Tuesday, March 1, 2011

What Do You Think About Investing in ___________ (fill in the blank)?

I sometimes get asked what I think about investing in a particular type of investment; here are examples:

  • Emerging Market Stocks
  • REITs (Real Estate Investment Trusts)
  • Gold
  • Futures or Options
  • Trust Deeds
  • Annuities

The simple answer is that you should have an investment plan and stick to it, and not jump into a particular type of investment just because you’ve heard something about it from a friend, salesperson, or news article. For most people, a rational investment plan involves investing in low-cost stock and bond index funds, and using FDIC/NCUA insured deposit accounts, such as CDs and high-yield savings and checking accounts, for short-term reserves.

If you hear about an investment that has been providing high returns, remember that high returns always involve high risks, and that past performance is not an indicator of future performance.

With respect to the specific examples listed above, here are a few comments.

Emerging Market stocks and REITs are asset classes that are reasonable to include in a diversified portfolio, and that can be owned using low-cost index funds. They are included in my portfolio. You don’t want to buy them because they’ve performed well recently, or because you think you or someone else has some special insight into how they’ll perform in the future. You may want to own them because the evidence indicates that it’s rational to allocate a designated percentage of your portfolio to them. For example, you may decide to allocate 10% of your domestic stock allocation to REITs, and 25% of your international stock allocation to emerging markets. Similar comments would apply to other asset classes such as large-cap US or foreign stocks, small-cap stocks, value stocks, and bonds. Periodically you will rebalance your portfolio to ensure that each asset class doesn’t deviate too much from its target percentage.

Gold is a speculation, not an investment. Gold doesn’t generate dividends, earnings, or any other cash flows upon which a rational price can be based. If you buy it, you are simply hoping that someone else will buy it from you later at a higher price. Although gold has had high returns in recent years, its returns over longer time periods are very poor compared to stocks (and even bonds), and its price is extremely volatile. Although there is some rationale to include gold in certain portfolios, I don’t include it in mine. For a more in depth look at gold, see this article.

Futures and options are examples of derivatives, which are highly leveraged and extremely speculative. You may have heard of people making a lot of money on them, but people probably don’t brag too much when they lose a lot of money on them. Most ordinary investors should not consider investing in derivatives.

You may have seen advertisements offering high returns—10% or more—by investing in trust deeds. This is basically loaning money to a property owner, with the loan secured by a deed of trust on the property (commonly referred to as a mortgage). This is how mortgage lenders, like banks, make money, and everyone has heard of all of the problems mortgage lenders have gotten themselves into in recent years. Do you want to join them?  I’ve seen the ads, and the rates look very attractive, but I just remind myself that if it were such a good deal, banks and other big investors who are much smarter than I am would be making these loans, and there would be no need to target advertisements to smaller investors like you and me. Also, if there were really a secure investment paying 10%, everyone would want to buy it, and that would drive the rate of return down to current market rates—it’s Economics 101.

Annuities come in different varieties, and I won’t go into any depth on them here. A rule of thumb is that variable annuities are not good investments, but single premium immediate annuities (SPIAs) can be good for older folks who may not have enough assets to get them through the rest of their lives. For a deeper look into SPIAs, see this blog post by the Oblivious Investor (a good investing blog—I’ve added it to the Investing Blogs list on my blog). Variable annuities provide high commissions to the salespeople trying to sell them to you; do not buy an annuity from a salesperson.

So instead of being seduced by the latest investing fad, take some time to learn a bit about what 60 years of academic research has taught us about investing, develop an investment plan that fits your personal willingness, ability and need to take risk, implement the plan, and stick to it.

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