 4%. This large difference is mostly due to people trying unsuccessfully to time the market.
A more sensible  approach is to consider the intended use of the money sitting in money market. Is it for a short term purpose, such as next September’s college tuition or buying a car? If so, the funds should probably stay in money market. Is it for a long term goal, such as retirement or saving to buy a house on the beach in 10 years? Then, buying stocks may be something to consider.
As an investor, you should have a long term plan that allocates your money to goals and to investments.  Whether to buy stocks now or not to buy stocks now should not depend upon how well the market is doing. If you need a plan, or you need to update one, speak with your Financial Planner. If you need a planner, contact us or the Financial Planning Association of Massachusetts.
Apr 22

High-Yield Bonds: Income Potential at a Price

By Chris Chen CFP | Financial Planning , Retirement Planning

High-Yield Bonds: Income Potential at a Price

High-yield bonds have long been a popular source of diversification for long-term investors who seek to maximize yield and/or total return potential outside of stocks.(1)  High-yield issues often move independently from more conservative U.S. government bonds as well as the stock market.

These bonds — sometimes referred to as “junk” bonds — are a class of corporate debt instruments that are considered below investment grade, due to their issuers’ questionable financial situations. These situations can vary widely — from financially distressed firms to highly leveraged new companies simply aiming to pay off debts.

As the name “high yield” suggests, the competitive yields of these issues have helped attract assets. With yields significantly higher than elsewhere in the bond market, many investors have turned to high-yield bonds for both performance and diversification against stock market risks.

These are valid reasons for investing in high-yield bonds, especially long term. But as you read about what these issues could offer your portfolio, it’s also wise to consider how these bonds earned their nicknames.

The Risk-Return Equation

In exchange for their performance potential, high-yield bonds are very sensitive to all the risk factors affecting the general bond market. Here are some of the most common risks.

  • Credit risk: A high-yield bond’s above-average credit risk is reflected in its low credit ratings. This risk — that the bond’s issuer will default on its financial obligations to investors — means you may lose some or all of the principal amount invested, as well as any outstanding income due.
  • Interest rate risk: High-yield bonds often react more dramatically than other types of debt securities to interest rate risk, or the risk that a bond’s price will drop when general interest rates rise, and vice versa.
  • Liquidity risk: This is the risk that buyers will be few if and when a bond must be sold. This type of risk is exceptionally strong in the high-yield market. There’s usually a narrow market for these issues, partly because some institutional investors (such as big pension funds and life insurance companies) normally can’t place more than 5% of their assets in bonds that are below investment grade.
  • Economic risk: High-yield bonds tend to react strongly to changes in the economy. In a recession, bond defaults often rise and credit quality drops, pushing down total returns on high-yield bonds. This economic sensitivity, combined with other risk factors, can trigger dramatic market upsets. For example, in 2008, the well-publicized downfall of Lehman Brothers squeezed the high-yield market’s tight liquidity even more, driving prices down and yields up.

The risk factors associated with high-yield investing make it imperative to carefully research potential purchases. Be sure to talk to your financial professional before adding them to your portfolio.

Note (1): Diversification does not ensure a profit or protect against a loss in a declining market.

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