Internet Safety

I found a very interesting video online that matched the theme of my last post on password security.  We all access information online nowadays and it is important to keep vigilant when connecting to important financial accounts.    Always be on the safe side when browsing the internet and make sure you have up to date security.  I  use Microsoft Security Essentials but just make sure that whatever software protection you use  is up to date.

Protecting Your Passwords and PINs

There is a surprising (or perhaps unsurprising) lack of sophistication with how many people set PINs and passwords.  A study done by Data Genetics analyzed passwords from released or exposed password tables and found that the most common 4 digit password was "1234."  "1111," "0000," and other strings of the same number were also very common.  A list of most common passwords published by SplashData include "password" and "123456."  Others on the list that might be slightly more sophisticated include "qwerty" and "qazwsx" for passwords and "2580" for PINs.  You can easily see that these just have to deal with the placement of the characters on the keypad or keyboard to help people remember them easily.  However, this makes it extremely easy for someone to just guess what your secret code is if you lose your ATM or credit card.

What's Your Allocation?

Studies have shown that a very large driver of variation in returns for portfolios is derived from different asset allocations.  Focusing on having the right asset allocation can help improve your returns on investment over time and is a more reliable driver of returns than either stock picking or market timing.  There is often much debate over any "ideal" asset allocation as it differs among individuals.  I'll just go over some of the general themes and rules of thumb on how to think about asset allocation.

Retirement Investment Strategies

Dreaming about vacation spots on beaches or taking a trip on a cruise ship?  Imagining the future when you aren't working and don't have a care in the world with all the money you need already saved up from years of work?  If you answered yes then you are probably thinking about an ideal retirement scenario.  Aside from my initial post introducing The Smart Nickel, it seems like my retirement post has been one of the most viewed.  In order to make some of those dreams more realistically achievable, I thought I'd write another post looking at my idea of an ideal retirement strategy.  I will talk about the basic strategies that go into investment planning and how that will apply to planning for retirement.

The ETF

We have talked about the benefits of diversification before.  This technique should be used in your overall portfolio and within each asset class in your portfolio (meaning you should have a mix of stocks, bonds, etc. and diversification within stocks, within bonds, etc.)  If not, you might end up with the diversification they have in the cartoon.

So since we are on the topic of stocks, I am going to be introducing the exchange traded fund (ETF) which is an easy way to diversify your stock holdings.  The ETF is a security that tracks an index (a basket of different stocks or other assets) but trades like a stock.  You get the ability to buy it like a stock or short sell it and some of the advantages include lower fees than mutual funds (which we will talk about later).

Diversifying Your Risk

Now that you have learned a little bit about stocks and bonds and since we are on the topic of risk, let me go on to probably the number one issue you should address before starting: risk management.  You often hear that the stock market is risky and it is much better to put your money in a safe bank account.  However, I would argue that prepared correctly, the stock market is actually much better suited to guarantee a more prosperous future for you.  The main tool that you use to manage the risk you take on is diversification.

Let's take a simple exercise.  If I offered you the chance to play a game where I'll flip a fair coin, and if it lands heads you win $20 and if it lands tails you get nothing and the game costs $5 to play, how many times would you want to play it?  Probably as many times as you can.  Why?  Because the expected value of the winnings is $10 (50% * $20 + 50% * $0) and the cost to play is only $5.  Although technically, you should play the game even if you were only allowed to play once, it is much more assured that in the long-run you will make $5 on average each time you play.  Playing the game once is risky, but the payoffs when you do win should more than make up for the losses if you play many rounds.

The same can be thought of for stocks.  If you put your money into one stock and it happens to do poorly, you would have lost a lot of your savings.  However, putting your money into multiple stocks diversifies the risk, as if you were playing the coin flip game multiple times.  There is a more logical mathematical proof of decreasing the risk because variance of the outcome goes down as you increase the number of stocks you own, but I won't go into detail unless a lot of readers want to hear about it.  The main idea is to, like the old saying, not put all your eggs in one basket.

The main takeaway is that you are probably as diversified as you can be by having 30 or more unique assets that are different in terms of market capitalization, industry sector, and asset class.  I will go over these more in detail later on, but hopefully my example was clear enough to demonstrate how preferable it is to have a diversified portfolio when thinking about investing since you limit your exposure to the extreme cases and try to aim for a guaranteed return.  We will next take a look at how, as a whole, stocks have given a very consistent return on investment over the long-run.

Risk Versus Reward

With any asset, there is always a trade off between risk and reward.  Often times, it feels like you are trying to walk a tightrope balancing the two of them.  First of all, let's define risk and reward.

Risk is the variance in possible outcomes.  For example, a stock that may shoot up from $10 to $20 one day and then drop down to $5 the next day is much riskier than a stock that stays at $8 over the span of a certain time period.  Or you can think of lottery tickets as being extremely risky while coupons are not.  With lottery tickets, your winnings can vary from $0 to $1,000,000+ and with a coupon, you know for certain what you are getting for certain.

Reward is pretty obvious.  In most cases, it either is or can be exchanged into money (for comparison purposes).  It is what we seek to gain from certain actions.  When you think about investing your savings, you are seeking the highest return possible (or highest growth in your assets) which is your reward.

So what is the relationship between risk and reward?  They are usually positively correlated: as you find something that gives a higher reward, it usually carries a higher risk.  The simplest example is stocks versus bonds.  There are some stocks that can increase 300% over the course of a year while others drop 90%.  Bonds, on the other hand, earn you maybe 1-3% for certain over the course of some specified time frame.

So what combination is right for you?  You should probably take a risk tolerance test online (or I might just post one up on this blog later on) to see what risk profiles you should be looking at.  Generally, younger students should take on a riskier portfolio that a retiring senior since young adults don't have to worry too much about short term fluctuations.  It also depends on how well you handle emotions and stress.  Would you be able to sit through losing half of your money on the possibility of doubling it?

As you'll see in the next post, stocks in general have the most potential and have proven to be consistently the most rewarding in the long run.  For the ambitious who want to make the most of their money, they will probably want to have an aggressive portfolio of mostly stocks, but I'll talk more about asset allocation later as well.  You should think about what time horizon you are looking to keep your money invested and find the right risk tolerance level before choosing a specific allocation.  I'll continue to give more examples as we continue discussing risk management and stocks and bonds.