Do you subscribe to the greater fool theory of investing? That would be buying a stock at a certain price without knowing about the fundamental or technical attributes, then realizing that it’s going to tank. You promptly sell the stock to someone else believing this person to be the greater fool. It’s all about strategies, so here are some of the ones I have used in my investing lifetime.
The 60/40 split: This breaks the portfolio down to 60% stocks and 40% bonds or other fixed investments. The 60/40 split strategy benefits investors who are still working and do not need to withdraw money from their investments for regular monthly expenses. The stock portion should be set up according to pyramid risk, which means a smaller allocation to stocks with the highest risk, middle allocation to stocks with moderate risk, and the largest allocation to stocks with the lowest level of risk. Investors that are younger can accept a larger percentage to the upper two risk categories. But as the investor approaches retirement when he/she will need to withdraw money on a regular basis, the stocks should drift towards dividend paying stocks and those that fit into the middle and lower tiers.
The bonds or fixed income portion should be invested exclusively in investment grade corporate bonds as these are, generally speaking, safe enough and pay better than either municipal bonds or Treasuries. If a 60/40 investor wants better yields, I would recommend a high yield mutual fund that is managed by a professional manager plus staff who are experts in the area of risky bonds. This segment of the fixed income portion should be smaller than the remainder as per the risk pyramid. If the investor needs to withdraw cash for any reason on a non-regular basis, the interest earned from the bond portion of a 60/40 split can be withdrawn for this purpose. If the date of the need is known in advance, such as school tuition and fees, overseas vacations, or a new car, the interest can be placed in certificates of deposits with satisfactory expiration dates, or in Treasuries which are easily marketable generally without much loss in capital. If no known expenses are foreseeable, some method of routinely rotating interest payments into short-term interest-bearing investments should be used to accumulate enough capital for a new corporate bond position without leaving the earnings to languish in the portfolio uninvested.
The long/short approach: The long/short approach is how most hedge funds manage their client’s assets. The approaches may vary, but the most common one is 130/30. In this strategy, the fund invests 130% of its assets—the sum of all long positions plus the sum of all short positions. The fund will acquire short positions up to 30% of the long positions, thereby investing 130% of the money paid in by clients. Short positions are in themselves inherently risky as there is no ceiling to how high the stock’s price can go and therefore no limit to the amount of loss a short position could bring with it. Further, it’s very hard to successfully execute short positions when the stock market is in a bull run driven by massive stimulus from the federal government. It takes nearly as much skill to sell short as it does to buy long. The process comes easier and should be utilized during market pullbacks only. For most investors short sales should be of short duration, as the danger of increased volume that drives a stock’s price up can squeeze short positions suddenly with adverse results. Finally, most brokers will only process short positions on a margin account, and will charge interest up to 8.5% for any cash shortfall in that account. This would mean that if a private investor wanted to use a hedge fund’s long/short approach, he/she would have to tie up the 30% proceeds from the short positions into cash earning only the bank interest the broker is willing to pay for it. If the long/short approach works best for you, pick out a good performing hedge fund and let them deal with all the risks and vagaries involved.
Income Averaging: With income averaging the investor sends a certain amount of his/her paycheck to an investment account, ordinarily one that has a planned investment approach or strategy in place. It is the easiest and best way to begin saving for the future as it requires little knowledge of high finance or stock markets. For many wage earners the 401K is a prime example of income averaging as a portion of the worker’s income is deducted from the paycheck and placed into the company’s 401K. Depending on the employer, there may be different risk levels and/or strategies for the employee to choose from. But in any case, the money is withdrawn from the employee’s pay and cannot be accessed until retirement—with a nominal number of exceptions. Income averaging is often managed by an Individual Retirement Account (IRA) or Roth which are roughly the same except for certain tax considerations—the traditional IRA provides a tax deduction upon depositing into the IRA up to a predetermined limit. This could be advantageous during the worker’s pre-retirement years when taxable incomes are usually high. The traditional IRA then taxes the withdrawals during retirement when taxable incomes are usually lower. The Roth account is not taxed upon withdrawal, but it does not provide the handsome tax deduction upon deposit either.
The retirement income approach: When any worker retires from his/her job, sells a business, or otherwise discontinues the revenue stream that has been sustainable for most of their adult lives, a retirement income approach is necessary. Retirement income can begin with Social Security, a pension, a military or government retirement, or some other income stream other than a person’s savings. It then should be augmented with regular or scheduled withdrawals of whatever savings plan the investor has used over the actively working years. In virtually every case these withdrawals will include income earned by the investment account regardless of strategy, and also potentially some of the principal. Planning the amount of this regular withdrawal is a critical part of a private investor’s overall strategy, as withdrawing too much too soon could leave the retiree in desolation. On the other hand, not withdrawing enough could take away some of the pleasures the retiree has spent a lifetime working toward. The most important consideration to be made is that a retirement income supplement usually cannot be replaced when it is gone. So, wasting or mismanaging it could be the worst mistake of a lifetime.
One way to protect a retirement savings is to spend only the retirement investment’s income and not liquidate and spend any of the principal that earns that income. This would be most beneficial if the supplements to the retiree’s income could remain small, or at least small enough to be covered by dividends, interest, rents, or other forms of income that do not consume capital. As we age, our needs are often different and more expensive such as higher medical expenses, assisted living, higher insurance costs, and other care concerns. Careful planning can still meet these additional needs with only some liquidation of principal so that the bulk of the savings will last through most of retirement.
The Greater Fool: The greater fool in investing is usually considered to be the person who buys an investment of some sort from a person who was a fool in the first place to get into the same investment. If you were a fool for buying a nice house in what turned out to be a bad neighborhood, the greater fool might be the person who buys the house from you. The same applies to a business that just can’t make it with you managing it, so the greater fool buys it from you. In the financial crisis of 2007/8 certain investors were buying collateralized debt obligations (CDO’s) from sellers who bundled them together mixing in loans from subprime borrowers who were destined to default, making these buyers the greater fool. The last person into a stock position before it pulls back could also be considered the greater fool. If you buy any bad investment thereby taking a fool off the hook, you could be considered as the greater fool.
Conclusion: For me, the greater fool is someone who does not have any strategy in mind when investing and simply follows the herd without realizing that the herd is headed for the slaughterhouse.
Thanks David. Good advice.