Part II: Knowing the Alphabet for the Portfolio as well.
In the last blog, I wrote about the basic starting point for the financial planning process. This time, I write to articulate some key fundamental items that relate to investing. Again, like last week, we are starting with a foundation. An appreciation of these concepts is key to having a basic understanding of the behavior of investment markets.
- An investment’s value is the present value of future cash flows. This is fundamental to all investment markets during all times, even this one. In order for an investment to have value today and create value in the future, it must generate cash flows. Cash flow can come from dividends, interest, rent, and/or realized appreciation. An ownership in a share of stock is a right to receive a share of future earnings. An ownership in a bond is a right to received interest payments. An ownership in real estate is a right to receive a share of net income and cash flow. (Note: This is also why a primary home is never an “investment.”)
Those cash flows are then discounted to today by the investor’s required return. This return is dictated by all the participants in the market. The market is made up of all investors, including us. The discount rate fluctuates daily. This is why markets are often volatile — because bot the cash flows and discount rates are constantly being reassessed by the market as new information is brought to light.
- Risk and return are related, but risk never guarantees return. This is often greatly misunderstood. By seeking higher return, one must be willing to take higher risk. That means, though, that risk (or loss) could or will be realized. We are seeing this today. Losses were realized because risk occurred. Gains were realized in the past and will likely be realized again in the future because risk occurs.
- Bear markets are inevitable. It is not only common sense, but also prudent, to prepare for a bear market. Bear markets and recessions occur in most developed nations about three times every 10 years. Preparation for a bear market does not mean one can avoid them. Many investment managers claim they can successfully navigate their way around bear and bull markets. This is simply wishful thinking, if not an outright lie. No one knows when a bear market will begin or end.
- Stocks are risky, no matter what your time frame. Subsequently, money needed in the short-term should never be tied to stocks. Stocks, though, “tend to” outperform bonds over a long period of time, and thus, why it is reasonable to consider a portion of your portfolio allocated to stocks, especially if you are accumulating wealth over a long period of time or if you intend to have a long retirement.
- In a world of short-term volatility and long-term inflation and taxes, there is NO risk-free investment. Just as it is equally important to realize that stocks are always risky (especially in the short-term), bonds and cash are also risky (especially in the long-term). Inflation could eat the long-term stability of a dollar today, 10, 20, or 50 years from now. Furthermore, taxes can take a piece of your interest income every year, so the after-tax return in a bond portfolio often does not meet inflation.
These fundamentals above do not change in any capitalistic economic environment. Your awareness of this, though, can help you make a choice prospectively on how you want to act.
This article contains the opinions of the author. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services described in this website or that of the author’s.
Mike Dubis does not guarantee the relevancy, appropriateness, or accuracy of any outside information or links. Mike Dubis does not render or offer to render personalized investment advice or financial planning advice through this medium. All references that might be made to an investment or portfolio’s performance are based on historical data and one should not assume that this performance will continue in the future.
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