Managing Your Investment Portfolio: Part Nine
Investment Style
by Gerald Townsend, Financial Editor
September 2010
Iloved the old Phantom cartoons about the ship-wrecked survivor of a pirate attack who went on to become the masked man protecting innocent people from similar villains. Periodically, the cartoonist would have a series titled, "For those who came in late," which brought new readers up to speed on the history of the Phantom and why he did what he did.
So, for readers of this column who have "come in late," here is what "Managing Your Investment Portfolio" is all about: This is a one-year series looking at the basic building blocks of portfolio management. We began with the importance of setting realistic goals and assessing your financial resources, risk tolerance and risk capacity. We’ve discussed overall economic considerations, asset allocation and last month looked at how stocks are classified by sectors and industries. If you missed any of these prior columns, you can find them on the Boom! website at boomnc.com.
This month we are focusing on "investment style," which for our purposes will be defined as the degree that you invest in a "conservative" or an "aggressive" fashion.
First of all, let’s recognize that most people don’t have all their investments in things they would consider to be extremely conservative or wildly aggressive. The inherent risk of that strategy is obvious: Super-safe, conservative investments may not generate the long-term growth needed to accumulate money for retirement or to sustain your capital during your retirement years. On the other hand, the failure of a very risky investment may destroy your hard-earned savings. Therefore, some type of balance between these two extremes is necessary. But, what is that balance, and how do you determine what is conservative vs. aggressive?
People often think of bonds as being "conservative" and stocks as "aggressive," but in reality, you can be an aggressive bond investor and a conservative stock investor, as we shall see.
Bonds
Bonds are debt investments. You are loaning your money to a corporation, a municipality, or the federal government with the expectation they will pay you regular interest, and at a future maturity date will also return your original principal. Will the borrower be able to honor its guarantee? That’s the big question and big risk with bonds. If the borrower is the federal government, or one of its agencies, the assumption is that they will repay their obligation. After all, the federal government has a printing press and can always print more dollars and repay debts. Of course, there are some potentially nasty economic side effects if that should happen, but the fact is that the government is considered a "safe borrower."
Municipalities and state governments have historically been viewed as relatively safe borrowers, but the devastating recession we are still dealing with has highlighted the weak finances of many cities, counties and states. Whereas municipal and state governments at least have their ability to levy and collect taxes to support their bond repayments, corporations are dependent on maintaining their solvency in a fiercely competitive global market.
Bonds are more conservative when they have a shorter maturity and a higher quality. They become more aggressive — and risky — the longer their maturity and the lower their quality. Rating agencies, such as S&P and Moody’s, rate the quality of bonds, but the ratings themselves have been questioned as a result of the collapse of some formerly highly-rated bonds.
Low-rated bonds, also known as "high-yield" or "junk" bonds, attract investors because their yields far surpass yields on higher-quality bonds. These lower quality bonds can have a place in a portfolio, as the higher yields may compensate for the higher risk. However, it is wise to limit your exposure to them to a small percentage of your portfolio. In addition, they are investments you want to be in as an economy is emerging from a recession, but can be lethal to own when an economy is slipping into recession.
Stocks
All stocks are not created equal. There is a huge risk difference between owning the stock of a company with a conservative balance sheet, a reliable and diverse product offering, and that has a long history of paying and growing their dividends vs. the stock of a highly-leveraged company with great potential but little actual results.
If a company is viewed as having great prospects — a new technology or a breakthrough drug or a hot product — investors pay for this fantastic potential and it is evident when you view any of the valuation ratios of the company. If the company can deliver on these high expectations, the lofty valuation ratios may be justified and investors can be handsomely rewarded. However, should it fail to meet expectations, the market will severely punish the stock price.
So, whether you are investing in bonds or stocks, you can still be taking a conservative or an aggressive approach. Most likely, you will want to blend the two. You may want more short-term bonds, but some long-term bonds. Most of your bonds will be higher-quality, but a few lower-quality bonds might be appropriate. If you view yourself as generally conservative, then stick with those dividend-paying stocks with reasonable valuation ratios and good balance sheets.
Using a football analogy, if the bulk of your stock and bond portfolio is held in those big, steady linemen, at that point it might be OK to put a smaller amount in some of those fast and flashy wide receivers.
Gerald A. Townsend, CPA/PFS, CFP®, CFA® is president of Townsend Asset Managment Corp., a registered investment advisory firm. Email: Gerald@AssetMgr.com