Going Against the Conventional Investment Wisdom

Most financial advisors put a great deal of emphasis on diversification. While this is probably appropriate for most people, I personally don’t buy it. The idea is that it limits risk. While it does indeed limit risk, for me it also limits my upside potential way too much. Therefore, I basically disregard the whole concept. Most advisors will encourage investing for the long term. This strategy is generally successful in building wealth, but unfortunately for me, it wouldn’t until after I’m old or dead. I invest for the short and intermediate terms.

I also do not buy or trade individual stocks. Instead, I buy and trade no-load mutual funds, including index funds. Even with the use of a deep-discount broker, commissions from trading individual stocks will add up and cut into my profits. True no-load mutual funds don’t cost me anything to buy or sell. Besides, owning shares in a mutual fund is like owning shares of a lot of different stocks at one time without having to actually buy any of those stocks. Instead of buying individual stocks, I am buying classes or groups of stocks. I also don’t have to worry about which stocks to buy or sell, as that job is being taken care of by the fund managers.

Now, let’s talk about some guidelines I use specifically for my conservative strategy. I only buy funds that have earned a "Five-Star" rating from Morningstar (www.morningstar.com). They must also have a Morningstar risk rating of "low", "below average", or "average." In addition, they must have a Morningstar return rating of "above average" or "high." Also, they must be long-term winners, i.e., near the top of their categories in five-year and/or ten-year performance. I also require them to be "Lipper Leaders", as deemed by Lipper (www.lipperleaders.com), in the categories of "Returns", "Capital Preservation", and "Consistency."

In my mind, consistency is just as important as high overall return and capital preservation. An inconsistent or volatile fund can cause problems for short and intermediate term investors, even if its longer term performance is excellent. Here’s the problem: Let’s say a fund that I invested in went down 50% in the first year I owned it. It would have to go up a whopping 100% the next year for me to break even after two years. However, let’s say it went down 25% after the first year. In that case, the fund would only have to go up 33% in the second year for me to break even. A 20% drop in the first year would need only a 25% increase in the second year to break even; a 15% drop would need only an 18% increase; a 10% drop would require only an 11% increase; and so on. Therefore, I stick with funds that have never gone down more than 10-20% in any one year. I prefer funds that have never had a losing year, but those are very hard to find.

What about my more aggressive strategy? This is the one that I’m using more and more often and is becoming more profitable, although I probably couldn’t quit my job and make a living off of it just yet. Is it going to make me rich? Probably not. However, I hope it will eventually put me in a financial position to retire early. This strategy involves actively trading various no-load market index funds. The experts say you can’t successfully time the market. I believe this is true when using the strictest definition of the term, “market timing.”

However, I have been able to trade successfully with the short-term momentum already established by the market. Why no-load market index funds instead of individual stocks or Exchange Traded Funds (ETFs) that mirror various market indexes? Because no-load market index funds allow leveraging and short selling without the need for a margin account. Also, some of these funds allow twice-daily trading (which is important for exiting early on bad days). In addition, the fund company I use doesn’t charge redemption fees for actively trading its funds. Most fund companies, even those that specialize in no-load funds, charge these fees.

Like I said at the beginning, I’m not going into great detail, especially about my more aggressive strategy. However, I should define some terms so all of this will make more sense to those who are novices in the world of investments.

What is leveraging? Leveraging, in this context, is the ability to buy shares of a stock or mutual fund and realize a multiple of its gain or loss during the time you hold it. For example, if you buy a fund leveraged at 2 times a given stock index and that fund goes up 20%, you realize a 40% gain. However, if it goes down 20%, you incur a 40% loss. With individual stocks or ETFs, you need a margin account to do this. With a margin account, your broker is loaning you money on “margin” at a rather high rate of interest to cover the leveraged (or extra) amount. Obviously, this could be very risky and costly. However, there are some funds that have this leveraging built in at no cost to you. These funds automatically give you one-and-a-half or two times the gain or loss of a given stock index.

What is short selling? Short selling is when you sell a stock (that you don’t already own) immediately at its current market price while agreeing to buy it at whatever the market price will be at a fixed point in the near future. In other words, you are betting that the stock will be going down, so you can buy it for less than you sold it for. Have you ever heard anyone say “don’t sell me short”? Well, this is where that term came from. Selling someone short is tantamount to treating them like a bad stock that you believe is going down. Yes, it’s backwards of the normal process of buying and selling stocks. As with leveraging, you need a margin account to do this for individual stocks or ETFs. Your broker loans you money on “margin” (actually buying the stock temporarily), so you can sell a stock that you don’t own yet.

Once again, however, the funds I use have this short selling mechanism already built in to them at no cost to you. For example, you can buy a fund that gives you the inverse performance of the Nasdaq-100 Index. When that index goes up 10%, the fund goes down 10%; conversely, when that index goes down 10%, the fund goes up 10%. There are even funds with leveraging and short selling built in to them, at no cost to you! For example, there is an available fund that goes up 20% when the Nasdaq-100 Index goes down 10%. Of course, that same fund goes down 20% when then the Nasdaq-100 Index goes up 10%. As you can probably imagine, these funds can be powerful tools for profit-making for those who know how to use them, but can be highly dangerous for those who do not.

For more information about any or all of these concepts and to find out what kind of investment is right for you, contact your financial advisor and/or do your own research. Hopefully, I have provided some food for thought as well as several resources that might be helpful to you when doing your own research.