Taking a Stroll Down Investment Beach
5 minutes to read
Sitting along the shore one beautiful summer's day,
I stared out into the ocean and realized that
the waves coming on shore were very similar to the Stock and Bond markets.
I know what you're thinking.
“...What? ...Huh? How does a bunch of waves rolling into shore have anything to do with the Stock and Bond markets?"
"Did you get bumped on the head recently?”
Maybe I did, but let’s press on anyhow and take a stroll down to Investment Beach.
From a twenty year old's perspective
Looking at the picture above you’ll see five distinct sets.
Set 1 is the closest to the shore.
Sets 2, 3, 4 as you go farther out into the ocean.
Set 5 is a forming wave, outside.
"How you look at the waves has a lot to do with your age."
I remember in my early twenties my eyes would immediately have went to the last and biggest set 4 and the forming outside set 5.
Risks be dammed, I wanted the thrill of the biggest ride.
It also helped that I was in terrific shape to deal with the increased danger of playing in the biggest waves.
Now I didn’t have to be surfing in the waves.
I could be body surfing, boogie boarding, or just riding up and down and swimming on them.
The shore breaker set (set 1) and the next set out (set 2) would have looked so boring to me.
I just needed to hurry up and get by them.
The third set from the shore looked a little more interesting.
It had some open face waves with some height to them.
Set 3 might serve as a little practice area to warm up and get use to the water and the wave's pace.
The next set out, #4, was where the action was.
Big, open face waves that would surely give me a thrill while I came ripping down the face trying to stay ahead of the wave collapsing right or left.
But, if you look behind the fourth wave you’ll see the next big wave forming.
Set 5 is where the thrill and uncertainty is.
That building wave could be just another one of the same size or it could be the first of a BIGGER set that occasionally rolls in.
That’s where the biggest danger and thrill would be found.
So that forced me to stay in the last biggest set waiting for a huge set to occur.
Now remember all of these thought processes were occurring in my early twenties when the thrill of a big ride completely outweighed the risk of the danger of getting into a big, painful wipeout.
From a sixty two year old perspective
While I write this I am pre-medicare(65) age.
And you know what?
The beach waves look way different at Investment Beach now.
"It’s amazing how time changes your perspective."
In the first place I might sit on the shoreline all day.
I might never even enter the water. (It's kind of cold now)
But that would still be a fine day at the beach for me.
If it was a hot day, maybe I would decide to wonder out into the water just to cool off.
Now looking at sets number 1 and 2 they look pretty dang good to me.
Just walk in and cool off.
I wouldn’t have to worry about getting knocked down or a wave crashing onto my body.
I wouldn’t have to worry about getting run over by surfers, boogie boarders or body surfers.
Just take a nice cooling off dip in the surf.
Now I might get a little bored after a while and move out to set number three just for a little while just to see if I’ve still “got it” as they say.
But I’d be very careful not to get injured or body slammed by a wave I didn’t see coming.
I’m pretty sure I wouldn’t stay there very long even if I did decide to risk it.
As for sets 4 and 5,“Forget about it”.
There is no way I would subject myself to the risk of getting picked up and body slammed by the wave and risk major injury and even death or drowning.
Wow! I've never felt the fear of the waves until now.
The "fun waves" went from looking like an awesome playground to a death trap in roughly forty years.
Now a different look at the same beach from a market perspective!
Introducing... Investment Beach
How this picture looks like the market.
I know what your thinking, "OK this is how this old guy is trying to tie the beach with the market."
Let’s talk about cash and set #1.
The funniest pointer to me is cash.
It means I’m not risking anything.
I’m comfortable sitting right here on the shore.
But as they say nothing risked, nothing gained.
The problem with staying in cash is something called inflation.
Inflation happens to be running at close to a 2% rate these days.
So sitting out of the financial community has its own risks.
Sometimes though being in cash is smart too.
A hurricane offshore could make the waves so big, being in the water, or in the market in this example, might not be very safe.
A smarter way to go about it might be to get out of the water, let the storm blow over and make a decision to get back in afterwards.
Set #1 CDs
Now those little tiny shore breakers or set #1 look pretty tame.
Although there appears to be almost zero risk in going into them you might still trip and fall over or twist your ankle.
So some small risk still exists.
Now lets compare those waves to the risk associated with them.
Although they look completely tame, as CDs are, there still is interest rate risk.
That is you could be stuck for one year or eighteen months with a percentage rate return that is below what you could have got if you had waited as interest rates were rising.
An example is:
- you bought a one year CD in early 2005 it was paying 1.75% return.
- 6 months later, 1 year CDs were paying up to 2.25% in interest.
- So for a least 6 months you were receiving less than the market value for 1 year CDs.
But your money is still guaranteed and you're going to receive what you signed up for.
This is also called an opportunity cost (since you lost the opportunity to invest elsewhere).
The other risk is that you may need the money for an unplanned emergency.
However, pulling the money out early will cost you some of the gains you were hoping for.
These financial problems are akin to a twisted ankle in Set #1, painful but not long-lasting and easily corrected.
One way to lessen the chance of problems with CDs is to stagger your investments.
If you invest in several long-term CDs at different intervals, you’ll be able to take advantage of higher interest rates, while always knowing that one of your investments will mature soon.
Set #2 Bonds / Fixed Income
This second set out has a little more risk than set #1.
- The water is a little deeper and higher.
- The waves are knee high.
- There are potentially more things hidden to step on.
- Fall risk is increased.
Just like comparing CDs to bonds there is more risk in bonds.
The big risk with bonds is “Interest Rate Risk”.
This means that if interest rates rise, the value of the bonds you're holding falls.
This makes sense since you're holding a lower yielding interest contract for a specified amount of time than the current market is paying.
There is also risk in who issued the bond to you.
Listed next is the least to most risky:
- The federal government
- municipal governments
- investment grade corporate bonds
- high yield (junk) bonds.
So still some risk but way safer than the next sets out.
Except for Junk bonds, of course (unless you do lots of homework BEFORE you invest).
Stick to short- and intermediate-term issues.
Maturities of three to five years will reduce the potential volatility of your bond holdings.
They fluctuate less in price than longer-term issues, and they don't require you to tie up your money for ten or more years in exchange for a relatively small additional yield.
Don't buy bonds when interest rates are low or rising.
Acquire bonds with different maturity dates to diversify your bond holdings.
Diversify by buying bonds from several issuers or by investing in bond mutual funds/ETFs.
Set #3 Low Volatility ETFs
Ok, now we're starting to get out where the action is at Investment Beach.
First let’s look at set #3.
As you’ll notice there are two surfers on set #3.
So the risk level jumped up considerably from the calm and low risk of the first two sets and way above your initial position on the beach.
Now you're in the market baby!
But these waves aren’t as large as farther out, so a fall from them won’t be as bad.
So risk is up but reward went up also.
I labeled these as Low Volatility ETFs.
What that means is an index of stocks, could be 100 to 2000 are chosen.
The high beta(high volatility stocks) are taken out to create an index of lower volatility stock positions, hence the label “Low Volatility Index ETF.”
What this ETF provides is:
- diversified market exposure
- smaller reaction to the major indexes moves both up and down
- A smoothing price effect since one individual stock move will have limited effect.
- Investment in more defensive stocks
Sounds like a good first step into the market.
These ETFs are very popular with the risk averse investors.
At my age they're looking pretty good to me also.
Find low volatility ETFs with low expense fees and that have the kinds of stocks in them you'd feel comfortable owning.
Also double check who runs the fund and how much money is invested in it.
Set # 4 Market ETFs
Take a deep breath... we're going into set #4 at Investment Beach.
Notice the most surfers on these waves.
Don’t think of them as surfers but a market professionals.
They have the market experience and financial resources to analyze and catch the best waves.
That’s who your now competing with now to catch waves, pros.
I called these Market ETFs because these investments don’t have any volatility taken out of their index.
Where the market goes, they go.
There are a large amount of these market ETFs to pick from.
They can be chosen to focus on:
- cap size
- many other possibilities.
There are some designed for purely defensive positions but they fall into the low volatility group.
Here’s where you can catch a big ride (return) or take a big wipeout on the bottom (loss).
Two ETFs could focus on one sector like Bio-Tech but could have completely different underlying stock holdings.
Be sure to examine what EXACTLY is being held in the ETF to better understand its risks.
ETF.com's "Segment Reports" offer investors a complete look at all the ETFs competing for investor attention in different areas of the market.
Set #5 Individual Stocks
This set is where the most uncertainty lies at Investment Beach.
This is where the stock pickers hang out.
They are waiting for the biggest waves or at least stay close to them by being in set #4.
They are always looking to the horizon.
Now let’s say you spot a big set coming in and race out to catch it.
You could catch a big wave and get rewarded with a big thrill.
Or it could wall out on you and wipe you out!
You never really know...
With a good wave
You could spot a wave before anyone else and be the first one on it.
As soon as you catch it you smile to yourself since you were smarter than the other surfers.
You saw the opportunity for a big wave before they did.
Now ONLY you get to ride it in to the shore!
Like spotting a new, upcoming company and buying stock early when it isn't expensive yet.
You smile as you watch its value double or triple over time.
With a bad wave
If you made a judgment error and caught the wrong wave, you could be in trouble.
You could be sick of waiting, getting cold, or the "I'll just catch one more and go home."
A wave starts rolling in and without too much thought, you know it'll be a big wave, you start paddling.
As soon as you pop up you realize there is no where to go on the wave.
You made a mistake...
A quick decision to jump off the wave early backfires and you end up going "over the falls."
The monster sucks you down to the bottom and slams you against the sand...
The wave holds you down underwater for a long time, then you finally pop up for air, but guess what?
The next big wave is ready to crash down on you again.
Does this sound like getting caught in a market correction with a bunch of individual stocks that keep going down time after time?
Or owning a stock and watching it decline after missing quarterly earnings several quarters in a row?
Want to try riding the big waves?
We suggest limiting your risk and committing no more than 10% of your portfolio to this type of investing.
Some final thoughts
So what’s the point of this whole story and what can we learn from it?
Well to begin with, always analyze your capabilities against the position your putting yourself into.
- How old are you and what shape are you in?
- How educated in the situation are you?
- How experienced are you?
- How much risk can you handle?
- How much reward are you looking for?
- How quickly can you recover or heal from a wipeout?
It’s funny all of these questions apply to both the beach and to the market.
Now you don’t have to be alone in the water or the market.
Most beaches have lifeguards to help inexperienced swimmers or surfers who get in trouble because of their lack of respect for the ocean.
Similarly there are market professionals like the ones here at Longhouse Wealth Management who can help you respect the market.
We can keep you from going out too far.
We'll provide advice (think of it as a life raft) if you wander out too far and need to be pulled back in.
In closing, one thing to come away from reading this article is how complex and time consuming it really is to manage your future assets.
This world is very busy and everyone’s career field takes up a major portion of their life.
Again this is where Longhouse Wealth Management comes in to play.
We have the TIME to be dedicated to watching the market like a hawk.
All of your invested money is controlled and held by our custodian of choice, Interactive Brokers, a financial institution we researched with the most economical and fair practices in the industry.
If you are not in a position at this time to be your own financial expert, please know that we are here for you.
We will consciously treat your assets as your greatest future investment!
Thank you for your time, I hope you found this story enlightening and enjoyable.
I’ll bet you’ll never look at a set of waves at the beach the same again.