What has happened to investing for the long term? Lately there have been news stories about students day-trading with their tuition money, buying on margin, getting a margin call, and losing it all. Here are some basic tenets of investing that you may want to share: Never gamble what you can’t afford to lose. Leverage is a great way to buy more of a (supposedly) good thing. It is also a way to get badly burned. If an investment sounds too good to be true, it probably is. With 3 percent daily swings in the stock indices and 5 percent (or more) weekly swings, it doesn’t take many days to get into big trouble.
Never use one highly leveraged investment to acquire another highly leveraged investment. Borrowing, other than in a margin account, to buy securities is a no-no. Taking out a home equity line of credit to invest in that hot IPO or mutual fund is not a good idea. It is probably also not legal. That is why new account forms have a line for “source of funds.” It has only been a few years since housing markets were sinking like stones, and many people owed far more on their houses than they could get in a sale.
There are reasons why margin accounts have limitations and strict collateral rules. Recent market volatility and increasing interest rates are amplified in a margin account. In a rising market, these two factors work to the borrower’s advantage, but in a volatile or falling market they can really hurt. The Securities and Exchange Commission doesn’t allow a firm to lend additional money to margin account holders and imposes strict limits on the amount of losses in a margin account. When these limits are reached, the account holder must immediately come up with more cash or marginable securities, or else their position(s) will be sold off, regardless of where the market is later the same day.
Never buy high-risk investments if you are not going to be able to sleep at night or concentrate on your real life wondering what will happen next. One of the most valuable roles a financial advisor has is to assess a client’s risk tolerance, help the client set goals and keep him/her focused.
The market run-up we have seen over the past several years is not the norm. In early March 2000, the Dow Jones industrial average was down about 15 percent from its early-2000 highs. The Nasdaq and Standard & Poor’s 500 averages were doing a bit better, but not much. A 10 percent drop in an index defines the start of a correction. While it’s not 1987 (yet), there are an awful lot of “investors” who believe 20 percent or 40 percent or even 100 percent returns on an annual basis are normal.
Don’t chase returns. While most mutual fund journalism has matured, a magazine writer can still look back at the top funds for the past year, or five years, or any other period, and publish “The Top Ten Funds to Buy Now,” or “Five Mutual Funds That Will Double in the Next Three Years.” Securities-licensed financial advisors can’t say that. Remember the disclaimer, “past performance is no guarantee of future returns,” or whatever phrase your broker-dealer uses. Chasing returns is a great way for investors to lose significant sums since they are violating the rule: “Buy low and sell high.” Dollar-cost averaging, which means making regularly-scheduled and equal investments, can have significant benefits, particularly in a rising market.
In 1929, “investors” were borrowing everything they could and sinking the money into the stock market. Then the bottom fell out and recovery took more than 20 years. Since then, the government has created laws and structures to protect the small investor. Licensing requirements have been tightened for registered representatives and registered investment advisors. Nonetheless, the government can only do so much.
Personally, I do not think we are entering a prolonged correction, or bear market, but I do believe we will continue to see the high market volatility that has plagued the late 1990s and continues today. The Federal Reserve wants inflation held to 2 percent to 3 percent. The present administration wants to increase government spending, while the opposition wants to cut taxes. As long as these three entities see what is best for the country and the economy from such diametrically opposed points of view, stock markets will be continuously buffeted.
Financial advisors can play an important role in positioning clients to benefit from the longest economic expansion ever and from a stock market that has been rising or steady for over a decade. Education and “getting back to basics” hold the keys.
Janet Arrowood is managing director of Investment Decisions, Inc., in Denver, a provider of advanced business and estate planning for business and individuals. She is a registered representative and has written for various business and legal media.