THIS IS MY 69TH BLOG ON UNDERSTANDING MONEY TOOLS
Recently, I was in a conversation with a friend who was
successful over the years in his expertise, however asked me questions I felt
very basic on the risks associated with stocks, bonds and annuities. We have
covered many topics in the past, but I will try to hit on a couple of risks
that perhaps many people don’t think of when looking at investments.
Totally safe investments, there ain’t none! Let’s look at
stocks first. Many people don’t know that companies can dilute their stock that
is openly traded in the market, and this could very well lower prices. Let me
give you an example using a well-known, old-line company like General Electric.
G.E. became a publicly traded company in 1892 on the New York Stock Exchange.
The company sold 1,000 shares of common stock at $100. per share. That has
changed significantly today along with many other companies. G.E. currently has
10,075,929,000 shares of common stock issued and outstanding, with the G.E.
Boards having authorized a total of 13,250,000,000 shares of common stock and
50,000,000 preferred shares with a par value of $1.00. A lot has changed, those
figures are in the billions!
As previously discussed, when incorporating a company will
file a charter, this will include the initial “authorized” shares of stock and
subsequently to that the company will “issue” stock from the authorized shares.
As with General Electric’s example above, the Board can change the stock
formation from it’s original charter.
The other important matter is price to earnings ratios. Over
history stocks have averaged around a 15:1 P/E ratio. Currently, the S&P is
at a 21:1 ratio. Ratios can take many forms. One analysis may be a “trailing”
P/E of actual earnings from the past 12 months. Another analysis may be a
“forward” P/E predicting what the earnings “should be” moving forward based
upon history. During war years and going back to around the 1900s P/E’s were
lower, about 5-10 could be common. Then, you have the exuberance of investors
feeling no market corrections were in site like 1929 and 2000. Before these
crashes the average P/E’s reached 35:1 and higher.
I am not sure many investors realize how much they are
paying for a stock or index fund. Could you sell a private company for 21 times
earnings? Very doubtful. Some publicly traded, and well-known companies are
trading for 50, 80 and more than 100 times earnings. What does this mean? Let’s
bring people back to earth. This means that if you buy a stock with an 80:1 P/E
it will take you 80 years to recoup your original investment, unless some
really crazy things happen to improve the company in the future.
Let’s turn to bonds. As most people realize interest rates
are close to zero, whether it is a savings account at the bank, or bonds. Many
people turned toward safe investments over the past 15 years like bonds. Losing
money in bonds can be just as easy as with stocks. Market value of a bond is
immaterial if you are with a good company, municipality or the US Government
and hold the bond until maturity. One risk is the type of bond; corporate,
municipal or US Government and the ratings. If you had a high yield corporate
bond it most likely was “called” as the company would have refinanced the debt.
Another risk is the lowering of ratings of the entity that issued the bond,
this will affect the market value or if you will ever see all your investment
returned. New York City bonds in
the early 1970s was a prime example.
As we have discussed in other blogs, bonds are very interest
rate sensitive. If interest rates go down, market value of bonds go up. If
interest rates go up, market value of bonds go down. Interest rates are close
to zero so they can’t go lower, even though some countries like Switzerland
have gone negative interest. Here is a formula many use on bond risk. For every
1% rise in interest rates, the market value of a bond should go down equal to
the duration remaining on the bond. As illustrations, if the government raises
interest rates 1% and you have 15 years remaining on a 30 year government bond
and need or want to sell, you most likely will lose about 15% in market value
of your bond. If you have a 10 year bond with 8 years to maturity and interest
rates go up 1/2% you will expect to lose 4% in market value. (This was
determined by taking the 1% rule of thumb which would be an 8% loss and
dividing by 2.)
Annuities are an insurance product based on actuarial
statistics and interest rates. There are downsides to annuities. They have relatively high management
fees and sales commissions, and not all companies are rated the same. See a
financial advisor and select an A rated company that has been in business for
many years and should be around in the future so that you will see a
continuance of payouts.
Before you see an advisor it would be wise to Google types
of annuities to familiarize yourself with various types. Here are a few
examples:
- Length
of term? Life annuity, or a
specific number of years. Your monthly or quarterly payout will be higher with
shorter terms.
- If
you are married you may want your spouse to continue receiving benefits from
the annuity. This could also be for his/her lifetime or for a given number of
years.
- The
amount of payout, of course, depends on the amount of initial funding and when
you start to take payouts.
I hope this blog brings some value to you, and gets your
mind working on finances.
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