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Investment Risks to Watch Out For

Investing your money always comes with risks. But, leaving your cash in the bank with negative real interest rates means you are accepting a slow and steady decline to your purchasing power. As the stock market has continued its rally in the wake of the Financial Crisis, the chief concern of many investors (and pundits) has been market risk. Have stocks gone too high and too fast? When will be the next crash or correction? There are more investment risks to watch out for and those who are prepared are likely to avoid a lot of pain and suffering along the way.

Important Investment Risks to Watch Out For

Here are nine different risks for investors to be aware of. Each comes with its own level of risk and ways to avoid that particular risk.

  1. Market Risk
  2. Liquidity Risk
  3. Concentration Risk
  4. Credit Risk
  5. Reinvestment Risk
  6. Inflation Risk
  7. Horizon Risk
  8. Longevity Risk
  9. Foreign Investment Risk

Market Risk

Market risk is what most investors worry about. How is the economy going to affect their investments? How will the K-shaped Covid-19 Recession recovery affect their portfolio? Is the VIX telling us that the market is going to crash? The specific market risks include equity prices themselves, interest rates, and currency exchange rates. Interest rate changes have direct effects on bond prices and indirect effects on stock prices. Currency risk has to do with your foreign investments.

Liquidity Risk

One of the reasons that we warn investors about penny stocks is that when you need to sell them there may not be any buyers. In general, the larger the company the more shares they will issue and the more liquid will be their stock. Thus, your investment in a company like Apple, Microsoft, or Amazon.com will less likely to trap you in a stock you cannot get out of than a penny stock that you bought on a tip from a friend and turns out to have been a pump and dump situation.

Concentration Risk

The vast majority of investors do not have the skill set of Warren Buffett who says that if you know which stocks to pick you don’t need to diversify your portfolio. For mere mortal investors, diversifying your investments spreads the risk across market sectors, investment types, and even world markets. In fact, when a recession hits and stock prices fall in the growth stock sector they will go up with value stocks in the consumer goods sector.

Credit Risk

This risk applies to corporate bonds or even government bonds. If a company (or country) is not doing well, has had to borrow money by issuing bonds, and now is stressed because interest rates have gone up and they will have to pay a higher rate when they issue bonds again. To make sure that you will get paid for your investment check the credit rating of the company. You should get higher interest rates for companies with low credit. It turns out that if you pool lots of such junk bonds from lots of companies the higher interest rates more than compensate for defaults making such investments more profitable than bonds with higher ratings.

Reinvestment Risk

When you routinely roll over CDs, reinvest corporate bonds, or use a dividend reinvestment plan you incur reinvestment risk when the original investment is not providing a high enough rate of return. Many investors put part of their money into vehicles like US Treasuries to protect the principal but then accept the reinvestment risk of slow loss of purchasing power of that investment vehicle. In general, younger investors accept more risk and older investors who will soon need the proceeds to live on continue with such investments.

Inflation Risk

Inflation is the loss of purchasing power due to the steady decrease in value of a currency. As a rule of thumb, investors in bonds expect to make enough on their interest to stay ahead of inflation by a few percent. That has been difficult in the last few years. Real estate is usually an investment that protects against inflation as property values tend to go up and rents can be increased to compensate for the steadily decreasing value of the currency.

Horizon Risk

Are you investing for retirement in 30 years, to put your children through college in 20 years, or to start a new business in 5 to 10 years? Which is your investment horizon? Each one has a horizon risk. The long term risk is that you will be in conservative investments too early and forego the profit potential of growth stock. The shorter term risk is that you will get caught in a market crash just when you expected to have the money you had accumulated with your investments. As a rule, investors roll over their risky assets into more-conservative ones as the time comes when they will need money for retirement, kids’ college education, or investment in the business they have dreamed of starting.

Investment Risks to Watch Out For - Longevity Risk

Longevity Risk

When they set up Social Security in the 1930s the average life expectancy was 60 years for men and 64 years for women. Since the age to start receiving benefits was 65, more than half of workers were expected no to live long enough to receive benefits. Today, life expectancy in the USA for a sixty-year-old is 21 more years for a man and 25 more years for a woman. In investing, your longevity risk is that you will outlive your savings, investments, and Social Security. Thus, investors approaching retirement need to balance the risk of a market downturn versus the risks of exiting growth stocks or stocks that pay healthy dividends just when they will start needing that money.

Foreign Investment Risk

Many times the opportunities of investing offshore outshine those of staying in US markets. And, then a new government comes into power, nationalizes all of the foreign companies and drives the country into a depression. Or, your foreign company does OK but the national currency takes a nosedive and takes your investment with it. Foreign investment risk is why many investors stay at home. But, if you want to diversify offshore the options include US-based funds that track foreign regional investments.

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Crypto Bank or Pawnshop?

As noted in a recent article in The New York Times, banking regulators are concerned about companies that offer cryptocurrency loans and deposit accounts (in crypto) with potentially very high yields. Although the goal of the cryptocurrency world is to create a world in which one would never need any traditional currencies, that has not been the case until now. Companies like BlockFi offer deposit accounts, loans, and credit cards all based in cryptocurrency rather than dollars, euros, yen, or pounds. Because you need to deposit cryptocurrency with these folks in order to get loans or earn interest, the State of California raised the question with such company if they want to be a crypto bank or a pawnshop?

What Is a Bank?

In simple terms, a bank is an institution that takes deposits and pays interest, loans money and charges interest, invests to maintain obligatory financial reserves, offers debit and credit card services linked to a customer’s account and has FDIC backing for account categories and banks. Banks in the USA and elsewhere are regulated by the government because of their important role in the economy. And, all accounts are backed by a guarantee by the Federal Deposit Insurance Corporation to $250,000 per bank, per ownership category.

Is a Crypto Bank Really a Bank?

As we noted, companies like BlockFi offer loans, interest-bearing accounts, and credit/debit cards. They do not offer anything like FDIC insurance on their accounts. However, savings accounts can provide returns approaching 90% and there are no background checks for loans as everything is based on how much of a crypto currency is on deposit. Because cryptocurrencies are so volatile there is the potential for huge gains and devastating losses. Some of this potential and risk is lessened by using cryptocurrencies called stable coins which are pegged to the dollar. The biggest difference from a bank is probably the fact that crypto institutions are routinely hacked and there is no protection against loss of all of your assets on deposit.

Crypto Bank or Pawnshop

What Is a Pawnshop?

This question comes to mind because when BlockFi first applied for a banking license in California they were advised to get a license as a pawnbroker. This is because, like a pawn shop, a customer gives the crypto bank cryptocurrency on deposit and then can borrow money in dollars up to half the value of the account. A pawn shop or pawn broker is a business that loans money to people using personal property as collateral. Because BlockFi accepts cryptocurrency and not gold jewelry the folks in California who do pawn broker licenses said BlockFi did not qualify as a pawn broker.

Benefits and Risks of Crypto Banks

The benefits of using a crypto bank include not having to worry about credit checks when you want a loan, having your assets in a “currency” with the potential for exceptional growth, and not having to sell your cryptocurrency and pay taxes on your cryptocurrency profits when you need cash. The primary risk is that someone will hack the bank and take all of its assets. Then you will not have the FDIC protection afforded by a traditional bank account for a bank that goes belly up. Or, your crypto bank may be doing just fine but your cryptocurrency hits the skids and now you have a third of the value in dollars that you used to have just when you need cash.

What If the Fed Starts Issuing Cryptocurrency?

What to do about cryptocurrencies has been the subject of discussion at the highest levels including the US Federal Reserve. Fed Chairman Powell noted that if the USA had its own digital currency you would not need any of the current digital currencies. Because “you cannot fight the Fed” this could be the most compelling argument against banking with a crypto bank!

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Defensive Investing Strategies

The stock market keeps going up despite the Delta variant wave of Covid-19 and the bull market that has been going on since the depths of the Financial Crisis continues. But, as investors keep driving the S&P 500, NASDAQ, and DOW to new records, many are employing defensive investing strategies. Defensive investing strategies are not so much meant to grow your portfolio as to prevent losing what you have gained over the years. Common defensive investing strategies include blue chip dividend stocks, short term US Treasuries, AAA Bonds, diversification across countries and market sectors, and keeping a portion of your assets as cash. Additional measures include trading options to hedge investment risk.

Investing in Dividend Stocks

Companies that have been paying dividends for decades and even more than a century are typically secure investments. When the economy sours, the stock market falls, and investors look for safety they typically buy companies that sell consumer staples, are in the health sector, or have amazingly strong balance sheets. These companies commonly pay dividends as well. If you have put part of your portfolio into a strong dividend stock before a market correction or crash you will typically see a bit of appreciation as other investors pile in later.

Investing with Treasuries and Corporate Bonds

US Treasuries are generally considered to be the most secure interest-bearing investment vehicles followed by AAA corporate bonds. A problem with this approach is that with increasing inflation and interest rates as low as they are today, you are saving with negative real interest rates. Your choices are to use long term treasuries or bonds to get higher interest rates or go very short term and accept extremely low rates. With this approach you will protect your dollars but not necessarily your purchasing power over time. The good part is that if the market does crash, you will have cash to pick up bargains as the market bottoms out.

Defensive Investing Strategies - AAA Bonds

Portfolio Diversification as a Defensive Investing Strategy

Many investors put their money into several US market sectors as well as abroad in order to benefit from where the growth is. Many also diversify in this manner so that investing mistakes in one sector are hopefully offset by growth in another. The best way to do this for most investors is to put your money into one or more ETFs that track the S&P 500, one or more of its sectors, and foreign markets. A problem for the average investor is that they have a “day job” that takes up the majority of their work day. This makes it difficult to adequately follow more than five or so investments. The ETF approach makes this less of a chore.

Defensive Options Trading Strategies

An approach used by professional investors, as well as options traders, to protect stock positions is to buy puts. A put is an option contract that gives the buyer the right to sell a stock at its contract price (strike price) at any time during the duration of the contract. The buyer is essentially purchasing insurance against the stock (or ETF) being taken down in a correction or crash. If the bottom does fall out of the stock price, the put buyer can execute the contract and sell the stock at the strike price even though it may have fallen ten or twenty percent. Alternatively, they can sell the contract to exit and get cash.

Three Versions of Defensive Puts

The basic defensive put strategy is to buy one more put contracts on the stock that you want to protect. Each contract is for 100 shares.  Depending on how much of a loss you are willing to accept before having the put kick in, you can pay quite a bit for the contract or not very much. Assuming that you hold a lot of the stock and that you set your strike price rather high, this can get to be expensive if you continually roll over the contracts to continue the protection. There are two approaches that make this less expensive.

Synthetic Short Stock

If you are certain that your stock is going to fall in price, you can use a synthetic short stock approach. In this case, you buy a put but also sell a call. While the put you sold gives you the right to purchase the stock, the call contract gives the buyer the right to buy the stock from you at the strike price of the contract. You set this up with the same strike price for the puts and calls and the same expiration date. The premium that you receive for selling the call contract will reduce your cost for the trade and may even leave you with a small credit. If the price goes down you can treat this strategy like a protective put and if it goes up the buyer will execute the contract and you will sell the stock for the strike price. Although this approach is cheaper than a simple put, there are a couple of issues.

defensive investing strategies - protective collar

Protective Collar

This approach is the same as the synthetic short stock route but it has two advantages. First, it is cheaper and second, it protects you from selling your stock due to normal market fluctuation. A protect collar sets the put and call strike prices at different levels. The put is much lower than the current stock price and the call is much higher. Since the put and call are out-of-the-money, they are cheap. Thus you can use this approach over the long term if you choose to. And, because you set the strike prices far enough apart, you will not end up selling the stock just because the market fluctuates a little and then see the market stabilize.

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Hedging Your Investments with Index Futures

Investing in the stock market can provide an excellent return on investment over the years. Simply by purchasing shares of the SPY ETF one can match the performance of the S&P 500. However, the stock market, not to mention individual stock prices, can be volatile. Bull markets tend to be followed by bear markets before bull markets re-emerge. One of the ways that you can protect yourself against short term loss is by hedging your investments with index futures.

What Is a Futures Contract?

A futures contract is an agreement entered into via a futures exchange in which the buyer takes on the obligation to purchase a security or commodity asset at an agreed upon price at a future date. The seller accepts the obligation to sell that security on the agreed upon date no matter what the market price is. If a person does not exit the contract before expiration they are obliged to buy or sell as specified in the contract. However, most futures traders and investors hedging their investments with futures exit by selling if they had purchased and buying if they had sold. Because the price of the futures contract will generally have gone up or down, the person will have made or lost money. The point of hedging your investments against loss with index futures is to make money by selling index futures and cover the losses in your portfolio.

How Do You Hedge a Stock Portfolio With Futures?

What stock investors are worried about is that the market will correct or crash and that their stocks will lose value. Index futures are commonly used to hedge against loss in a market downturn.  This is because an index like the S&P 500 moves up and down with the economy and generally runs parallel to a basket of large cap stocks. By selling index futures such as for the S&P 500 the investor protects against a downturn as the futures contract will increase in value if the index falls. Rather than waiting for the contract expire the investor will exit the contract by buying and use the profit to offset portfolio losses.

Hedging Your Investments with Index Futures

What Are Index Futures?

Index futures are cash settled futures contracts on indexes like the S&P 500, Dow Jones Industrial Average, or NASDAQ. Most of these contracts settle quarterly in March, June, September, and December. The futures market trades nearly 24 hours a day with a brief break for settlements six days a week. The S&P 500 futures contract is the most heavily traded index future. The SP contract is the base futures contract for the S&P 500. Multiply the S&P 500 by $250 to get its price. As of this writing, the S&P 500 is 4441.37 which makes the SP contract worth $1,110,342.50. The E-mini future contract is a fifth of the SP contract making it worth $222,068.50. If you choose to trade index futures to hedge your stock portfolio you will need to have money in your brokerage account to cover the necessary margin. In general, the amount needed for margin for futures trading is less that needed for day trading but it needs to be enough to cover your obligations as the market progresses. The CME requires at least $6,300 in maintenance margin for overnight trading of futures and most experts suggest the traders only risk one or two percent of account equity on any given trade.

Is It Better to Hedge Risk with Options or Futures?

Depending on the strategy that you use, both options and futures can add risk to your investment life instead of taking it away. If you are interested in hedging your investments with index futures or options you need to be clear about your strategy, understand the risks, and pay constant attention. If you are unable or unwilling to do this, both approaches can lead to trouble. Because when you buy a call or put option you have the choice of exercising the contract or not, this is commonly a safer route that futures where you are locked into the contract unless you exit at a loss.

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Saving With Negative Real Interest Rates

As historically low interest rates persist and inflation accelerates, saving with negative real interest rates becomes increasingly futile. In this article we take a look at real interest rates and how to save and invest in the current era. We have written about how negative interest rates can affect your investments. For now rates are not likely to go negative but also the Fed appears to be in no great hurry to raise rates despite inflationary pressures. Thus, many are confronted with the problem of saving with negative real interest rates for the foreseeable future.

What Are Real Interest Rates?

The return as measured in purchasing power that an investor receives for an interest rate investment (bank savings, US Treasuries, bonds) is the real interest rate. Simplistically, this is the rate of a savings account, CD, Treasury, or bond minus the rate of inflation. In an article about how now is a terrible time for savers, The New York Times notes that savers have two choices. One is to keep their money safe with interest rate investments like CDs and Treasuries and accept that they will be losing purchasing power on those investments. And, two is to continue to invest in stocks with the potential for a greater return on investment along with the risk of the stock market correcting or crashing with substantially greater losses.

Saving With Negative Real Interest Rates
Real Interest Rates for Inflation-Adjusted Bond

What Is Your Rate of Inflation?

The rate of inflation that you experience will depend on what you need to buy. If you are in the market for a new home, prices are up 15% year on year since 2020 and if you need to buy lumber for an addition to your home, expect to pay 400% more than last year for the same materials. Used cars are up as are new cars as chip shortages have cut back on new car production. But, if you own your home and expect to drive your car for years, you are better off. Costs of health care, insurance, and medicines are rising at a rate faster than the reported 2+ percent of inflation. If you are employed in a growing business sector you can expect to see your wages go up to compensate for inflation. If you are retired, you can expect to need to count your pennies more and more over the years.

What Can You Do About Negative Real Interest Rates?

According to Investopedia inflation eats away at your retirement. Despite yearly inflation, the government does not always increase Social Security payments every year and when they do they use an index that is more appropriate for younger people and not old folks for whom things like health care are major parts of their budget. Standard advice for those going into retirement has always been to rotate more and more of your portfolio into interest bearing vehicle such as bonds, CDs, and Treasuries. The rationale has always been that retirees cannot afford the risks associated with all of their wealth being tied up in stocks. However, today it would appear that retirees cannot afford to see their wealth being eaten up by the corrosive effects of negative real interest rates.

Stable dividend stocks, utilities especially, have traditionally been part of retiree portfolios. Today, the safest way to invest in the stock market is probably to use dollar cost averaging and invest in an ETF that tracks the S&P 500. The SPY which tracks the S&P 500 passes through the dividends that are paid out by the stocks it invests in. The current rate is 1.26% per year. The point is to retain a steady cash flow along with appreciation in value to your portfolio in an attempt to stay ahead of inflation and avoid just saving with negative real interest rates.

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Lithium Mining Investment Issues

As the world moves steadily towards electric vehicles and efficient means of storing energy with batteries, lithium batteries have become a major player. Lithium batteries are rechargeable repeatedly, light weight, and can store large amounts of electric energy. They are used in car batteries and that use is expected to go up to ten times the current use by 2030 while GM, Volkswagen, Tesla, and others bring more and more electric vehicles into service. While the USA has abundant sources of lithium only one lithium mine exists in the USA producing about 2% of current production. Lithium mining investment issues will become increasingly important as the USA moves to both mine more lithium and manufacture lithium batteries domestically for domestic use.

Domestic Lithium Battery Supply Chain

Currently, two-thirds of the world’s lithium batteries are made in China. As the USA found out in the early stages of the Covid-19 pandemic, disruption of supply chains for foreign-made products can lead to manufacturing halts, loss of business, and other painful results. As the USA and China increasingly compete to dominate the global economy, the USA is moving to develop supply chains for products like lithium batteries that will not be at risk due to trade disputes or power play supply cutoffs. In short, mining lithium and producing lithium batteries in the USA has become a national security issue closely tied to the health of the American economy.

Problems with Mining Lithium in the USA

The New York Times wrote about the lithium gold rush to power electric vehicles. While lithium batteries are part of the answer for a greener future, lithium is a mixed blessing when it comes to mining it and the other minerals, like cobalt, needed to make lithium batteries. One of the projects they write about is a proposed lithium mine project in Nevada called Lithium Americas that has drawn criticism.

But the project, known as Lithium Americas, has drawn protests from members of a Native American tribe, ranchers and environmental groups because it is expected to use billions of gallons of precious ground water, potentially contaminating some of it for 300 years, while leaving behind a giant mound of waste.

It turns out that while the USA has lots of lithium reserves, traditional mining of these reserves can have very “non-green” side effects when the point of using lithium batteries for cars and energy storage is to create a “greener” world. From an investor’s viewpoint, national security concerns will probably overshadow many of the environmental concerns for many projects. However, not all sources of lithium and not all ways of extracting lithium are as problematic as the Lithium Americas project.

Lithium Mining Investment Issues - Open Pit Mines

Extracting Lithium from Brine

Lithium is found in brine deposits and this is where much of the lithium “mined” in South America comes from. A new process that holds promise for extracting lithium more efficiently and economically may also hold promise for investors. Lilac Solutions has developed ion exchange beads that can be used to more-efficiently extract lithium from salt brines without the many polluting issues related to traditional lithium mining.

Lithium Mining Investment Issues - Ion Exchange Extraction

A site where investors plan to try this approach is the Salton Sea in Southern California. The sea sits atop an extinct volcano and the plan is to build geothermal power plants that by them themselves will generate income and pay for the extraction process of taking lithium from the hot water from 4,000 feet below the surface as is passes through the power plant. Because salt brines contain large amounts of lithium, this approach may be a more commercially and environmentally feasible way to extract large amounts of lithium than traditional mining.

While Lilac Solutions is a privately owned company they don’t do the mining. They produce the means for ion exchange lithium extraction from brine. We suggest that while the stampede begins to mine lithium and build battery production facilities in the USA that investors consider lithium mining investment issues such as those associated with traditional mining when choosing where to invest their money for a greater profit with fewer problems.

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Investing With Synthetic Stock

When we talk about synthetic stock we are really talking about stock options. Synthetic stock is a way to establish a long position in a stock with substantially less investment capital than if you want to buy the stock outright. Synthetic stock also carries risk. “Buying” synthetic stock is done by purchasing calls on the stock in question and then selling puts on the same stock in order to reduce the cost of the calls. The cost of this approach is less than buying calls and greatly less than buying the stock. The risk of investing with synthetic stock lies in the possibility that the stock will fall in price.

Understanding Calls and Puts in Options Trading

If you are interested in investing with synthetic stock you need to start by understanding calls and puts in options trading.

What Is a Call?

A call is an option contract in which the buyer gains the right to purchase a stock at the price stated in the contract, known as the strike price. He or she can do this at any time during the duration of the contract for an American style option and at the end of the contract for a European style option. The seller of the call contract earns a premium but takes on the obligation of selling the stock at the strike price if the buyer exercises the contract. With a long-term options contract such as a LEAPs option that can run three years the buyer may simply choose to leave the contract open as the stock price goes up.

What Is a Put?

A put is an option contract in which the buyer gains the right to sell a stock at the price stated in the contract, the strike price. For American style options this can be at any time during the duration of the contract and for European style options at the end of the contract. The seller earns a premium for which he or she takes on the obligation of selling the stock at the strike price even when the stock has fallen significantly in price, creating a substantial loss.

Basically you buy a call or sell a put when you think a stock will go up in price and you sell a call or buy a put when you think that the stock will fall in price.

Using Call Options to Invest

Because we are talking about investing with synthetic stock, we are talking about using call options to invest. A good example for investing with synthetic stock is Amazon.com. The stock has had a great run and the company has dominant positions in all of its business sectors. As such it would seem to be a great long term investment. One of the problems is that Amazon.com stock sells for more than three thousand dollars a share, $3,292 as we write this. However, one can purchase call options on Amazon.com for substantially less than what it costs to buy the stock. How much less depends on the strike price that you choose. Calls that are substantially “out of the money” because they are priced much higher than the price of Amazon.com today can be purchased for pennies a share.

What Happens When You Buy Synthetic Shares?

In order to make money using call options to invest, you need to buy enough options and hold them long enough for the strategy to gain a reasonable profit. LEAPs call options can be contracts that run up to three years. However, you are tying up your money for three years too. To further reduce your investment you can also sell put options. This is what happens when you buy synthetic shares. You are buying call options in expectation of a profit and selling put options to reduce the cost of the investment. Provided that the stock, like Amazon.com goes up in price over the next couple of years you will gain a profit similar to what you could have gained by buying the shares but you will have done so for a greatly reduced price.

Is Investing With Synthetic Stock Safe?

Options trading can help investors leverage their investment capital which is what happens when investing with synthetic stock. But, some options strategies carry a risk. Selling puts to allow you to buy more call options and control more shares also puts you at risk of loss if the stock falls unexpectedly in value. If we look at where Amazon.com was five years ago at $772 a share and where it is today $3,392 a share, we can see how well a synthetic stock strategy can work for some who gets in before a nice rise in a stock price.

Investing With Synthetic Stock - Amazon 5 Years
Amazon.com Last Five Years

But, if we look at just this last year, when Amazon.com started at $3,191 a share and has peaked at $3,531, $3,443, $3,471, and $3,719 only to land back at $3,292 today, we can see the risk of investing with synthetic stock. This investment strategy offers a way to leverage a small amount of investment capital into huge profits but comes with the potential for huge risk.

Investing With Synthetic Stock - Amazon 1 Year
Amazon.com Last Year

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How SPY Investing Works

Since the depths of the Financial Crisis the S&P 500 has gone up from 825 to 4441 today. Because of how well the S&P 500 has done over the years, many investors have chosen to invest in this index rather than choose individual stocks. Since you cannot buy shares of the S&P 500 index, what can you do? The choice that many investors make is to buy shares of the SPDR S&P 500 Trust ETF or SPY, an ETF that tracks the S&P 500. How SPY investing works is just like buying individual stocks except that you are investing in the 500 largest publicly traded US companies.

What Is the SPY?

The SPDR S&P 500 Trust ETF or SPY is a popular way to trade the Standard & Poor’s 500 stock index. Because of the breadth of its constituents, the S&P 500 is considered a benchmark of the US economy. When one invests in the SPY they do not have any individual stock-specific investment risks. Rather, the S&P 500 and therefore the SPY is driven by factors that drive the entire economy. Because the SPY is an ETF in which you can buy and sell shares, the “overhead” is less than with something like a mutual fund or paying someone to manage your investments. Commonly investors use dollar cost averaging to add to their SPY investments.

Is It Good to Invest in SPY?

Many investors do not have the time or the expertise to successfully pick and track stocks to invest in. And, the S&P 500 and therefore the SPY have beaten many managed investment services over the last few years. The overhead is low. Because you do not need to do a lot of research before investing in SPY you are saving time. Because the S&P 500 keeps going up, you are making money by investing in SPY. So, is it good to invest in SPY? Yes, it is. In fact, Warren Buffett suggested that most investors would be more successful with this sort of approach because they do not have the time or expertise to successfully pick stocks and time purchases.

How SPY Investing Works

What Is the Minimum Investment for SPY?

Because the SPY lets you buy fractional shares, you can invest as little as $1 in SPY. The fractional share aspect is good when you use dollar cost averaging because you do not need to calculate just how many shares to buy every pay period, month, or quarter. As of August 10, 2021, the SPY goes for $442 a share. This price in dollars is about a tenth of the S&P 500 index which is 4432 at the same time that SPY trades at $442. When you buy shares or fractional shares of SPY you also pay fees and commissions but you do not pay management fees like with a Mutual Fund or managed account.

How Do You Invest in SPY?

As with all stock investing you need to go through a stock broker. You can do this online with someone like TD Ameritrade, Fidelity, Charles Schwab, Interactive Brokers, or E*TRADE. Simply set up a brokerage account and add money to the account. If you want an investment that tracks the S&P 500 you will be able to choose between various mutual funds and ETFs. If your choice is the SPY, simply choose that and make your investment.

Is the S&P 500 a Good Investment?

A good investment should be one that makes money, has limited or no risk, does not cost a lot to maintain, and falls within your time and ability to manage it. An investment that tracks the S&P 500 and especially the SPY win on all points. You may choose to limit your investing to the SPY or you may use the SPY as a proxy for the S&P 500 for the “conservative” part of your portfolio. In either case an investment vehicle that tracks the S&P 500 is a good idea for most investors.

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The VIX as a Guide to Your Investing

The VIX or so-called “fear index” is an indicator of near-term stock market volatility. Using the VIX as a guide to your investing can keep your portfolio out of trouble and result in profits. Since this indicator focuses on the options market 23 to 37 days hence, it is a better tool for guiding short and medium term investing more so than the long term. Never-the-less, long term investors commonly step into the market to pick up bargains during downturns which makes the VIX a useful tool in alerting these investors as to when a correction will be coming.

What Is the VIX?

The VIX or fear index is the CBOE Volatility Index. It was created by the Chicago Board Options Exchange and shows options market expectations in real time. It assesses near-term expiration (23-37 days out) options for the SPX index which in turn tracks the S&P 500. It indicates apprehension in the wider market and gives a heads up for coming market volatility, either up or down. The VIX doesn’t say which way the market is going. It just indicates volatility in the coming days.

VIX Calculation

The VIX is arrived at daily by a complex calculation. It uses SPX put and call options that expire 23 to 37 days out and generates a volatility measurement for the next 30 days. Using options prices to determine volatility is one of two means of measuring volatility. The VIX looks at prices of calls and puts within the time frame measured and uses that information to tell us what the options market expects. The calculation is complex and has been updated from its original form. By checking a range of strike prices of the dates sampled it provides a real-time measure of expected volatility.

Volatility and Your Investments

The stock market corrects by 10% or more about every two years on the average. Stock market crashes of 20% or more happen every decade or more often, on the average as well. Meanwhile, the market and individual stock bounce up and down as market sentiment drives them. Market volatility may mean investment risk but also can lead to significant profits. Long-term investors watch stocks during volatile markets and compare market prices with projected prices based on intrinsic stock value. They pick up underpriced stocks that have been dragged down by market panic and enjoy the fruits of their investing for decades as these solid stocks continue to grow and produce solid cash flow. The bottom line is that you can use the VIX to spot volatility and then scout for bargains.

The VIX as a Guide to Your Investing

What is a Normal VIX?

First of all, market volatility comes and goes, so a “normal” VIX simply is any number that reflects current market expectations. An “average” VIX in an average market runs between 12 and 22. A VIX less than 12 is seen in a very quiet market and any VIX above 23 goes with increasing volatility. It is important to realize that the VIX is, to a degree, self-correcting. The market looks volatile. Options traders hedge their bets and the VIX goes up. Investors and traders adjust their tactics based on the expectation of increased volatility and thus volatility generally goes down. This is, in fact, “normal” VIX behavior.

Can You Buy the VIX?

The VIX is an index just like the S&P 500 whose call and put options it tracks to make its calculations. As such you cannot buy or trade the VIX directly. But, just like you can buy or trade the SPX which tracks the S&P 500, you can buy shares of ETFs and ETNs that track the VIX. But, while you could buy and hold shares of any of these ETFS or ETNs, you very likely do not want to, EVER! These instruments are useful for short term traders in stocks, futures, and options. Because the VIX goes up and down, so do these ETFs and ETNs. There are highly experienced traders who “buy” and “sell” volatility in terms of these instruments on a daily basis in search of short term profits. This is not the place for a long term, buy and hold investor to be.

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Extreme Weather and Your Investments

The forest fires in the American and Canadian West as well as historic flooding in Western Europe, China, and India have brought us to consider the relationship between extreme weather and your investments. In this case, we are not talking about the planet warming but about repeated local destructive climatic effects of that warming. As an example of an extreme weather event, we chose a 1941 blizzard that paralyzed the upper Midwest long before climate change or extreme weather events were ever thought of.

Economically Destructive Extreme Weather Event Caused by El Niño – 1941

On November 11, 1941 the Armistice Day Blizzard hit the upper Midwest. Temperatures fell from above average to below freezing, a foot of snow blanketed a region hundreds of miles North by South. 150 people died as well as thousands of livestock. In this era when no one had ever heard of climate change it was an El Niño year. Beside there being storms along the Pacific Coast of the Americas, more energy was imparted to storms into the midsection of North America.

Extreme Weather and Your Investments
1941 Armistice Day Blizzard

The point of this example is that a warmer climate is likely to generate more extreme weather events.

Economic Effects of Extreme Weather Events as Opposed to Global Warming

Global temperatures are rising according to long term measurements. Does this affect your investing? For example, the argument that higher temperatures will cause more droughts is countered by the arguments that more Northern and Southern regions will be available for growing crops and that higher CO2 levels will have a “fertilizer effect” that will increase food production.

The extreme weather that we are seeing is likely an effect of “more energy” in the atmosphere and as temperatures rise is likely to continue. Thinking about extreme weather and your investments is not such a bad idea if you want to protect your investments. Here are some of the many local risks associated with extreme weather events.

Where Are the Extreme Weather Risks?

Sea coast cities come to mind as we are seeing stronger and more frequent hurricanes with powerful tidal surges. Add these events to gradually rising sea levels and property investments in coastal cities become risky. Of the ten largest cities in the world, eight are coastal.

  • Tokyo, Japan (coastal)
  • Mexico City, Mexico
  • Mumbai, India (coastal)
  • Sáo Paulo, Brazil
  • New York City, USA (coastal)
  • Shanghai, China (coastal)
  • Lagos, Nigeria (coastal)
  • Los Angeles, USA (coastal)
  • Calcutta, India (coastal)
  • Buenos Aires, Argentina (coastal)

Insurance Risks of Extreme Weather

In 2005 hurricane Katrina hit the US Gulf Coast and generated insurance claims totaling $41.1 billion across six states. It was the largest total loss in the history of the insurance industry. July 2021 German floods have caused an estimated $8 billion in claims. California wildfires in 2020 caused $6 billion in losses. As extreme weather events become more common, so will insurance losses.

Local Agricultural Losses Due to Extreme Weather Events

While global agricultural production of crops such as wheat, corn, and soybeans will typically not vary a great deal year to year, yields in specific areas are susceptible to droughts, floods, and severe storms.

Extreme Weather and Your Investments - Flooded Crops
Flooded Cropland in the UK

As the climate warms, extreme weather events will become more common endangering local investments but not necessarily the entire agricultural sector. Large agricultural companies are diversified across food sectors and geographical areas giving them protection from extreme weather losses.

Local Extreme Weather Risks for Tourism and Construction Industries

Like agriculture, these industries are scattered across the globe. While extreme weather may be devastating in one area it will not affect others. As such investing in a hotel chain like Marriott would be safer than investing in a single hotel in one city. Likewise, investing in a construction conglomerate would be safer than in a single local construction company.

Extreme Weather and Electric Power Companies

When a recent cold snap froze Texas, natural gas pipelines froze and electric power lines were both put out of action. Businesses shut down and people burned furniture to keep from freezing. Electric utilities that do not prepare for extreme weather conditions will increasingly become investment risks. The choice that many of these companies face is to risk problems down the line or spend money now to prepare and reduce their dividends for a time.

Safe Investments as Extreme Weather Events Become More Common

Our belief is that despite a fair amount of recurring chaos associated with global warming and extreme weather events society and the economy will adapt. Setting up business right on the shoreline in a coastal city and only in that location could be risky. Avoiding investments in hurricane, flood, and forest fire-prone areas would seem to be a better idea. Companies that have assets scattered across the country or the globe will be less likely to be devastated by singular events and companies like Apple, Microsoft, Amazon, and the rest that have assets on the internet are likely to avoid any single devastating weather event. Likewise, investments in ETFs that track whole sectors or the entire S&P 500 should be decent ways to avoid having your wealth destroyed by one blizzard, dry summer, flood, or other extreme weather event.

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