ETF's as a hedging tool?

A while a go I wrote a post that discussed the difference between ETF’s and and Index Funds for diversification purposes … and, you know what I think about diversification.

But, for those who are just passing by the blog and thought you’d like to drop in [AJC: my regular readers will skip over this post because they wouldn’t be interested in diversification either ūüėČ ] here is an interesting article from the Tycoon Report:

If you haven‚Äôt already, you should start moving your money out of mutual funds and into ETFs (Exchange Traded Funds).¬† In my opinion, they are tailor made for the ‚ÄúAverage Joe‚ÄĚ investor to get the benefits of a mutual fund without their crazy fees.

For a detailed listing of all of the fees, etc. that come with mutual funds, you can visit http://www.sec.gov/investor/pubs/inwsmf.htm#how.

In my opinion, the only downside (for some people) with respect to ETFs may be that you can buy and sell them as easily as you can.  The reason that I say that this may be a downside for some people is because, if you are impatient or have an addictive personality,etc., then you may know yourself well enough to stay away from investments that you can easily get in and out of.

In other words, if your personality is such that you are tempted to trade without a logical reason to do so, then perhaps the difficulties (such as fees) that come with a mutual fund will prevent you from trading needlessly.  An ETF, on the other hand, may (because of their ease) encourage certain types of people to trade.  If you do not have this type of issue, then you should certainly choose ETFs over mutual funds.

I like ETFs personally because they are less risky than individual stocks.¬† As you may know, you can never totally eliminate risk, but you can reduce it.¬† You can reduce risk by hedging, diversification, and insurance.¬† ETFs reduce risk through diversification, as you’re not assuming the risk that your investment will go to zero based on the demise of one single company.

Nice summary. Here’s where I sit …¬†if you’re using the ETF for:

1. Speculation– Using an ETF (or any other ‘broad-based’ investment) as a hedge against short-term risk is fraught with danger … you are speculating. Yes, you are ‘hedging’ against the risk of any particular stock tanking (conversely, spiking) but you are really just betting with/against the whole market – if people knew where the market was going, they would be richer than Buffett. On the rare occasions that I do speculate (anything less than a 5 – 10 year outlook going in is speculating to me), I prefer to speculate¬†with options and/or¬†just a select handfull of the¬†underlying stocks.

2. Investment– Now, if I am going to invest with a 5 – 10+ year outlook going in, then I am¬†less likely to be speculating and more likely to be¬†‘saving’ or¬†‘investing’. It’s important to realize that I may not actually hold the investment for that long ( who knows what the future will bring?), but I certainly have the expectation of holding, going in. I don’t like to ‘invest’ in a broad-based ETF/Index because then I am¬†truly ‘investing’ in paper, and market sentiment/emotions. I would not be investing with the understanding of the fundamentals of the underlying business, which is the only way that I expect to ‘beat the market’ in the long-term: buy under-valued businesses that I would be prepared to hold forever, and wait for the market to ‘catch up’ to my way of thinking … this is pretty much what Buffett does (actually, did … when he was a little smaller and could make smaller investments) with the stock investment part of his portfolio. If I get it wrong, but I llike the business and it makes good profits (else, I wouldn’t have bought it … then, I don’t mind holding. If I get it right, and the price spikes up to ‘fair market value’, I may end up selling early.

3. Saving– I don’t have ‘saving’ strategies – my speculation (20%) and investment (80%) strategies seem to cover me pretty well. But, if you just want to plonk your money away¬†… either as a one-off (Uncle Harry left you some money) or on a more regular basis¬†(you have a 401k or just want to regularly save) … AND you have a 20+ year outlook, then this is where ETF’s or Index Funds finally come into play! Plonking your money into a Spider ETF or broad-based Index Fund can be better options than CD’s or Bonds. Just don’t get fancy here … the good news is that Warren Buffett also recommends this strategy for the “know nothing investor” as he calls them … he also calls it “dumb money“, but he means that in a nice way ūüôā

Now, as to selecting an ETF v a broad-based Index Fund, it’s a close call.

Finally, I was a little amused this little ‘teaser’ on the very same page as this very nice Tycoon Report article exhorting you to ‘invest’ in ETF’s; it said:

Most ETF Traders Will Lose … And Lose BIG

ETFs are the hottest new investment around, and for good reason. But many everyday investors who jump into ETFs without a proven system to guide them will lose their shirts.

Then [of course] it went on to the ‘solution’: On Thursday, June 12th, Teeka Tiwari will reveal the secrets of using ETFs to generate enormous wealth. But, there’s nothing wrong with a little good marketing …

My advice? Keep your shirt buttoned!

Are you in the habit of saving or are you in the business of investing?

If you’re in Colorado, tune your dial to KRYD FM tomorrow morning (that’s May 22) @ 7.15 am when 7 Millionaires … In Training! hits the airwaves!!

If you listen in, you’ll find out that I have a face for radio and a voice to match … c’est la vie …

Take note that I said OR … I didn’t say AND …

In fact, most financial writers/bloggers/commentators take it as a ‘given’ that you will do exactly that: save a certain % of your salary and plonk it into your 401k to get the company match and have it invested in the restricted group of managed funds offered by your employer and/or 401k provider.

They’ll recommend that you dollar-cost-average your way into, say,¬†a low-cost Index fund … and, you’ll be surprised to know that I agree and so does¬†Warren Buffett:

What advice would you give to someone who is not a professional investor? Where should they put their money?

Well, if they’re not going to be an active investor – and very few should try to do that – then they should just stay with index funds. Any low-cost index fund. And they should buy it over time. They’re not going to be able to pick the right price and the right time. What they want to do is avoid the wrong price and wrong stock. You just make sure you own a piece of American business, and you don’t buy all at one time.

Now, I agree that this is indeed an elegant and simple long-term SAVING strategy for the Average Joe who thinks that they can save their way to wealth … $1 million by 65 … whoohoo!

But, if you want more (and, you probably should), then you have to move to Part B i.e. get¬†“in the business of investing” …

That usually means one – or, for the rare genius,¬†a combination of –¬†four things:

1. Get in the business of running a business (that’s what¬†Warren Buffett¬†does … contrary to popular belief, he is primarily a business owner … he¬†owns or controls¬†76 major businesses!)

2. Get in the business of learning about and selecting a FEW individual stocks (that’s what Warren Buffett does … he¬†owns / has owned¬†stock in Coca Cola, Kraft and many others)

3. Get in the business of learning about and actively investing in real-estate (that’s what the rehabbers, flippers, foreclosure experts, etc. do)

4. Get in the business of climbing/clawing/backstabbing your way to the very top of the corporate ladder (that’s what America’s Fortune 500 CEO’s do)

Usually, it means choosing just ONE of these as your main Making Money 201 path to income – at least, that’s what I did – then choosing a SAVING strategy to convert that income to passive assets to keep your wealth growing and fund your eventual retirement:

I was in a corporate job for¬†nearly 10 years … after about 6 years, even though I was doing ‘very well’ (for my age, position, seniority, etc.) I realized that Option 4. wasn’t for me – I would never become a CEO of somebody else’s company.

I didn’t know much at all about either 2. or 3. but I did have a sudden urge for Option 1. – so that’s what I chose!

My first business was a bit of a ‘sleeper’ – it started its life as a very small (and new … I joined one year after inception) family business and grew fairly slowly. Because it was barely breaking even, I bought the family out and managed to get it to grow rapidly and substantially.¬†I still keep it 15 years later, although, it has run very well without me for a number of years now.

I used the profits from that business (the nice little cash-cow that I turned it into) to fund a few start-ups, most of which I subsequently sold.

But, when all of these business were¬†running, I SAVED a good proportion of the profits in various¬†‘savings’ vehicles: mainly real-estate and a little (at that time) in stocks … none in funds.

Why do I say ‘saved’?

Because I didn’t ‘actively invest’ in them … I wasn’t in the business of investing … I was simply in the habit of saving.¬†I happened to¬†select a non-standard mix of savings vehicles to put my money into (e.g. real-estate and stocks,¬†rather than CD’s and¬†Funds)¬†… then I held on to them¬†… and let time (and the markets) take care of the rest. Because I could put so much in, I eventually got so much out.

It was a Making Money 101 strategy.

My % returns from the businesses were spectacular … my % returns from my ‘savings’ were ordinary … yet, each played a critical part in my current financial success. Interestingly, my overall $ returns from both were excellent!

In the last few years, as I geared up for my ‘retirement’, I have revisited these options and moved away from business and to investing … because I gave myself so much exposure to both real-estate and stocks over the years, I have built up the skills in both to allow me¬†(for some time, now) to actively (as well as¬†passively) invest in both as¬†a Making Money 301 wealth protection strategy.

But, if you want to become financially free, at a relatively young age, with a relatively decent passive income (you’ll have to plug in your own numbers), then you will need to find¬†one of these four options¬†that interests you, and hope that it delivers spectacular returns for you …

… for most people, Warren Buffet and I also agree that it’s unlikely that it will be in stocks, at least according¬†to this little exerpt¬†as reported by¬†Soul Shelter¬†(whose brother, Charles,¬† attends Berkshire Hathaway events in Omaha each year) who¬†relayed this anecdote from Buffett‚Äôs 2006 shareholders‚Äô meeting”:

One shareholder asked a question along the lines of ‚Äėhow should I study investing in order to build wealth in my spare time?‚Äô

Buffett replied that, for most people, the bulk of their income is going to come from earning power in their chosen profession. Therefore, from the standpoint of building wealth, free time is better spent sharpening one’s professional skills rather than studying investing.

This statement applies directly to my Option 4.; it equally applies with a little modification to any of the other options (e.g. Option 1: … for¬†some people, the bulk of their income is going to come from earning power in their chosen business. Therefore, from the standpoint of building wealth, free time is better spent sharpening one‚Äôs business skills rather than studying investing).

In other words, select where you will make your money, and focus all of your energy, research, and attention into that … focus!

Of course, if you’ve decided that your financial future lies in the business of investing then here’s what you should do:

Do not as Warren says … do as Warren does!¬†

PS We were featured in the Q&A for the latest Carnival of Finance; visit it here: http://moneyandvalues.blogspot.com/2008/05/carnival-of-personal-finance-153-q.html