October 2012 ACap ReCap
1. How can I tell if I’m taking too much or too little risk with my investments?
I get this question often and have a hard time providing a one-size-fits-all answer. That’s because risk is subjective and varies from person to person. While there are rules of thumb that are good starting points, your attitude toward risk plays a big role in how much risk you should take on. Risk tolerance is made up of two components: your ability to take risk and your willingness to assume risk. If you do not rely on your portfolio for current income, have a steady job, are young and healthy, and have an emergency fund, you clearly have the ability to take on more risk. But if you get nervous seeing your portfolio decline 5 percent even though you may not need the money, your willingness to assume risk is lower. As a result, you should take less risk with your investments in order to feel more secure.
2. What will happen if the U.S. deficit is not reduced?
In short, the US will raise the debt ceiling and borrow more money. Just as a household or business must stay within its means and not overspend, the Federal government has a responsibility to its citizens to spend less than it earns. Unfortunately, the US spends more than it earns each year for a variety of reasons and must borrow from savers (most notably China) to close the gap. Luckily, interest rates have been very low, making it extremely cheap for the US to borrow. Theoretically, if the government borrowed at these low rates and reinvested in the economy to earn higher interest rates, the economy would benefit and we wouldn’t need to borrow as much in the future. However that is not the case today because the government uses the loan proceeds to pay for basic operating expenditures. If this continues, foreign buyers of our debt will stop buying and/or demand a higher interest rate on their money. When (not if) this happens, US interest rates will rise and crowd out private business. Crowding out will occur because banks use US Treasury rates as a baseline to determine how much they will charge on business loans. In other words, no bank will lend money to a private business at a rate lower than that of a US Treasury, so private lending rates will most likely increase as well.
3. What is the difference between I-Bonds and TIPS?
This is a fantastic question that I recently received from a client wondering why I have him invested in Treasury Inflation Protection Securities or TIPS. TIPS and I-Bonds are both issued by the US Treasury and are meant to protect bond investors from inflation risk. While the two types of bonds share similarities, they appeal to different types of investors for these reasons:
- Tradability: The largest difference is that I-Bonds are not tradable (they can’t be bought or sold in your brokerage account), whereas TIPS are easily tradable.
- Limits: There is a $10,000 annual limit on I-Bonds, whereas TIPS have no limits (if purchased through a mutual fund or ETF).
- Fee/Cost to Purchase: I-Bonds can only be purchased through TreasuryDirect at no cost, but investors must pay a commission to buy/sell their TIPS within their brokerage account.
- Inflation Adjustments: Lastly, both bonds are adjusted for inflation, but at different frequencies: I-Bonds are adjusted every six months and TIPS are adjusted daily.
4. How can I invest internationally?
There are several ways to invest internationally depending on the country. I recommend starting with a mutual fund/ETF that invests internationally because it offers the diversification that you need at a low cost and convenience. Alternatively, you could buy a stock directly in a country on their exchange or buy an American Depository Receipt (ADR) in the US. Let’s assume you wanted to buy shares of electronics-maker Sony from Japan. You could open a US brokerage account and place a trade to buy Sony stock on the Tokyo Stock Exchange. If you did that, you would then face a currency risk (Yen), possible double taxation, and higher commissions. Luckily, Sony also lists its shares on the US stock exchange through what are known as ADRs, which are shares of a foreign company that trade in the US in US dollars. ADRs allows US investors to conveniently buy shares of a foreign company in the US. Just because an ADR is US dollar denominated, it does not eliminate currency risk; exchange rate fluctuations are reflected in the ADR price. Keep in mind that buying a stock on the foreign exchange or through an ADR does not give you diversification.
5. What is a REIT?
Ever wish (daydream about?) you could own part of the US Bank Tower building in downtown Los Angeles or the Bank of America building in San Francisco, but are short a few hundred million dollars? A Real Estate Investment Trusts (REIT) allows you to do exactly that. REITs are tradable securities, like stocks, that represent real estate. There are two types of REITs: equity and mortgage. Equity REITs actually own properties, collect rent, and distribute the rent to shareholders. Mortgage REITs buy and trade mortgage-related securities such as mortgage-backed securities. Mortgage REITs don’t actually own properties, but they are influenced by real estate market cycles. REITs are know for paying high yields because by law, they have to distribute 90 percent of their taxable income to their shareholders. REITs are an excellent diversifying asset class and allow for investors to obtain exposure to large commercial properties at a low cost.
Have a question or need advice on how to manage your retirement accounts? Contact ACap Asset Management at firstname.lastname@example.org or 818-272-8511.
Ara Oghoorian, CFA, CFP® is the president and founder of ACap Asset Management, Inc., a “Fee-Only” investment management firm located in Los Angeles, CA specializing in helping doctors and physicians make sound financial decisions. Visit us at www.acapam.com