Investor appetite for a “good thing” seems to be boundless, and the pursuit of a good thing, some investments might not meet expectations. Before the credit crisis investors flocked to Mortgage Backed Securities (MBS) because of the yield and great credit ratings. How could you lose? A Puerto Rico investor’s pursuit of a “good thing” in the form of greater after-tax income, is led by a comparison between “tax free” vs. “taxable” income. However, tax free income for this Puerto Rico resident means risky investments in the tiny island economy to achieve tax free income. How could someone ignore such a risk? Higher investment yields might not be a “good thing”, but a “red” flag. What is a “good thing” in today’s securities markets and what risks might be ignored?
Monetary Policy and Securities Prices
Since the credit crisis, the Federal Reserve has kept interest rates historically low which created distortions in the prices of assets, including stocks and bonds. European Central Bank (ECB) recently announced a “quantitative easing” in monetary policy through the purchase bad bank debt with includes sovereign debt of the European Economic Union (ECU) members. The price of oil in U.S. dollars has dropped in half over the last 12 months. Foreign currency exchange rates have changed precipitously between the U.S. dollar and the currencies of its trading partners. U.S. corporations that derived the majority of its revenues from outside the U.S. can expect significant headwinds from foreign currency translation loss risk.
Stay Constant in a Constantly Changing World
How can investors remained balanced throughout securities market cycles to meet expectations, without losing your balance. Stay constant by first, checking your investment policy statement to make sure your goals and risk tolerances have not changed. Next, rebalance your portfolio allocations to comply with your asset allocation model which forces you to remain disciplined while risk remains more constant through changing times. If circumstances, attitudes or new perceptions have changed your investment objective, risk tolerance, or investment time horizon, these changes should be incorporated into the investment policy statement and in turn, the asset allocation model strategy.
What Can Be Done to Avoid Unmet Investor Expectations
There are a few pitfalls investors should avoid to improve investment outcomes. First, avoid concentrated investments in any type single type of security. Minimize exposure to any single issuer, sector, geographical region, or type of financial product. Second, avoid leverage justified by any promise of higher returns. The more leverage you use, the more risk you take. There’s no rule that says how much leverage is too much, but once you get in excess of 10%-15%, it’s certainly worth taking a hard look at the direction you’re headed. Beware of the use of derivatives in lieu of borrowing which magnify gains and losses alike. Third, avoid higher costs whenever possible unless there is an indispensible reason for the strategy to incur the additional fees and costs. The costs of leverage, derivatives and transaction costs all increase the breakeven point for an investment strategy which requires greater investment risk. Fourth, avoid extremes, in other words, avoid investment strategies that are novel, exotic or esoteric in any way trying to game the system through proprietary algorithms designed to produce superior returns. Avoid investment strategies that expose investors to marginal increase in risk in order to amplify investment returns. .
Investment policy statement (IPS) establishes the parameters and criteria by which decisions are made based on what’s a “good thing” for your investment needs. The IPS determines amongst many factors, allowable securities, allocation percentages, credit risk, bond duration and cash needs which are all considered when the asset allocation model is determined, monitored and rebalanced. True North Financial Advisors provides personalized financial planning and investment management services through Certified Financial Planner® professionals to individual, trusts and closely-held business in Boca Raton and throughout Palm Beach County.
