Investing All-in-One For Dummies. Eric Tyson

Investing All-in-One For Dummies

Trying to predict what happens to the stock and bond markets and to individual securities consumes many a market prognosticator.

In the 1960s, to the chagrin of some market soothsayers, academic scholars developed a theory called the efficient market hypothesis. This theory basically maintains the following logic: Lots of investors collect and analyze all sorts of information about companies and their securities. If investors think that a security, such as a stock, is overpriced, they sell it or don’t buy it. Conversely, if many investors believe that a security is underpriced, they buy it or hold what they already own. Because of the competition among all these investors, the price that a security trades at generally reflects what many (supposedly informed) people think it’s worth.

Therefore, the efficient market theory implies that trading in and out of securities and the overall market in an attempt to be in the right stocks at the right time is a futile endeavor. Buying or selling a security because of “new” news is also fruitless because the stock price adjusts so quickly to this news that investors can’t profit by acting on it. As Burton Malkiel so eloquently said in his classic book A Random Walk Down Wall Street, this theory, “taken to its logical extreme … means that a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by the experts.”

Some money managers have beaten the market averages. In fact, beating the market over a year or three years isn’t difficult, but few can beat the market over a decade or more. Efficient market supporters argue that some of those who beat the markets, even over a ten-year period, do so because of luck. Consider that if you flip a coin five times, on some occasions, you get five consecutive heads. This coincidence actually happens, on average, once every 32 times you do five coin-flip sequences because of random luck, not skill. Consistently identifying in advance which coin flipper will get five consecutive heads isn’t possible.

Strict believers in the efficient market hypothesis say that it’s equally impossible to identify the best money managers in advance. Some money managers, such as those who manage mutual and exchange-traded funds, possess publicly available track records. Inspecting those track records (and understanding the level of risk taken for the achieved returns) and doing other common-sense things, such as investing in funds that have lower expenses, improve your odds of performing a bit better than the market.

Various investment markets differ in how efficient they are. Efficiency means that the current price of an investment accurately reflects its true value. Although the stock market is reasonably efficient, many consider the bond market to be even more efficient. The real estate market is less efficient because properties are unique, and sometimes less competition and access to information exist. If you can locate a seller who really needs to sell, you may be able to buy property at a sizeable discount from what it’s really worth. Small business is also less efficient. Entrepreneurs with innovative ideas and approaches can sometimes earn enormous returns.

Moving the market: Interest rates, inflation, and the Federal Reserve

For decades, economists, investment managers, and other (often self-anointed) gurus have attempted to understand the course of interest rates, inflation, and the monetary policies set forth by the Federal Reserve. Millions of investors follow these economic factors. Why? Because interest rates, inflation, and the Federal Reserve’s monetary policies seem to move the financial markets and the economy.

Realizing that high interest rates are generally bad

Many businesses borrow money to expand. People, who are affectionately referred to as consumers, also borrow money to finance home and auto purchases and education.

Interest rate increases tend to slow the economy. Businesses scale back on expansion plans, and some debt-laden businesses can’t afford high interest rates and go under. Most individuals possess limited budgets as well and have to scale back some purchases because of higher interest rates. For example, higher interest rates translate into higher mortgage payments for home buyers.

If high interest rates choke business expansion and consumer spending, economic growth slows or the economy shrinks — and possibly ends up in a recession. The most common definition of a recession is two consecutive quarters (six months) of contracting economic activity.

The stock market usually develops a case of the queasies as corporate profits shrink. High interest rates may depress investors’ appetites for stocks as the yields increase on certificates of deposit (CDs), Treasury bills, and other bonds.

Higher interest rates actually make some people happy. If you locked in a fixed-rate mortgage on your home or on a business loan, your loan looks much better than if you had a variable-rate mortgage. Some retirees and others who live off the interest income on their investments are happy with interest rate increases as well. Consider back in the early 1980s, for example, when a retiree received $10,000 per year in interest for each $100,000 that he invested in certificates of deposit that paid 10 percent.

Fast-forward to the early 2000s: A retiree purchasing the same CDs saw interest income slashed by about 70 percent because rates on the CDs were just 3 percent. So for every $100,000 invested, only $3,000 in interest income was paid.

If you try to live off the income that your investments produce, a 70 percent drop in that income is likely to cramp your lifestyle. So higher interest rates are better if you’re living off your investment income, right? Not necessarily.

Discovering the inflation and interest rate connection

Consider what happened to interest rates in the late 1970s and early 1980s. After the United States successfully emerged from a terrible recession in the mid-1970s, the economy seemed to be on the right track. But within just a few years, the economy was in turmoil again. The annual increase in the cost of living (known as the rate of inflation) burst through 10 percent on its way to 14 percent. Interest rates, which are what bondholders receive when they lend their money to corporations and governments, followed inflation skyward.

Inflation and interest rates usually move in tandem. The primary driver of interest rates is the rate of inflation. Interest rates were much higher in the 1980s because the United States had double-digit inflation. If the cost of living increases at the rate of 10 percent per year, why would you, as an investor, lend your money (which is what you do when you purchase a bond or CD) at 5 percent? Interest rates were so much higher in the early 1980s because you would never do such a thing.

In recent years, interest rates have been very low. Therefore, the rate of interest that investors can earn lending their money has dropped accordingly. Although low interest rates reduce the interest income that comes in, the corresponding low rate of inflation doesn’t devour the purchasing power of your principal balance. That’s why lower interest rates aren’t necessarily worse, and higher interest rates aren’t necessarily better as you try to live off your investment income.

So what are investors to do when they’re living off the income they receive from their investments but don’t receive enough because of low interest rates? Some retirees have woken up to the risk of keeping all or too much of their money in short-term CD and bond investments. A simple but psychologically difficult solution is to use some of your principal to supplement your interest and dividend income. Using your principal to supplement your income is what effectively happens anyway when inflation is higher — the purchasing power of your principal erodes more quickly. You may also find that you haven’t saved enough money to meet your desired standard of living — that’s why you should consider your retirement goals well before retiring.

Investing All-in-One For Dummies. Eric Tyson