Streetwise for Friday, March 2, 2018
To successfully accumulate the financial assets necessary to achieve financial independence, it is necessary to save and subsequently invest those savings. In other words, investing is how you transform today’s income into tomorrow’s purchasing power. You do so by means of a portfolio of equity investments.
A prudent selection of these investments will not only protect your purchasing power from the ravages of inflation and taxes but will allow it to grow as well. Poor portfolio management will do exactly the opposite. It will destroy the value of your portfolio and jeopardize your chances of achieving financial freedom.
While there is no one correct approach to building your portfolio, every methodology entails dealing with the future, which means dealing with uncertainty. For years, investors relied on stalwart companies with household names to consistently deliver both dividends and rising share prices.
My Dad, when he was managing money, used to refer to them as, “widow and orphan stocks,” meaning that you could justifiably sell them to widows and orphans because of their low risk profile. Unfortunately, events such as the Great Recession have shown in grim detail that even the mightiest of companies, AT&T, General Motors and General Electric to name a few, can disappear or at best be decimated.
Every investor must underwrite some degree of risk to achieve future rewards. This especially true in today’s markets. Although risk can be mitigated, it can never be eliminated. So, what exactly is risk?
Risk can be defined as a combination of market risk, where market forces determine an asset’s value, and interest rate risk, where asset values move in either in tandem with or against interest rate fluctuations. Assets are also subject to purchasing power risk, meaning returns may not keep up with taxes and inflation. There is also non-systematic risk, but this is eliminated through diversification.
Your willingness to bear risk is a critical determinant in your investment strategy. Higher risk, if managed properly, will usually be rewarded with higher rates of return.
Unfortunately, investors often have a skewed concept of risk. Risk is not that certain components of your portfolio might suddenly decline in price. Prices of most financial instruments fluctuate continuously. Judge a portfolio against a predetermined set of criteria over a defined period and do not worry about what happens in the interim.
Trying to pick the exact day and time to purchase a security does not reduce risk. Market timing can be nerve-wracking, and its usefulness is highly questionable.
However, you always have two weapons with which to vanquish risk, diversification and time. Diversification is sort of modern day alchemy. It has the effect of transforming a heterogeneous group of securities into a portfolio with predictable characteristics.
The reason it works is that the weakness of one security is balanced against the strength of another. In total, the group is stronger than the individual parts would appear to indicate.
They say time heals all. While it might not be a cure-all, time will help heal an underperforming portfolio. One-year investments are risky. The longer you invest for, the more likely you are to come out ahead.
As you move closer to financial freedom, the concept of investing will take on new meaning. You will become increasingly adept at managing a diversified portfolio as you will recognize and become comfortable with the degree of risk you are willing to assume.
Note to Readers: I will be teaching Investment Redux, an 8-session course that will stress such topics as the role the economy plays in investment selection on Mondays, beginning March 5, at 9:00 AM for Ringling’s Lifelong Learning Academy. 941-309-5111 to register.
Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddReport.com.