Are My "Safe" Investments
Really Safe?
by
Joseph A. Monaco, Ph.D.
The sight of the “safe fixed-income” part of their portfolios declining in value more than the “risky stock” part of their portfolios has perplexed both professional and non-professional investors alike. How can this be?
Let me let you in on a little secret about my business. One of the most frequently asked questions that financial advisors get from the clients of other financial advisors goes something like this, “My financial advisor told me that this investment was safe, but I lost money. Did he lie to me or is he just uninformed?”
The answer to that question may also be the answer to why over the past few months the “safe” part of people’s portfolios has been the part that has been losing them the most money.
Let me fill you in on the most important lesson I’ve learned in my 27-years of investment experience: safe does not mean risk free. If someone asked me if it’s safe to drive to the mall I would say, “Of course!” And you would certainly agree, because if you thought it wasn’t safe, you would never put your kids into the back seat of your car and go to the mall. And yet, even though you know that driving to the mall is a very safe procedure, you also know that accidents can and do happen. That even with safe investments, things can and do go wrong from time to time explains how over the past couple of months the “safe part” of people’s portfolios may have performed worse than their stocks, traditionally considered the “risky part.” Well, which of the myriad of problems reported by the news is the one that made your “safe” investments decline in value?
You’ve probably heard about the billions of dollars that both commercial banks and investment banks have had to write-off due to the sub-prime mortgage crisis. But did you realize that in addition to making loans, these institutions keep an inventory of bonds? And when people and institutions want to buy bonds, they buy them from this inventory. And when people and institutions want to sell bonds, they sell them to commercial and investment banks which then put them into their inventory for future re-sale. News reports have stated that in the past year, over $500-billion has been lost by the banking system due to bad loans. Logically then, the banking industry has about $500-billion less to spend, loan and invest into their bond inventory than they did at this time last year. And although the banks have significantly less capital to purchase bonds than they did, unfortunately there aren’t any fewer bonds out there.
This affects your investment account value because when you own bonds (be it individual bonds in your account or via professionally managed portfolios), those bonds have to be priced daily. Otherwise, how could your investment firm tell you its price each day? So, every day these firms must get a “bid price” for their holdings. They get this price by going out to the market place and asking commercial and investment banks how much they would pay to buy the various investments. In normal times these banks would compete for these bonds by giving a price that they believe to be fair value; remember, these banks now have $500-billion less than they used to have. So, while they may believe, for example, that $1-million is fair value for a particular bond, if they only have $900,000 available right now, that’s all they’re going to bid. Why? Because they feel it isn’t really worth $1-million? No! Or perhaps they’re worried that the borrower won’t be able to repay them? No, not necessarily! Because they are low on cash and really don’t want to commit their money to buying an inventory of bonds when they would rather be making loans to their banking customers? YES, exactly so!
As William Shakespeare would say, “And therein lies the rub.” You see, here you are with bonds which may be perfectly good (whether in your account or in your professionally managed portfolio) and neither you, nor I, nor your portfolio manager have any desire to sell them right now. Nonetheless, since these commercial and investment banks are giving low bids for these bonds that you have no intention of selling, those abnormally low bids are what show up as the value on your brokerage account statements.
So to answer the question, “Did your financial advisor lie or is he just uninformed?” it is important to understand that there are two ways to define investment risk. Sometimes risk is defined as the probability that your investment will permanently lose its value and other times risk is defined as the chance that your investment will fluctuate in value. For example, perhaps you asked your advisor if he thought Coca-Cola (NYSE symbol KO) was a safe investment and he said yes. Well, if you were defining risk as the probability that Coca-Cola would go out of business in the foreseeable future, then the answer would be that Coca-Cola was a safe investment. On the other hand, if you were defining risk as the probability that Coca-Cola’s stock price might be lower after you bought it, then the answer would be it isn’t safe at all, because stocks can and will fluctuate in price. So the answer to whether or not your safe investments are really “safe” may depend more on you and your financial advisor using the same definition of safe than what the specific investment actually is.
Therefore, don’t necessarily be discouraged if the part of your portfolio that you thought would give you stability is currently giving you what my grandmother would call “agita.” Talk with your financial advisor about what your investments really are “safe” from and if their recent decline is from a decaying of the bond issuers finances or if it is simply from short term market gyrations.
