Financial Diversification Beyond Wall Street

There are many ways to diversify beyond Wall Street’s offerings:

  • CDs (Certificates of Deposit)
  • Bank at a Credit Union
  • iBonds and/or Savings Bonds
  • Residential Real Estate
  • Commercial Real Estate
  • Starting a Small Business
  • Collectibles (gold, silver, platinum, art, vintage cars)
  • DIY home improvement

Paying down debt is also an investment:

  • Paying off (or paying down) credit cards
  • Paying off auto loans
  • Paying off student loans
  • Paying down mortgage(s)

These debt-lowering options have the side benefit of improving your credit score and lead to a healthier credit report.

Additionally, there are “investments” that benefit your finances and offer other non-financial advantages.

  • Education and training.  Either self-taught or formal. (including reading this blog!)  Increase your earning potential.
  • Exercise, and healthy diet.  The longer and healthier you live, the greater your potential to earn and prosper.
  • Strengthen your social network.  You will feel happier, more motivated, have more job networking opportunities.

Finally, there are methods to reduce and diversify your cost of living expenses:

  • Learn to cook, grill, or otherwise eat at home more often.  If you are persistent you may find you are eating better, healthier, and more economically.
  • If you like coffee… brew your own.  It may take time to learn what you like, but when you do you’ll love it.  Whether it is is store-ground hazelnut drip, Vietnamese coffee with Chicory and sweetened, condensed milk, French Roast, or a plethora of other choices you will benefit.
  • If you love high-quality craft beer, consider brewing your own.  After the initial investment (~$200) you can brew your own for less than $4 per six-pack.  Share it with friends, and grow your social network.
  • Use those DIY skills to make your house more energy-efficient by installing low-E windows, LED light bulbs, and even update weather stripping and doors.
  • Grow a garden.

I have employed all of these financial ideas except commercial real estate (not counting REITs), certificates of deposit, and gardening.  My point is that it is possible to invest beyond Wall Street’s offerings.  Wall Street now offers some great investments including ETFs, and excellent brokerage companies like Vanguard, Fidelity, and Interactive Brokers (for sophisticated investors).  Finance and investing extends beyond stocks, bonds, ETFs, and Wall Street.

Thinking about Asset Allocation

In my blog post Financial Toolkit: Indexing the World I discussed 5 ETF building blocks for diversified investment portfolio construction.  In this financial blog post I’m going discuss a hypothetical investing situation:

Deborah is a 40-year-old woman with a $100,000 401K who just changed jobs.  She transferred her 401K to an IRA, and has $100,000 now sitting in cash.  Deborah’s new job pays $60K/year and she plans to contribute $10K/year to her new 401K.  How might she invest her IRA funds?

As a proponent of diversified index investing, I suggest the following category questions… What percent  1) Domestic vs. foreign?  2) Stock versus bond?

I put forward the suggestion that Deborah’s choices in regard to these two questions will predict 80-90% of the performance of her chosen portfolio.  (Don’t believe it, then read this asset allocation paper sometime when you are afflicted with insomnia.)

Let’s say Deborah decides that a 80/20 domestic versus foreign allocation, and 60/40 stock versus bond allocation are right for her.  Working out the math that’s $80,000 for US investments and $20,000 for foreign investments.  Applying the second stock vs bond ratio to each yields the following: $64,000 for US equities, $16,000 for US bonds, $12,000 for foreign equities, and $8,000 for foreign bonds.

The US part is pretty easy to achieve.  Plunk $64,000 in a low-cost, broad-market ETF (or mutual fund) like SCHB, and $16,000 into a total (aka aggregate) bond ETF like BND.  The foreign stock component is easy too; but $12,000 into VXUS.  Only the foreign bonds require two ETFs because there are no foreign total bond ETFs (to my knowledge); thus I suggest $4000 in a foreign government-bond ETF like IGOV and $4000 in a foreign corporate-bond ETF like IBND.

There you have it.  A simple example of asset allocation.

My personal opinion is that an initial asset allocation process can be very simple and effective.  Notice that I was able to avoid several secondary asset allocation measures such:

  • Value vs Growth (stocks)
  • Large-cap vs Small-cap (stocks)
  • Sector allocation (stocks)
  • Developed vs Emerging markets (stocks and bonds)
  • Short-term vs Long-term (bonds)
  • Average Maturity or Duration (bonds)
  • Government vs Corporate (bonds)
  • Investment-grade vs non-investment grade (bonds)
  • Average credit rating (bonds)

All of these “secondary asset allocation factors” can be side-stepped by purchasing “total” stock and bond funds as outlined above.  Such total (or aggregate) ETFs seek to own a slice of the total, investable, market-cap-weighted investing universe.  Essentially, a total US stock fund seeks to own a piece of the whole US stock market.  Similarly with a total US bond fund, etc.

In summary, if you have a diversified, low-cost investment portfolio, the two biggest ratios to know are domestic/foreign and stock/bond.    [If you don’t have a diversified, low-cost investment portfolio you might want to think about changing your strategy and your financial adviser!]

Are Options, Futures, and Derivatives Useful?

Some of my friends and family like to give me a hard time about the evils of Wall Street, banks, and the financial industry.  They like to argue they produce nothing physical and simply keep coming up with gimmicks and schemes.

When I point out that the stock market allows the raising of capital to launch and expand real business.  Banks serve a similar purpose, especially in supporting small business.  Usually after this they concede these points, but argue that derivatives are pointless, useless, and wasteful.  That they are primarily tools for spectators.

The classic comeback is what about farmers, airlines, and insurance?  Farmers benefit from futures contracts (and crop insurance).  Airlines use futures and options to avoid getting pinched by rapidly rising fuel prices.

The classic retort is “Okay, maybe, but only consumers and producers should be able to participate; speculators should be excluded.”

My thought is who would take the other side of the trades?  Who would take the other side of corn or oil futures contracts?  Sure there would be a bit of action from oil producers and oil consumers, a bit of action from corn consumers (e.g. Kellogg’s).  But the action would be thin, the spreads wide, and the trades few.  Can you spell “illiquid”?

At which point my generic conversation partner tends to say something like “Don’t give me none of the financial gibber-jabber!”

But is it?  I think not.  I believe that commodities futures and options are potentially useful to producers (like farmers) and consumers (like Nestlé) and that “speculators” provide liquidity.  I put “speculators” in quotes, to include not only speculators, but hedgers, investors, arbitrageurs, and market makers.

I’ve only begun to delve into this topic.  To be continued…

From the Financial Toolkit: Short Selling

In the previous blog post I wrote about the mechanics of options to help smooth out and reshape investment volatility.  In this blog post I want to discuss another investment tool:  short selling.

Short selling involves borrowing shares of stock and selling those borrowed shares.  This immediately does two things to your portfolio:  1) It gives you a liability for the shares, 2) It gives cash proceeds from the sale.

An investor, Alice, may choose to short a stock (or ETF) because she expects its price to fall.   She may expect one security  to fall relative to another security.  For instance, if Alice expects AAPL to outperform MSFT over then next six months, she could short MSFT and use the cash proceeds to purchase AAPL.  Even if MSFT goes up, Alice will make money so long as the value of her AAPL holdings go up more.

Suppose things don’t go according to plan for Alice.  For some crazy reason MSFT shares go way up, while AAPL shares remain flat.  As this trend continues, Alice’s portfolio net asset value (NAV) erodes.  This decreases Alice’s margin and increases her portfolios’ leverage.  If the trend continues Alice will eventually receive a margin call and have to cover her short position by buying MSFT stock to close her short position.

There are a few details to be aware of before entering a short position on a security.  The first is determining whether (and how much) stock is currently available for short-sale.  Once you’ve determined that your chosen stock is available for shorting, you should find out the particular terms for borrowing the stock.  For instance, you may forfeit a small percentage of your short-sale proceeds.  Often highly liquid stocks will be cheaper to borrow than less liquid ones.

Once you’ve found an stock with short-availability and an acceptable borrowing rate, you can execute a short-sale.  Since you will have a negative position (say -100 shares) you will pay rather than receive dividends on every share.  See also this helpful explanation of how, where, and why short-shares become available.

That’s the basics of short-selling.  Short-selling provides an alternative way to bet against a stock.  Buying puts is one method, short-selling is another.   Short-selling is allows going long-short… picking winners AND losers.  Short-selling is a tool that opens many investing opportunities and exposure to additional investing risks.