Investment terms | Financial Planner | Retirement Planning | Korving & Company Suffolk & Virginia Beach

What is the purpose of a stock market?

Before there was a stock market, there were stock companies.

A stock company allows individuals to pool their money to create an organization to operate and grow. Stock is used to determine how much a person owns of a company. Owning a stock does not necessarily create wealth. Wealth creation can only occur if the stock can be sold to someone else who is willing to pay you more for it than what you originally paid. This led to the creation of a market for people who owned shares in stock companies.

A stock market has two functions. First, it allows the owners of stock to sell their ownership interest easily and quickly. Second, it also allows people who would like to be owners to buy an ownership interest quickly and easily. Now even people who do not have substantial financial resources can participate in the growth in value of large enterprises.

For example, the founders of Apple were able to raise money for their company by selling their shares of Apple stock to people who were willing to bet that the company would be successful. That was 1976. In 1980 the shares of Apple were first allowed to be publicly traded. As a result, the founding shareholders were able to profit from their original investment and the company itself raised millions of dollars that it could invest in growth. It also allowed people who did not personally know the founders to become partial owners and benefit from the company’s growth. The stock market allowed people who believed in Apple computers to bet on the company’s future, and also provided them with a ready market for their shares if they needed to sell or decided they no longer believed in the company’s future.

The bottom line is that the stock market creates liquidity. Without liquidity it becomes much harder for a company to raise the capital it needs to grow in a modern economy.

Dynasty Trusts

“Dynasty trusts,” are designed to avoid the federal estate tax. It’s a never-ending trust that pays each generation of heirs only what they spend, while the rest of the money grows. In most states that is not possible because of an ancient rule limiting the duration of trusts to the lifetime of a living heir, plus 21 years. South Dakota repealed that rule in 1983, and in addition it has no income tax. As a result, a large number of very wealthy people opened offices in South Dakota to create a trust that can shield a big fortune from taxes for centuries, escaping tax bills as it hands out cash to great-great-great-grandchildren and beyond.

There is a long an informative article about the way South Dakota has used this as a way of attracting big money by literally renting out rooms in a former five-and-dime store in Sioux Falls.

As we head into the New Year, we hope that some of our readers are in the same league as the Pritzker family, the Carlson Family Trust Co., serving the Minnesota family behind Radisson and the TGI Friday’s restaurant chain, and the heirs of hedge fund pioneer Jack Nash. If not, we hope you get there soon.

Five lessons to be learned from the Madoff scandal

Five years ago we learned about the Ponzi scheme engineered by Bernie Madoff. How can you avoid being scammed like the people who lost billions to Madoff? Here are five things to look for when working with an investment firm:

1. Demand Assets Be Held at Large Custodian

Be sure your assets are held by a large reputable custodian like Charles Schwab. The custodian will be the one sending you your statements and trade confirmations. In the Madoff scandal, all of the clients’ funds were accounted for only by Madoff’s firm, and investments were held by Madoff’s wealth management operation, which was at the heart of the scam. If client funds were held at a legitimate, large custodian like Charles Schwab, the scam would have been virtually impossible to carry out since the account statements would flow from the custodian, and the discrepancies would have been exposed immediately.

2. Fraud Diversification

Diversification is one of the primary keys to risk control. No one should have all of his assets in a single fund or a single stock.

3. Ask Questions and Demand Answers

When clients asked Madoff questions about his returns and management style, he refused to answer them. This is a massive red flag. Clients are entitled to answers regarding holdings, investment strategies and costs. Failure to provide this sort of information is a major warning sign.

4. If Investments or Strategy Can’t Be Readily Explained, Don’t Invest

Often investment scams are hidden in the obscure, opaque and complicated. Madoff claimed to use a “split-strike” strategy for generating steady returns for investors by investing in the largest stocks in the S&P 100 index while simultaneously buying and selling options against either these particular stocks or the S&P 100 index. If it sounds too confusing or can’t be explained simply, avoid it altogether.

5. If It Sounds Too Good to Be True Watch Out

Investors often fall victim to big lies more easily than small lies. Madoff used decade-long consistency to lure investors in. Don’t believe anyone who tells you that you can earn higher returns while assuming a lower risk. If you’re realizing high returns, then you’re also accepting increased risk.

Call Korving & Co at 757-638-5490 or use our contact page for more information.

What’s a "Bubble?"

The word “bubble” has been thrown around a great deal with the Dow Jones Industrial Average (DJIA) at 16,000, the S&P 500 at 1800, and the Nasdaq Comp above 4000. The term “bubble” is a scare word that makes people think of a repeat of the Tech Crash of 2000 or the real estate bubble that led to the financial crisis of 2008.

Cluifford Asness, whose firm manages $80 billion has a pet peeve and one of them is the loose use of the term “bubble.”

“The word “bubble,” even if you are not an efficient market fan (if you are, it should never be uttered outside the tub), is very overused. I stake out a middle ground between pure efficient markets, where the word is verboten, and the common overuse of the word that is my peeve. Whether a particular instance is a bubble will never be objective; we will always have disagreement ex ante and even ex post. But to have content, the term bubble should indicate a price that no reasonable future outcome can justify. I believe that tech stocks in early 2000 fit this description. I don’t think there were assumptions — short of them owning the GDP of the Earth — that justified their valuations. However, in the wake of 1999-2000 and 2007-20008, and with the prevalence of the use of the word “bubble” to describe these two instances, we have dumbed the word down and now use it too much. An asset or a security is often declared to be in a bubble when it is more accurate to describe it as “expensive” or possessing a “lower than normal expected return.” The descriptions “lower than normal expected return” and “bubble” are not the same thing.

Bloomberg columnist Barry Ritholtz comments:

“It would only take a small marginal improvement in the economy, or a small uptick in hiring, or heaven help us, even a modest increase in wages to increase revenues and drive profits significantly higher,”he current market valuations do not, in my opinion, have the characteristics of a “bubble.” “

Whether stocks, bonds or commodities are fairly valued, undervalued or overvalued will become apparent over time. In the meantime, unless you are being paid to opine, it’s best to realize that fortune-telling is not the way to manage your portfolio. Creating an all-weather portfolio with the asset allocation that will allow you to face any reasonable future is the best strategy.

Top 5 Tax Mistakes Investors Make

The tax laws are fairly complex and people make mistakes, but there are some mistakes that investors should not make.

Taking short-term gains when waiting will turn the gain into a long-term gain. Appreciated gains on assets held one year or longer are taxed at a lower rate than those held for less than a year.
Foreign stock investments held in a tax-qualified account. Many foreign companies are required to withhold foreign taxes on dividends paid. U.S. investors can claim a tax credit on their tax returns, effectively recouping this lost dividend, but only if the foreign stocks are held in a taxable account.
Failing to realize capital gains. If you have a gain in a stock and believe that stock is now overvalued, do not allow fear of taxes to sell and lock in a gain. That is the trap that many tech stock owners fell into in 1999, just before the tech bubble burst in 2000.
Failing to take capital losses. If you have a loss in a stock, the loss can be used to offset a realized gain in another stock, thus reducing your tax liability. If you still like the stock you have a loss in, you can buy it back later as long as you observe the “wash sale rule.”
Taking a direct distribution from a 401(k) or similar retirement plan. Distributions from retirement plans should be done via a custodian-to-custodian transfer or you can be subject to taxes as well as potential penalties if you are under 59 1/2.

Hedge Funds

What are “hedge funds” and what should you know about them? First, to correct a misunderstanding, they are not a separate assets class. They may be thought of as “alternative investments.” They can go long or short any asset class, including derivatives and collectibles but also plain old stocks and bonds. And they can double down on their bets with leverage. In other words, it’s how these funds invest that makes them different from, say, mutual funds or ETFs – not what they invest in.

Regulators limit participants in hedge funds to wealthy investors, defined as those with net worth of at least $1 million and income of over $200,000, under the assumption that they are particularly financially savvy. Take it from me, this is not necessarily so.

Then there is managers’ compensation. They are high compared with mutual funds. A typical hedge fund manager receives 20{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93} of fund gains plus a 2{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93} management fee. If they do well you win and they win. If they lose, you lose and they still win. This is the main reason why top performing mutual fund managers often open hedge funds. It’s where the real money is.

How are stockbrokers and RIAs different?

Do you ever wonder what do others think about you? Often, the image people have of themselves is different from how they are viewed by others. We regularly meet with clients to get feedback from them. asking them how they view us. We’re pleased and often flattered by hearing that they like us, using terms such as “trustworthy,” “personal service” and “integrity.” But in a recent interview we found that one of our oldest clients still did not understand the important change we made when be left a major global investment firm to create our own Registered Investment Advisory (RIA) firm.

He was still stuck in the past, when stockbrokers would call their clients to sell them stocks and bonds. That’s still the model at the “big box” stores that you see advertised on TV. They may call their brokers “investment advisors” and use that term in their advertizing. But internally they refer to their brokers as the “sales force.” Because that’s what their job is: to sell products to their customers.

As RIAs we think about things totally differently. We don’t sell stocks, bonds, mutual funds, annuities, partnerships or life insurance. These may all be part of your total financial portfolio, but they are a means, not an end. We create investment portfolios that are designed to accomplish your personal financial needs and goals.

To use a real estate analogy, a stockbroker tries to sell you a kitchen one day, a bedroom the next and then a new roof on the third. We provide a home designed for you and your family.

With rising interest rates, what to do about bonds.

With interest rates increasing investors are noticing that their bonds are not doing nearly as well as their stocks. In fact many investors may have lost money on bonds this year. For example, the typical tax exempt bond fund has lost between 4 – 5{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93} year-to-date. What should investors do about bonds when the likelihood of rising interest rates is high?

The October issue of Financial Planning magazine give us an insight into what happened in the past when interest rates rose.

During the five-year period from 1977 through 1981, the federal discount rate rose to 13.42{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93} from 5.46{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}, an increase of nearly 800 basis points, or 145.8{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}. During that period, the five-year annualized return of U.S. T-bills was an impressive 9.84{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}. But T-bills are short-term bonds.

But bonds did not fare nearly as well. The Barclays one- to five-year government/credit index had a five-year annualized return of 6.61{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}, while the intermediate government/credit index had a 5.63{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93} annualized return. The long government/credit index got hammered amid the rising rates, and ended the five-year period with an annualized return of -0.77{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}. Finally, the aggregate bond index had a five-year annualized return of 3.05{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}.

As every investor should know, bonds go down in price when interest rates go up but that decline is offset by the interest paid on the bonds. If an investment manager knows what he is doing and protects his portfolios by avoiding exposure to long-dated government bonds the results will be acceptable. An annualized return of 5.63{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93} is quite good when rates are increasing.

But one important note: It does not seem prudent to avoid bonds entirely during periods of rising interest rates. Bonds are a vitally important part of a diversified portfolio containing a wide variety of asset classes – during all times and seasons. Rather than trying to decide whether to be in or out of bonds, the more relevant issue would seem to be whether to use short-duration or long-duration bonds.

This, of course, is consistent with a strategic approach to portfolio design. Rather than completely remove an asset class from a portfolio, advisors and clients would be well advised to thoughtfully modify the components of an asset class. To use a nautical metaphor, rather than swapping boats, we simply trim the sails.

The 401(ok) opportunity

One of the major problems with 401(k) and similar defined contribution plans is that the people who set them up are not really that interested in them. Nobody runs a business for the purpose of having and managing a 401(k) plan. Like insurance and other employee benefits, retirement plans are a side issue for employers, often a distraction from their job of running the business. Besides that, the typical business owner may be good at running a dry cleaning business, a medical practice or an automobile dealership but he’s not an investment professional.

As a result, the typical 401(k) may have a selection of mediocre funds, high expenses and little or no guidance for the employees regarding their investment choices.

This is where some innovative Registered Financial Advisors can make a huge difference. Not only can they provide the business owner unbiased guidance with regard to the investment choices in the plan and help to reduce plan expenses, but also provide guidance to plan participants in creating a portfolio that’s right for them.

Korving & Company can help both the plan sponsor and the employee to maximize the benefit of their 401(k) and transform it into a 401(ok).

What is Liquidity?

As part of our educational series we want to acquaint our readers with terms that are in common use in investing but may not be completely understood by the public. One of those terms is “liquidity.” The Dictionary of Finance and Investment Terms says liquidity “is the ability to buy or sell an asset quickly and in large volume without substantially affecting the asset’s price.” Stocks in large blue-chip stocks like General Electric, Microsoft or Apple are liquid because they are actively traded in large volumes and therefore the price of the stocks will not be affected by a few buy or sell orders.

However, shares in small companies with relatively few shares are not considered liquid because a few large orders can move the price of the stock up or down sharply.

A house is another example of an illiquid asset because it can’t be sold quickly, its price can fluctuate widely because it’s not traded regularly on an exchange and the price is set by bidding between one or a few buyers and a single seller.

Liquidity also refers to the ability to convert to cash quickly. Examples are money market mutual funds, checking accounts, bank deposits or treasury bills.

401(k) Help and Advice

You have to be a certain age to appreciate how retirement planning has changed. I am, unfortunately, that old. So for you youngsters, let’s take a walk down memory lane.

Long, long ago, a retirement plan was having enough kids so that you could move in with one of them when you got too old to work. Then came Social Security and company pension plans that paid you a monthly income for the rest of your life. Retirement benefits – including medical benefits – got richer over the years until some companies, like General Motors, were described by their financial chiefs as “retirement plans with a car manufacturing subsidiary.” And so GM went broke, largely under the weight if maintaining a massive retirement pension and medical benefits plan. Other companies took notice and today the pension plan – known as the “defined benefit” plan – is fast becoming obsolete, replaced by the 401(k) type plan known as the “defined contribution” plan.

“Defined benefit” meant that you knew what monthly benefit you were going to get in retirement based on some formula that included years of service and salary. “Defined contribution” meant that you knew what you were putting in, but not what you were going to get when you retired. The switch from defined benefit to defined contribution means that the responsibility for a secure retirement was switched from the employer to the employee. That’s why it’s so important to know and understand the investments available in your 401(k) plan.

When 401(k) plans were first introduced the investment choices were fairly simple. You could pick a stock mutual fund, a bond mutual fund, a fixed fund or put your money into company stock if you worked for a publicly traded company. Then the federal regulators and the financial wizards of Wall Street came along who said that those basic choices were not enough. That’s why the typical 401(k) plan today has scores of choices and is so confusing.

The average worker is not an investment expert. He or she goes to work, collects a paycheck and puts some of his pay into his company’s retirement plan – often without knowing what the choices are or how they may affect his future. And that’s critical because for many people their 401(k) plan will be their largest single source of retirement income once they quit working.

If they go to the company benefits department for advice, the chances are that they will not get any. The reason is twofold. First, if a company employee provides advice regarding investment options, they expose the company to serious liability. Second, the people in the benefits department are not investment professionals; they do not necessarily have the expertise to counsel people and provide them a roadmap to retirement.

The typical investment firm is little help. They make their money from fees or commissions on assets they manage in-house. The 401(k) custodian is also little help. Some may have some on-line software that people can access, but no one that they can talk to about their plans or dreams.

For those seeking guidance regarding the array of investment choices open to them in their 401(k) plan, independent firms of financial advisors have begun offering advice, for a fee, without requiring employees to open an investment account. If you participate in a 401(k) plan and wonder whether your investment choices are the right ones for you, you may want to look into this. It may mean a more informed and better prepared retirement plan.

What is an ETF?

Exchange Traded Funds, otherwise known as ETFs, are essentially index mutual funds that trade like stocks. ETFs’ popularity is growing in part because some of the biggest names in the financial services industry are promoting them as alternatives to regular, or open-ended, mutual funds.

Benefit of ETFs?

What’s the benefit of an ETF? First, most have a low expense ratio. An expense ratio is simply the amount of money that the fund charges in fees. A second advantage is that an ETF can be traded (bought or sold) any time that the market is open. For example, if you believed that the stock market was going to go up during the day, you could buy a stock market index ETF in the morning and sell it in the afternoon and capture the gain (or loss). You can’t do this on an intra-day basis with a regular open-ended mutual fund.

What are the disadvantages? Up till now the buyer or seller of an ETF incurred a commission, just like the individual who bought or sold a stock. This is not the case with no-load mutual funds that don’t charge a fee for either buying or selling. That is in the process of changing as some of the biggest names like Schwab and Fidelity are offering free trades on a growing number of ETFs.

The other disadvantage for the typical investor is that most ETFs are index funds rather than actively managed. That means that there is no-one actually making a decision about what stock or bond to buy, sell or hold. Buying an EFT requires your active participation and management or you risk putting your investments on auto-pilot and hoping that they don’t crash.

Tag: Investment terms