Consulate U – Class 2 – The Rest of the Universe of Investing

Consulate U – Class 2 – The Rest of the Universe of Investing

We’ve discussed the Risk-Free Rate, but if that return is not enough to meet your goals, where do you turn? There are no shortage of options, and we’ll attempt to cover most of them in this article and upcoming webinar.

The glossary below will define each type of investment, but it is important to first discuss the big picture and how each of these investment types can play a role. No investment strategy and subsequent asset selection can happen without an understanding of your goals. Your goals will determine what sort of rate of return you need which will inform the types of investments you will utilize. Another extremely important piece of goals is time horizon. The shorter the time horizon, the less volatility you want your investments to have, which can drastically alter the types of investments you choose. This exercise, as well as using sophisticated Monte Carlo modeling, can help you arrive at an ideal asset allocation.

Asset Allocation is nothing more than the percentages of each type of investment that should make up your overall portfolio. For example, yours may be 60% stocks, 35% bonds, and 5% cash. This is the beginning, and then you must choose what assets to fill those buckets.

As you can see, asset selection can only happen after determining your ideal asset allocation, which in turn can only happen after you determine what you are trying to accomplish with your money.

Once you get to this point, it is time to select your actual underlying investments. While many share similar characteristics, it is important to note the subtle differences. For example, public equities typically have much more transparency and due diligence done on them as opposed to private equity.

Please contact your advisor if you have specific questions and we hope to see you on the webinar!

Glossary

Equity – ownership in a company (also called stock), typically used to invest for growth and income.

  • Private – a company that is owned privately (such as the Financial Consulate)
  • Public – traded on an exchange such as the NYSE or NASDAQ and stock held amongst many owners
  • Mutual Funds – pooled investment vehicle with an objective, primarily used for diversification. The value of your share of the fund equals the underlying value of the investments.
  • Exchange Traded Fund (ETF) – is a mutual fund, but traded on a stock exchange, typically more tax-efficient than a mutual fund
  • Closed-end Funds – a mutual fund, but the value of the mutual fund can deviate from the underlying investments. This is also traded on an exchange.
  • Separately managed accounts – like a mutual fund, but instead of owning a share of the fund, you own the actual individual stocks and/or bonds in the portfolio. Typically, more tax-efficient than mutual funds.
  • Long versus short – Taking the “long” side means you own the stock and you think the investment will go up. Going “short” means you sell a stock you borrow and hope to return the stock at a lower price therefore you think the investment will go down.

Debt – a loan to an entity or individual, often in the form of a bond. In general debt is typically less volatile than equities. Price movement is based on borrower’s ability to repay debt and present value of the interest you’re receiving.

  • Commercial Paper- refers to short-term loans (less than 1 year) given to companies.
  • Residential – also called mortgage backed securities, these bonds own a pool of mortgage payment streams
  • Corporate – refers to debt issued by a for-profit corporation.
  • Consumer Asset Backed Securities – Like a pool of car loans or a pool of cell phone loans.
  • US Government – also called treasuries, the short-term bills are what we consider the risk-free rate. The US government also issues longer term bonds. US Government bonds will typically yield less than other bonds due to the perceived safety.
  • Municipal – bonds issued by states, cities and other municipalities. Typically not taxed federally and are state tax free if you are a resident of the respective state.
  • Foreign – bonds of other countries and owned in a different currency therefore involve risk of currency as well as interest rate and default risks.
  • Bond Mutual Funds – pooled investment vehicle, primarily used for ease of diversification. The value of your share of the fund equals the underlying value of the investments.
  • Bond ETF – like a mutual fund, but traded on an exchange, typically more tax-efficient than a mutual fund.
  • Bond Closed-end Funds – a mutual fund, but the value of the mutual fund can deviate from the underlying investments. This is also traded on an exchange.
  • Money Market Mutual Funds – Diversified pool of short-term commercial paper and US Government debt. Designed to be safe and not go below $1 per share, but still yield more than a bank account.

Real Estate – invested for income (rental properties) or short-term profit (think house flipping).

  • Rental Properties – can be single family homes or multifamily housing
  • Personal Use Rentals – such as vacation homes. There are some tricky tax rules with this one.
  • Commercial – renting a property to businesses.
  • Office, Retail, Warehouse- a subset of commercial
  • Personal Business use Properties – renting a property to your own business. There can many tax advantages to this.
  • Farm Land- typically leased to a farmer, but also hunters
  • Real Estate Investment Trust (REIT) – pooled investments for diversification purposes. REITs are legally required to pay out 90% of their profit so they are typically used for income purposes. Also qualified for the new Section 199A tax deduction so there are advantages to holding them in taxable accounts. REITs are typically traded on a stock exchange, but they can also be private and illiquid.

Partnerships for accredited investors – refers to the wrapper more than the investment. A partnership can be formed to invest in any type of the securities listed.

Commodities

  • Tangible (like gold, silver …). You can hold these and keep them in your house, preferably in a safe.
  • Futures and Options (Oil, Gasoline, Corn, Copper, Soybeans …). These are simply contracts that fix the future price. Originally used to hedge prices for farmers and merchants, these have become popular speculation tools, because you don’t have to take delivery of the underlying commodity.

Equity Futures and Options – These are contracts that fix a future price.

  • Puts – gives the holder a right to sell a stock in the future at a specific price
  • Calls – gives the holder a right to buy a stock in the future at a specific price

Collectibles (Art, Wine, Cars…) – highly speculative, and taxed at a higher capital gains rate than other assets. Cost to buy and sell normally requires significant price appreciation to make these investments worthwhile.

Peer to Peer Lending – somewhat newer and a subset of private debt. Borrower gets a loan from a sponsor (SOFI and like Lending Tree are two examples), but many different people can fund that loan (see Crowdfunding). For example, you can loan as low as $25 to a borrower you’ve never met to refinance credit card debt.

Private Equity – refers companies that buy private entire companies. Private Equity specialists then use their skill in management to make the company more profitable and either sell them or take them public 5-7 years later. Commonly structured as partnerships that pool money together to buy these companies. A well-known Private Equity firm is Blackstone

Venture Capital – similar to Private Equity however Venture Capital firms typically invest in startups and do not typically buy 100% of the companies they are investing in. Venture capital helps a new company to develop and ultimately to either be sold or go public. Marc Andreessen is a famous Venture Capital investor with deals such as Facebook, Twitter and Pinterest.

Hedge Funds – An Investment vehicle fund open only to accredited investors typically using very sophisticated trading techniques. The underlying investments can be anything. Warren Buffet bet that in ten years the S&P 500 would beat the majority of Hedge Funds and Warren won on December 31st, 2017. Buffett has often said the costs are far too expensive in the typical Hedge Fund. Ray Dalio (and his firm Bridgewater Associates) is an example of a well-known Hedge Fund manager.

Crowd Funding – Venture Capital for small investors. A company with a cool idea, and possibly nothing more, chooses to raise funds from small investors.Crowd Funding does not necessarily mean you get a piece of the company, it can mean you are just the first to get the product they are creating. This is still a somewhat murky area of finance.

Cryptocurrencies – Popularized by Bitcoin, a cryptocurrency is a supposed alternative to hard currency. Crypto currencies are secured by a blockchain which is a sophisticated mathematical model that must be verified by numerous computers called miners. There are many digital Cryptocurrencies other than Bitcoin such as LiteCoin, Ethereum, Ripple and many, many more. So far, these currencies have been highly volatile and unproven. Each “coin” has their own somewhat unique features. For most, there is no underlying value, contributing to the volatility.