Ken Himmler.com

What is it?

 

Caution:   This topic covers a wide range of complex and highly technical issues. This discussion is not an exhaustive discourse on this subject, but is merely elementary and meant as a basic reference only.

 

Managing and monitoring

 

Managing an investment portfolio is not–and never has been–an easy task, but this final step in the investment planning process is a key to successful investing. Managing actually encompasses two distinct functions: portfolio management and portfolio monitoring.

 

Portfolio management refers to the selection of specific investments and the choice of timing to buy or sell, according to your goals and disposition. A higher level of expertise is needed for this than most investors possess. These investors should seek the help of a professional advisor and/or money manager who may or may not be under the direction of an advisor.

 

Portfolio monitoring is an ongoing program that provides you with information needed to evaluate your portfolio’s performance and allows you to rebalance the portfolio to keep it on track in achieving your objectives. This function, too, is often left to a professional.

 

Caution:   If you have the time and expertise to monitor your own portfolio well, use a software package specifically designed for this purpose. Do not attempt to monitor a portfolio manually.

 

Using an advisor and/or money managers

 

The advisor’s role can be all-encompassing or limited to certain tasks. Either way, the duties can be broken down into four major categories:

 

·         Managing all or part of your portfolio: Typically, an advisor will employ and oversee money managers who evaluate and implement investment options and strategies. You may also simply employ money managers to implement your own investment decisions.

·         Reviewing your portfolio’s performance: This entails measuring the overall performance of your portfolio, as well as the performance of asset classes and individual investments within the portfolio.

·         Reporting to you: Reports from your advisor should provide you with information about your portfolio’s performance, compliance with your investment policy (see Constructing an Investment Policy), progress toward your financial goals, and the effects on cash flow and taxes.

·         Recommending changes to your investment plan: A rebalance plan should be proposed, unless a buy-and-hold strategy (see below) is recommended.

 

What you need to know

 

Managing a portfolio requires some understanding of environmental factors (e.g., political and social influences) that may affect the portfolio’s performance, so when certain events occur, you can respond appropriately. You also need to be aware of the costs involved in managing the portfolio in order to control investment-related expenses. Of course, to monitor performance, you will have to educate yourself on the various measuring techniques. Most importantly, you must have a clear vision of your investment goals and a thorough knowledge of the investment and rebalancing strategies and vehicles that have been or should be implemented.

 

 

Environmental factors that may affect a portfolio’s performance

 

War

 

Historically, the stock market declines when the United States is on the brink of war, because investors (both foreign and domestic) become cautious. On the other hand, if war does break out, it may actually stimulate the U.S. economy and lead to more investor activity, which normally has a positive influence on the stock market. Your portfolio can be affected by foreign wars, particularly if you have invested in international stocks or mutual funds.

 

The Federal Reserve

 

The Federal Reserve is the national bank of the United States that controls the money supply. All U.S. banks are part of the Federal Reserve system and borrow money from the Federal Reserve to lend to their customers. The interest rate charged by the Federal Reserve when it loans money to member banks is called the discount rate. In general, the lower the discount rate, the more money banks will borrow and the more money will be pumped into the economy. However, if too much money is pumped into the economy, prices may escalate and inflation may result. By comparison, if too little is pumped into the economy, a recession may result as economic activity drops.

 

You should watch for signs that the Federal Reserve is about to lower the discount rate, because when it is lowered, interest rates are lowered as well. This will affect the price and return of both stocks and bonds. In addition, consumers and businesses may have more money to purchase goods and services. This may lead to higher profits for businesses and thus raise the value of shares of stock in that business. Finally, you may have more money to save and invest, and you may want to consider putting more money into riskier investments as returns on safer investments may be low.

 

Judicial system

 

The return you receive on your investment depends upon the success of the company whose stock you’ve invested in. That company’s success may, at times, be linked to the judicial system. That is, if a company must pay damages resulting from a lawsuit, the company’s earnings and profits may decline, and the value of stock shares in that company may drop. If this happens, investors who currently hold stock may suffer financial loss. However, if the setback is temporary, it may mean a financial boon for investors who buy shares when the price is low and then sell the shares when the company and stock price recover.

 

Federal government

 

Some industries are stringently regulated by the federal government (and may also be regulated at the state level). Since industry regulation can directly affect prices of stocks and bonds related to those industries, it’s important to pay attention to the actions of the legislative and executive branches of government. These branches also set and change monetary and fiscal policies that can affect your investments.

 

Tax laws

 

Tax laws (on both the federal and state levels) can significantly affect your overall investment strategy. For instance, you may be investing in a certain vehicle because of the tax advantages it offers, but if tax laws suddenly change and those tax advantages disappear or become less significant, you may need to make changes to your investment portfolio.

 

 

The costs of managing a portfolio

 

The rewards of controlling investment-related expenses are twofold: (1) you pay no more than is necessary, and (2) you pay enough to ensure that your portfolio provides strong returns.

 

A cost-effective implementation of your investment plan begins with an understanding of the charges associated with managing a portfolio. Some of the most common include:

 

·         Advisor’s and money manager’s fees: Advisor’s and money manager’s fees vary widely, depending on the size of your portfolio and the services rendered. Those advisors and managers who are registered with the Securities and Exchange Commission are required to publish a fee schedule. Some states permit performance-based fees. Under these arrangements, the advisor or money manager receives a higher fee if the portfolio performs better than expected (a benchmark is predetermined for this purpose).

·         Trading costs: Whenever securities are bought or sold, commissions and execution costs are incurred. The commission fee is generally calculated as a function of the number of shares traded, price per share, and degree of trading difficulty, among other things. The execution cost (also referred to as the spread) is the difference between what you pay for a security (the ask price) and what the dealer pays for the security (the bid price).

·         Custodial charges: A custodian serves as the keeper or guardian of the investment and actually holds the securities. This custodian (typically a brokerage firm or trust company) is the intermediary between you and the advisor or money manager. Generally, an annual fee is charged for each account held by the custodian.

 

Tip:           Advisors and money managers should adequately disclose any management costs and expenses. An above-the-line expense (e.g., administrative expenses) appears on your invoice as a separate line item. Below-the-line expenses (e.g., trading costs) are netted out of the performance of the portfolio.

 

 

Monitoring and measuring your portfolio’s performance

 

Benchmarking

 

Benchmarking measures the performance of your investment portfolio against certain models. Although you can use something like the latest 10-year Treasury bond, for instance, as a benchmark for all bonds, the term usually refers to comparisons with standardized indexes. The best-known and most reliable indexes include the Standard & Poor’s 500, the NYSE Composite Index, the Nasdaq Composite Index, Dow Jones 30 Industrials, the Wilshire 5000, the Russell 2000, and Nasdaq 100.

 

Caution:   Although benchmarking has proved highly effective, bear in mind that past performance (daily, annual, and so on) as reflected by the various indexes does not necessarily predict future performance.

 

For more information on investment portfolios or concepts for investing, you can go to http://kenhimmler.com.

 

 

Investment vehicles

 

Selecting and screening specific investments

 

When you were designing your investment portfolio, you decided what types or categories of investment vehicles were right for you, based on such factors as your goals and tolerance for risk. You also decided how to allocate your assets among these different categories (e.g., 10 percent Treasury securities, 30 percent growth funds, 30 percent blue chip stocks, and 30 percent aggressive stocks). (For additional information, see Designing and Managing an Investment Portfolio.) Now you need to select individual securities to buy within each of these broad groups. This is when working with an advisor is most essential.

 

To accomplish this, you should implement a screening system based on certain criteria or minimum standards that you expect the investments within each category to meet. For example, if selecting bonds, examine the creditworthiness of various debt issuers. If choosing growth funds, look at the growth companies’ total return over the past year.

 

For more information on this topic, see Selecting Specific Investments/Screening Investments and Analyzing Investment Types.

 

Individual securities vs. mutual funds

 

Over the past two decades, many investors have favored mutual funds over individual securities. Which approach is better for you? Here’s a quick look at the strengths and tradeoffs of individual securities versus mutual funds.

 

Strengths of individual securities:

 

·         Customization is possible (securities that fit your personality)

·         Especially suitable for large cap stocks

·         Protects against the herd mentality

·         Potentially higher returns

·         May lower costs

·         May allow you to manage tax liability

 

Tradeoffs of individual securities:

 

·         Diversification requires a higher minimum investment

·         Lacks professional management (unless you work with an advisor/money manager)

·         Potentially higher risk

 

Strengths of mutual funds:

 

·         Achieves diversification for a smaller investment

·         Professional management provided

·         Especially suitable for small cap, foreign, and emerging-market stocks

·         Potentially lower risk

 

Tradeoffs of mutual funds:

 

·         Difficulty in choosing among funds

·         Funds are “off-the-rack”

·         Potentially lower returns

·         Higher costs

·         No ability to manage tax liability

·         May contain large imbedded capital gains

·         Susceptible to the herd mentality

 

For more information, see Analyzing Specific Investment Types and Mutual Funds.

 

Convertible securities

 

Convertibles are hybrid securities with the characteristics of both bonds and stocks. A convertible bond has a fixed coupon and a maturity date, and can be exchanged for a predetermined number of shares of common stock. A convertible preferred stock has a fixed dividend, no maturity date, and can be converted into a predetermined number of shares of common stock.

 

The unique risk/reward characteristics of convertibles can make them excellent investment vehicles. They offer investors the limited downside risk of fixed income securities with the upside potential of common stocks.

 

Annuities

 

An annuity is a contract between you and an insurance company that allows you to accumulate tax-deferred earnings. When you purchase an annuity, you pay a fixed amount of money, which the insurer invests in a mutual fund, real estate portfolio, or fixed income account, according to your financial objectives. On a specified date, you may either withdraw part or all of the accumulated cash value, or annuitize the annuity contract. If you annuitize, the insurance company distributes a specific amount each month for your lifetime or perhaps for your and your spouse’s lifetimes. You choose the time and method of payment most appropriate for your income needs and tax situation. Annuities are generally designed as retirement vehicles.

 

For more information, see Strategies for Annuities.

 

Life insurance

 

Permanent life insurance–whether whole life, variable life, universal life, or variable universal life–provides an investment feature called the cash value in addition to the death benefit. As you pay premiums, the policy’s cash value accumulates on a tax-deferred basis. You may also withdraw or borrow against the cash value at relatively low interest rates, with possible tax-advantaged treatment (although this may reduce the policy’s death benefit).

 

For more information, see Strategies for Life Insurance.

 

Liquid/marketable securities

 

High levels of liquidity and marketability are desirable characteristics in investments. You should avoid investing in assets that are illiquid and/or unmarketable.

 

Liquidity refers to the ability to quickly convert assets to cash. A money market deposit account has instant liquidity, since you can write checks against the funds. Other liquid assets include savings accounts, checking accounts, money market mutual funds, and Treasury bills. Liquidity also refers to the ability to convert assets to cash without substantially affecting price. A high level of liquidity indicates a good market for an investment.

 

Marketability refers to how quickly and easily you can access a market of potential buyers and sellers. An actively traded stock with a large number of outstanding shares is highly marketable. Shares in a small, closely held, or less well-known company are less marketable because there are fewer potential buyers or sellers.

 

Caution:   Although liquidity and marketability are desirable characteristics, their presence does not indicate an asset that will provide a favorable return.

 

 

Investment strategies for stock

 

Market timing

 

Market timing involves investors making decisions about when to buy or sell securities using (1) economic factors, such as strength of the economy and direction of interest rates, or (2) technical indications, such as direction of stock prices and volume of trading. Investors may implement their market-timing decisions by switching from stocks to bonds to cash and then back again, as the market outlook changes. The market timer is relying on his or her ability to determine when significant high and low points are achieved in a certain investment or category as the main factor when deciding to buy or sell.

 

Caution:   This strategy is generally considered a fool’s game because of the statistical improbability that an investor can consistently time correctly when to be in or out of the market.

 

Buy and hold

 

The buy and hold is a well-proven investment strategy whereby an investor purchases assets and holds them over an extended period of time. If you adhere to the buy-and-hold strategy of investing, you are trying to ride through the ups and downs of the market to achieve potentially higher returns than you could if you bought and sold securities at what you believe to be opportune moments in the market.

 

Some advantages of the buy-and-hold strategy include:

 

·         No hassle involved in timing the market

·         Generally lower transaction costs and expenses

·         Long-term capital gains taxes may be favorable

 

Some of the disadvantages of the buy-and-hold strategy include:

 

·         Actual results may differ from those forecasted

·         Psychologically difficult for some investors

 

Growth investing

 

Growth investing is a strategy that selects securities in growth companies, those firms that have been experiencing significant gains and are expected to continue to do so. In other words, a growth company is a successful one, showing improvement quarter-to-quarter and year-to-year.

 

Growth investors believe that improvements will continue and result in rising stock prices. Growth stock is generally sold at a premium, but growth investors are willing to buy high to sell higher. The challenge to growth investing is knowing when a growth company has matured or is about to experience a permanent decline. This strategy is generally most successful during a bull market period.

 

Value investing

 

Value investing is picking stocks in companies that are undervalued and poised for a turnaround. In other words, value investors look for a bargain–buying low to sell high. The key to value investing is knowing what a particular stock is really worth.

 

Some of the advantages of value investing include:

 

·         Value stocks are less vulnerable to downturns in the market

·         Most value stocks offer high dividend yields

·         Value investing is considered a relatively conservative style of investing, so even risk-averse investors may participate comfortably

 

Some of the disadvantages of value investing include:

 

·         A value investor must know whether stocks are bargains or just poor investments. This takes some research into the financial data of the company and the ability to correctly interpret such data, as well as a detailed knowledge of the company’s business and market environment.

 

Technical Note:   Value investing is said to represent a contrarian style of investing because it focuses on the assets of a company more than its earnings or growth rate.

 

For more information on this topic, see Value Investing.

 

Contrarian investing

 

Contrarian investors do the opposite of what most investors are doing at a particular time–they buy stock that is out of favor and sell stock that is popular. Here’s their reasoning: If most people who say the market is going up are fully invested and have no additional purchasing power, then the market is at its peak. When most people predict decline, they have already sold out, so the market can only go up. Thus, contrarians buy securities that nobody else wants at the moment, betting that the current market trend is about to be reversed. Value investing (see above) is a type of contrarian-style investing.

 

Indexing

 

Indexing, a passive investing style, involves designing an investment portfolio to match a broad-based index, such as Standard & Poor’s 500, so as to match its performance. Index investors believe that trying to beat the index is not worth the risk.

 

The main categories to index are as follows:

 

·         Dow Jones 30 Industrials

·         Standard & Poor’s 500 Index

·         Russell 2000 Index

·         Nasdaq 100

 

The advantages of index investing include:

 

·         No need to select stocks or time the market

·         Increased diversification

·         Generally lower implementation costs

 

The disadvantages of index investing include:

 

·         Requires an efficient market

 

Hedging/option strategies

 

As an aggressive investor, you face a great risk from changes in the market’s direction, including the loss of your principal. Hedging is a strategy that allows you to offset this risk. The objective is to protect you against loss from future price changes.

 

Options are a widely used hedging technique. An option gives you the right to buy or sell a specified number of shares for a set price within a predetermined period of time, usually several months. Options are traded as (1) a put, a contract to sell shares, or (2) a call, a contract to buy shares. Options are traded on a number of exchanges, of which the Chicago Board Options Exchange is the oldest and largest.

 

Hedging can also be accomplished through the use of warrants, stock index futures, and interest rate futures. For example, suppose you have $65,000 invested in stocks during a bear market, but you don’t want to sell the securities. You can consider selling stock index futures contracts to offset the potential loss on your shares. This would allow you to keep your portfolio intact and also earn a profit on the futures if the market falls.

 

Leveraging/buying on margin

 

Leveraging refers to using borrowed money to fund your investments. Just as a lever magnifies the effect of force applied to it, leverage can potentially boost the return from your investments.

 

You can borrow from any number of sources, using, for example, a home equity loan or personal line of credit. Since you generally pay interest on borrowed money, you can benefit from leveraging only to the extent that the return exceeds the interest on the loan. Leveraging also increases risk.

 

Buying securities on margin through a broker is another example of leverage, since margin purchases are made partly on credit. Typically, you pay a higher percent in cash for stocks–usually 50 percent cash and 50 percent credit–than for bonds, because the risk is greater. You must also pay interest to the brokerage house on the money you borrow, usually at a rate higher than the prevailing bank rate. You must leave a minimum in cash or securities on deposit to open a margin account. If your portfolio’s value declines significantly, the broker will send a margin call requesting more cash or securities, or requiring you to sell some securities. If you don’t answer the margin call, the broker may close the account.

 

Tip:           Interest payments on funds borrowed from some sources, such as home equity loans, may be tax deductible.

 

 

Investment strategies for bonds

 

Laddering

 

A laddered bond portfolio is one in which you stagger the maturity dates. This diversifies your portfolio over time, reducing your exposure to interest-rate risk and increasing the likelihood you’ll receive a higher-than-average interest rate. You can use a laddered portfolio for U.S. government, municipal, or corporate bonds.

 

Rebalancing your portfolio

 

Some time after you have designed your portfolio and allocated assets accordingly, you will probably notice that your original allocations have changed. Investment gains and losses, and influxes or unexpected outlays of cash, may alter the percentage holdings in each investment category. In order to maintain your asset class weightings, you may need to employ a rebalancing strategy.

 

Rebalancing vs. redesigning

 

Rebalancing is not redesigning. Redesigning is a more drastic measure that involves dismantling your old portfolio and starting fresh with a new one, made up of different investment categories. You may want to consider redesigning your portfolio when you are faced with major life changes, such as retirement, or if your investment goals or needs have changed.

 

Rebalancing simply involves restoring your original asset allocation by shifting your funds among investment categories to regain the ratios you decided on when you first designed your portfolio.

 

Tip:           Many investment advisors recommend using shifts of 5 percent or more as a trigger for rebalancing. Others recommend that it be done every year. Tax time or year-end are natural times to think about rebalancing.

 

Caution:   You should consider the transaction costs and/or tax consequences that might result from rebalancing. For example, selling shares of a mutual fund might trigger redemption fees and/or capital gains tax.

 

For more information, see Rebalancing a Portfolio vs. Redesigning and Changing Allocations as Your Goals or Time Horizons Change.

 

Selling investments

 

One way to rebalance your portfolio is to sell investments. However, this strategy should be considered only if it is advantageous to do so.

 

When it may be advantageous to sell:

 

·         The investment has performed poorly, well below your expectations

·         The investment has performed well and exceeded your expectations

·         It is beneficial from a tax standpoint

 

In addition, the timing of a sale may depend on factors unique to a particular investment.

 

Caution:   An investor may wish to sell for a variety of other reasons (e.g., to generate cash flow, or to purchase a superior investment). A wise investor will understand the importance of properly timing the sale of an investment, as well as any capital gains tax consequences.

 

For more information, see Selling Investments: When You Should Sell an Investment.

 

Taking income from a portfolio

 

An investor may take income from a portfolio that generates dividends and interest, in an attempt to rebalance his or her portfolio or because of a need for cash. There are libraries filled with books that discuss the income tax consequences of taking income from a portfolio, so be aware that this paragraph shines only the slightest glimmer of light on the subject.

 

Stock and stock mutual funds may pay dividends. Qualifying dividends are currently taxed at the tax rates that apply to long-term capital gains. Only dividends paid by domestic corporations and qualified foreign corporations to individual shareholders qualify for this tax treatment. Certain dividends (e.g., those paid by credit unions and mutual insurance companies) are taxed as ordinary income at ordinary tax rates. See Stocks: Tax Planning and Mutual Funds: Tax Planning.

 

Tip:           For tax years beginning on or after January 1, 2003 and before January 1, 2011, qualifying dividends paid to individual shareholders from domestic corporations (and qualified foreign corporations) are taxed at capital gain rates. For tax years beginning prior to January 1, 2003, however, dividends were taxed at ordinary income tax rates; this generally resulted in significantly more tax due. Absent further legislative action, dividends will again be taxed as ordinary income beginning in 2011.

 

Interest income is paid to you from your bank, credit union, or other financial institution, and may be paid to you on bonds as well. At the end of the year, you should receive a Form 1099-INT that reports interest has been paid to you. You generally need to report any interest income over $1,500 on a separate schedule, and all interest income on your tax return. Interest income is taxed at ordinary income tax rates.

 

Caution:   You may not receive a Form 1099-INT for interest income of less than $10. However, you still need to report this income, as well as any interest you have received on personal loans you have made to others.

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