Something To Keep An Eye On!

Word is out that China's four largest banks: The Bank of China; The Industrial and Commercial Bank of China; The China Construction Bank, and The Agricultural Bank of China are planning to introduce a new gold ETF on mainland China sometime in the very near future.

These are huge institutions, and when China's new gold ETF debuts, there will likely be a mad rush by millions of Chinese investors who could find it difficult to buy the needed gold all at once.

So what does this mean to you if a portion of your portfolio has been invested in gold in the form of GLD - the gold ETF for instance? It means that your investment in gold is doing just fine, and if anything, this is going to be a time to buy even more!

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The Wisdom of Warren Buffett

"Wall Street is the only place that people ride to in a Rolls-Royce to get advice from those who take the subway."


Warren has always thought it strange that highly successful and intelligent businesspeople, who have spent lifetimes making huge sums of money, will take investment advice from stockbrokers too poor to take their own advice. And if their advice is so great, why aren't they all rich? Maybe it's because they don't get rich off their advice but off charging you commissions?

One should be aware of people who need to use your money to make you rich, especially when the more things they sell you means the more money THEY will make. More often than not, their agenda is to use your money to make themselves rich. And if they lose your money? Well, they just go out and find someone else to sell their advice to.

Warren feels so strongly about where Wall Street's true loyalties lie that he refuses to even look at the business projections that its analysts put together because, regardless of the nature of the business, the projections are always way too rosy.

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Inventing Success

Money may be the husk of many things, but not the kernel. It brings you food, but not appetite; medicine, but not health; acquaintance, but not friends; servants, but not loyalty; days of joy, but not peace or happiness.

-Henrik Ibsen


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Conservative Speculation

Perhaps this sounds like an oxymoron but conservative speculation IS possible, and it's done through warrants.

Simply put, a stock warrant allows you to buy a given stock for a set price at any time during the life of the warrant. When new, warrants usually run three, four, five and sometimes even ten or more years in length. Additionally, unlike with their common stock cousins, the owner has no voting rights, no say in the corporation and receives no dividends. Just the right to buy the stock at a set price during a set time period.

An example might help to explain the value of this. Let's suppose you like XYZ, Inc. Its stock is currently selling for ten dollars per share and you think it's good for twenty dollars per share in the next few years. You could simply buy a hundred shares for one thousand dollars and be done with it. If the stock goes to $20 and you sell, you've made 100%.

On the other hand, you also notice that XYZ, Inc. has warrants selling for one dollar apiece that allow you to buy shares of the company for $15 (but remember it's currently selling for $10, so the warrants are "out of the money"). But let's assume you buy the warrants anyway and the stock rises to $20 (as you thought it would) within the life of those warrants.

Your return when you sell the warrant will be four times as great. You've made 400% on the $4 rise in the value of the warrant. The mathematical bases for this - an investment concept called "parity" - comes in here. Simply put, the maximum any new buyer would ever pay for a $20 stock is obviously $20. The minimum amount any seller of a $20 stock will sell for is $20 also. Consequently, if your warrant gives you the right to buy a $20 stock for $15, the $5 difference has to show up in the value of the warrant. The warrant you bought for $1 you could now sell for $5. But nevertheless, in effect the new buyer will always pay $20 for the stock - either $20 directly in the marketplace, or $5 for the warrant and an additional $15 when exercising the warrant. The money to be made is either in buying the stock for the price ($15) the warrant allows and then selling that stock for its market value ($20), or selling the warrant for a price ($5) reflecting its increase ($4) in value. So all things being equal, parity is the invisible referee of the market place.

The biggest benefit in using warrants is - if you are correct about both the growth and the timing of the growth - you can substantially leverage your returns. (You only had to put out $1 to buy the warrant as opposed to $10 for the stock.) But the key here is the timing. If you're wrong, and the stock doesn't go higher than the exercise price before the expiration date of the warrants, then you are out of luck. The warrants expire worthless and you lose.

With the stocks themselves, a month or year may not make a difference. With warrants, this time factor is crucial. And it is the key reason to buy warrants in the first place.

So here's how to go about picking and using warrants. First and foremost, make sure you like the company you are investing in, and that careful research has convinced you it will grow.

Next, check to see if the company has warrants available. And finally, make a complete and thorough check of the expiration date and the conditions, if any, of the warrants. Do you feel the stock will grow to your target price before the warrants expire? It does you no good if the stock reaches the price you projected six months after the warrants have expired.

Lastly, and perhaps most importantly, check to see what the institutions and the insiders are doing with the company's stock. Are they buying and selling? You can find this out by checking the S&P Stock Guide.

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Hopscotching The Investment Media

The Wall Street Journal recently pointed out an interesting retirement strategy that can work for the fixed-income portion of your retirement portfolio. This is to put some money into money market funds and short-term bonds. Use that money to pay for the first five years of your retirement. In addition, buy TIPS maturing in five, 10, 15, 20, and 25 years. As each block of bonds matures, use the proceeds to pay for the next five years of retirement. This strategy will assure you that your portfolio will deliver a yield around two points higher than inflation. And you could also put extra cash in the 25-year TIPS, planning to buy a lifetime-income annuity at maturity - if your health is good.
NOTE: it would also make sense to add some stocks to such a portfolio in order to provide for growth potential.
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In Smart Money, we read that among several stock screens, the top performer in 2006 was one that looks for stocks with a high return on equity and a modest price/earnings ratio. By restricting picks to companies worth at least $1 billion, you reduce the risk that people using this screen will send up the price just before you buy. On the other hand, a similar screen (low price/sales ratios, steady earnings growth, and recent share-price momentum) actually picked losers in 2006. Reason? Too many of the companies selected were tied to commodities prices, which fell.
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Business Week tells us this is the first bull market in the past 45 years where the price/earnings ratio of the S&P 500 has contracted. In 2002, the typical S&P 500 stock traded at 17 times the next year's earnings. Today, the forward P/E ratio is 15. That means blue-chip stocks are moderately-priced and have room to run. What's more, high-quality, high-capitalization stocks are the safest place to be if the U.S. economy is heading for a soft landing - as most forecasters expect. After lagging small-caps for the past six years, large-caps may become leaders in 2007.
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Understanding Asset Allocation

Many investors mistakenly believe they can get all the diversification they need by holding a variety of different companies in their portfolios. Unfortunately, such thinking is totally off base!

Asset allocation does NOT mean diversifying among different securities. You can prove this quite easily by looking at the NASDAQ 100 which holds 100 different stocks, but has only a very slight diversification value.

Instead, asset allocation means diversifying among different classes of financial assets. Sometimes investors think of this as just dividing their money between stocks, bonds and cash. But true asset allocation goes much further.

Within the category of stocks, there are large-caps and small-caps, foreign and domestic, growth and value, etc. Then, within the bond category, there are governments and corporates, high-grade and high-yield, inflation-adjusted treasuries, mortgage bonds, etc. And the beauty of asset allocation is that it allows you to take these non-correlated assets (assets that don't move in tandem) and combine them in such a way that you maximize your returns while minimizing risk.

Here's an example of what we're talking about. If you had invested in the S&P 500 for 30 years, ending on December 31, 2001, your money would have compounded at 12.2% a year. Not bad you say?...Perhaps. But if instead of just holding the S&P 500, you asset allocated your portfolio to hold 50% S&P 500, 25% foreign stocks, 20% small cap stocks and 5% real estate investment trusts (REITs), you would have experienced less volatility, fewer down years, and beaten the S&P 500 too!

But it gets even better. You could have been even more conservative. A portfolio that was 40% S&P 500, 20% foreign stocks, 16% small caps, 4% REITs and 20% bonds would have been considerably less volatile, had fewer losing years, and still beaten the S&P 500! And none of these figures include the even higher returns you would have achieved if you had simply rebalanced the asset allocation in your portfolio once a year.

The reason it's crucial that you have this knowledge is because the vast majority of investors accept as gospel the conventional wisdom that higher returns require greater risks. They don't. Independent research on asset allocation repeatedly demonstrates this basic truth.

Unfortunately, talking about asset allocation isn't anywhere as thrilling as discussing the latest takeover target or the next hot IPO, but it hapens to be essential to managing your money intelligently. In other words, it's all about taking smart risks, not big risks.

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Glimpse the Future with the Yield Curve

While there is no definitive method of predicting the economic future, the yield curve provides fact-based clues that can help guide investment choices. And here are several questions and answers that will help you better understand how to apply the yield curve to your own investment strategy.


What is the yield curve?

The yield curve is a graphic representation of the interest rate movements of U.S. Treasury bonds of various maturities. While the rates on bonds of different maturities move independently - even in opposite directions - the curve itself depicts an overall pattern of rate movement in a single composite. And the type of curve can be an indicator of the future expansion of, or contraction in, the U.S. economy.


What types of curves are there?

1. A "normal" curve, which occurs whenever long-term rates are higher than short-term rates. This generally indicates that the Fed will be friendly toward the markets, with a steeper curve indicating economic expansion.

2. A "flat" curve, which occurs when all maturities have the same yields. This can be a predictor of an economic transition, signaling a move into or out of a recession.

3. An "inverted" curve, which occurs when short-term rates move higher than long-term rates. This often means the Fed is intentionally slowing the economy, and that investors feel interest rates will eventually move lower. A steeper inversion often accurately indicates a greater risk of recession. In fact, eight of the nine most recent bear markets occurred along with or shortly after a yield-curve inversion.


How can you use the yield curve?

If you invest in bonds, the curve can help you determine which maturities may be right for you. If you hold credit card debt or an adjustable rate mortgage, the curve can help you determine if you should consider changes in how you manage that debt. And because of its depiction of the potential expansion or contraction of the U.S. economy and financial markets, the yield curve can also help you decide how much to weight your portfolio toward U.S. equities.

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Becoming A Better Investor

NOTE: this is taken (abridged) from a column on page 28 of the January, 2007 edition of Kiplinger's Personal Finance.


Warren Buffett noted in 1999, that "success in investing doesn't correlate with IQ, once you're above the level of 25." And he's right too because investing isn't nearly as hard as most people think. And yes, proper temperament is important. But to really succeed at investing, you also need good strategy and good tactics. So as another year begins, here's a simple guide to both.

Your strategic checklist. First, decide why you're investing. You can't achieve a goal unless you know what it is. For many investors, the prize is a comfortable retirement, perhaps 20 or 30 years away. The more distant the goal, the higher the proportion of stocks you should own in your portfolio. Also, you have no business owning an individual stock (as opposed to a stock within a mutual fund) if you do not intend to hold it for five years or longer.

Second, know your pain threshold. Stocks are volatile. Standard & Poor's 500-stock index has declined in 23 of the past 80 years. The dips can be sharp, unexpected and disturbingly enduring. In one day in 1987, the Dow lost nearly one-fourth of its value. The S&P 500 fell every year from 2000 to 2002, skidding from 1469 to 880. These things happen. If you can't tolerate that kind of pain, then choose bonds over stocks, but realize that your returns will inevitably be about half as much, if history is any guide.

Third, develop a view about the economy and stick to it. If you are continually shifting your opinion of the economy, you will also be continually shifting your portfolio, and you can't be a good investor. Don't pay attention to the Fed or to the unemployment rate. If you buy for the long term, think long term!

Fourth, be a partaker, not an outsmarter. Markets are generally efficient, so do not expect to beat the historic averages by very much over time. The annualized return for the S&P 500 since 1926 is a little over 10% -- figure 9% with expenses. If you can beat that mark by one or two points a year, you are doing spectacularly well.


Your tactical checklist. Construct a portfolio and know what's in it. Stick with stocks and bonds and don't buy commodities.

Approach the investing process systematically. The exact proportions of stocks and bonds are determined by your goals, age and risk tolerance, all of which may change over time.


Balancing act. Keep your allocations consistent by rebalancing. Over time, it's likely that the value of stocks will rise faster than the value of bonds, so a 60-40 stock-bond portfolio will eventually become 80-20. To avoid this "allocation drift," you'll need to sell stocks and buy bonds. And don't forget to reallocate within broad asset categories.


Be a partner. Don't trade stocks. Think of your purchases as making you a long-term partner in great businesses. And when you buy, jot down the reason you bought and save the note to retrieve should your resolve weaken. Of course, if the business stumbles badly, new competition develops, key products fail or changes in management produce poor results, then consider selling. Otherwise, hang on to what you buy and prosper with the company.

Owning stocks and bonds inside of mutual funds or exchange-traded funds is a perfectly acceptable alternative to owning individual securities. But understand that, large-company stock funds consistently fail to earn a return equal to their benchmark. Research found that through 2005, in only three of the preceding 20 quarters did the average large-company fund beat the Russell 1000 index of large companies - even before expenses. In addition, the returns of mutual funds are more similar to one another.


Play the tax angle. Finally, remember that everything you do in investing has tax consequences. Tax rates on dividends and capital gains dropped to 15% in 2003 but are scheduled to rise again in 2011 unless Congress acts. Meanwhile, opportunities for tax-deferred investing through 401(k) plans and IRAs are expanding. What counts is what you ultimately put in your pocket.

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