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By Ralph Bovitz, CPA, PFS
Lawyers generally know little about investment planning, even the ones who
spent their undergraduate years majoring in business administration,
economics or finance. Aspiring attorneys who majored in history, political
science or sociology probably received even less exposure to it. As a
result, you may view the capital markets, meaning stocks and bonds, with
some distrust or even dismay. This is understandable. When things look good,
the market goes down and when things look bad the market goes up, which
doesn’t make sense. Yet the money you are making needs to be invested in
something that pays better than a savings account or certificate of deposit
if you want to cope with inflation and see your money grow.
A lesson in fundamentals may be all that is necessary to feel comfortable
investing your money in stocks and bonds, and still focus on your law
practice.
Bonds are interest-generating investments. Interest-generating investments
are promises by a company or the government to repay you the amount you lend
them on a specific future date; until then, the company or government will
pay you interest for allowing it to use your money. You will receive the
money that you loaned them unless the company or government goes bankrupt.
Although bonds generally incurs a lesser risk than stocks, the
negative for such an investment is inflation. With a 3.1 percent inflation
rate, $1,000 loaned today will have a buying power of $737 in 10 years, when
you are repaid. So bonds are best used for short-term investments, generally
less than five years. Then the impact of inflation is not as serious.
Stocks, on the other hand, are equity investments. These represent direct
ownership of a company, unlike a bond that is just a loan to a company or
the government. Stocks have a potential for greater growth and, yes, loss.
Unless you are buying high-risk, speculative stocks, however, your potential
for total loss is possible but not likely.
The downside to investing in stocks is euphemistically called "volatility."
Said another way, when the share price zooms up and then just as suddenly
and dramatically zooms down, you are experiencing volatility. Generally, you
are compensated for that zooming and possible loss by a bigger return than
you would receive from a bond. Because of this volatility, investment in
stocks should be undertaken when the need for the money is many years away,
usually more than five years. Historically, as the years pass, the zooming
smoothes out, accompanied by a general upward growth to your investment. The
goal for stock investments is typically retirement or a child’s education.
To achieve adequate diversification in order to lessen your risk of loss,
many stocks should be owned. To get the best break on the transaction cost
of buying stocks, purchases should be made in lots of 100 shares.
It is generally easier and cheaper for busy attorneys to buy stocks through
a mutual fund, where with a modest investment in the neighborhood of $1,000,
you can buy mutual fund shares that individually represent pieces of
hundreds of different companies. The stocks that a mutual fund buys normally
display similar characteristics, based upon the investment policy the fund
adopts. For instance, a mutual fund may declare it will only buy very large
companies, very small companies, companies in-between or foreign companies.
It is considered important for mutual fund stocks to remain "pure" because
certain categories or types of stocks behave differently than other types at
the same point in time. For example, when large company stocks are falling
in value, small company stocks may be increasing in value or not falling as
much. A mutual fund describing itself as a foreign stock investment that
adds a significant domestic presence will be diluting the foreign exposure
you are seeking for your portfolio.
Another good way to diversify is to select different categories of mutual
funds. Categories that may be included in your portfolio are small, large
and foreign company stocks. To that mix add foreign and domestic corporate,
municipal and U.S. Treasury bonds. Asset allocation is the moniker applied
to the selection of different categories of stocks and bonds. Over
time, asset allocation has shown itself to be the most successful way to
achieve the best return, consistent with an acceptable amount of volatility
and risk.
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