Personal Finance Strategies: Dropping interest rates

As a guest on the IBA English news this week, I was asked to comment on the effects the recent interest-rate drops will have on the man in the street. I feel this is an important issue, and will address it here.

As has been reported in the media, the shekel interest-rate has followed the dollar interest-rate downward, and is currently at an historic low level. This interest-rate drop is a double-edged sword - good for some, and not for others.

Those people who have borrowed money from banks are happy about the fluctuating interest rates because their monthly repayments have dropped. Those who have money in the bank, and are living off the interest, will find that their income has dropped; they will be struggling to make ends meet.

Many savers, especially elderly people, are attracted to the relative security a fixed-income deposit offers. The cost for this, however, is being felt now, as their income is dropping. The question I have often been asked is, "What alternative is there?" My answer is simple: One needs to assume a greater investment risk, but in a calculated manner. That means exposing oneself to a diversity of investments that give a higher return than money in the bank, but not necessarily exposing oneself to an overall greater risk. This is achieved by diversifying an investment portfolio into different segments that are not affected by the performance of another segment.

Examples of investment strategies that are different than interest deposits include stocks, bonds, real estate, hedge funds and commodities such as energy or gold. At first glance, an investor who is unfamiliar with such strategies may be scared off, but it is possible to access these investments by using the skills of professionals in the specific area. The easiest way to do this is via a mutual fund. By using mutual funds as building blocks, it is easy to build and easy to manage a well-diversified investment portfolio.

One area of opportunity is bonds. They are basically IOUs issued by governments or companies that carry a fixed repayment rate. As interest rates in the market drop, the value of these bonds rise. So in an environment of falling interest rates, a bond investment can be very lucrative.

I would caution, however, not to buy only one bond, as there is always the risk that a bond issuer could default. In addition, one has to pay attention when interest rates begin to rise again; the bond's value will fall.

My last comment is the most important. I suggest that everyone needs to set long-term goals, such as " retire in comfort" or "educate the children," and not focus on the short-term results. Over a long-term period we are inevitably going to encounter periods of turbulence. But that should not mean the eventual goal will not be reached. If we set such goals, and stick to the strategies, they likely will be achieved.

pbraude@anglocapital.com

Philip Braude is an accountant, personal financial planner and licensed investment marketer. He is CEO of Anglo Capital Limited.

What is Standard & Poors 500?

Also called the S&P 500, the Standard & Poors index, which most professional money managers say that they use as the benchmark against which they measure their own investing prowess, is the one that has become the dominant benchmark in U.S. investing in recent years.
Although the S&P is not really the appropriate measure of performance for bonds or the stocks of small-sized companies, nor the apt standard against which to judge international investments, the index is still used to gauge these investments’ performances anyway.
The S&P 500 tracks the performance of 500 stocks, comprised of 400 industrial companies, 40 utilities, 20 transportation companies, and 40 financial firms. A committee at S&P reviews the companies periodically and may replace up to 30 for reasons that include, for example, bankruptcy. The performance of the 500 stocks is run through a computer software program that calculates a daily measure of the market’s rise or fall as well as an overall performance figure. These are the numbers you hear reported on the nightly news, see in the newspapers, and can view on your computer screen if you log on to a personal finance Web site.
The S&P tells you the average performance of the stocks in the index. This performance is reported as both numbers and percentages. If the S&P goes up, your newspaper might report that “ the S&P went up 2 points or 6% today.” When the stock market is doing well the numbers and percentages go up. When it’s doing poorly, they go down. The S&P 500 is home to some of the hottest stocks of the late 1990s, including AOL and Dell, the latter of which gave investors an unrivaled 79.7% average annual return, not for a day, not for a month, but for 10 years. With so much fanfare, the S&P has become the index to beat for mutual fund managers. Outperforming it is cause for celebration — only 1 out of 10 mutual fund managers do so in any five-year period.

What is Indexes?

An index is a statistical yardstick used to gauge the performance of a particular market or group of investments. By tracking average prices or the movement of prices of a group of similar investments, such as small or large company stocks or corporate bonds, an index produces a benchmark measure against which you can assess an individual investment’s performance.

Think of using an index the same way that you may use a list of comparable home sales when you shop for a house in a neighborhood. If the list of comparable homes shows you that the average three-bedroom colonial sells for $189,000, you can’t expect to buy a similar house for too much less than that. At the same time, you don’t want to pay too much more. In the same respect, the benchmarks produced by an index show you a reasonable performance target. A return is an investment’s performance over time. If you’re looking at performance for a period of time, say five years, look for an average annual return. If the same mutual fund returned 10% over the course of those five years, its average annual return would be 10%. Its cumulative return, which simply totals an investment’s performance year after year, would be 50% for those five years.

If an investment’s performance over the course of a year is vastly superior or inferior to the appropriate index’s return, you’ll want to know why. Your investment may be outpacing its peers because it’s a lot riskier. A mutual fund, for example, may invest in stocks or bonds that are far riskier than other funds it may resemble. On the other hand, an investment may be lagging its peers simply because it’s a poor performer. Bear in mind, however, that you have to build a performance history over time to determine the character of a particular investment. Notice that in Figure 8-1, the mutual fund is performing below average, which may prompt you to sell that investment.

The following sections offer a look at the indexes that are likely to come in handiest as you try to determine expected performance from your investments.
Start by tracking an index that represents or follows your stock or mutual fund. After you become familiar with that index, then pick up another index to follow. Be careful not to follow too many indexes, though — it can become confusing and time-consuming.

Gold is safe investment option during choppy markets

With the stock markets on a downhill trek, a wave of panic has gripped the retail investors. In these uncertain times, you may have also found yourself struggling, and sometimes worried, on how to get the right portfolio mix and avoid the bear’s claws.

The same stands true for 45-year old Anand Sharma, who ran out of his wits after his year-long investments eroded in a matter of few seconds. If analysts are to be believed, in such turbulent phases, you can always look up to gold as an investment option not only as an insurance against the choppy markets but for better returns as well.

The Golden Scenario
With an expected slower US growth momentum, Fed rate easing, a weakening dollar, rising oil prices and heightened geopolitical concerns, gold prices appear to be firmly supported in the months ahead. Strong investor demand coupled with strong jewellery demand from Asia and the Middle East is also likely to push the prices. “In the present context, gold is expected to provide better capital appreciation, provided it is bought at a right price. It is also a good hedge against inflation,” says Mukesh Agarwal, director of Wealthcare Securities.

Strong fundamentals put aside, gold has also given a return of 18% in the first two months of 2008. “Today, it is the most recession-proof asset and is actually playing the role of insurance in the investor’s portfolio,” says Vandana Bharti, senior research analyst (commodity) at SMC.

The ETF Route
Analysts feel that in the present market conditions gold is expected to provide better capital appreciation. While the sensex has fallen more than 20% in the last three months, gold Exchange Traded Funds (ETFs) have given returns of over 25%. “If you’re looking for gold as an investment then it is better to invest through ETFs instead of holding gold physically,” says Bharti of SMC.

Agarwal explains that it has a triple advantage. The first, that gold held via ETF would be treated as a long-term asset in one year whereas you’ll have to hold the physical gold for three years to classify it as long-term. “The other two benefits are that there is no wealth tax attached and if you hold it in demat form, there are no issues about its purity,” he adds.

Gold Funds
If you’re bullish about gold and other precious metals, it can be an interesting move to buy a mutual fund scheme which in turn invests in the shares of mining companies of gold, silver and platinum. Explains, Pankaj Sharma, executive vice-president and head of business development and risk at DSP Merrill Lynch: “If you invest through an ETF, it is kept for three years and the amount of gold backing remains the same (it does not grow). However, in those three years, a gold mining company could have increased in the share price, could have given dividends and achieved higher valuation (share price) on account of corporate actions (like mergers, acquisitions).”

Agarwal also feels that investing in a gold fund would benefit more as with the increase in gold prices, the profits of gold mining companies increase manifold on account of operating leverage. Launched in 2007 in India, DSP ML Gold Fund has given a return of over 60% in last six months.

Glitter Effect
According to analysts, though gold is expected to provide very good returns this year, it would also come with higher volatility. So before you plan to invest in ETFs or gold funds, it is pertinent that you should get an outlook of dollar and crude price behaviour, physical demand for gold in the global market and performance of equity markets. “The entry time is very important while investing in gold. One should consider the seasonal pattern such as wedding seasons,” says Bharti of SMC.

Analysts caution that if you don’t understand the dynamics of the commodity markets, avoid buying through futures because when the price goes against your position (price falls after you have bought) then you have to give the difference (known as marked-to-market) immediately to the broker.

Today, all major investors have 3-15% of their portfolio in gold, and as of now it looks like an opportune time to bet on the precious metal. And exercising a bit of caution will only add glitter to your investments.

Monitoring certificates of deposit

When you invest in a certificate of deposit, you receive an actual document that indicates the principal you invested, the interest rate, the length of time of the investment, and the final amount you will receive. Some institutions include your balance information on the statements you receive from other accounts you have with them, but not all do that. Possibly the most important thing to keep in mind with your CD investment is to keep track of the dates, because right around the time your CD matures you will receive a notice giving you the option to roll over the money from that account into an identical CD. You must respond during the 10-day period just prior to your maturation date or else it automatically rolls over.

If you miss that 10-day window of opportunity to cash in your CD, your investment automatically rolls over into an identical CD account and the financial penalty for withdrawing that money before it matures can in some cases cost you the amount you gained through interest.

Keeping saving accounts monitored

Monitoring your savings account is a lot like monitoring your checking account. You receive statements from the institution (bank, credit union, or savings and loan) that tell you your balance including accrued interest. Many institutions also have a telephone number — often toll-free — that allows you to access balance information by using your account number and your personal code number. In addition, more and more institutions have online banking that allows you to access your account information from your computer. Like savings accounts, you can access your money market account balance information either by reading the statements you regularly receive, by telephone, or via Internet connection to your account.

Purchasing Mutual Funds Tips

When you are ready to invest in a mutual fund, you can either work through a broker or, in many cases, you can buy directly from the mutual fund company. Many funds offer a toll-free number for placing orders, and you can buy shares of their funds.
Unlike stocks, you don’t have to specify the number of shares you want to buy. You tell the fund company or broker that you want to invest a stated amount, and the fund or broker tells you how many shares you will get. Unlike stocks, mutual funds sell partial or fractional shares.

A mutual fund company can’t sell you shares of a fund unless you have first received the prospectus for that fund. Whether you call or request the prospectus on the Web, you have to give your name and address. Fund managers need this data to prove that they have fulfilled their obligation to supply you with a prospectus.

When you begin to look into mutual funds, pay close attention to those that come in families — preferably big families. The term family refers to companies that offer several different kinds of funds. How big is big? Think in terms of ten or more funds. You can spot these families easily by looking at the mutual fund reports in the business section of your daily paper. You typically see some kind of headline in the columns followed by a list of funds offered by a particular firm. It’s easy to spot the big families at a glance; these include Fidelity, Oppenheimer, T. Rowe Price, and Vanguard. Families of funds that charge commissions (also called loads or load charges) provide the opportunity to switch among their funds without paying additional commissions. You can save considerable money with this option over the long term. Make sure to check out this possibility.

A mutual fund has professional management, which comes at a price. You, the investor, pay for this management, either through commissions you pay when you buy or when you sell and other fees that you are billed for periodically. These fees reduce your return on investment and can run as high as 7 to 8% a year, but 2% or lower is more common. No-load funds don’t charge sales loads. No-load funds are available in every major fund category.

Although not all mutual fund companies charge commission, you need to know that the term “ load” is often used in two ways. One is to specify commission charged when you buy a fund (referred to as front-end load), and the other refers to commission charged when you sell your shares in a fun (known as back-end load).
Many investors wonder why they should pay a commission to buy shares of a mutual fund when they can buy a similar fund without a commission. The answer is that, in most cases, there’s no good reason to buy a load fund rather than a no-load fund. Several studies have indicated that the performance of the two types of funds doesn’t differ. Unless you come across that rare case in which the performance of a load fund is so superior that it compensates for the load, save your money and buy no-load funds.

Almost all mutual funds charge some kind of annual fee. Analysts tally all these up into one measure called the expense ratio, expressed as a percentage of the invested funds. Expense ratios range from about 0.75% to 2%, but a few charge as much as 7%. The fund’s prospectus discloses the current schedule of fees.
Beware of any load fund with a high expense ratio. Avoid funds that charge a back-end load. These high fees and loads are a large drain on an investment’s overall return; few funds deliver performance consistently high enough to offset high expenses.