How Do the Markets Really Work?

December 21, 2014 — Sam H. Fawaz

We all do it.  But what do we really know about investing?  A recent post about investing wisdom features a lot of interesting (and often overlooked) facts and figures, plus some insights from Warren Buffett, Jeremy Siegel, William Bernstein, Nobel laureate Daniel Kahneman and a few economists you may have heard of.

Regarding market predictions, the post had this to say: The phrase “double-dip recession” was mentioned 10.8 million times in 2010 and 2011, according to Google. It never came. There were virtually no mentions of “financial collapse” in 2006 and 2007. It did come. A similar story can be told virtually every year.

According to Bloomberg, the 50 stocks in the S&P 500 that Wall Street rated the lowest at the end of 2011 outperformed the overall index by 7 percentage points over the following year.

Many of the items offered insight into how our investment markets actually work.  For instance:

  • Since 1871, the market has spent 40% of all years either rising or falling more than 20%. Roaring booms and crushing busts are perfectly normal.
  • Apple increased more than 6,000% from 2002 to 2012, but declined on 48% of all trading days during that time period. (Investing is never a straight path up.)
  • Polls show Americans for the last 25 years have said the economy is in a state of decline. Pessimism in the face of advancement is the norm.
  • A broad index of U.S. stocks increased 2,000-fold between 1928 and 2013, but lost at least 20% of its value 20 times during that period. People would be less scared of volatility if they knew how common it was.
  • There were 272 automobile companies in 1909. Through consolidation and failure, three emerged on top, two of which went bankrupt. Spotting a promising trend and identifying a winning investment are two different things.
  • According to economist Tim Duy, “As long as people have babies, as long as capital depreciates, technology evolves, and tastes and preferences change, there is a powerful underlying impetus for growth that is almost certain to reveal itself in any reasonably well-managed economy.”

The post had a few zingers about some of the best-paid executives in the financial and investment community:

  • Twenty-five hedge fund managers took home $21.2 billion in 2013 for delivering an average performance of 9.1%, versus the 32.4% you could have made in an index fund. Hedge funds are a great business to work in — not so much to invest in.
  • In 1989, the CEOs of the seven largest U.S. banks earned an average of 100 times what a typical household made. By 2007, that had risen to more than 500 times. By 2008, several of those banks no longer existed.

And finally, if you want to understand the difference between daily fluctuation and the underlying growth of value in the markets, consider this:

Investor Ralph Wagoner once explained how markets work, recalled by Bill Bernstein: “He likens the market to an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch. But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the market players, big and small, seem to have their eye on the dog, and not the owner.”

If you would like to discuss your current portfolio or any financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Source:

http://www.businessinsider.com/things-everyone-should-know-about-investing-and-the-economy-2014-12

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Should We Fear—Or Cheer—Plunging Oil Prices?

December 18, 2014 — Sam H. Fawaz

Chances are, you’re celebrating today’s lower gas prices.  AAA reports that the national average price of gas is $2.48 today, the lowest since December 2009.  The result: an estimated $70 billion in direct savings for U.S. consumers over the next 12 months.  At previous prices, the average American was spending about $2,600 a year on gasoline, so the 20% price decline would result in $520 more to save or spend.

It gets better.  Even though gas prices (and, therefore, the cost of driving) have plummeted, the Internal Revenue Service is raising the standard mileage rates that people can deduct on their tax return for business travel, from 56 cents in 2014 to 57.5 cents per business mile driven next year.

Only the investment markets seem to think that cycling an extra $70 billion into the U.S. economy is a bad thing.  This past week, large cap stocks, represented by the S&P 500 index, saw their prices fall by 3.5%—their biggest drop since May 2012. Why?  The only possible explanation is that rapid Wall Street traders believe that lower oil prices will harm the economies of America’s trading partners, and therefore impact the U.S. economy indirectly.

So let’s take a closer look.  While U.S. consumers are cheering the decline in oil prices, and non-energy producing nations like Japan and countries in the Eurozone are seeing a boost in their economies, who’s NOT celebrating?

As it turns out, some of the biggest losers are American domestic shale oil producers, who basically break even when oil prices are at their current $50-$60 a barrel levels.  Any further drop in prices would slow down domestic energy production, and probably create a floor that would keep prices from falling much further.

Another big loser is the socialist government in Venezuela (remember Hugo Chavez?), which needs oil prices above $162 a barrel to pay for all of its social programs.  You can also sympathize with Iran, which reportedly needs oil prices to move up to $135 barrel to stay in the black, due to continuing sanctions from the world community over its nuclear program, and the high cost of supporting Hezbollah and its own military ventures in the Middle East.

The biggest loser is probably Russia, which requires oil prices of at least $100 a barrel for its budget to withstand international sanctions and finance its own military adventures against neighboring nations.  Economists are projecting that Russia will fall into a steep recession next year, when GDP could decline as much as 6%.  The nation is experiencing what economists call “capital outflows” of $125 billion a year—a fancy way of saying that wealthy Russians are taking money out of Russian banks and either investing abroad or putting their rubles in banks located in more stable foreign jurisdictions.  And in the process, they are exchanging their rubles for local currency, as a way to protect against the recent free-fall in Russia’s currency.  Bloomberg News recently published the below graphic which many Americans will find entertaining, but which is probably not happy news for Russian President Vladimir Putin.

Fear or Cheer Plunging Oil Prices

It’s interesting that the markets seem to be worrying about low oil prices when the economies with the most to lose are not only less than minor trading partners, but actual political enemies of U.S. interests. Cheaper oil will eventually be regarded as a plus for our economic—and political—interests, but the downturn suggests that Wall Street traders are hair-trigger ready to be spooked by anything they regard as unusual.

If you would like to discuss your current portfolio or any financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Sources:

http://www.marketwatch.com/story/5-countries-that-will-be-the-biggest-losers-from-oils-slide-2014-11-20?page=2

http://blogs.piie.com/realtime/?p=4644

http://www.accountingtoday.com/news/irs-watch/irs-raises-standard-mileage-rate-for-businesses-72990-1.html?ET=webcpa:e3476082:a:&st=email&utm_content=buffer4179f&utm_medium=social&utm_source=twitter.com&utm_campaign=buffer

http://www.forbes.com/sites/northwesternmutual/2014/11/27/lower-oil-prices-give-a-gift-to-consumers/

Posted in Consumers, energy stocks, Financial Planning, General, markets, retirement planning. Tags: , , , , , . Leave a Comment »

Relative Prosperity

November 30, 2014 — Sam H. Fawaz

You might have read that the U.S. investment markets are jittery on the news that Japan has experienced two consecutive quarters of economic decline—the official definition of a recession.  But if you turn the news around, it offers us a reminder that, however much we complain about slow-growth recovery from 2008, Americans are actually part of one of the most robust economies in the world.

The statistics tell an interesting story.  The U.S. economy is growing at a rate of about 2.95% for the year, which is (as the complainers correctly point out) slightly below its long-term pace.  But this doesn’t look so bad compared to the 2.16% growth average for the G7 nations in aggregate, and our growth numbers are well ahead of the European Union, whose economies are expanding at an anemic 1.28% rate this year.

Look deeper and our story looks even better.  The current recession is Japan’s fourth in six years, despite long-term stimulus efforts that make the Fed’s QE program look like a purchase at the candy store.  Europe is rumored to be teetering on the edge of recession, which would be its second since the 2008 meltdown.  The published GDP figures coming out of China (which are very unreliable due to heavy government editing) could drop to about half the long-term rate this year, and Brazil entered recession territory last summer.

But what about the 5.8% unemployment rate in the U.S.?  That’s better than the 10% rate at the end of 2008, but it’s not good—right?  Compared with the rest of the world, America’s jobs picture looks downright rosy.  The list, below, shows that only 13 countries have lower jobless rates than the American economy, and some of those (Malaysia, Russia, Saudi Arabia) may be giving out numbers that their leaders want to hear.  Yes, it would be nice if the long, sustained GDP growth we’ve enjoyed these last six years were faster, and we all hope that the unemployment rate continues dropping.  But compared with just about everywhere else, life in the U.S.—on the economic front, at least—is pretty good

Global unemployment rates

Malaysia (2.7%)
Switzerland (3.1%)
South Korea (3.5%)
Japan (3.6%)
Norway (3.7%)
Taiwan (3.9%)
Denmark (4.0%)
Brazil (4.9%)
Russia (4.9%)
Germany (5.0%)
Mexico (5.1%)
India (5.2%)
Saudi Arabia (5.5%)
UNITED STATES (5.8%)
Indonesia (5.9%)
Pakistan (6.0%)
United Kingdom (6.0%)
Australia (6.2%)
Israel (6.5%)
Canada (6.5%)
Chile (6.6%)
Philippines (6.7%)
Venezuela (7.0%)
Czech Republic (7.1%)
Argentina (7.5%)
Sweden (7.5%)
Netherlands (8.0%)
Austria (8.1%)
Colombia (8.4%)
Finland (8.5%)
Belgium (8.5%)
Iran (9.5%)
Turkey (10.1%)
France (10.2%)
Ireland (11.0%)
Poland (11.3%)
Egypt (12.3%)
Italy (12.6%)
Portugal (13.1%)
Iraq (15.1%)
Spain (23.7%)
Nigeria (23.9%)
South Africa (25.4%)
Greece (25.9%)

If you would like to discuss your current portfolio/asset allocation or any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

Sources:
http://www.washingtonpost.com/business/economy/japan-recession-europe-stagnation-cast-pall-over-global-economic-outlook/2014/11/17/5cd81612-6e8f-11e4-ad12-3734c461eab6_story.html

http://www.washingtonpost.com/world/japans-economy-tips-back-into-recession-in-another-blow-for-abe/2014/11/16/9a8f2e94-8c9c-44cf-a5e8-b57a470fd61f_story.html

http://www.washingtonpost.com/world/japans-abe-says-tpp-trade-talks-with-us-are-near-the-final-stage/2014/11/07/24ba0b42-63a8-11e4-ab86-46000e1d0035_story.html

http://www.washingtonpost.com/world/british-prime-minister-david-cameron-says-red-warning-lights-flashing-on-global-economy/2014/11/17/acc29d06-c38f-49a1-b478-30d334fd3389_story.html

http://www.tradingeconomics.com/country-list/unemployment-rate

http://www.economywatch.com/economic-statistics/year/2014/

http://vicshowplanet.blogspot.com/2014/08/brazils-economy-falls-into-recession.html

https://uk.news.yahoo.com/ebrd-says-russia-certain-fall-economic-recession-122646029–business.html#PklpsIB

http://online.wsj.com/articles/chinas-slowdown-raises-pressure-on-beijing-to-spur-growth-1413893980

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When Diversification Fails

November 26, 2014 — Sam H. Fawaz

Correlation coefficients are one of the most complicated areas of the asset management world, but the idea behind them is pretty simple–or, at least, most of us thought it was until the 2008-2009 meltdown.  The basic idea is that you study the price movements of, say, the stocks of large companies (represented by the S&P 500), and then look at the price movements of, say, stocks in the NAREIT (real estate) index.  You find that, on average, they tend to march to different drummers; when one goes up, the other goes up less, or it may go down.  When the other goes down, the first asset may go up or stay the same.  They have, in the parlance of experts, a low correlation.

These correlations between various flavors of stocks and real estate, commodities, bonds and other assets are expressed mathematically, and are one of the factors that professional investment advisors take into account when they build portfolios.  Whenever one kind of asset is going down, ideally you want something else in the portfolio to be going up, responding to different influences.

But all of these carefully-crafted models and all the higher mathematics went seriously awry during the 2008-2009 downturn, when every risk asset–from commodities to real estate to stocks–went down in concert as if the correlation coefficients had suddenly decided to converge at exactly the wrong time.  How could this happen?

At a recent investment conference, the outlines of a possible explanation began to emerge.  It was noted that all of those risk assets had one thing in common: they were financed or owned by the same small number of investment banking and brokerage institutions.  When Lehman Brothers went bankrupt and Bear Stearns was essentially folded into J.P. Morgan, when Citigroup and Merrill Lynch and Goldman Sachs suddenly had to rebuild their balance sheets, they all needed to sell assets to raise money.  The result: the world’s largest owners of risk assets were all desperate sellers at the same time.  Suddenly, all those assets, no matter how different their underlying economics, were in the same boat: they had to be sold so that companies could meet their net capital requirements and stave off bankruptcy.

And, of course, this caused those assets to have something else in common: they were dropping in value so fast that the average investor was scared out of his wits.  Instead of a run on the banks, as we saw in the 1930s, there was a run on the markets, fueled by the same kind of panic: will I be able to get my money out before it disappears?

This explains how the normal historical correlations failed to protect even the best-diversified portfolios.  The discussion then turned to: is there anything we can do about this going forward?  The solutions under discussion ranged from buying expensive hedges (which, of course, become dramatically more expensive during a panic), to selling into the teeth of the storm (and locking in significant losses), and, in general, the answers weren’t very satisfying.  The consensus was twofold: first, these kinds of panics don’t happen very often.  Interestingly, the mathematics of modern portfolio theory suggest that a 2008-like downturn should happen every 65-80 years, and that happens to be just about how long it was between the Great Depression and the Great Recession.

Second: these panics seem, in retrospect, to be great times to buy risk-based securities.  When others are selling in a panic, you can almost name your price, and to the extent that you don’t believe that civilization is coming to an end, you trust that sooner or later the stocks you bought cheaply will, when the panic subsides, rediscover their true value.  The trouble, as one advisor put it, is: how are you going to tell your frightened clients, in the height of a storm, that this is a great time to put more money into the market?  Is anybody going to listen to that advice when the largest global investing organizations are trying to unload those same assets at any price they can get?

The bottom line here is that professional investors are finally getting a handle on why well-diversified portfolios didn’t protect against the 2008 downturn.  But the fact remains that the people who can control their panic seem to be the only ones who will be protected the next time there’s a panic run for the exits.  Until we invent a cure for the human tendency to flee with the herd, investment portfolios are likely to go down the next time we experience a serious market downturn.  Let’s hope we’ll have to wait 60-80 years.

If you would like to discuss your current portfolio/asset allocation or any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch.

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Cheap Oil Gets Cheaper

November 23, 2014 — Sam H. Fawaz

Dear Clients, Prospects & Friends:

The economic news that everybody is talking about lately is the sudden unexpected drop in oil prices.  One type of oil, West Texas Intermediate crude, has fallen from over $140 a barrel in the summer of 2008, and $115 a barrel as recently as June, down to $91, and there is no sign that the decline will stop there.

The price drop seems to be the result of a perfect storm of factors, both on the supply and demand side.  On the supply side, U.S. production has risen to the point where only Saudi Arabia extracts more oil from its soil.  In the recent past, America’s additional production was offset by sharp declines in production caused by the civil war in Libya, plus production declines in Iraq, Nigeria and the Sudan.  Those countries are now back in business, adding the production equivalent of 3 million barrels a day, a significant fraction of the 75 million barrels a day of global production.

On the demand side, meanwhile, China’s growth has fallen by half, European economies are weakening, and people everywhere are driving more fuel-efficient cars and living in more energy-efficient homes.

As always, a major shift in global economics is producing some winners and losers.  American consumers are among the most prominent winners, since they consume more oil and gas per capita than the citizens of any other country.  The stiff drop in oil prices this year has resulted in U.S. gasoline prices falling 26¢ to an average of $2.88 per gallon, down from $3.14 a month ago. That’s equivalent to a $40-billion tax cut that will benefit various the transportation sector, energy-dependent manufacturers and, of course, the handful of Americans who drive automobiles.

Lower energy prices are also a boon for countries that import a significant amount of crude, including India, which brings in roughly 85% of its oil, and Japan, which is importing oil again now that its nuclear reactor industry is on hiatus.

Losers?  You can expect the major oil companies to report lower profits in the months ahead, and the Russian economy which is heavily dependent on energy exports and already feeling the impact of an impending recession, is being crushed.  Surprisingly, some believe the biggest loser is Iran, whose social program spending and high costs of extraction imply a break-even well above today’s prices, estimated as high as $130 a barrel.

As mentioned earlier, oil prices could—and probably will—drop further.  But don’t believe the predictions that have popped up in the newspapers and on the financial TV stations of a new era of oil abundance.  Oil prices almost certainly won’t fall to pre-2007 prices, which can be seen on the accompanying chart.

Why?  According to the International Energy Agency, the capital cost of producing a unit of energy—that is, the cost of finding oil and gas, drilling for it (and hiring the people who will do these things, who are some of the best-paid workers in the world), moving it from the well to the refinery and refining it have doubled since 2000, and the rise in these costs increases yearly.  If oil prices drop much further, shale oil producers in North Dakota and Texas will find it unprofitable to keep drilling.

Another floor under prices is the OPEC cartel, which together supplies about 40 percent of the world’s oil.  A Bloomberg report noted that OPEC nations—particularly Saudi Arabia—have been surprisingly relaxed about the supply/demand shifts.  The cartel nations pumped 30.97 million barrels a day in October, exceeding their collective output target of 30 million barrels for a fifth straight month.  However, if oil prices were to dip closer to $80 a barrel, the cartel could well turn down the spigot and change the equation back in favor of higher prices. An OPEC meeting scheduled on Thanksgiving Day should have market moving implications for oil prices.

What should you do about all this?  Enjoy it!  When was the last time you saw prices fall dramatically on an item that you use every day, and that you could hardly function without?  Chances are you’ve been whacked by higher gas prices a few times in your life; this is your chance to enjoy a different dynamic—while it lasts.

Oh…  And don’t spend a lot of time worrying about the big oil companies.  Somehow they’ll manage to muddle through and stay profitable long enough to reap big gains the next time prices jump in the opposite direction.

If you would like to discuss any financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.

Sources:
http://www.theglobeandmail.com/report-on-business/industry-news/energy-and-resources/increased-spending-required-to-meet-future-demand/article18953856/
http://oilprice.com/Energy/Gas-Prices/Why-Despite-the-Boom-in-Oil-Production-are-Gasoline-Prices-Still-High.html
http://oilprice.com/Energy/Oil-Prices/Why-Oil-Prices-Are-About-To-Settle.html
http://www.vox.com/2014/10/7/6934819/oil-prices-falling-russia-OPEC-shale-boom-gasoline-prices

Posted in energy stocks, Financial Planning, investing, markets, retirement planning. Tags: , , , , , , . Leave a Comment »

The Pandemic That Isn’t

October 29, 2014 — Sam H. Fawaz

Omigosh!  There are cases of Ebola in the United States!  Someone with Ebola has flown on a domestic airplane!  Schools are closing in Texas!  Let’s show photos of healthcare workers in Hazmat suits who look like they’re dressed for the Moon, and report on anyone who might have been exposed, whether or not they’ve come down with the virus!

If you want to sell newspapers or catch eyeballs on cable news, nothing works like fear, and the Ebola virus has proven to be a great way to play games with our collective startle reflex.  Get ready for more breathless coverage, like the time when it made headlines when somebody sneezed on an aircraft.

There’s only one thing wrong about this: Ebola is not likely to become a health crisis, much less a global pandemic.  In other words: it’s okay to calm down.

To date, four people in the U.S. and one Spanish nurse have contracted the deadly disease since its outbreak in Guinea, Sierra Leone and Liberia, three West-African nations which which have, so far, experienced 1,000, 2,000 and 3,500 cases respectively.  Ebola has spread as far as it has in those countries for a variety of reasons not present in the U.S. and Europe: dysfunctional health systems, people living in close proximity in slums with hygiene that would appall most Americans, a lack of trust in authorities, and years of armed civil strife.  Remember, these are countries where there is a one in ten chance of catching cholera, and a higher incidence of malaria.

The thing to remember is, Ebola is not an air-borne disease.  You don’t catch it by sitting next to somebody on the plane, which is why no cases were reported as a result of that now-famous flight to Atlanta–or, for that matter, on that flight taken by the first patient who eventually succumbed to the disease in Dallas.  You catch Ebola through close contact with the bodily fluids of someone who is in the advanced stages of the disease, when the patient is vomiting and plagued by diarrhea.  That’s why the only transmissions in the U.S. so far have been healthcare workers in close contact with the patients.

Other countries, with far less medical resources, have already faced Ebola and kept it from spreading to the general population.  Senegal reported a single Ebola patient, who apparently never transmitted the disease to anyone thanks to local healthcare officials who immediately identified 74 people who had close contact with the patient.  These people were monitored twice daily, and when five developed influenza-like symptoms, they were tested repeatedly.  None had contracted the virus, but if they had, their isolation and monitoring meant that others would not have been infected.

There was a similar story in Nigeria, where an airline passenger collapsed on the tarmac, and the two co-workers who helped him into a cab to the hospital also contracted the virus.  Nigerian authorities identified everyone who had come in contact with the sick people.  In all, roughly 900 individuals were exposed, and they were identified and monitored.  Eighteen of them contracted Ebola, and the plague ended there–in a country whose healthcare system is far from perfect, where one in five deaths is due to malaria, one of only three countries in the world where polio is still endemic.

The lesson here is that, unless you work in a hospital and have had close personal contact with an Ebola patient, there is virtually a zero chance you will contract the disease.  It is even more unlikely that Ebola will grow into a national or global pandemic.  It is an undeniable tragedy in West Africa, which could have been prevented if pharmaceutical companies had been following up on promising treatments in their laboratories.  The U.S. Ebola scare has belatedly changed their priorities, but chances are the vaccine and the cure will actually be needed elsewhere.

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Using Options To Enhance Portfolio Returns

February 8, 2014 — Sam H. Fawaz

When people think or hear about using options in their investment portfolios, they tend to think of them as risky instruments that lose their entire value, or worse, cause them to lose multiples of their value. But when used correctly, options can be a powerful tool to help enhance portfolio income, reduce overall portfolio risk, and make risk-defined bets on a stock, sector or fund.

What’s an Option

An option is a financial instrument, tied to or based on an individual stock or exchange traded fund, which gives the purchaser the right, but not the obligation, to buy or sell an underlying stock or fund. Options are unique in that they have a defined price to buy or sell the shares and a limited time to do so.  If you don’t “exercise” your right to buy or sell the shares within the time limit, whatever you pay for the option expires and is lost.

Options are sold as “contracts” for 100 shares each.  Remember, with options, you’re buying the right to buy or sell shares, not the shares themselves

There are two basic kinds of options: calls and puts. Let’s talk about each.

Calls and Puts

Think of calls as options to buy a stock or fund at a certain price. I liken a call to an option to buy a home at a certain price for a defined amount of time.

Let’s say that you’re interested in buying a home for $250,000 but aren’t sure that you can get the financing or whether the house is really worth the asking price. So you might offer the seller a sum of money to hold and sell you the house for $250,000 within 90 days. You might pay him a $2,500 “premium” for that option while you investigate financing or determine the true value of the home. During that time, the seller can’t offer to sell the home to anyone else.

If you can’t secure the financing, or you find out that the house is worth far less than $250,000, then you walk away having spent $2,500 for that right (but not the obligation) for 90 days to buy the home. If the true value of the home turns out to be $200,000, you just saved yourself $50,000 less the cost of the option (or $47,500).  If the value of the home instead turns out to be $300,000, then the seller is still obligated to sell you the house for $250,000. In that case, you would exercise your option and you just made an unrealized profit of $47,500 ($300,000 less $250,000 less the cost of the option or $2,500).

Think of puts as an option to sell a stock or fund at a certain price. In many ways, a put is akin to an insurance policy.

Let’s say that house that you just bought for $250,000 is insured for $250,000 and then burns down for a total loss. In that event, the insurance company would pay you for your loss as you “put” the (burned down) house to them. But in order to do that, you had to pay the insurance company an annual insurance premium of say $2,000. If nothing happens to the home, that premium paid is lost forever.

A Stock Example

Let’s turn the discussion to call options on stocks.

Say that you own 100 shares of Apple common stock currently trading for $500, which you bought for $400 per share and you want to generate additional income on those shares (besides the corporate dividend). To do so, you can sell a call option giving someone the right to “call away” your shares for a per share price of $550 within 45 days. For that sale, someone might pay you $1,000 (you don’t ever know who that someone is, but there’s always a willing buyer at the option exchanges for the right price). Note that there are many prices (called strike prices) that you can choose from to decide where you want to part with your Apple shares.

In this example, if Apple shares move down or never exceed $550 per share by the time the option expires, the buyer of that option will walk away without buying the shares and will be out $1,000, but you’ll be $1,000 richer. In that case, you keep your Apple shares and then repeat the process at a new appropriate sales price. Remember, if the buyer of the option can buy shares on the open market for less than $550, she has no reason to exercise that option.

If, on the other hand, Apple shares are at $575 by expiration, you’ll have to part with your shares for a price of $550 (plus the $1,000 that you pocketed for selling the option). The buyer of the option the exercises her option and then owns the shares and any appreciation over $550. You just made $150 per share profit plus the $1,000 option premium. You can then choose to buy new shares of Apple and repeat the process at a higher option price.  Note that the option buyer can call away the shares any time before they expire, but won’t do so unless the price of the shares is higher than $550.

Of course, with any option, you’re free to be the buyer of the calls to speculate on the price of any stock or fund. In the Apple example above, you could have been the buyer of the call option instead of being the seller and thereby speculate on the price of Apple appreciating.

So what about put options on a stock?

Lets continue the Apple example above. At $500 market value per share, you currently have $100 of unrealized profit per share. Now suppose you’ve become worried about a short-term decline in the overall market or in the price of Apple shares, but you don’t want to sell them yet.  Just in case, you might want a short-term insurance policy in the event that Apple shares tumble. In this case, you might buy a $500 put option for $1,000 to give you the right to “put” those shares to someone else for no less than $500 each.

So if Apple shares drop to $450, you’ll still get $500 for your shares when you exercise your put and the seller of the put will be out $4,000 ($500 minus $450 times 100 shares less $1,000 premium received). However, if the shares of Apple are trading for more than $500 by the expiration of the put option, then the put expires worthless and you’re out $1,000 and the seller pockets $1,000.

Safe Ways To Use Options

By now you may have realized that selling options is a nice way to make some extra income. When you consider that most options expire worthless, it is indeed better to be the “house” selling the options rather than the “bettor” buying the options.

The above examples are greatly simplified to help you with the understanding of options. We’ve left out all the mechanics and nuances of option trading to aid in understanding.

The reason that options get such a bad rap is because most people are buyers of options rather than sellers, and they usually buy far too many of them. Since each option contract is good for 100 shares, you shouldn’t buy or sell more contracts than you would buy or sell an equivalent number of shares of stock. Some people even sell calls on stocks that they don’t own (this is allowed), not realizing that stocks can sometimes go much higher than they can imagine. So if you sell an option “naked”, to a certain extent, you’re taking nearly unlimited risk.

In our client portfolios, we may generate income by selling calls against shares we own, so we only have the risk of the stock being called away. We may also hedge our portfolios with options to take advantage of short-term volatility. We may do so by trading puts, but do so in a risk defined way to minimize our premium outlay or maximize our premium generation. In other words, we don’t take unnecessary unlimited risk bets with options and use them only in the safest ways possible.

Hopefully this post helps you to better understand how we (and you could) use options in your own investment portfolios. Of course, if you want to dabble in options, I highly recommend that you get yourself a good book on options and study it carefully before trying them out. Option investing is where a little bit of knowledge is helpful, but can also be dangerous if you’re not sure what you’re doing.

If you’d like to know more about what we do to enhance and hedge investment portfolios, please don’t hesitate to contact us or just ask any questions.

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Fee-Only Financial Advisers Who Aren’t

September 21, 2013 — Sam H. Fawaz

Today’s (Saturday September 21, 2013) Wall Street Journal contains an article entitled ” ‘Fee-Only’ Financial Advisers Who Don’t Charge Fees Alone” written by award-winning writer Jason Zweig, better known as “The Intelligent Investor.” Jason acts as beacon to guide investors towards the better practices of saving and investing and warns them of the tricks and traps.

In this article, Jason points out that “You might think a “fee-only” financial adviser will never charge you commissions or other sales charges that could induce him to favor selling you something that is better for him than for you. Think again.”

Through his research, he found that many advisors who hold themselves out as “fee-only” indeed earn commissions, kickbacks, trails or other hidden compensation even though they might not sell you a product that generates one. He found that numerous advisors (661) that were Certified Financial Planners (TM) and worked for large Wall Street brokerage firms such as Morgan Stanley, UBS, RBC, Wells Fargo, J.P. Morgan Chase, Bank of America Merrill Lynch, Raymond James and Ameriprise Financial also listed themselves as fee-only advisors on the CFP (r) website. By definition, based on the nature of the firms that they work for, they cannot designate themselves as fee-only advisors or planners.

Many people also confuse fee-only with fee-based. They are definitely not the same. Fee-based means that the advisor can earn both fees for services as well as other commissions or kickbacks for selling investment, insurance or other financial products.

NAPFA, the National Association of Personal Financial Advisors (the de facto fee-only organization of planners and advisors found at napfa.org), the Financial Planning Association and the Certified Financial Planner board of standards are currently working on more clearly defining the “fee-only” standard and urging members to update their profiles and re-assert that they meet the more clearly-defined standard. I applaud this effort.

I wish to reassure our clients, prospects and friends that our firm, YDream Financial Services, takes a very serious and crystal clear stance on meeting the fee-only definition. Fee-only planners, like us, are compensated solely by fees paid by our clients and we do not accept commissions or compensation of any kind from any source. We also don’t earn any money or consideration from trails, referrals or markups. We have zero incentive to recommend any financial products and don’t accept anything (except perhaps trinkets from wholesalers or fund companies worth $5 or less handed out at conferences) that influences our recommendations. Our custodian, Charles Schwab does not reimburse or compensate us for any trade commissions or for the use of any particular financial products that they offer.

As a fiduciary, we take our responsibility to put your interests first and we endeavor do that in every recommendation or transaction that we initiate on your behalf. Finally, any conflicts of interest that our compensation approach might present are clearly discussed and disclosed with our clients and prospects prior to implementing the recommendation or moving forward with the engagement.

You can find the Wall Street Journal Article here http://goo.gl/23Oy3B. It’s worth the short read. If the link requires a log in or subscription to the Wall Street Journal Online, I suggest typing the title of the article above into your favorite search engine then click on the search hit that it finds.

Posted in Fee-only, General, investing, markets. Tags: , , , , . 1 Comment »

Your Returns Versus the Market

September 2, 2013 — Sam H. Fawaz

One of the most misleading statistics in the financial world is the return data we are routinely given by the financial media, telling us how much investors made in the markets and in individual stocks or mutual funds over some time period.  In fact, your returns are almost guaranteed to be different from whatever the markets and the funds you’ve invested in have gotten.

How is this possible?  Start with cash flows.  We are told that the S&P 500 has delivered a compounded return of about 7.8% from 1992 through 2011, which sounds pretty positive until you realize that this return would only be available to somebody who invested all his or her money at the beginning of 1992 and didn’t move that money around at all for the next twenty years.  If you invested systematically, the same amount every month, as most of us do, then you would have earned a 3.2% compounded return.  Why?  A lot of your money would have been exposed to the 2008 downturn, and not much of it would have enjoyed the dramatic run-up in stocks from 1992 to 2000.

In addition, there is the difference–only now getting attention from analysts–between investor returns and investment returns.  Human nature drives investors to sell their stocks and move to the sidelines after their portfolios have been hammered–which is often the worst possible time to sell.  And it drives people to start increasing their equity allocations toward the peak of bull markets when they perceive that everybody else is getting rich.  That means less of their money tends to be exposed to stocks when the market turns from bearish to bullish, and more is exposed when markets switch from bullish to bearish.

Understand also that owning a diversified portfolio means that only a portion of your investments are exposed to stocks. Assets such as cash, bonds, real estate, commodities and other non-stock investments all have returns that are inherently different than stocks, making overall portfolio return comparisons an “apples to oranges” one.

This would be bad enough, but people also switch their mutual fund and stock holdings.  When a great fund hits a rough patch, there’s a tendency to sell that dog and buy a fund that whose recent returns have been scorching hot.  Many times the underperforming fund will reverse course, while the hot fund will cool off.  The Morningstar organization now calculates, for every fund it follows, the difference between the returns of the mutual fund and the average returns of the investors in fund, and the differences can be astonishing.  Overall, according to Morningstar statistics and an annual report compiled by the Dalbar organization, investor returns have historically been about half of what the markets and funds are reporting.

And then there’s the tax bite.  Some mutual funds invest more tax-efficiently than others, and generate less ordinary income.  Beyond that, if a fund is sitting on significant losses when you invest, you get to ride out its gains without having the tax impact distributed to your 1040.  If the fund is sitting on large gains when you buy in, you could find yourself paying taxes on gains even if the fund loses money.

Sources:

http://www.forbes.com/sites/financialfinesse/2012/06/20/why-your-investment-returns-could-be-lower-than-you-think/

http://www.thesunsfinancialdiary.com/investing/understanding-ms-total-return-and-investor-return/

http://corporate.morningstar.com/cf/documents/MethodologyDocuments/FactSheets/InvestorReturns.pdf

My thanks to Inside Information publisher Bob Veres for his contribution to this post.

Posted in General, investing, markets, retirement. Tags: , , , , . 1 Comment »

The Rollercoaster Effect

June 23, 2013 — Sam H. Fawaz

There are two kinds of investor in this world.  One type pays close attention to the daily (and sometimes hourly) flood of information, looking for a reason (any reason) to jump in or out of the markets.  The other kind of investor is in for the long haul, and recognizes that the markets are going to experience dips and turns.  If these people are particularly wise, they know that the dips and turns are the best friend of the steady, long-term investor, because as you put money into the markets, as you re-balance your portfolio, you gain a little extra return from the occasional opportunities to buy at bargain prices.

Last week, the investment markets made an unusually sharp turn on the roller coaster, and showed us once again the sometimes-comical fallacy of quick trading.  See if you can follow the logic of the events that led to last week’s selloff.  Federal Reserve Board Chairman Ben Bernanke and the Federal Open Market Committee issued a statement saying that the U.S. economy is improving faster than the Fed’s economists expected.  Therefore (the statement went on to say) if there was continued improvement, the Fed would scale back its QE3 (quantitative easing) program of buying Treasury and mortgage-backed securities on the open market, and ease back on stimulating the economy and keeping interest rates low.

Everybody knows that the Fed will eventually have to phase out its QE3 market interventions, and that this would be based on the strength of the economy, so this announcement should not have stunned the investing public.  Nothing in the statement suggested that the Fed had any immediate plans to stop buying altogether; only ease it back as it became less necessary.  The statement said that this hypothetical easing might possibly take place as early as this Fall, and only if the unemployment rate falls faster than expected.  At the same time, the Fed’s economists issued an economic forecast that was more optimistic than the previous one.

The result?  There was panic in the streets–or, at least, on Wall Street, where this bullish economic report seems to have caused the S&P 500 to lose 1.4% of its valueon Wednesday and another 2.5% on Thursday.

In addition–and here’s where it gets a little weird–stocks also fell sharply in Shanghai and across Europe, and oil futures fell dramatically.  How, exactly, are these investments impacted by QE3?

The only explanation for last week’s panic selloff is that thousands of media junkie investors must have listened to “we plan to ease back on QE3 when we believe the economy is back on its feet again,” and heard: “the Fed is about to end its QE3 stimulus!”

It’s possible that the investors who sold everything they owned on Wednesday  throughFriday will pile back in this week, but it’s just as likely that the panic will feed on itself for a while until sanity is restored.  If stocks were valued daily based on pure logic, on the real underlying value of the enterprises they represent, then the trajectory of the markets would be a long smooth upward slope for decades, as businesses, in aggregate, expanded, moved into new markets, and slowly, over time, boosted sales and profits.  The roller-coaster effect that we actually experience is created by the emotions of the market participants, who value their stocks at one price on Wednesday, and very different prices on Thursday and Friday.

The long-term investor has to ask: did any individual company in my investment portfolio become suddenly less valuable in two days?  Did ALL of their enterprise values in aggregate become less valuable within 48 hours–and at the same time, did Chinese and European stocks and oil also suddenly become less valuable?  Phrased this way, the only possible answer is: no.  And if that’s your answer, then you have to assume that eventually, people will eventually be willing to pay the real underlying value of the stocks in the market, and the last couple of days will be just one more exciting example of meaningless white noise.

With all that said, it’s prudent to be cautious about going “all in” on this pullback in the market and to perhaps take some hard-earned partial profits on positions you’ve been holding. In our clients’ portfolios, we’ve upped our hedges and taken partial profits on short-term positions, but are still holding the majority of our equities and bonds.

With the action in the markets last week, we officially have the beginnings of a downtrend, but that can be very short-lived in this QE environment, so we remain on our toes. Be sure to consult with your advisor if you’re uncomfortable with your holdings or have trouble sleeping at night because of your positions. Nothing in this message should be construed as investment advice or suggestions to buy or sell any security.

If you have any questions or comments, please don’t hesitate to contact us or post them here. We are a fee-only fiduciary financial planning and investment advisory firm that always puts your interests first.

Have a great week!

Sam

Sam H. Fawaz CFP™, CPA
Registered Investment Adivsor Representative
NAPFA Registered Fee-only Advisor
Financial Planning Asssociation Member
(734) 447-5305
(615) 395-2010
http://www.ydfs.com

TheMoneyGeek thanks Bob Veres, publisher of Inside Information for his help with writing this guest post.

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