Investing 201

Last issue, we told you about annuities, dollar cost averaging, capital gains, investment returns, and cash and cash equivalent investments. If you missed it, look for the article online on this site along with others in our Live Secure series.

Now that you have the basics, let’s put these in context. This article will focus on discussing how professional money managers use diversification in managing a portfolio and how those concepts can work for you.

Diversifying your investments means going beyond percentages of assets in stocks and bonds. It also extends to looking at the investment styles a money manager is using, whether the investments work across multiple investment sectors and other factors.

You already know that a mutual fund is intended to provide diversification of risk by assembling a portfolio of securities in a pool off of which you buy a share. The majority of money managers who put together portfolios attempt to diversify their investments in various ways. There are some, of course, who run portfolios composed of a very small number of securities, but even with these types of funds, there is diversification. In some cases the mutual fund portfolio manager picks investments based on the “investment style” of the investment; in some cases, the manager stresses diversification within different market sectors such as pharmaceuticals, high tech, communications, etc.

Stock funds invest in stocks. But, the portfolios differ based on the investment objectives of the fund and the fund managers’ investment style.

Investment Styles: Investment styles refer to the type of return you will get on your investment in certain stocks. The three major styles are income, growth, and value. You will find mutual funds labeled with these styles.

  • An “income” stock or mutual fund, for example, intend to provide you with a long and sustained history of paying dividends. An electric utility stock is an example of an income stock. “Blue chip” stocks are examples of income stocks. As an investor, if you hold an income stock, you are looking for steady, regular current income through the payment of dividends. An asset manager can further diversify his or her focus by using “income” stock available through “small cap” companies, for example.
  • A “growth” stock or mutual fund is expected to achieve high rates of growth in operations and earnings. For a company to achieve higher than normal rates of growth, it will generally reinvest its earnings in the company rather than paying them out in the form of dividends. Therefore, you as an investor will expect to receive low or no dividends on a growth stock. Over the long-term, however, if you hold a growth stock, you are looking for long-term appreciation in the stock price and therefore capital gains when you sell the stock. Growth stocks are inherently riskier than income stocks—high tech companies, companies with new and unproven businesses are examples of growth stocks.
  • “Value” stocks or mutual funds are considered to be under performing, that is the prices for value stocks are lower than the investment managers think they should be. An investor buying value stocks is paying lower prices than for growth stocks believing that the price of the value stocks will rise when whatever causing the underperformance is solved. A company’s stock may be considered a growth stock in some years and a value stock in others. If, for example, a company that is categorized as a growth company experiences a turnover in management that causes the stock market to lose confidence in the company (demonstrated by a decline in the value of its stock), then that company may fall into the value category. Companies will change categories from growth to value and vice versa only on fundamental changes such as management turmoil, industry problems, etc.

There are other investment styles as follows:

  • “Cyclical” stocks or funds are those that follow business cycles. Steel, housing, natural resources are types of cyclical stocks since they tend to rise or fall in value based on where the economy is. In a recession, for example, fewer houses will be built, so, the market value of building companies or lumber companies is likely to fall. When the recession ends and building of houses resumes, such stocks are likely to rise.
  • “Defensive” stocks or funds are the opposite of cyclical stocks. These are stocks that are expected to perform well even through difficult business cycles. Stocks such as those representing food companies, beverages, pharmaceuticals are considered to be defensive stocks since demand for the goods these companies produce isn’t likely to lessen based on economic circumstances.
  • “Blue Chip” stocks or funds are what you think they are. They represent the highest quality companies, those with regular dividend paying records in good times and bad. Stability is the characteristic of the blue chip company stock.
  • “Balanced” mutual funds mix income and growth stocks to offer the benefit of both.
  • “International” mutual funds focus completely on international stocks, including emerging markets.
  • “Global” mutual funds mix U.S. and international stocks.
  • “Socially conscious” mutual funds screen potential investments to meet certain social, ethical or religious criteria.
  • “Regional” mutual funds concentrate stocks in one region.
  • “Sector” mutual funds buy stocks in one industry or area of the economy.

All of the above represent investment styles or approaches to classifying stock. Investment managers of mutual funds use these classifications to assemble the portfolios of stocks in a fund.

Sectors. Sectors are ways of grouping companies that are in the same business. So, sector funds are offered for pharmaceutical stocks, utilities, high tech, and any number of different businesses. As an investor, you are offered the choice through a sector fund of buying shares of many different pharmaceutical companies so that if one company experiences a problem you hope the other companies in your portfolio will compensate for the problem and offer you stable returns. Remember, however, that if you buy a sector fund, you are a believer in the sector itself. High tech funds (particularly the dot com funds) grew tremendously over the 1990’s, but certainly have declined in market value in 1999-2000. Sector funds are volatile.

Index Funds. Index funds are mutual funds that track a particular index, such as the Dow Jones Industrial Index. The managers of these funds purchase securities for the fund that match the index. An investor buying an index fund is therefore making an investment in all the securities in the index and hopes that the index itself will grow in value over time. Index funds have been very successful in attracting investors for two primary reasons 1) the basic premise of an index fund is that the index itself will outperform most professional money manager. 2) Since there is no need to pay for a professional manager, it is less expensive to purchase an index fund.

Index funds are also interesting because there is very little risk that a shareholder will have to incur any capital gains taxes. Since the securities in an index have already been chosen and do not usually vary, there is little trading of securities in an index fund. A mutual fund may have a great deal of trading occur within it and such trading can produce capital gains that by law must be distributed to the fund shareholders at least annually.

When a mutual fund portfolio manager sells a stock at a profit, the fund incurs a capital gain that must be passed to the shareholders of the fund. Suppose the mutual fund trades a lot of securities and incurs a large capital gain while at the same time it performs poorly and loses money? The shareholder of such a fund faces the troublesome prospect of having invested in a poorly performing fund while still having to pay its share of the capital gains taxes on the fund.

In boom market times, index funds have outperformed most other types of mutual funds. This is not true in down markets, of course. There, investors have the choice of using a “managed index fund” where a portfolio manager is involved in making investment choices, but the basic securities in the fund parallel the chosen index. A managed index fund can incur the types of capital gains other mutual funds incur and pass to shareholders.

About the Author: Lyn Striegel is an attorney in private practice in Chesapeake Beach and Annapolis. Lyn has over thirty years experience in the fields of estate and financial planning and is the author of “Live Secure: Estate and Financial Planning for Women and the Men Who Love Them (2011 ed.).” Nothing in this article constitutes specific legal or financial advice and readers are advised to consult their own counsel.