“A ship is safe in harbor, but that’s not what ships are for.”
~ William G.T. Shedd
By Catherine Austin Fitts
Listen to the Equity Markets MP3 audio file
I have been getting an increasing number of questions about risks in the equity markets. I thought as part of the Solari Report Second Quarter Equity Overview that a brief overview of risk issues would be helpful for subscribers thinking through their personal governance and management of equity investments.
I have addressed risks categorized in the following groups:
- Portfolio Risk
- Liquidity
- Diversification
- Investment Strategies
- Specific Risks
- Ethics
- Conclusion
EQUITY PORTFOLIO RISK
Custodian
The custodian is the person who really has your money.
There is no more important task for you to exercise than making sure that you have a trustworthy custodian. You need a large, experienced, well-capitalized institution – ideally one which sees serving retail customers and being a custodian as part of its core business.
I do my best to avoid institutions that have investment banking operations and derivative or other leveraged principal positions which could create significant conflict of interest.
There is an old adage: never keep all your money in one place. That means, never invest all your money with a single custodian.
Governance
You are the governor of your money – unless you are disabled and have a trust officer doing it for you. That means you need to assume a “Chairman of the Board” position and take responsibility to ensure excellence in leadership throughout your portfolio – whether custodians, managers, analyst and company management – and to know where your money is, what it is doing and why.
There is an old adage: What you pay attention to grows. That means you need to set up a process and budget time to ensure that you are doing a good job for you.
If it is economical, you can hire advisers or use subscription services to help you monitor and stay informed about the markets and to monitor portfolios and positions.
Management
You can manage some or all of your equity investments. If you hire other people to do it, you can use investments involving passive management or instead use active management by hiring one or more active managers. There are pros and cons to both approaches. Whether you use one or both, you will still need to govern (oversee and monitor) the managers.
Jurisdiction
There are benefits to having your assets in more than one national jurisdiction. The idea is that if the US launches a nuclear war with Russia, it would be nice to have assets in the Southern Hemisphere.
Given the connectivity of the global securities markets, protecting against these kinds of worst-case situations is best addressed with physical assets (offshore properties, bullion) or cash in a reliable depository vault, rather than securities.
However, even in the case of securities, there are benefits to having funds in other jurisdiction, IF (and this is a big if) the jurisdiction has excellence in custodians and legal and financial infrastructure and whether you have sufficient assets to invest the time and money to set up a reliable situation. Many of the offshore opportunities I am asked to review as an investment advisor involve more expense and fees for less reliable custodians in jurisdictions where a foreigner who is a stranger may not fare so well.
LIQUIDITY
Market Liquidity
An asset is liquid if you can buy or sell it quickly without the time required for the sale having a material impact on the price.
A healthy personal balance sheet is one that has a balance between liquid and non-liquid assets.
For example, I own a foreign REIT that is not particularly liquid – it is traded OTC in the US and the volume is light. It is yielding 8%. I bought it for the yield and I anticipate holding for the long term.
I see a lot of subscribers and clients approached with numerous non-liquid equity investments, most of which I discourage. You should be a high net worth individual before considering most of these types of investment. Alternatively, you can budget a certain portion of your assets for private equity – just make sure that you are clear that the total budgeted amount is something you can afford to lose. Because you may lose it all (or lose a great deal) to fees and transaction costs.
Liquid assets are generally subject to far more disclosure and sunshine. There is nothing like having millions of other investors in an open market helping you monitor – they use price as a signal.
That’s why accurate pricing – divorced from political manipulation and interference – is so important.
Cash Management
As the turn in the bond market begins, more and more people are concerned about cash holdings. For US citizens, the most conservative approach is to:
- (i) Keep cash in a trusted depository or a safe
- (ii) Use FDIC insured deposits
- (iii) Keep cash in cash equivalents such as US Treasury bills or a AAA short term sovereign bonds (beware the currency risk)
Less conservative are government-only money market accounts and Treasury ETFs. Beware “fear porn” on cash management issues.
To the extent that you value SIPC insurance for US brokerage accounts, remember that it covers securities, not cash.
DIVERSIFICATION
If you have not read my post, Rethinking Diversification, I recommend doing so.
Diversification in your securities portfolio is designed to optimize performance on a risk-adjusted basis – that is, within the parameters of risk tolerance which you define.
- Allocations: Your most important decision is to set your high level allocations: cash, fixed income, equities and commodities. Each of these allocations has sub-allocations. For equities, these allocations can be defined in numerous ways. Two of the most important are places and sectors.
- Places: As more economies develop and create stock markets, it has become easier to access investment opportunities globally. As the percentage of global GDP generated by different places grows and changes and the percentage of local economic activities are securitized into the stock market, investors are diversifying to reflect these changes. Now that we have a broad selection of regional and country-based ETF’s and funds, we can invest in places.
- Sectors: Sectors relate to the industry groups of the investments. For a popular breakdown of sectors and individual industry classifications, you can check in with morningstar.com. There is a great deal of investment analysis which describes the investment characteristics of different industry groups and individual industries. Technology is also creating new and more flexible ways of grouping companies in trends (see Motif Investing).
In a period of great change and uncertainty, my vote is that broad diversification is desirable.
Securities markets are now subject to significant intervention by central banks and Treasury subsidies. To ensure that your portfolio is diversified, it should not be highly dependent on a particular government or government policy. I once reviewed an equity portfolio in which all stocks were highly dependent on the US government for purchases and contracts. In essence, these positions were one big bet on the growth of US government spending and the ability of large corporations to enjoy government largesse. Although the stocks were in different sectors, there was little-to-no diversification of economic risk.
INVESTMENT STRATEGIES
Individual Stocks vs. Baskets
You can invest in individual companies or you can invest in baskets via:
- Funds (only no load, please!)
- Exchange Traded Funds (ETFs)
Funds can be:
- Actively Managed
- Passively Managed (Index Funds)
Assuming that you are focused on mutual funds (as opposed to hedge funds or other variations), the advantage of funds is they have superior disclosure and governance provisions. In some instances, they offer access to active managers who have a history of outperforming the equivalent index fund. The disadvantages are:
- Funds have higher costs
- They may have minimums (which may be more than you want to invest)
- They typically charge redemption fees if you exit within the first 90-180 days of entering
Seasonal & Historical Patterns
One of the beauties of the securities markets is that they lend themselves to quantifiable analysis. Over long period of times, there are definitely seasonal patterns. It pays to know them.
For example, the majority of gains in the US stock market historically occur between November and June. The old adage, “sell in May and go away,” makes some sense. Take the time to understand the seasonal and historical patterns which relate to your investments and recognize that they don’t always apply.
Value vs. Trend
Grossly oversimplified, value means buying stocks when they are cheap (low P/E) and trend means buying stocks when they are going up (which may mean buying at a high P/E). The challenges are that cheap stocks may have further down to go and expensive stocks may run out of gas. Each strategy has advantages but requires different tools and monitoring. This is where strategies involving stop prices or trailing stops, limit prices and options strategies may help – although they can make things more complicated.
Interest Rates
Since 1980, we have been living in a period of generally falling interest rates and a bull market in bonds. This is now changing and there is a lot of speculation regarding rising interest rates. Higher interest rates can have a major impact on everyone and everything. Governments cannot afford to borrow as much and mortgages cost more. On the other hand, many banks and insurance companies may see rising profits. Historically, the US equity markets can handle rising interest rates up to approximately 150 basis points (1.5%) a year. After that, earnings may be hurt. US corporations may be susceptible: a large portion of their improved earnings-per-share has come from stock buybacks, many of which are financed by taking on low-cost debt.
In your portfolio, make sure that you know which stocks and funds (such as utilities and real estate) are sensitive to rising interest rates.
Rising interest rates can be expected to put pressure on bond prices, particularly long maturity bonds and those of lower credit quality. The question is, where will all the money in the bond market go? If it moves toward stocks, there will be more investors seeking dividends.
Dividends
Dividends matter a lot. Especially in the current business environment. Look for companies that have the ability to continue to meet their dividends – even grow them – during challenging times. See Solari Report Equity Overview: Why Dividends Matter.
Naked vs. Hedged
There are numerous ways of hedging your portfolio against interest rate risk, currency risk and market risk. You can also invest in funds and ETFs which do this. Understanding and using options involves greater complexity and expense, but it can be beneficial if you want to protect yourself against volatility or loss.
Creative Destruction
One of the most compelling arguments for broad diversification is the creative destruction occurring throughout the global economy. Global re-balancing, new technology, fiscal and monetary policies, the shift from Global 2.0 to Global 3.0, and rising interest rates – all these things can cause dramatic changes in valuations. See these Solari Reports on this subject:
- 2013 Annual Wrap Up: Global 2.0 to Global 3.0
- 2014 Q3 Quarterly Wrap Up
- 2014 Q3 Equity Report: The Shift to Global 3.0
- 2013 Annual Wrap Up
Earnings Announcements
US stock performance is dependent on earnings. This means that you can get meaningful swings when quarterly and annual earnings are announced or earnings expectations change. Price drops can create opportunities to buy. If you are concerned about potential swings on earnings announcements, you may want to use use stop prices or options to hedge your positions.
SPECIFIC RISK ISSUES
Debasement and Inflation
Rising stock prices many not be an indication of a strong economy or earnings. They may be the result of inflationary monetary policies. In many cases, this will mean that if you are not invested in relevant, real assets or equities, the value of your savings will be diminished.
Corrections
Equity markets can be bull markets (rising) or bear markets (falling). One of the most important issues is to be able to differentiate between a correction (for example, a 10-25% drop as a market consolidates before rising) and a bear market (when markets values are falling and continue to fall for an extended period).
Investment performance is significantly enhanced by avoiding bear markets. Consequently, modified buy-and-hold strategies outperform strict buy-and-hold strategies. As one of my favorite preachers says, “My elevator only goes to the first floor. If you are going to the basement, you need to get off.”
It is important that you have a strategy for managing corrections and defining the levels at which you will “throw in the towel.” You need to develop this strategy before the time has come to use it, as well as how you will implement it.
Fraudsters
Don’t do business with criminals and psychopaths – even if they are socially prestigious criminals and psychopaths. This should be self-evident. However, I have found that some people are attracted to criminals and psychopaths. This includes the desire to be “in” or to get “inside deals” and to find “magic’ which only happens when you don’t understand how something works and are impressed with promises of above-market returns. In addition, our media is full of entrainment technology – and this technology can be used by phone and at investment conferences. It is important that you understand it so that it cannot be used to manipulate your financial decisions.
See the Solari Report on Entrainment Technology, Subliminal Programing and Financial Manipulation
Black Swan & Extreme Scenarios
There is no financial solution for extreme political problems such as war or catastrophic environmental events. In a scenario in which the securities markets collapse and stay collapsed, your securities investments will likely be lost or worthless. Extreme scenarios are best addressed by physical preparation. On this point, I spend most of my time worrying if people will have what they need in the non-extreme scenarios, such as the ones I provide every year in our annual wrap up (example: the slow burn). Extreme scenarios can get your adrenalin going or help some people express their anger and frustration. This is why the Internet is full of “financial fear porn.” However, these stories distract you from taking actions which will give you the power and the tools to protect yourself and to build wealth now.
Facing Uncertainty
The most important aspects of governance, enforcement and the economy are secret. That means we do not have the knowledge we need to determine likely futures. I encourage the use of scenario designs to help think through investment strategies and to position assets in a manner which provides for success in all but the most extreme scenarios. The single worst investment strategy you can have is one predicated on a certain view of the world and the future, let alone a strategy based in fear.
Think about it this way. Imagine yourself in 1900 – you have radical changes in technology coming, multiple wars and numerous totalitarian regimes poised to commit genocide on a massive scale. Throughout the century, inventors created, entrepreneurs built and real estate developers constructed. Great fortunes were made and lost. In one sense, our situation is no different.
ETHICS
Every investor should consider the ethical “filters” and constraints they will include in their investment choices. What companies and activities do you wish to avoid? Adding ethical filters can result in using active managers and investing in individual stocks. Baskets lead to automatic investment in large groups of stocks which cannot be screened. An exception is Motif Investing, which allows investors to select specific holdings within a particular investment “motif.”
IN CONCLUSION
The world is changing and this change creates financial risks. However, the majority of those risks can be anticipated, understood and managed. The worst investment mistakes come from greed and fear – greed that leaves the door open for fraudsters and fear that causes you to stop investing rather than put money to work in the creation and building of the enterprises that are addressing the needs and the challenges before us.
Remember, the future is created by the people who build it – not by people who predict that it will not exist.
I wish you good hunting!