The Two Faces of Risk

August 3, 2014

Investment Newsletter for the end of July, 2014

July was a bad month.  In fact, the last two months have not been good.  The market as a whole was down and your portfolios were down accordingly.  So what does this fact mean?  What do we do now?

Risk has two faces.  One face is the up periods.  The other face is the down periods like July.  You cannot have the up periods without the down periods.  They go together.  Think of risk as fluctuations above and below an average point.  Without risk, you have no bad months and no profit.

I cannot say if this down period is the start of a major slide, a temporary reset because the next gain, or a sidewise stumble that does not mean a darn thing.  Trying to time the market is impossible and usually wrong.  Trading commissions and market emotions are a bad combination.  You tend to buy when everyone is feeling greedy (market top, wrong time to buy).  You tend to sell when everyone is feeing fear (market bottom, wrong time to sell).  The broker (the casino) gets a paycheck every time you trade.  The broker’s revenue is many times larger than the stated commission.  They make money on trades several ways that are not called commission.

Sticking to the plan suppresses both commissions and emotions.    Several months ago, clients were beating on me to be more aggressive.  They wanted more stocks funds and less bond funds.  The market had a taste of greed.  I held the clients back telling them to hold to the plan. I told them increasing risk would increase the loss in bad times.  They acquiesced not because they were happy about my recommendation but because they trusted me (thank-you by the way).   Funny, no one contacted me this month telling me to increase their risk.  I have been contacted, however, by people feeling fear.

So what am I going to do now?  I am sticking to the plan.  I am looking at all portfolios to see if they need to be rebalanced.  I suspect that at this point, most portfolios are close to the allocations we agreed upon.  If the market goes down much more, I will rebalance to the agreed allocation.  What that means to you is that I will buy more stocks when market is very down and very frightened.  Rebalancing is facing into the emotional wind and spitting.  This discipline yields exceptional profits.   I will not rebalance unless the difference is significant.  I am not interested in Schwab making more revenue.  I am interested in you making more profit over time.

Please contact me with any concerns or changes in your situation.  I answer tax, accounting, or investment questions with all my heart.  If you have a question, probably most of you have a similar question.  If you have an idea for me to write about, even better.

Thank-you for your trust and your business.

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Risk Vs. Return

July 2, 2014

Investment Newsletter for the end of June, 2014

It was a good quarter and all of you made a profit.  How much profit depends on your particular allocation.  Some portfolios are in riskier or are in more conservative structures than others.

It is a central theme of finance that there is a relationship between risk and return.   As your portfolio takes more risk, you will earn more profit OVER TIME.  If you accept little risk, then you will receive little return.  Risk is the fluctuation in market price over short periods (months, quarters, maybe even a year).  You cannot get more return unless you pay the cost (cost being the higher risk).  This theme is sometimes called “there is no such thing as a free lunch.”

For this conversation, I going to compare three estimations of the market.  The Dow Jones Industrial Average (the Dow which everyone thinks of when you say the “market”), the S & P 500 Index, and the Russell 2000 Value Index.  None of these are really the market.  They are samples of the market.  The Dow is the 30 biggest US stocks.  The S&P is the biggest 500 US stocks.  The Russell 2000 Value is 2000 relatively smaller US stocks that also have a value tilt (in contrast to a growth tilt).  The Russell 2000 Value is similar to the DFA small cap value fund that is in almost all your portfolios.  It is a riskier group of stocks than the other two indexes.

This quarter, the Russell 2000 Value index went up 1.7%.  This performance was substantially worse than the S&P 500 index which went up 4.69%.  The Dow went up 2.2%.  The Russell 2000 was the worst of the three and also the riskiest.  That bad taste you are noticing right now is the cost of that risk.

For the year to date, the Russell 2000 Value index went up 2.52%.  The S&P 500 index went up 6.05%.  The Dow went up 1.5%.  Once we lengthened the term from 3 months to six months, the Russell 2000 did better than the Dow but still worse than the S&P.  How about 2013.  For the calendar year, the Russell 2000 went up 37%.  The S&P went up 29.6% and the Dow went up 26.5%.  The Russell was clearly highest.  Risk was then tasting sweet.  And then finally for Jan 1, 2013 to June 30, 2014 (the full 18 month period to date), Russell outperformed again at an increase of 40.5%.  S&P was at 37.4% and Dow at 28.4%.  Very sweet results.

Risk is a cost and you paid with lower results this quarter.  Risk also gave you far higher than normal return in 2013.  Risk causes higher return over long terms.  It also causes a wilder roller coaster ride over short periods.

If you have any questions or changes in your situation, please let me know.  The portfolios need to reflect where you are in life.  I need to change if your situation changes.   You may also have questions as to the structure of your portfolio, my methods, tax, potential choices, etc.   I am available almost always.  Thank-you for your trust.

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Timing the Market

June 1, 2014

Investment Newsletter for the end of May, 2014

I have said to all of you and to anyone else who will listen that it is impossible to time the market.  But what does timing the market mean?

There are two kinds of timing.  The first tries to determine the right moment to buy or sell a particular stock.  The “expert” based on investment news, company reports, insight, etc. decides on the right time to trade.  This type of timing is based on fundamental data.  The trades may happen every month or perhaps every few years.  The problem is that all that news is old before the expert ever sees it.  It is old news when the talking heads on TV mention it.

It is old news when it is first published anywhere.  The market instantly reflects all news and all insights in its pricing.  I am not saying the market price is always right.  I believe there are bubbles and fear storms.  Almost always, however, the market is right.  To say the market is wrong is pure emotion.

The second kind of timing is based on charts.  It is called technical trading.  The “expert” based on 52 week high/low records, trend lines, head and shoulder graphs, etc. determines when to trade.  Every economist since before I was born says technical trading is nonsense.  These charts mean nothing as to the future.  It does, however, generate a lot of trading commissions.  The typical technical traded account may transact up to 25 or more times per day.  I once completed a tax return that had 3,000 stock trades.  Often the positions were held for only a few days.  The market was slightly up that year.  The client lost money.  The broker made a big profit.

We all have a tendency to think the market is at a high; let’s get out.  Or a low; let’s get in.  If you act on that impulse, that is timing the market.  It is an emotional response.  Predicting when the market will move is not possible.  We all know the market will go down.  Perhaps tomorrow, perhaps two years from now.   I have been thinking the market is at a high for six months.  If I acted and sold your accounts, you would have missed several hundred points of continued gains.  It is still climbing.

I trade based on the original allocations.  As soon the actual deviates from the allocation enough to justify a trading commission, I order a transaction.  I trade only to rebalance the portfolio to the original allocations.  I am not trying to time the market and I am trying to eliminate the emotional part of the decision.

Most deviations from actual to allocation are small.  A mutual fund commission even at a discount house like Schwab can be up to almost $50.00.  A $1,000 trade is not going to generate enough advantage to overcome two commissions, one to sell and another to buy (commission here would be $32 each way).  As a rule of thumb, I want trades to be at least $5,000 and often more.   You have noticed that I do not trade often.  I am reviewing all accounts right now and will be rebalancing in the next day or two.  However, many accounts will have no trades.  If the benefit is not higher than the cost, then I do not trade.

Thank-you for your business and trust.  I am reachable at any time if you have questions or concerns.

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Market Indexes

May 1, 2014

Investment Newsletter for the end of April, 2014

There is some confusion as to what the market is and what an index is.  The terms are usually used incorrectly.

The market is all the investments that is possible to buy.  It includes many tens of thousands of different stocks.  It includes both US and international (all countries).  It includes small companies and big companies.  It also includes real estate investments, bond investments, options, and etc.  You get the idea.  It is huge and it is impossible to put a number on how it is doing.  There are too many pieces and different ways of calculating gain.

The short cut that is used is to take a sample of the market.  The Dow is the ending price of thirty very big US companies.  Thirty companies is not the market.  The Dow is an index.  The S&P 500 is the ending price of 500 big US companies.  It is not the whole market.  It also an index. There are hundreds of indexes in use, depending on what you are trying to measure.  I pay a lot of attention to the Russell 2000 value index.  This index represents 2000 small stocks that have a value (rather than growth) orientation.  It is also not the whole market.

I bring these terms up because of the results this month.  Yesterday, the Dow closed at an all-time high of $16,580.84.  The month was up $123.18.  The headlines said the market hit an all-time high.  Not true, the index hit an all-time high.  The S&P index went up from $1,872.34 to 1,883.85.  The Russell 2000 value index, however, was down from $1,173.04 to $1,118.79.  So what did the market really do?  It is an unknown.  What index do you use?   Many sections of the market do not indexes.  As an example, can you tell me exactly to the dollar what all real estate went up this month?

Because I weight portfolios towards small cap value, the Russell 2000 value index is a fair sample of your version of the market.  This index was down this month.  Most of your portfolios were also slightly down accordingly.

Small cap value historically outperforms large cap (little companies have bigger investment returns than big companies do).  The Russell 2000 value index will outperform the S&P 500 index.  It will outperform over long periods of time.  It did not do so this month.  In the last 12 months, the S&P was up 17.9%.  The Russell up 18.1%.  Over ten years, Russell up 99.9%.  S&P up 70.1%.

This year has brought my investment practice substantial growth.  I have both new clients who started accounts with me and old clients who increased their investment.  I am deeply humbled and appreciative of this trust.  It seems this newsletter was a factor for many existing clients.  It seems all of you read them.   I intend to organize/re-edit my newsletters of the last two years or so.  It is my agenda to create a small book; explaining investment concepts, my philosophies as to market behavior, and so on.  I have no idea yet what to call it.

Thank-you, all of you.

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Mutual Funds

April 3, 2014

Investment Newsletter for the end of March, 2014

Last month I started talking about risk. I argued that there are two kinds of risk.  Individual company risk, which can be diversified away with mutual funds and market risk, which cannot be eliminated.   The example for the first would be BP when their oil platform blew up.  Since you have (hypothetically) 100’s of other stocks, BP’s crash did not upset your total very much.  The example for the second would be the towers getting hit.   If the whole market crashes, it does not matter how many stocks you own.

The profit for a portfolio is the weighted average of the pieces.  There is no reward for the portion of risk that you can rid of.  Since I can eliminate a portion of the risk by diversifying into many issues with no drop in average profit, I choose to diversify holdings.  I could buy many stocks of different kinds and self-construct a diversified portfolio.  This method is very common among the ultra-rich.   I choose to use mutual funds to achieve diversification.  Rather than buy 100’s of stocks for a client, I buy 4-10 mutual funds.

A mutual fund is just a big basket of investments.  Mutual fund “Dollinger” might hold $100 million in hundreds of widely diversified stocks (I wish).  As an individual investor, you are not rich enough to hold hundreds of stocks.  Instead you invest in .1% of the ownership of “Dollinger.”  You have invested $100,000 and hold INDIRECTLY hundreds of widely diversified stocks.

A stock or equity mutual fund holds many stocks.  A bond mutual fund holds many bonds.  A real estate mutual fund, etc etc.  Every mutual fund has a stated theme.  Think of the theme as a contract.  The mutual fund managers are claiming to you that they will only buy according to the theme.  All of my clients hold the DFA small cap value fund.  The manager is Dimensional Fund Advisors (DFA).  They have stated the theme for the fund to meet three qualifications.  They invest in US stocks, the stocks must represent the smallest 10% of the companies in the market, and the companies must have a high financial statement book value as compared to the fair market value on the market.  The last item cuts the growth stocks; stocks with minimal profits, minimal assets, lot of dreams, and a very high stock price.

If a mutual fund deviates from the stated theme, they need to be fired.  As an investor, I need to know what I am buying.  Mutual fund drift is common.  Using the DFA example, if a company suddenly grows so that it is no longer in the smallest 10%, it needs to be removed from the mutual fund.  Often mutual funds are tardy in making these changes.  It is a constant battle.   DFA is actually pretty good at staying true to theme.

A mutual fund is a private company.  They are in business to make money.  They make money by charging the investors a fee every quarter.  The fee can range from .2% to over 2% per year.  Sometimes they pay commissions to the advisors who recommend them.  Index funds buy a major section of the market, do not try to out-guess the market, and charge a low fee.  Active funds pick stocks according to what their expensive managers think best.  Active funds charge a high fee.  They are often sold by commission based advisors.  Since I do not believe it is possible to out-guess the market and I do not collect commissions, I do not use active funds.  I use index funds.

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Refresh the Basics Part 3

March 1, 2014

Investment Newsletter for the end of February, 2014

I am continuing with my theme from last months of refreshing the basics.  It never hurts to reinforce the core concepts.  I always aspire to promote and expand other people’s financial knowledge.

First, I need to gloat a bit.  Last month I criticized Bitcoin as lacking any reason to exist.  This month, the largest seller went bankrupt, with hundreds of millions US dollar equivalent missing.

The market was great in February.  Almost all the January decline went away.  In December, when the market was soaring, I received several phone calls from clients wanting to go more aggressive.  I convinced them to hold to the plan.  In January, when the market stunk, I received panicked phone calls.  These clients wanted to know if they should cash out.  I convinced them also to hold to the plan.  The profit is made by not reacting to the greed and fear cycle.  The crowd is often wrong in these short term swings.  Only half way joking, when someone (not a client) flagged me down at the doctor’s office and asked if they should sell out and asked why the government isn’t doing something about this month’s economic collapse, I knew it was time to buy.

But is there anything you can do about risk?  Partially.  Investment risk is broken into two components.  Individual company risk and total market risk.  An example of the first would be Microsoft being sued by the federal government (bad risk) and later winning the lawsuit (good risk).  Microsoft stock price changed but the market as a whole did not.  An example of the second would be the stock market crash of 2008.  Everything went down.

The individual company risk can be diversified away.  If I have 50 companies in my portfolio, Microsoft being sued does not change my total very much.  Also, the weird good risks and weird bad risks balance against each other.  This risk is diversified out of existence with mutual funds.  A mutual fund is simply a collection of many stocks.

The market risk cannot be diversified away.  If the whole market is tanking because the towers were hit, combining stocks into a portfolio does not change the decline.

You are rewarded with potentially higher profits for taking risk.  Which risk?  Since you can get rid of the company risk, there is no reward for it.  Market risk is rewarded.  If you have a more aggressive portfolio, you will have higher returns over time.  You will also be on a more exciting roller coaster.

I believe that there is no legally available knowledge which will tell you in advance if a stock will go up or down.  All knowledge is publically available and immediately reflected in the stock price.  The only factors left that can change the stock price are the two risks above, company risk which can not be predicted, and overall market risk.  This point, in a nutshell, is why I do not buy individual stocks.  I can get rid of the company risk in a mutual fund.  Since all knowledge is already in the stock price, the mutual fund will have the same return as the stocks in it.  The same profit for less risk.

Thank-you for your trust.  Let me know if you have a topic that you are interested in.

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Refresh the Basics Part 2

February 1, 2014

Investment Newsletter for the end of January, 2014

I am continuing with my theme from last month of refreshing the basics.  It never hurts to remember the core issues.  I also have several new clients.

Before I start, I need to discuss the month.  It stunk.  It was looking fabulous until the very end of last month.  There was no clue that the Dow was about to go down 1,000 points.  The news was all rosy and the experts were optimistic.  It was not possible to time when the decline would happen.  None of you should be surprised.  I have been talking about it for half a year.  So now what?  There is no way to determine how deep this downturn will go or when it will recover.  I know that if I stay out, I will miss the rebound.  I will therefore honor our agreed allocation.  In summary, I will rebalance and buy more stock as it goes down.  When it goes back up, you will be richer for it.

The value of the stock share is not just based on the company value.  I was over simplifying last month to make a point.  The more correct answer is that the stock price includes peoples’ expectations as to future earnings.  People can be irrational, filled with fears and prejudices, be over optimistic, etc.  These expectations can rapidly change.  This change in expectation is why the stock market fluctuates even when companies are relatively steady.  You see the same expectation changes in real estate prices, gold prices, and every other investment.  Expectations can change dramatically.  Greed can turn to fear in one day (the stock market tanked when the towers were hit in 2001) or over longer periods like what is now happening to gold prices.

In my opinion, Bitcoin (some type of digital currency) is the next collapse.  I can not see any economic substance to it.  It has no reason to exist and has no assets or country behind it.  It is being created by private companies in computer programs.  When greed turns to fear, people will not touch Bitcoin with a pole.  Bitcoin will have no value.

A rational decision process cannot predict irrationality.  I cannot analyze my way to predict the next greed fit or fear storm.  I can not predict when Bitcoin will collapse.  It may be next month or two years.

I do not believe that anyone can predict the stock market.  The stock market is the collection of all stocks.  Each stock is going up and down based on millions of buyers and sellers bidding the price up or down.  These buyers and sellers are motivated by greed, fear, retirement planning, education planning, or may be computer programs.  It is a mix of different reasons, knowledge, and understanding of the market.   It is not logical in the short term.  In the long term, prices are based on company profits.  Stock prices do not have patterns like the technical traders say.  Any new information about a company is instantly reflected in the stock price.  It is old news before you ever hear it on TV.

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Refresh the Basics

January 6, 2014

Investment Newsletter for the end of December, 2013

I wish to refresh the basics.  It never hurts to remember the core issues.  I also have several new clients.

A share of stock is an ownership right in a company.  For example, if I were to own one share of Intel that means I own a very very tiny fraction of the company.  Intel currently has just under 5 billion shares.  Intel originally issued shares to raise money for operations.  They split several times since then.  The value of the company has gone up as the company has grown.  With profits have come accumulating assets.  Since the company is worth more money, my teeny tiny fraction is worth more money,

The splits do not increase the value of what I have.  Stock splits have absolutely no impact on how much my investment is worth.  If a company is worth $100 million and it has one million shares, each share is worth $100.  If you have 100 shares, your investment is worth $10,000.  If now the company declares a 2 for 1 stock split, they will add 100 shares more into your hands.  You now have 200 shares instead of the old 100 shares.  As a whole, the company now has two million shares instead of the old one million shares.  But, the company is still worth what it was, $100 million.  Sales have not gone up.  Profit is the same.  Assets are the same.  Nothing has changed except on paper.  Since the company is still worth $100 million but now there are two million shares, each share is now worth $50.  Your 200 shares is now worth the same $10,000 you had before.

A mutual fund is a collection of many different stocks. The fund may have stock of 100 or more companies.  Instead of owning $10,000 of Intel, you would $10,000 of mutual fund xxx.  The mutual fund may have thousands of owners.  This mutual fund would accumulate your cash as well as all the other owners.  It would then buy some Intel, some Microsoft, something else, etc.  Mutual funds serve to reduce risk.  You can now indirectly own pieces of 100 companies without being rich.

The mutual fund is a for profit enterprise.  They charge a fee for accumulating stocks and owners into a big pot.  Some mutual fund companies use expensive managers and claim that they are experts at picking stocks. These funds are called actively managed.  They are typically sold by commissioned representatives.  They almost always have either a big front end fee (nearly all of which goes to the salesman) or a back end fee if you try to leave before a certain number of years (also called a deferred sales charge).    They also have a high ongoing fee of as much as 2% per year.

Other mutual funds claim that there is no such thing as special expertise at picking stocks.  They do not know what the next winning stock is going to be.  They try to match the market or a component of the market as inexpensively as possible.  They buy big baskets of stocks with some predefined characteristic, such as all the small cap value stocks in the market.  These funds are called passively managed or index funds.  There is no front fee, no back fee, no commissioned salesman, and an ongoing fee of .5% per year or less.  The two best mutual fund companies of this type are Vanguard and DFA.  I heavily use both company’s products when designing portfolios.  I also believe that there is no such thing as special expertise.  I also do not collect commissions.

I hope you all had a good holiday.  May this next year be as profitable as the last.  Thank-you for your business.

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Bond Ratings

December 2, 2013

Investment Newsletter for the end of November, 2013

This month I am going to continue discussing bonds.  First, however, the happy score card.  The Dow closed the month at 16,086, up 540 points for the month (a 3.47% increase).  The S&P 500 closed at 1,806, up 49 points (a 2.79% increase).  The Russell 2000 increased to 1,143, up 43 points (up 3.91%).  Everybody made a lot of money.

Bonds are issued either by corporations or by government entities.  The issuer wants to borrow money.  If I buy an original issue bond, I am loaning my money to the issuer.  I want to be paid interest and I want my money to be safe.  I can sell my bond on the market at whatever price exists at that time.  If I buy a bond on the market rather than from the issuer, I am not loaning money to the issuer.  I would be assuming someone else’s loan.  The issuer still owes me money, I still want to be paid interest, and I still want my money to be safe.

I have limited ability to evaluate the issuer’s finances.  There may be different levels of collateral on each bond issue.  There may be complicated financial setups and intercompany arrangements.  There may be a history of paying bond holders no matter what or stiffing them at the first excuse.  The evaluation is highly specific to the corporation or government entity.  To evaluate this issuer, a specialist is needed.

Luckily, when there is a need, someone is willing to sell a solution.  There are five private companies in the United States that rate bonds for financial security.  Only three are big enough to matter.  The three are Moody’s, Standard and Poors, and Fitch.

They issue their ratings with a letter grade.  The ratings range from AAA (called a triple A rating) to a low of D.  D is for issuers already in default.  The exact letter line up varies among the rating agencies.  There are many in between steps.  The above average grades are A (upper medium), AA (high quality), and AAA (best quality).  The B grades are average creditworthiness.

Risk is rewarded by higher profit.  Low risk is punished by lower profit.  Lower bond ratings mean higher risk, which in turn means higher a higher interest rate.  If you buy very low rated bonds, you have bought junk bonds.  You will be rewarded with very sweet interest rates, unless the issuer defaults and you lose everything.

Some issuers, like government entities, must continually issue new bonds.  There is always a new airport expansion, library construction, need for operating capital, etc.  These issuers care deeply about the credit rating.  A drop in credit rating means they have to pay more interest on future issues of bonds.  Because the borrowings are often large, the interest pay outs can often increase by many millions of dollars per year.

The bigger problem for bond holders is what happens when they already hold a bond and then it is down rated.  Since interest rates have to go up, the value of your bond must go down.  The issuer is only changing the payout for future issues.  You are stuck with the same payout.  The bond goes down in price so that the payout divided by the price (i.e. the yield) equals the market rate.

Thank-you

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Bonds

November 1, 2013

Investment Newsletter for the end of October, 2013

This month continued strong.  The Dow increased from 15,130 to 15,546 (a 2.75% increase), the S&P 500 increased from 1,682 to 1,757 (a 4.46% increase), and the Russell 2000 Value Index increased from 1,074 to 1,100 (a 2.42% increase).  The market is near its all-time high.

This month one of clients asked me to discuss bonds.  I realized then that I had often written about portfolio strategy, the markets, risk, taxes, etc.   However, I have never discussed bonds.  Thank-you Mary.

At its simplest, a bond is a debt.  A company or a government borrows money for some purpose from investors.  The investor can and often will sell these rights to receive future money to another investor.  The key points.

1.  Face Value.  The face value is the original amount borrowed.  It may not be what you paid.  You may have bought the bond from someone else.  That person may have sold the bond to you at a profit or at a loss.  The face value is however exactly what the company or government will repay at maturity.  When that payoff happens, you may have a profit or a loss.

2.  Duration.  How long before the maturity date.  Very short term bonds can mature in only a few more months.  Very long term bonds might be 30 years.  If the bond matures later today as an extreme example, the price this morning will be virtually the same as the face value this afternoon.  There will be no fluctuation in price.  If the bond does not mature for ten years, the price can still bounce around like a teenager’s ideal roller coaster.

3.  Interest Rate.  The company or government pays interest to the investor.  The amount depends on the contract interest rate, often called stated yield.  It is paid according to a schedule, often every half year.  I am ignoring here bonds that are originally sold with a deep discount and then do not pay interest.  The interest rate you actually get depends on the payment amount and what you paid for the bond.  If you buy a bond for $1,000 and then receive $100 interest, your actual yield is 10%.  Its stated yield may be 5% (face value of bond is $2,000), 20% (face value of bond is $500), etc.  In general, as market interest rates go up, bond prices go down and vice versa.

4.  Quality.  Bonds can be secured against real estate, revenue from a project, the full faith and credit of the issuer, or unsecured.  The better the security, the safer the bond.  The city of Detroit is in bankruptcy.  Would you rather have an unsecured bond or a bond with a first mortgage on the real estate used for parking lots?  The issuer is also rated by several rating services (Moody’s, S&P, etc) as to their financial health.  These ratings are usually letter based.  Triple A, etc.  Detroit’s rating is very poor.  It is very likely that the unsecured bond holders will lose their money.  Therefore, the bonds are being sold for a tiny fraction of what was originally paid.

Bonds are not safe.  They fluctuate in price based on how long before maturity, quality of the issuer, security, and changes in interest rate.  I use only short term bonds to minimize this fluctuation.  I want the risk to be in the equities not the bonds.  Equity risk has a fatter reward.

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