Question:
I’m still concerned about municipal bond default—look, Rhode Island just filed bankruptcy. What do you think?
Answer:
Central Falls, Rhode Island began bankruptcy proceedings on Aug. 1, 2011, as it failed to come to an agreement with the Police and Firefighter’s Union on ways to meet it pension obligations to the public employees. Central Falls is reportedly the 47th municipality to enter into Chapter 9 protection since 1980. The municipality says its pension plan will run out of funds in October, as the city is reported to have accumulated an $80 million unpaid pension liability. At this pace only 6,250 more failures of the same size will have to occur this year to meet Meredith Whitney’s projected $500 billion in municipal defaults.
Basically, as we read the news reports of what happened, it seems the city needed to cut costs, and the unions were not willing to make a deal. The city opted to go into bankruptcy proceedings, which then negated all of the union contracts. Some of these bonds were general obligations of the city.
We looked back 30 years, and there have been only three prior instances of general obligations that were rated by Moody’s that defaulted. Only one that was a limited taxing authority did not pay back 100% to the bondholders. Very few bonds never get paid. Some bonds may not earn interest for five or six years, but almost always, principle is paid back to the bondholders. Overall, we maintain that municipal bonds are a good investment.
Many investors assume that bonds are a safe investment without ever examining the underlying characteristics of the bonds. It is almost as difficult to select a bond as it is to select a stock once you leave the federal government. One advantage of U.S. Treasury bonds is you know it is backed by the full faith and credit of the United States—and they print the dollars. Your fear on U.S. Treasurys is one thing: inflation.
Question:
During the last few years I, like many others, have neglected my portfolio… I’ve decided that it’s time to take back the reins. I’ve noticed I’m really overweighted in Technology (including my company’s stock). What do I do from here?
Answer:
We feel you must first consider your time horizon of when you need the money. We work with the Ten Year Rule, meaning any money needed within the next 10 years should be invested in fixed-income securities. Any money not needed within 10 years should be invested in high quality growth investments. We feel stocks are the best growth vehicle.
When it comes to stocks, you need to look at portfolio diversification. You can diversify many ways:
Value vs. Growth
Value stocks generally have low price-to-earnings ratios, low price-to-book ratios, and can provide high dividend yields, while growth stocks generally have high price-to-earnings ratios, high price-to-book ratios and may offer low dividend yields.
Market Capitalization
Large companies offer more stable books of business, while small companies have more ability to grow their earnings at higher rates.
Sector
Different industries react to economic cycles in different ways. Consumer Staples tend to hold up well as they can pass along inflation quickly; Industrials tend to be more cyclical with the economy; Energy prices often coincide with economic expansions and contractions, while Information Technology companies can have recurring revenue streams from maintenance, but business or consumer spending can be cyclical.
We suggest owning holdings in at least eight of the 10 sectors. How you choose to over or under weight each sector will have some effect on the performance of your portfolio, but we feel you should have exposure to most sectors.
We warn investors to not put all of their eggs in the same basket or similar baskets. For example, at the start of 2006, if you thought the housing market would continue its tremendous run, and you invested a third of your portfolio in homebuilders as well as a third in each Home Depot and Lowe’s, you’d be looking at a total holding period loss of 44%. Had you invested in a diverse index, such as the S&P 500, your total loss would only be 11%. Likewise, at the start of 2007, if you thought a diverse portfolio of strictly financials, such as Regional Banks, Insurers, and Credit Card Issuers, would continue to outpace the market, you would have a holding period loss of more than 70% vs. the S&P’s 23% loss.
Also, we warn investors to be wary of holding too much of your company’s stock. If your 401k plan includes company stock as an investment, the absolute max you should have allocated to that stock should be 10%. If the company is struggling to meet its numbers, its shares likely have been hammered in the market, which then can tank your 401(k). If your boss were to tell you the company will need to let you go, not only would you be out of a job, but your savings could be gone as well.
Diversifying also offers protection from massive hits. For example, at one point, AIG was a triple-A rated company, a Dow member, and what many would deem a world-class organization. Say you invested 50% of your portfolio in this seemingly stable insurance giant before the Lehman bombshell dropped. Collateral calls on its CDS exposure forced a federal government intervention to prevent AIG’s bankruptcy. Shares that once traded at a split-adjusted price of nearly $500 in June 2008, trade around $23 today, a loss of about 95%.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
