Editor's Note: Max Isaacman is the author of Blizzard of Money and Winning with ETF Strategies.
Stock market investors are wounded and weary from the last 12-year bear and sideways market.
As judged by the S&P 500 Index
(INDEXSP:.INX), over that time the market produced zero net return while being scarily cut in half twice along the way, which is enough to drive investors away for a generation or so. Investors have become ready customers for products and strategies that promise avoidance of losses, rather than good possible returns.
In this negative stock market sentiment time, coupled with low volume, an investor not in the market could be giving up a chance for real profit, especially on a one to two year outlook.
Yet, turning away from the stock market could have the consequence of not participating in a market advance.
Many potential investors are not aware that the market has been rising without them over certain time periods. Franklin Templeton surveys individual investors annually, asking investors what the market had done the previous year. In 2010, 66% of investors said the S&P had fallen in 2009, when it actually had gained 26.5%. In 2011, 48% of investors said the markets were down in 2010, when the S&P had risen more than 15%. And in September 2012, 53% of investors think the S&P declined in 2011, when the index actually rose 2%.
Brokerage firms create investments that their clients want. What clients very much wanted before the market break in 2008 were AAA-rated, government-guaranteed bonds that were backed by various collateral, the most familiar of these being single-family mortgages. This market collapsed when people could not make their mortgage payment. What clients want may not be the best investment.
Alternative Investment #1
If a person can’t afford or doesn’t want to take the risk of being in the stock market, then she shouldn’t be in the market. But with the riskiness of stocks embedded securely in the public mind, there is a stealth danger that investors could assume more risk than they mean to, through investing in something that seems to offer safety. For instance, bonds and dividend-paying stocks could be looked at as being cash or money market substitutes, which they clearly are not.
One safer investment than the stock market, while still a way to participate in the market, is Market Linked Certificates of Deposit (MLCD). These CDs participate in stock market moves, with the feature that if the CD is held to maturity, the government agency FDIC guarantees the return of principal, no matter what the market does. Maturities are usually in the four- to six-year range. Usually there is interest paid for the time the CD is held. Many of these CDs have a “Death Put,” meaning that if you die before the CD matures, your heirs can redeem the CD at par. [MLCDs are offered by Chase Bank
(NYSE:JPM), Wells Fargo
(NYSE:WFC), and many other banks.] Typical terms could be that at maturity the CD pays back your principal plus the greater of (a) a percentage, for example, 2% for the term held or (b) the sum of the quarterly percentage changes of the index, which is related to the performance of an index, such as the S&P 500 Index. Negative quarterly percentage returns are usually uncapped, and positive quarterly percentage returns are usually capped at 4% to 5%. The purpose is to capture 60% to 100% of the gain of the index, depending on the issue.
In most issues there is no guarantee that there will not be a loss if a CD is sold before maturity, if the CD can even be sold before maturity, since there is no guaranteed secondary market. These details are spelled out in each offering’s term sheet. There are other details and these will be found in the MLCD Preliminary Disclosure Supplement for each issue.
Alternative Investments #2 & #3
Another alternative to the stock market is bonds. The problem with bonds is that should interest rates go up, which at some point they probably will, bonds would go down in price. Conventional bond funds, in either mutual fund or ETF form, do not have maturity dates, and their prices can get hit when interest rates are rising. If you happen have to sell during a big sell-off, you can lose more principal than you are receiving in this paltry yield time. Even so, a collapse in bond prices because of a sharp rise in rates does not seem to be a big risk right now, as the US economy continues through post crisis deleveraging.
One solution is to buy one or a number of fixed-date maturity ETFs, such as the
suite of target-maturity ETFs, for instance the Guggenheim BulletShares 2013 Corporate Bond
(NYSEARCA:BSCD).These ETFs mature much like individual bonds, and allow investors to use laddering strategies and in other ways manage their interest rate and quality risk. There is still risk with these ETFs, but since they contain a diversified portfolio of bonds, the risk is diminished. The ETFs have maturities ranging from 2012 to 2020, and if you hold an ETF until maturity you receive the bond equivalent of par. Par with these ETFs is usually $20 per share.
Another way to receive some income outside of the stock market is to buy zero-coupon bonds, and in high taxed states such as New York and California, you might consider buying tax-free zero-coupon bonds. To solve the principal risk problem you can consider shorter term maturity zero coupons, such as three to six years maturity. Remember you still have default risk, and if you want to offset this somewhat, you could buy higher quality bonds. This does not completely solve the default risk, but the higher the quality, the safer you are.
Most municipal bonds pay semi-annual interest payments. There are no periodic interest payments with zero-coupon bonds, and the investor receives a par payment at maturity date, which is generally $1,000 per bond. The interest is calculated buy the price you pay for the bond and the amount you receive at maturity. Zero-coupon bonds are originally issued at a discount from their par value.
Consider the Ultimate Alternative
It may be counterintuitive, but the stock market may be a good place to invest right now. In early 1980, the stock market started moving slowly higher, and with each uptick, investors, who had sworn off stocks forever (like many have now) scoffed at the notion that it would continue. But it did, for almost 20 years.