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Excerpts from
Risk Management for
Amateur Investors
by Vernon K. Jacobs
and N. Richard Fox
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Risk Management for Amateur
Investors explains
how to protect your portfolio from
market cycles, business cycles, government interference,
unscrupulous brokers, incompetant advisors, income and estate
taxes and the litigation epidemic.
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We hope this report will help some amateur investors to have a better
understanding of the many and varied kinds of risk that expose them to
potential investment losses and how they can develop an investment
portfolio that will protect their savings without requiring a huge
amount of their valuable time and attention.
An “amateur” investor is an investor who is not an
investment professional such as a stock broker, registered investment
advisor, mutual fund manager, pension fund manager or financial
planner.
We did not write this book for financial or investment professionals.
We wrote this book for shell shocked individual investors who are more
concerned about the safety of their investments than about the
correlation of risk and return in the allocation of assets within a
portfolio.
We have “blown the whistle” on some of the
practices of (investment) professionals that cause their clients to
lose money in the investment market or to pay excessive commissions or
fees for advisory services.
This book describes a system that requires investors to make a
commitment about (1) whether to pursue “opportunities” by looking for
hot tips from brokers, friends, colleagues or even from investment
magazines – or (2) whether to focus on a system of risk management to
minimize losses from a wide range of risks.
This book will include some suggestions on how to
increase the real rate of return after taxes on an investment
portfolio through informed tax management.
There are at least eight significantly different approaches to
investing, each with different goals. (1) Hot Tips, (2) Traditional
Value Investing, (3) Dollar Cost Averaging, (4) Market Index Funds,
(5) Market Timing, (6) Contrary Investing, (7) Asset Allocation, and
(8) Asset Diversification
The focus of most investors and investment
advisors is on securing the maximum possible gains or income. The
focus of this book is on ensuring the maximum possible safety for an
investment portfolio
Few investors have the time or the money required to devote to a
comprehensive analysis of different companies in order to buy a few
shares of stock.
Dollar cost averaging presumes the investor never
needs to sell or to liquidate any investments.
Will Rogers is often quoted as having said, "I'm much more concerned
about the return of my money than the return on my money."
Any information (or investment system) available
to the public is quickly factored into the market price of a security.
No one can accurately and consistently predict future prices of
investments in an efficient market.
The prices of different asset groups seldom move
in the same direction at the same time
Risk management is an organized and systematic process of identifying
various risk exposures and then selecting the most cost effective way to
deal with each risk.
There isn’t any insurance to protect investors
from making bad investments.
Most individual investors who try to use market timing end up putting
all of their money into one type of market and then the bottom falls out
of that market.
A great many tax planning strategies lead
taxpayers to assume excessive risk in the form of having too much of
their money in one type of investment or with one company.
The most important single principle for an investor is to remember
Murphy's law.
"If something can go
wrong, it will, and at the worst possible time."
Because there are many different types of risk,
assets should be diversified in as many ways.
There are at least seven categories of risk that an investor should
consider.
1. Interest Rate Risk (Rising/Falling Rates)
2. Economic Risk (Inflation/Deflation/Disinflation)
3. Business Risk (Fraud/Incompetence/Competition)
4. Market Risk (Supply/Demand)
5. Conversion Risk (Liquidity/Marketability)
6. Government Risk (Taxes/Regulations)
7. Suitability Risk
Inflation is basically caused by an expansion of
the money supply through the issuance of government debt.
Interest rates will tend to follow expected (predicted) inflation rates.
Government intervention through taxation and
regulation has substantial consequences on different investments. The
1986 tax law created a 40% loss in the value of rental real estate -
overnight.
One of the greatest risks for the high-income investor is the risk of
getting ripped off by some con man.
This may be very hard to swallow, but the "normal"
rate of return on U.S. government bonds is from 1/2% to 1.0%, without
inflation.
The real rate of return is the rate on investments after taxes and
inflation.
The highest real rate of return after taxes is
from the lowest nominal yield rate when there is no inflation.
Even though your broker may be your best friend, the broker can't make
any money unless you buy or sell something.
What is rarely discussed in investment circles is
the real rate of return after taxes. Perhaps it's because it's too
depressing to discuss.
In most cases, the higher the nominal rate of return on low risk
investments, the lower the after tax real rate of return; even to the
point of being negative.
The highest real rate of return after taxes is
from the lowest nominal rate when there is no inflation.
During the time your money is parked in a tax deductible plan like an
IRA, the taxes you would have paid are earning more income for you.
Greed leads investors to make stupid investments.
Hope causes investors to wait too long to make corrections in their
investments. Fear causes investors to make rash decisions.
One of the reasons why many investors make bad decisions is because
they lack the confidence to make independent decisions.
If your IRA trustee sells 1,000 shares of XYZ
stock and your personal stockbroker urges you to buy 1,000 shares of
the same stock, the only ones who gain are the two stockbrokers.
A system of asset diversification should include all of a family's
financial assets.
There is a great temptation by investors and
investment advisors to wait until the "hot" investment is a "sure
thing." Then they buy and often find themselves "jumping onto a
sinking ship."
You should not put more of your asset base into any one investment than
you can afford to lose, without disrupting your life style.
The income from the lower yield and more highly
liquid assets tend to be the most severely consumed by the combination
of the income tax and the inflation tax.
The need for spending liquidity is often incompatible with most of the
legal methods available to minimize taxes.
The tax favored approach is to allocate most of
the fixed-income assets to tax favored entities.
Even in the midst of a severe bear market, there are many very boring
companies that continue to produce a modest amount of dividend income or
annual growth.
There are many tax advisors who are opposed to the
use of a taxable C corporation for any reason. It's our position that
the best tax arrangement depends on the facts and circumstances.
Forcing all of your different portfolios of assets to be allocated in
the same way will expose you to excessive capital gains taxes and
commissions.
As a general rule, a highly liquid portfolio
generates a lower yield than a less liquid portfolio.
Most of the tax benefits are obtained by virtue of the form of
ownership of an asset (the entity) rather than by the actual type of
investment
From an asset protection perspective, joint
ownership can be the worst way in which to own property.
Assets in a living trust can avoid the probate process, but do not
provide any income or estate tax advantages or any asset protection
benefits. But the revocable living trust is very helpful in
managing the financial affairs of a parent or spouse during periods of
disability or infirmity.
The C corporation is the most common legal form in
which the client/spouse have accumulated most of their wealth.
As a general rule, we discourage investors from buying a deferred
annuity with pension or IRA assets. It’s like using a tax shelter to
buy a tax shelter.
By itself, asset diversification does not result
in significant income or estate tax savings.
Tax deferred investing for a period of years can have the same impact
as eliminating the tax on the investment. If you are in the highest tax
bracket, tax deferred investing is like a 50% increase in your after tax
rate of return – with little added risk.
The same rules of diversification that apply to
all assets are applied to any tax favored investments or entities.
Exempt bonds are of little value to lower income taxpayers.
Private annuities are a much discussed and rarely
used estate planning device.
Shareholders of mutual funds need to keep careful records of the annual
distributions for as long as they own the shares because those
distributions can be added to the tax cost (basis) of the fund shares
held by the investor.
The money that you pay to purchase a residence is
money that is not available to invest in the market or in rental real
estate.
Rental real estate is one of the few tax shelters left after the 1986
tax law effectively eliminated most kinds of tax sheltered investments.
Gifts of income producing assets to a child who is
over 13 can result in substantial tax free income for each child.
The family owned partnership, LLC or S corporation is an excellent way
to divide investment income among family members in order to take
advantage of multiple tax brackets and lower tax rates.
Foreign mutual funds are not an effective way for
U.S. investors to save taxes.
An irrevocable trust is an effective way to transfer taxable income to
dependent family members who are in lower tax brackets.
The primary legal use of foreign trusts today is
to insulate some assets from the litigation epidemic in the U.S., and
not to avoid taxes on the income of the trust.
The U.S. tax law is extremely generous to foreign investors who invest
in U.S. government securities or the debt obligations of U.S. financial
institutions or in the stocks of U.S. corporations. The U.S. tax law
is extremely punitive with regard to U.S. taxpayers who seek to invest
outside the U.S.
If a foreign based web site is offering any kind
of investment directly to U.S. persons, they either don’t know what
they are doing or don’t care because they are crooks.
The intentional failure of a U.S. taxpayer to include any foreign
source income on his or her tax return is a felony.
For those who are subject to extreme exposure to
litigation, a foreign limited liability company, foreign annuity,
foreign variable life insurance policy or foreign trust might be
justified.
The estate tax could consume 87.5% of an estate over three generations.
Property jointly held with parents or children is
at risk if either of the parties is sued and loses.
The historic purpose of the protection of the assets in a limited
partnership from the claims of creditors is to prevent an injury to
the other partners.
The U.S. courts will accept the flimsiest of
reasons to penetrate a trust formed for the benefit of a spouse or
children.
Because of the extreme bias of U.S. juries and judges against any
defendant who has substantial wealth, a growing number of people who
are concerned about potentially devastating lawsuits have resorted to
some form of offshore asset protection.
There are substantial tax disadvantages in the
ownership of a foreign corporation that is used mainly to hold
passive investments to earn investment income.
Due diligence is the process of investigating a potential investment.
Failing to undertake basic "due diligence" increases your risk relative
to an investment.
The process of due diligence is somewhat different
for different kinds of investments.
Excessive reliance on the FDIC insurance could be dangerous even though
it is a government agency.
Buying long term bonds at this point in time would
be like buying stocks near the peak of the stock indexes in early 2001.
A profitable company would make an average return of about 10% per year
on their invested capital at the beginning of the year.
At an inflation rate of 6% or higher, corporate
profits begin to decrease.
A lot of the junk that appears in corporate financial statements is
disclosed in the footnotes that few investors ever study.
You should be particularly wary of the stock
broker who works for one of the brokerage firms that market initial
public offerings (IPO) also known as new issues. They are under
enormous pressure to “move the inventory”.
Experience in preparing a tax return isn’t the same as having
experience in helping taxpayers to find legal ways to reduce their
taxes.
Lawyers are either the worst tax advisors or the
best.
In the brokerage business, you can’t make a good living giving
objective advice.
The life insurance industry consistently comes up
with the most creative products to help people to reduce their taxes,
but an insurance salesperson doesn’t get paid until he sells
something to someone.
Some wag once said that a financial planner is an insurance agent who
also sells securities or a stock broker who also sells life insurance
and annuities.
The best advice may be not to buy the investment
at all.
From Risk Management for Amateur Investors by Vernon K.
Jacobs and N. Richard Fox.
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