Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)
Part V. The Part of Tens
Chapter 24. Ten Investments and Strategies That Go Great with Stocks
IN THIS CHAPTER
Boosting your stock positions with options
Augmenting stocks with cash and low-risk investments
Accompanying stocks with exchange-traded funds
Yes, I love stocks, and I think some type of stock exposure is good for virtually any portfolio. But you must remember that your total financial portfolio should have other investments and strategies that are not stocks at all. Why?
Diversification means you have other assets besides stocks so you’re not 100 percent tied to the whims and machinations of the stock market. All too often, too many investors have too much exposure to the stock market. That’s fine, of course, when the stock market is raging upward, but potential down moves are there too. Therefore, you should consider investments and strategies that complement your stock investing pursuits. Check out ten of my favorites in this chapter.
Covered Call Options
Writing a covered call option is a great strategy for generating income from a current stock position (or positions) in your portfolio. A call option is a vehicle that gives the call buyer the right (but not the obligation) to buy a particular stock at a given price during a limited time frame (call options expire). The buyer pays what’s called the premium to the call seller (referred to as the call writer). The call writer receives the premium as income but in return is obligated to sell the stock to the buyer at the agreed upon price (called the strike price) if called upon to do so during the life of the option. The call option is typically a speculative vehicle for those who are buying them, but in this case I specifically refer to writing a covered call option.
Covered call writing is a conservative way to make extra cash from just about any listed stock of which you own at least 100 shares. Whether your stock has a dividend or not, this could boost income by 5 percent or more.
To find out more about writing call options on your stock positions, check out High-Level Investing For Dummies (authored by yours truly and published by Wiley). There you’ll find several chapters detailing the basics of options, along with their advantages and disadvantages.
A put option is a bet that a stock or ETF will fall in price. If you see the fortunes of a company going down, a put option is a great way to make a profit by speculating that the stock will go down. Many use puts to speculate for a profit, while others use put options as a hedging vehicle or a form of “portfolio insurance.”
If you’re holding a stock for the long term but you’re concerned about it in the short term, then consider using a put option on that stock. You’re not hoping the stock goes down; you’re merely using a form of protection for your stock-holding. If the stock goes down, the put option will rise in value. What some investors do is then cash out the put option at a profit and use the proceeds to buy more shares of that stock because the stock’s price is lower and possibly a buying opportunity.
For more on put options, see my book High-Level Investing For Dummies (Wiley).
Having some money in the bank or just some cash in your brokerage account comes in handy no matter what’s happening with the stock market’s gyrations. What’s that … the stock market is plunging? Whew! Good to have some cash on the sidelines so you can do some bargain-hunting for good value stocks.
As I write this, interest rates on savings accounts and similar bank vehicles are abysmally low, so cash isn’t a great investment. However, cash is an integral part of your overall wealth-building approach for several reasons:
· Cash you hold on the sidelines (either at your bank or, more conveniently, in your stock brokerage account or money market fund) is necessary when buying opportunities present themselves during the ebbs and flows of the stock market.
· Cash is necessary for an emergency fund in your overall financial planning picture. Not enough folks have an emergency or “rainy day” fund, which means a hundred different things (big medical expense, job layoff, and so on) could cause them a cash flow problem. If you need money for an unexpected big expense and you don’t have it in savings (or your mattress!), where will that money come from? It’s a good possibility that you’d have to sell or cash out some investment (such as your stock). See Chapter 2 for more about emergency funds.
· Cash is a good holding during deflationary times. When prices are low or going down, your cash’s buying power gets stronger.
EE Savings Bonds
The EE savings bond is issued by the U.S. Treasury and is a great vehicle, especially for small investors (you can buy one for as little as $25). It’s a discount bond, meaning that you buy it at below its face value (the purchase price is 50 percent of the face value) and cash it in later to get your purchase price back with interest.
The interest rate paid is equivalent to 100 percent of the average five-year Treasury note rate. If this rate is at 2 percent, then you get 2 percent. To get the full benefit of the rate, you must hold your EE bond for at least five years. If you cash out before five years and after one year (the mandatory minimum holding period), then you get a lower interest rate (equivalent to a savings account rate).
Here are several benefits of an EE bond:
· The interest rate isn’t fixed. Because the rate is pegged to Treasury note interest rates, it will rise (or fall) along with that rate. In the event that interest rates rise (which is a possibility for 2016 and beyond), EE bonds would benefit.
· The interest you earn on EE bonds is typically higher than a conventional bank account.
· EE bonds are free from state and local taxes. If you use the bonds for education, much of the interest can be tax-free.
For more details on the EE savings bond, head over to the U.S. Treasury’s site on savings bonds (www.savingsbonds.gov).
In the age of low-interest rate debt investments (such as bonds in general), the I savings bond (the “I” stands for inflation) is a different wrinkle altogether. This is a “sister” to the EE savings bond (see the preceding section), and it’s also issued by the U.S. Treasury. The twist here (making it a “twisted sister” I guess) is that the interest rate is tied to the official inflation rate (the Consumer Price Index, or CPI). If the CPI goes to 3 percent, then the interest rate on the I bond goes to 3 percent. The interest rate gets adjusted annually.
At the time of this writing, the CPI has been relatively low, and the environment is generally deflationary (a period of low prices), so the I bond’s interest rate has been under 1.5 percent.
I actually like the I bond for the coming years because inflation can easily return because of a variety of factors (increasing money supply and so on), and the I bond can be a solid part of your overall portfolio. For more information on I bonds, head over to www.savingsbonds.gov.
Sector Mutual Funds
I think that sector investing is a great part of your overall wealth-building approach; sometimes it isn’t easy to choose a single stock, but you can instead choose a winning sector (or industry). For many investors, a sector mutual fund is a good addition to their portfolios.
A mutual fund is a pool of money that’s managed by an investment firm (such as Fidelity, Vanguard, or T. Rowe Price); this pool of money is invested in a portfolio of securities (such as stocks or bonds) to reach a particular objective (such as aggressive growth, income, or preservation of capital). The investment firm actively manages the fund by regularly making buy, sell, and hold decisions in the fund’s portfolio.
A sector mutual fund limits its portfolio and investment decisions to a particular sector such as utilities, consumer staples, or healthcare. It’s your task to choose a winning sector, and the job of choosing the various stocks is left to the investment firm. (Flip to Chapter 13 for details on sectors and industries.)
Starting with only a few hundred bucks, you can have a theme-based portfolio that can augment your portfolio of individual stocks. Motif investing (covered in greater detail in Chapter 14) is a relatively new twist on investing (or speculating if you choose a risky motif). It gives you the convenience of investing in a pre-structured portfolio that’s designed to do well given a particular expected event, trend, or worldview that will unfold.
If you believe, for example, that interest rates will rise, you can with a single motif have a basket of stocks that would optimally benefit from that event. If you believe that inflation will rear its ugly head, then you can consider a motif that intends to benefit from that outcome.
The major decision on a motif is not necessarily the motif itself but on your particular worldview or expectations going forward. What do you expect in the coming months or years? If there’s one positive (or negative) trend that you’re fairly certain will unfold and you’re not sure how to profit from it through a single stock or fund, then take a look at motif investing. It may just be your cup of tea … or coffee (heck, there may even be a motif on tea and coffee!). Find out more about motif investing at www.motifinvesting.com (but you could’ve guessed that!).
Bearish Exchange-Traded Funds
Did you know that in 2015, 27 world stock markets were down by double-digit percentages? Fortunately, the U.S. stock market had a relatively good year, although the danger of a sharp correction persisted through the second half of 2015. And by the time you read this in 2016 (or later), a possibility of a sharp correction still looms due to general economic weakness, unsustainable debt, and global economic and financial difficulties. What should investors do given that possible event?
Investors can do plenty of things, both before and during tumultuous market times. If you’re invested in quality stocks, then you shouldn’t panic, especially if you have a long-term outlook. But hedging to a small extent can be a good consideration. In other words, why not consider a vehicle that will benefit in the event of a downturn in the stock market?
Exchange-traded funds (ETFs) are a good companion vehicle in your stock portfolio, and their versatility can become part of your overall strategy. If you believe that the stock market is or soon will be in difficult times, then consider a bearish stock market ETF. A bearish (or inverse) stock ETF is designed to go up when stocks go down. If stocks go down 5 percent, then the bearish ETF goes up by a similar inverse percentage (in this case, 5 percent).
What some investors do with bearish ETFs is cash them out when the market plunges and then take the proceeds to buy more of their favorite stocks (which presumably are cheaper given the market’s move down). Tactics such as this means you keep your portfolio growing for the long term while playing it safe during short-term market difficulties. Flip to Chapter 5 for general information on ETFs.
Dividend Yield Exchange-Traded Funds
The movement of stock prices can certainly be puzzling at times. Because they’re subject to buying and selling orders, their movement may not always be logical or predictable, especially in the short term (and I mean especially!). There is, however, one aspect of stocks that is much more logical and predictable: dividends.
Strong, profitable companies that have consistently raised their dividends in the past tend to reliably keep doing so in the future. Many companies have raised their dividends, or at the very least kept paying them, year-in and year-out through good times and bad. Dividends are paid out from the company’s net earnings (or net profit), so dividends also tend to act as a barometer gauging the company’s financial health, which basically boils down to profitability.
Finding good dividend-paying stocks isn’t hard; I describe them in Chapter 9. You can also find them with the stock screening tools that I cover in Chapter 16. However, investing in a strong basket of dividend-paying stocks by checking out dividend yield ETFs can be a good idea. A dividend yield ETF selects a basket of stocks based on the criteria of dividends — how consistently they’re paid and continuously raised. They make it easy to include dividend-payers in your portfolio with a single purchase. I cover ETFs in more detail in Chapter 5.
Consumer Staples Exchange-Traded Funds
You should consider having investments in your portfolio that are defensive in nature — investments tied to those products and services that people will keep buying no matter how good or bad the economy is. Sure, consider that sexy, high-tech gizmo stock if you like, but offset that with stocks of companies that offer food, beverages, water, utilities, and so on. However, sometimes it’s not easy to find that one great defensive stock, so why not buy the sector?
The consumer staples sector (I discuss sectors in Chapter 13) includes the “old reliables” of stock investing. Consumer staples ETFs may not skyrocket during bull markets (although they’ll perform respectably), but they’ll forge ahead during bad or uncertain times. Fortunately, the world of ETFs has made it a snap to invest in a basket of stocks that generally mirror a given sector.