The fourth type of risk is diversification risk, the exposure created when too much capital is placed in a single stock or series of stocks. Effective diversification requires more than spreading money around in different stocks. If all of the stocks are similar in nature, subject to the same cyclical or eco- nomic forces, or likely to rise and fall in the same patterns, the portfolio is not effectively diversified.
The risk is mitigated when capital is allocated among different market sectors such as energy, phar- maceuticals, and retail; different types of invest- ments such as stocks, real estate, and savings); and different venues such as stocks and mutual funds as a collective stock market segment of your portfolio rather than different stocks.
Markets Matched to
Investors who devote a large portion of their total investment capi- tal to the stock market will recognize the four types of risk and act ac- cordingly. It would be a mistake to invest your entire portfolio in one market or in one sector or stock. The market risk would be unacceptable for most people; lost opportunity risk would be high; and diversification risk would be very high. Only liquidity risk would be eliminated with a reckless program involving a singular investment strategy.
One effective way to diversify within the stock market is through the use of both individually owned stocks and mutual funds. Using balanced funds or bonds funds further diversifies a market portfolio between stocks (equity positions) and bonds (debt positions). While mutual funds are relatively liquid, exchange traded funds (ETFs) are types
of mutual funds whose shares trade just like stocks over exchanges. So diversification and liquidity can be achieved together via the ETF market. This solves many of the risk-specific problems stock market investors face, by reducing market, liquid- ity, and diversification risk in a single market venue.
Individuals may also want to keep a portion of their portfolio is savings, certificates of deposit, and other highly liquid money market accounts, to ensure that a portion of the total investment port- folio is available immediately. In addition, propo- nents of asset allocation are quick to point out that investors should also keep some of their money in- vested in real estate. While down payments and mortgages may be huge drains on investors, it is not necessary to set aside a large portion of capital in real estate, for two reasons. First, if you own your own home you already have an investment position in real estate. Second, you do not have to own properties directly to allocate your portfolio among stocks, bonds, and real estate. You can in- vest in real estate in many other ways. For example, buying shares in mortgage pools places you in a debt position in secured first mortgages. You can also buy shares of exchange traded funds that invest only in real estate stocks. Finally, you can also buy
exchange traded funds types of mutual funds with a pre- identified basket of stocks in its portfolio and whose shares trade over public exchanges just like individual stocks.
asset allocation a strategic portfo- lio management technique for identifying how capital should be divided among major markets (usually stocks, bonds, and real estate), based on current market and economic conditions, risk tolerance, and individual invest- ment goals.
units in limited partnerships and similar highly specialized investments.
So there are many venues for buying real estate beyond directly owner- ship of investment properties.
In any and all of these portfolio management concerns, fundamen- tal analysis applies. It is not only a stock-related function, although it is most closely associated with stocks. This is true because so many of the fundamental tests are derived from financial statements. However, in all types of investments, fundamental analysis should include tests of invest- ment viability. This is especially true in considering another form of risk that has two parts: inflation and taxes.
The inflation risk relates to the risk that inflation—the loss of purchasing power of money—will offset some or all of the profits you gain from investments. If you seek highly safe in- vestments, you may end up placing money in ac- counts whose yield is lower than current inflation.
In this situation, you lose money and suffer infla- tion risk. The tax risk is similar in the sense that you need to consider the net gains from investing after paying both federal and state taxes. These risks become especially important when consid- ered together.
One effective method for fundamental analy- sis of investments—as a starting point—is to look at inflation and taxes together, and calculate what rate of return you will need to break even. This breakeven calculation is essential, especially when your tax liability is high, because it is possible that investments will be so conservative that, on an af- ter-inflation and after-tax basis, you may lose even when the simple return appears positive.
M a r k e t s M a t c h e d t o R i s k To l e r a n c e 53
The combination of inflation and taxes is one of the biggest inhibitors to market profits. The more taxes you pay, and the higher inflation, the more you need just to break even. And the more you need, the higher the risk you need to take.
Key Point
inflation risk the risk that in- vestment net yield will be lower than inflation.
Consequently, your portfolio loses value when purchasing power (after-inflation value) is taken in to account.
tax risk the exposure of investments to tax liabilities.
Investment yield and risk should be evaluated on an after-tax basis to allow for the tax risk in the equation.
To calculate breakeven, you need to know two factors. First is the current rate of inflation. This can be found at the website of the U.S. Census Bureau (http://www.census.gov). Second is your effective tax rate. This is the rate of tax you pay on your taxable income. Be sure to consider both fed- eral and state rates. The breakeven formula is:
I
100 – T = B where
I = inflation rate T = effective tax rate B = breakeven rate
For example, if you assume a 3 percent rate of inflation, and you pay 15 percent federal plus 6 per- cent in state tax (combined 21 percent), your breakeven is 3.8 percent:
3 100 – 21 = 3.8%
Table 2.1 summarizes breakeven rates required for various tax brackets (combined federal and state) and rates of inflation.
In examining this table, you can see that the greater your tax liabil- ity, and the higher the rate of inflation, the more you need to earn from your overall investments, just to break even. This type of analysis is fun- damental because it involves a practical evaluation of profitability. When viewed comparatively among investments, and with risk levels in mind, breakeven analysis is a critical step to take. For example, in looking at two or more stocks, it is tempting to pick the one with the greatest potential for short-term price increases. But that also means exposing yourself to price volatility, a technical risk. This means that just as prices may rise, they may also fall, an example of how opportunity and risk are inescapably related.
breakeven calculation a formula used to determine the required breakeven point for investments, considering the effects of both inflation and income taxes. To calculate, divide the current infla- tion rate by the rate of after-tax income. (After-tax income is 100 minus an individ- ual’s tax rate, including both federal and state.)
In the next chapter, you will see how the basic information you find about companies—the audited financial statement—is put together and presented. This chapter also explains why you cannot depend solely on the audited statement and why you need to look beyond to ensure that the information you use in decision making is accurate and reliable.
M a r k e t s M a t c h e d t o R i s k To l e r a n c e 55
Tax Rate
INFLATION RATE
1% 2% 3% 4% 5% 6%
10 1.1 2.2 3.3
12 1.1 2.3 3.4
14 1.2 2.3 3.5
16 1.2 2.4 3.6
18 1.2 2.4 3.7
% % % 4.4
4.5 4.7 4.8 4.9
% 5.6 5.7 5.8 6.0 6.1
% 6.7 6.8 7.0 7.1 7.3
%
%
20 1.3 2.5 3.8
22 1.3 2.6 3.8
24 1.3 2.6 3.9
26 1.4 2.7 4.1
28 1.4 2.8 4.2
% % % 5.0
5.1 5.3 5.4 5.6
% 6.3 6.4 6.6 6.8 6.9
% 7.5 7.7 7.9 8.1 8.3
%
%
30 1.4 2.9 4.3
32 1.5 2.9 4.4
34 1.5 3.0 4.5
36 1.6 3.1 4.7
38 1.6 3.2 4.8
% % % 5.7
5.9 6.1 6.3 6.5
% 7.1 7.4 7.6 7.8 8.1
% 8.6 8.8 9.1 9.4 9.7
%
%
40 1.7 3.3 5.0
42 1.7 3.4 5.2
44 1.8 3.6 5.4
46 1.9 3.7 5.6
48 1.9 3.8 5.8
% % % 6.7
6.9 7.1 7.4 7.7
% 8.3 8.6 8.9 9.3 9.6
% 10.0% 10.3 10.7 11.1 11.5
%
TABLE 2.1 Breakeven Rates for Tax Brackets (in percent)