Your “To Don’t” List – 5 Poor Investment Choices

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A recent insightful article I read in Morningstar Advisor – yes, you read that right. Morningstar offered something insightful – got me thinking back to all of the various investment options that we have strongly advised our clients against over the years, either in one-on-one conversations or in the pages of our newsletter. And then I thought it might be worthwhile to compile all of those pearls of wisdom in a single article. So with a liberal amount of “borrowed” content from Morningstar and our own past advice, I offer you a “To Don’t” list, investments you may do well to say “no” to:

 

1) Hedge Funds

What they are: Actively managed pooled investment vehicles with far less restriction than traditional mutual funds.

Why they are (allegedly) good investments: Because they are not restricted to the universe of stocks and bonds available to traditional mutual funds, hedge fund managers can invest in a much wider range of financial instruments and can even “sell short” to hedge against riskier investments.

Why they can be (in our opinion) lousy investments: They escape SEC oversight rules applied to mutual funds. Hedge fund managers can get away with offering surprisingly little information about the assets and trades made in the fund by claiming that the trading strategy and style are proprietary information. And typically, the fund will charge management fees of 2% of assets plus 20% of profits. Perhaps these points are why a noted economist we know calls hedge funds “mutual funds for stupid people.”

 

2) Alternative Mutual Funds

What They Are: Pooled investment vehicles that use alternative or non-traditional investments or trading strategies. They may invest in global real estate, commodities, leveraged loans, start-up companies, and unlisted securities in addition to traditional stocks, bonds and cash.

Why they are (allegedly) good investments: All of those alternatives offer an opportunity for broader diversification across asset classes not included in a typical “stock and bond” portfolio.

Why they can be (in our opinion) lousy investments: They tend to be complex funds, employing complicated strategies and trading schemes. Couple that with typically relatively inexperienced fund managers, “newbies” trying to make a name for themselves and you have a recipe for unnecessary risk.

 

3) Commodities

What they are: Goods which are in wide demand across many markets, and though available from many producers, are bought and sold with no regard to who produces them.

Why they are (allegedly) good investments: Having low correlation to stock and bond classes, commodities can offer diversification to a portfolio. They are also considered to be less affected by inflation than other asset classes.

Why they can be (in our opinion) lousy investments: Well, in reality they aren’t good hedges against inflation, but that’s not the biggest problem with them. They are lousy investments because they are non-producing assets, meaning they have no inherent capacity to increase their own value. The price of commodities is purely a function of the markets and supply and demand. Stock-issuing corporations, on the other hand, can impact their stock prices through good management and profitable operations. That is an investment worth making.

 

4) Income Strategies

What They Are: When a portfolio uses an income strategy, it invests heavily in stocks that pay high dividends and bonds with high coupon rates.

Why they are (allegedly) good investments: Many retirees who rely on their investments for income make it their goal to generate enough monthly interest and dividends so that they can withdraw earnings and “not touch the principal” in their account.

Why they can be (in our opinion) lousy investments: While it seems like a sound and sensible approach to generating retirement income, it can put the investor in far too conservative a portfolio that doesn’t generate enough income for monthly needs, especially in a very low interest rate environment like the one we’ve had for several years now. To increase income the investor has no choice but to chase the yields from longer and longer maturities or lower and lower credit, thereby increasing the risk… in some cases dramatically. Additionally, withdrawing interest and dividend earnings is not as tax advantageous as using a growth-oriented strategy that relies more on capital gains to generate income.

 

5) Annuities

What They Are: Annuities are essentially a combination of an investment portfolio and life insurance. As you pay into the annuity, part of the money you pay goes into an investment account, and part pays for life insurance.

Why they are (allegedly) good investments: Unlike most other investment products, annuities typically come with a guarantee of income for life, a very attractive feature for retirees.

Why they can be (in our opinion) lousy investments: Annuities have some of the highest fees in the entire financial services industry. You pay through the nose for protection against market downturns, but if you are young, you can weather those downturns, and even for older investors there are much less expensive strategies to give yourself just as good a probability of not outliving your money.

AUTHOR

Northstar Financial Planners

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