Part 4 – Higher Risk Investments & Important Resources for New Investors

Kitch's Corner: A Young Lawyer's

Financial Guide for the Future

Part 4 – Higher Risk Investments & Important Resources for New Investors

Introduction

In the last article, we discussed Cash & Cash Equivalents and Bonds, which are generally considered to be the safest assets on the investment risk ladder. Today we are moving on to riskier assets, but before we dive in, I will start the article by explaining what diversification means and why it’s one of the most important concepts that an investor needs to understand. Then, towards the end of the article I will share some invaluable resources and tips to help you on your way to successfully investing for your future.

Understanding Diversification

Diversification is an investment strategy that aims to reduce an investor’s level of risk through the selection of different (or uncorrelated) types of securities. The basic logic behind the strategy is that certain unsystematic risks (like interest rate or regulatory risks) affect securities differently, so by having a portfolio comprised of uncorrelated securities, an investor is protected against suffering extreme losses if some of their assets fall in value.

A classic example of how this works is the 60/40 portfolio rule, which argues that investors can achieve diversification by putting 60% of their investment in stocks and the remaining 40% in bonds –stocks and bonds are generally considered to be uncorrelated securities, but this is not always the case. The stock portion is meant to generate higher returns while your allocation of bonds will protect your portfolio against losses during a downturn in stock prices. Studies have shown that over a long period of time, a diversified portfolio should have higher returns when compared to a non-diversified portfolio with the same level of risk.

Like all investment strategies, diversification does have its drawbacks. First, it is not a strategy for traders and short-term investors. Second, the tradeoff of having a diversified portfolio is that an investor might miss out on larger gains from riskier investments. Imagine that an investor used the 60/40 rule to invest $10K and that after a year the bond portion increased by 4%, while the stocks increased by 50%. In this case, the investor has a total of $13,160 but if they instead invested the entire $10K in the stock portion they would have made $15K. The extent to which an investor is willing to make this tradeoff will be determined by their individual risk tolerance. Finally, although diversification is important, there is no way of defining what “true” diversification is because there are so many asset classes, categories, and subcategories.

Mutual Funds and Exchange Traded Funds (“ETFs”)

Funds

A mutual fund (“fund”) is an investment vehicle that pools investors’ money and then invests that money in securities. The goal of the fund is to invest in a specific strategy that will generate returns for its investors in the form of regularly scheduled distributions. While most funds invest in a selection of stocks and bonds, the investment options are virtually endless (some even invest in other funds). Investors can purchase individual units (or shares) of a fund, which represent a proportional share of the total securities. In other words, if the fund invests in 100 securities, one unit represents a proportional investment in all 100 securities. This means that an investor can effectively diversify their portfolio by simply owning the units of a fund – and this is one of the most important reasons why funds are such a popular investment vehicle. To illustrate this critical point, if an investor wanted to diversify by gaining exposure to the Japanese stock market, they could simply invest in a fund (see here for example) instead of taking on the herculean task of picking individual stocks themselves. In theory, an investor can achieve diversification at a low cost by simply owning a handful of funds that provide exposure to a broad range of uncorrelated securities or markets.

Unlike other securities, funds do not trade on a stock exchange. Instead, investors purchase and sell (or redeem) units directly through the fund. Units are purchased at the fund’s Net Asset Value (“NAV”), which essentially represents the value of the underlying assets held by the fund. The NAV price is calculated at the end of the trading day and does not fluctuate during market hours. Note that when you redeem fund units, the redemption price you will receive is typically going to be the NAV of the next trading day (this is known as forward pricing). An investor profits from a fund by receiving distributions, or by redeeming units at a higher NAV price. Fund distributions come in the form of 1) dividends and interest payments from the underlying securities, and 2) capitals gains that are generated when a fund sells an underlying asset for profit.

Unfortunately, investors can be overwhelmed by the sheer number of fund options available to them, and that can lead them to make inefficient choices. My goal is to ensure that you are not one of those investors. So, before investing in a fund, the most important thing that you need to consider are fees and costs.

• First, you should review the expense ratio of the fund. This is an annual fee that is represented as a percentage of your investment. For example, a 1% expense ratio charges $10 annually for every $1000 invested.

• Some funds may charge a sales fee (known as “load” charges) at the time of sale or redemption, funds that do not charge any sales fees are called “no-load” funds. A fund can either be actively or passively managed, and this has a big impact on how much you pay.

• An active fund has a fund manager that is selecting and changing investments (sometimes daily) and will typically generate higher fees (see example), while a passive fund (known as an index fund), is usually designed to track or mimic the performance of a broad market index such as the S&P 500 (see example) and has much lower costs than an active fund. For an actively managed fund, a good expense ratio fee range is between 0.5% - 0.75% (passive funds should be at or lower than 0.2%). Any fund charging an expense ratio of 1.5% or more is considered quite high – note that the higher fee may be appropriate for funds with more complex investment strategies.

One of the greatest drawbacks of investing in funds is tax inefficiency. Fund investors are typically subject to two types of taxes: 1) ordinary income tax when the fund distributes non-qualified dividends or short-term capital gains, and 2) long-term capital gains tax when the fund distributes qualified dividends or long-term capital gains. Also, investors will be taxed at either the short-term or long-term capital gains tax rate when they redeem or transfer their fund units. In general, the long-term capital gains tax rate is a more favorable tax rate than ordinary income tax or short-term capital gains tax (but this is always subject to change). Investors can mitigate this tax issue in multiple ways. First, they can hold their funds in a tax-free (i.e., Roth IRA) or tax-deferred (i.e., 401K) retirement account. In a tax-free account, the investor will not have to pay any taxes when they make qualified withdrawals from the account (because the account is funded with after-tax dollars) – this means that the distributions of the fund grow tax-free. On the other hand, tax-deferred plans are funded with pre-tax dollars and allow the investor to postpone the payment of taxes until they actually withdraw from the account (generally in retirement) – these accounts are particularly attractive for investors who plan to have a lower income in the future (also, contributions to tax-deferred accounts are often tax deductible and can reduce your taxable income). Investors can also invest in “tax-exempt funds”, which may be exempt from local, state and/or federal taxes. These are typically funds that invest in U.S. Treasury securities and municipal bonds. Note that tax-exempt funds are usually more suitable for non-retirement accounts since they already enjoy unique tax benefits.

ETFs

For investors that are worried about the costs, lack of trading, or tax inefficiency of mutual funds, an exchange traded fund (“ETF”) provides an additional investment opportunity. In general, an ETF shares many of the same characteristics of a mutual fund. They are both pooled investments that have different strategies and expense ratios (and other fees) and can also be actively or passively managed – they even have the same tax treatment for most taxable events (such as distributions or sales). However, the big difference is that ETFs trade on a stock exchange like any other normal security and therefore they are not redeemable.

Many investors are attracted to ETFs because they are tradeable securities that allow the investor to take advantage of price swings during market hours. To illustrate, imagine that in the middle of a trading day, the market rallied by 35% but closed flat for the day – an ETF investor could capitalize on the increase by selling their shares during the rally, but due to forward pricing, the fund investor would be unable to realize the same gain. ETFs are usually managed in a way that limits (or even eliminates) the likelihood of capital gains distributions. Also, while both ETFs and funds distribute dividends, ETFs tend to make lower distributions. For these reasons, ETFs have become an increasingly popular investment and, in many cases, may be suitable for both retirement and non-retirement accounts.

Caution

Although funds and ETFs are generally considered to be safer than individual stocks, they are not risk-free investments. Many of them have complex investment strategies that can expose an investor to considerably high risk. For example, some funds and ETFs are designed to invest in derivatives, distressed bonds, and may even mimic ultra-high risk hedge fund strategies. Any fund or ETF with the following words in their name may indicate a high-risk or complex strategy: ultra/leverage/levered, inverse/short/ultrashort, buffer, high-yield, hedge, multi-strategy, hybrid, long/short (click on the hyperlinks for examples of how some of these strategies work). Before investing in a fund or ETF, make sure that you review the statutory prospectus and factsheet, which can be found on the website that is offering the fund. To be clear, while you should exercise extra caution when reviewing these more complex funds or ETFs, for certain investors, these strategies can play an integral part in their portfolio construction. At the end of the day, just make sure that you clearly understand how the investment works and how it will help you achieve your goals.

Stocks

Investors purchase stock (or equity) issued by a corporation in order to participate in the prosperity of the issuing company. Stocks are considered to be risker than bonds because they offer no principal/initial investment protection, and there are no guarantees that an investor will receive any returns. Also, unlike funds and ETFs, which are diversified and invested in multiple securities, an individual stock is only as good as the company that issues it.

The tradeoff for this additional risk is that stocks do not have a ceiling in terms of how high they can grow. In theory, stock prices can increase by 10%, 1000%, or even 10,000% – for example, if you bought shares of Monster Beverage Corp (the energy drink company) 20 years ago, then your return in 2020 would have been a whopping 87,560%. In practice, these sorts of extreme returns are rarities, but on average stock returns over a long period of time outperform most other asset classes. With that said, stock picking is a delicate process with varying degrees of risk depending on the companies and industries that you choose to invest in.

Investors can profit from stocks in two ways.

1. The first is typically referred to as “growth investing” and involves buying shares of a company with the hope of selling them at a higher price in the future. Without diving too deep into corporate finance, the basic idea is that growth companies typically do not distribute their earnings to shareholders through dividends. Instead, they reinvest their earnings into the company to accelerate their growth – essentially, shareholders are betting that the company will continue to grow faster than the overall market and they hope that this growth will lead to a higher stock price. Today, the most popular growth stocks are big technology companies such as Amazon and Facebook. Growth stocks are typically suitable for both traditional and retirement accounts. However, since they don’t distribute dividends, some long-term holders may prefer to keep them in a traditional account.

2. The second way to generate returns is known as “income investing”, and it focuses on owning shares of companies that generate steady income and issue regular dividends. Since dividend stocks do not offer the same level of principal protection as bonds, they tend to pay out higher yields, which make them an attractive option for investors seeking income generating investments. Stocks such as Exxon, Johnson & Johnson, and J.P. Morgan are examples of dividend bearing investments. Banks, utility companies, industrial companies, and consumer staple companies also tend to be dividend bearing stocks. Although dividend bearing stocks are affected by the same market forces as growth companies, their stock price tends to grow at a slower rate. Income stocks are also suitable for both traditional and retirement accounts, but some investors may prefer to hold them in a retirement account to reduce their effects on taxable income – especially companies with very high dividend yields.

Common vs. Preferred Stock

Stocks can further be divided into common and preferred stock. Most people are familiar with common stock, which is the price you see when you look up a public company. Preferred stock, on the other hand, is issued with a stated dividend which must be paid before a corporation can issue a dividend for common stockholders – but preferred shares usually have no voting rights.

To illustrate, say that investor 1 holds $10,000 of Company A’s common stock while investor 2 holds $10,000 of Company A’s preferred stock, with a stated dividend rate of 5%. Before Company A can announce a dividend payment for Investor 1 (which is not guaranteed), Investor 2 must be first paid. Investor 1 cannot receive payment if any preferred dividends are in arrears, but they have voting rights in the company while Investor 2 usually does not.

Although Preferred shares can be a great product for income investors, they do have certain disadvantages. First, most preferred shares are issued with a fixed dividend rate but overtime a company can become more profitable and start paying higher dividend rates to common stockholders. Second, since preferred shares are issued with face amounts (like a bond), they do not grow in value like common stocks do – so, unless the preferred shares have a convertible feature (and some do), then preferred shareholders can miss out on the upside potential of common stock. Also, a corporation is less beholden to preferred stockholders since they usually have no voting rights, which means that preferred shareholders have no say on important corporate matters.

Quick Tips on Stocks

As someone with financial experience and a general love of the capital markets, I tend to get asked a lot of questions about stocks! So, before wrapping up, I want to address a couple of questions I usually get:

• How do I decide to invest in a company? There is no definitive answer, some people will do extensive research and review the financial statements and management, others have belief in the company or the CEO (or even a product or service they provide), some will research the company’s commitment to social causes and issues, and others are just looking at chart trends or reading social media posts. Do what works best for you and your goals but make sure that you have a complete picture of what you’re investing in – a general rule of thumb in investing is that it usually pays to be at least a little bit skeptical.

• Should I invest in an IPO? An IPO, or initial public offering is the first time that a company offers their stock for sale to the investing public. Usually, when a highly valued private company goes public, the share price will rise rapidly for the first few days or weeks (or even months). However, there tends to be a dip afterwards. So, unless you are able to purchase a company at the IPO price (which is only offered to select investors), then it is typically more prudent to wait for the shares to “cool down” and not rush in and buy the stock during the first few days.

• What are SPACs and should I invest in them? A Special Purpose Acquisition Company (“SPAC”) is a blank check company that goes public with the intention to find a private company and merge with them (known as the “de-SPAC”) – the subsequent merger transforms the private company public. There are two ways that you can invest in a SPAC: 1) you can purchase units of the blank check company (each unit consist of stock nominally priced at $10 and warrants) during the IPO, or 2) you can purchase shares of the newly merged company. Overall, the process for determining whether to invest in these companies will be the same as any other investment. However, a critical issue to be aware of is that many of the companies being acquired have no revenue and some may not even have a product or service available on the market, so it is worthwhile to do additional research and diligence. For investors that purchase the blank check IPO units, they usually have an added level of protection because they are able to redeem their investment if they don’t like the merger target.

Alternative Investments

Unfortunately, it would be impossible for me to go over each investment in this class, but alternatives can play an important part in every investor’s portfolio. For instance, Gold is a commodity that typically does poorly during times of positive market activity, but when the market sours, it is known as a safe haven asset. As more and more investors pour into gold, the price usually increases. So, if you maintain a small allocation to gold in your portfolio, this acts as a “hedge” against any downturns.

Other alternative investments include real estate, structured products, cryptocurrency, commodities, and derivatives. Hedge funds and private equity funds are also alternative investments that are available for high-net-worth individuals. Crowd-funding sites also present opportunities for alternative investment, where you can investment in anything from Real Estate, to new inventions and startup companies. Last but not least, you could consider investing in a local company or small business, or support a friend or family member’s venture (or your own!). Like all the securities we’ve discussed, alternatives will have their own unique risk and reward tradeoff. Moreover, as you may have already realized, a generally low-cost way to invest in alternatives is to purchase a fund or ETF that has the desired exposure.

Important Resources for Future Investors

A well-informed investor is a good investor. You should familiarize yourself with the SEC’s Investor website, which provides excellent resources and educational tools for investors. Another fantastic resource is the North American Securities Administrators Association (NASAA). The NASAA regularly publishes information to help investors recognize fraud, protect their investments, and report any issues. You should also consider keeping up to date with financial events by reading publications like the Wall Street Journal, subscribing to Investopedia’s daily Market Summary newsletter, or watching financial news stations (like Bloomberg Business or CNBC).

Hiring a Financial Professional

If you are thinking about hiring a financial professional to manage your assets, you should first decide whether you want a real person or a robo-advisor. A robo-advisor is a neat online service, where you answer a few questions, and a computer algorithm designs a portfolio for you. This is a great option for lower income earners as the fees are usually quite low.

If you prefer to hire an actual person, then you may want to consider getting a fiduciary advisor (their official title is usually Investment Advisor) because a fiduciary has an obligation to recommend investments that are in their client’s best interest. Fiduciary advisors are usually more expensive than a traditional financial advisor. The fiduciary will charge you a rate of 1% of your overall portfolio and will usually require a minimum investment of around $250,000. You should look up potential fiduciary hires on BrokerCheck and confirm their credentials and experience. Also check out this list of questions that you should consider asking a financial or investment advisor before hiring them.

It is important to note that if you are planning to work at a law firm, you will typically be restricted from trading individual securities (such as stocks and bonds) due to client conflicts and the need to avoid insider trading. I recommend talking to your firm’s compliance department before you execute a trade as an associate or even a summer associate. Note that these restrictions typically do not apply to mutual funds and ETFs but again make sure you check with your firm first. If you are working at a law firm and would like to include individual securities in your portfolio, it’s highly advisable that you do not execute those trades yourself and that you find an Investment Advisor that has discretionary control (i.e., can execute trades without your input) of your account.

Conclusion:

Each of the investments listed above (and in the previous episode) have various categories and subcategories that I could not explain in a short article. To reiterate, every investment class, no matter where it falls on the investment risk ladder, has a wide range of risks. However, I hope that this overview of investment assets and resources will help you to make decisions about your future investments.

Finally, I want to stress the importance of patience and due diligence. Investing is not easy, there will be good days and bad days (and yes, maybe some catastrophic days), but you have to persevere. I know it’s difficult, but you have to tune out all of the noise around you – ignore the day trading frenzy (unless you are attracted to that sort of trading), don’t buy a security because everyone is doing it, and only invest in securities or funds when you are confident that they will help you achieve your goals.

Most importantly, always make sure that you understand your investment before you purchase it – especially if you decide to purchase alternative investments or more exotic investments such as derivatives and structured products.

Stay tuned for my next article, where I will go over some strategies for student loan repayment.

The mention of any security in this article is by no means a recommendation to buy, sell, or hold a particular asset. It's simply a vehicle for us to provide some real world examples and analyze how these investments are structured and behave. At the time of writing and publishing, the writer of this article held no position or interest in any security mentioned. PracticePro and the writer of this article does not provide tax, investment, or financial services and advice. Always consult with a financial professional or an accountant for the most up-to-date information and tax implications. This article is not investment advice, and it is not intended as investment advice.