I recently saw an article titled, “Use Puts and Calls to Finance Your Holiday Gift Shopping.” It proceeds to explain how you can employ certain options strategies (shorting puts and covered calls), to generate portfolio income – in this case, a little extra cash for purchasing holiday gifts.
“My Parsec advisor hasn’t suggested this to me,” you think. In fact, your Parsec advisor hasn’t suggested any options or derivatives strategy to you! What gives? Aren’t we supposed to be looking out for our clients’ best interests?
Yes, we are. And that is why we typically won’t suggest such a strategy to you. Not that there is anything wrong with it, per se, but most derivatives strategies are short-term in nature, and one of our main tenets is investing for the long-term.
Even though the author of this article is suggesting relatively safe (rather than speculative) strategies, there is risk involved, and the upside is limited. When you short (a.k.a. sell or write) a covered call, you give someone the option to purchase a stock that you own at a predetermined (strike) price, in exchange for payment (known as the option premium). Shorting (selling or writing) puts involves giving someone the option to sell you a particular stock at a predetermined price, also in exchange for a premium. If you enter into one of these contracts, you are obligated to either sell or buy the underlying stock if the owner exercises the option. If the option expires unexercised, you keep the premium without having to sell or buy the underlying.
The objective is to enter into contracts that you think are unlikely to be exercised based on your prediction of the underlying stock’s price movement, and earn income by pocketing the premium. Of course, there’s always the chance that the market will move in such a way that the owner will choose to exercise the option, and you will be forced to make a trade.
So let’s think about this – why would someone exercise a call option? Obviously because the market price has moved above the strike price and they can buy it for less, then turn around and sell it for a profit. So you’re selling a stock that’s going up (at a below-market price), and giving up any potential upside in that stock.
And why would someone exercise a put option? Because the current price of the underlying stock has dropped below the strike price, so they can sell it to you for more than it’s worth in the market. Even assuming that it’s a stock that you want to own, wouldn’t it be better to buy it at the lower market price? If you calculated the breakeven correctly, the premium earned on the option would offset the difference in strike and market price, but then you’re effectively at zero, having earned nothing (such as dividend income) in the interim.
Our philosophy is that the best results occur over a long time period, in portfolios consisting of a well-diversified array of carefully chosen, quality investments. We make buy and sell decisions based on in-depth research of underlying company fundamentals, rather than market predictions. In this way, we seek to avoid the pitfalls of human behavior and emotion, as well as the likelihood of inaccurate predictions. We like to be owners of companies with real earnings and dividends, and participate in long-term, profitable investments because this is how we help you attain your financial goals…such as a long, comfortable retirement as well as the perfect gift for everyone on your list.
Sarah DerGarabedian, CFA Portfolio Manager
Those that know me well can vouch for the fact that I am a frugal person. I feel that there is much that is virtuous about living a frugal life. Learning about delayed gratification and the important limits to set upon our role in a consumption based economy is a great path to happiness and peace. The famous economist and philosopher John Stuart Mill once said, “I have learned to seek my happiness by limiting my desires, rather than attempting to satisfy them.” This simple phrase rings true to me. This is especially evident as you stand witness to the constant bombardment of consumerism in our media and markets. Take stock of what you have and the blessings of life and you might not fall prey to the treadmill of consumption that will always be tempting you.
Top 10 rules to a frugal life:
- Budget – know where your money goes.
- Be guarded against lifestyle inflation; try to keep income growing faster than expense growth.
- Don’t be wasteful. Consider gently used items when buying cars, and other depreciating assets.
- Find discounts whenever possible.
- Trips and vacations are about experiences, not necessarily lavish accommodations.
- Frugal people rarely eat out, preferring to prepare their own food. I find it better and healthier, not to mention less costly.
- While there are many worthwhile private schools, there is a great value to be found in many of our public schools as well. Consider whether public schools, for both young children and college, may be right for your family.
- Frugal people care less about fads and trends; keeping up does not matter to them.
- Know the value of a dollar, if there is a lower interest rate find it.
- Don’t be cheap, stay generous. It is ok to part with money to help others.
Richard Manske, CFP® Managing Partner
Last night Parsec celebrated our Parsec Prize recipients. The event served as a means to get members from each recipient organization together to thank them for their important work in the community. One of these organizations is the Council on Aging of Buncombe County. The Council on Aging is dedicated to promoting independence, dignity and wellness for older adults through education, innovative programming, and coordination of resources.
At the event the Director of the Council on Aging reminded us that the Medicare Annual Election Period is now open. We thought this information was useful enough to pass on. Below is helpful information the Council on Aging provided us about the election period. Please remember that situations vary and you should consult a Medicare expert if you have questions.
Medicare Annual Election Period
October 15 – December 7
The annual election period for Medicare is October 15th through December 7th. During this period, Medicare enrollees can make changes to their Medicare coverage. You may want to contact your Medicare eligible clients and remind them of the annual election period.
Prescription Drug – Part D Coverage. Many of your clients may be covered by prescription drug plans through Medicare. These drug plans all have different formularies and premiums. A formulary means that the plan will only cover certain drugs and if the consumer’s drugs are not on the formulary they will have to pay the full cost of the medication. The important thing to remember is that the formularies and premiums can change from year to year. It is highly recommended that the Medicare beneficiary review their drug plan coverage every year to make sure that their medications (usually maintenance drugs) continue on their plan’s formulary. They can do this at Medicare.gov webpage under Find Drug and Health Plans or call the Council on Aging for a no cost review of their plan. If they do not change by December 7th they are locked in for the next year.
Medicare Advantage Plan – Part C. Some of your clients may be enrolled in a Medicare Advantage plan. If they are happy with it, they don’t need to do anything and will be renewed into the same plan. If they are not happy, they can change Advantage Plans or go back to original Medicare. If they indicate that they are considering returning to original (traditional) Medicare, caution them that they must also chose a free standing drug plan or they will have not drug coverage for the following year. This has happened to several consumers with extremely negative financial consequences.
Medicare Supplements (Medigap) Perhaps most of your clients will have Medicare supplement policies that help pay for deductibles and coinsurance. A supplement policy can be change at any time and is NOT subject to the annual election period. If a consumer already has a policy and wants to change, they will probably have to submit a health statement (medical underwriting) and if the new carrier does not like what they see, they can deny coverage. Always caution your clients not to cancel their old policy until they have been accepted IN WRITING by the new carrier. Sometimes beneficiaries cancel their old policy as soon as they apply to another carrier and if they are turned down they may be left without any supplement as they may not be able to rescind the cancellation. A trustworthy insurance agent should be able to guide them through that process safely.
Private Insurance Exchanges. Some retirees have Medicare secondary coverage through former employers. Many of these employers are moving to private exchanges in which they contract with a large benefits management company to administer the program. The employer funds a Health Savings Account (HSA) to pay the premiums; however, if the retiree wants to use those funds to purchase a Medicare supplement policy, they must do so through the private exchange and may have a limited choice of companies and policies from which to choose. Failure to do so may result in the retiree not being able to pay for the supplement from the HSA. Caution clients in this arrangement to follow directions carefully.
Retiree Coverage. Some clients will have retiree health coverage and will not be able to make many choices. If this is the case, they need to be sure to respond to information requests from the retirement plan on a timely basis. If choices are available and they fail to respond, they may be continued with the same coverage or placed in a default plan.
If you have any questions please feel free to call John Wingerter at the Council on Aging. 828-277-8288. Be sure to say you are calling from Parsec Financial. Navigating the Medicare benefits can be tricky and might result in penalties or loss of coverage if the beneficiary is not careful.
For Medicare assistance, clients may be referred to:
Council on Aging of Buncombe County: 828-277-8288
Charlotte Senior Center: 704-522-6222
The Shepherd’s Center of Charlotte: 704-365-1995
Moore County Senior Enrichment Center: 910-215-0900
Seniors’ Health Insurance Information Program of the NC Department of Insurance: 855-408-1212
Whenever I meet someone new and am asked the obligatory “what do you do?” I typically get two reactions. Roughly half of folks respond with an unconscious grimace and politely excuse themselves in search of someone more interesting. The second reaction is one of delight and surprise.
Once this exchange happens with an interested party, the next question I usually get is – what stocks do you like? Now I’m the one grimacing. The reason being is that stocks are as varied as the investors who own them. In addition to first understanding an investor’s risk tolerance, time horizon, and long-term goals, picking stocks requires a lot of analysis. One of the cornerstones of equity analysis begins with something called the required rate of return. If you’re not already grimacing, read on brave reader!
A required rate of return effectively measures what kind of payback you need to get in order to go forward with a stock (or any investment) purchase. To determine a stock’s required rate of return you need three inputs: (1) the economy’s real risk-free rate of return (2) the expected inflation rate and (3) a risk premium to make-up for the added uncertainty that comes with owning a stock. The first input, the real risk-free rate of return is a return you can theoretically get today with virtually no risk. We plan to own our stock for ten years, so we’ll use the 10 Yr Treasury bond as our risk-free rate proxy, currently yielding ~2.5%. We start with the “risk-free” rate because if nothing else, the stock you’re considering should at least deliver a return on par with a very safe US Treasury bond. And then some, because you need to be compensated for the additional risk you’re about to take. More on that in a minute.
Next, rising costs will diminish the purchasing power of your dollar over time, so you’ll want to have an investment that at least offsets the deleterious effects of inflation. Expected inflation is currently running around 2%, so we’ll add that to our risk-free rate of 2.5% for a required stock return (so far) of 4.5%. Finally, because of the added risk you take on by owning a stock, you should demand some kind of compensation for this uncertainty. We account for this risk by taking a stock’s beta or its volatility compared to the market, and multiplying it by an equity risk premium. The equity risk premium is generally estimated by subtracting the expected equity market return (stocks have returned 10% on average over the long-term*) from the risk-free rate. Thus, our equity risk premium is 7.5% or 10% minus the risk-free 2.5%. Phew. Using a pretend stock, Widgets-R-Us (Ticker: WIGGY) as our prospective stock investment, with a 5-year beta of about 0.90 – meaning it has historically been less volatile than the market – we get a total risk component of 6.75% (beta x equity risk premium or 0.90 x 7.5%). Putting it altogether we should require WIGGY to return at least 9.25% before wading in.
Congrats! You calculated a required rate of return. Although this is an important starting point, I’m sorry to tell you it’s just the beginning. It’s a good beginning because we now know what return we require in order to buy Widgets-R-Us, but you may have guessed that without an expected rate of return we don’t have a lot to go on. The good news is that there are plenty of knowledgeable investment professionals who can do the work for you. And importantly, are willing to take the time to explain how they come to their investment decisions.
*Ibbotson, large cap stocks 1926-2012
Carrie Tallman, CFA
Director of Research
Recently I was on vacation with a friend, and while enjoying the sunshine she received a CNN alert…
Breaking News: Dow Jones Industrial Average soars to an all time high.
She then asked me what the Dow Jones was exactly … “Should I know what this means?” My response was, “it’s a stock market index, of course.” Seeing the perplexed look on her face, I realized that she had no idea what I was talking about. After having this conversation, I wanted to share with you what I shared with my friend.
- What is a market index? – A stock market index is simply a measurement of the value of the market or a section of the market. Let’s break it down into a simple example. Assume ABC index is made up of 6 companies. At the end of trading on Monday the index is at 5,000 points. On Tuesday, three of the companies go up in value, two of the companies go down and the sixth company stays the same. The total value of the stocks change by 3% on Tuesday, so now the index is at 5,150 points. This tells you that this section of the market went up in value from Monday to Tuesday.
- Why are market indexes important? Choosing appropriate investments is only the beginning. One of the biggest challenges of an investor is to determine how well your portfolio is performing. Are you lagging behind the market or beating it? You can only know the answer to these questions if you have something to compare your investments to. Indexes allow you to measure the performances of your investments against an appropriate benchmark.
- How do you choose the right benchmark? In general, when you are tracking the performance of an investment, you look at a benchmark that is most similar to your investment. For example: If your portfolio is all U.S. large cap stocks you would likely use the S&P 500 as your benchmark. If your portfolio is all fixed income then you would most likely benchmark against the Barclays Aggregate Bond index. If your portfolio is a combination of both large-cap stock and fixed income you would want to use a blended benchmark of the two indexes.
- All of this is for naught if you don’t know what indexes track which stocks. Here are some of the most common market indexes and the companies they are comprised of.
- Dow Jones Industrial Average (DJIA) – This is one of the most popular measures of the market. A.K.A. “The Dow” or “Dow 30” is a price-weighted measure of 30 US blue-chip companies. The index covers all industries with the exception of transportation and utilities, which are covered by other Dow Jones indexes.
- S&P 500 Index – This index is based on 500 U.S. large cap companies that have common stock listed on the NYSE or NASDAQ. These companies are representative of the industries in the U.S. economy.
- Russell 2000 – This index tracks 2,000 small-company stocks. It serves as benchmark for the small-cap component of the overall market.
- Dow Jones Wilshire 5000 – This index covers over 5,000 US companies listed on major stock exchanges. This includes US companies of all sizes across all industries.
- Barclays Capital Aggregate Bond Index – This is a broad-based benchmark that measures the investment grade, US dollar-denominated fixed-rate taxable bond market.
- MSCI EAFE Index – This index is designed to measure the equity market performance of developed markets outside of the U.S. and Canada. EAFE is an acronym that stands for Europe, Australasia and Far East. (Check out Sarah DerGarabedian’s blog post from last week to read why it’s important to have an international allocation – http://wp.me/plOKq-oE)
- It’s important to remember when comparing your investment returns to compare your results to the long-term market, not just the past year. Typically analysts look at 3, 5 and 10 year returns. Short-term results can often be misleading due to short-term volatility. A quick Google search should provide you with the long-term returns of any of the major indexes.
After explaining all of this information to my friend, I think she had a better grasp on market indexes and hopefully this information is helpful to you too. One realization that came from our conversation is that sometimes financial advisors (nerds) forget that things that seem so common to us aren’t as familiar to those not in the industry. We never want a client to leave a meeting or conversation feeling confused or uncertain. If you have questions, please ask! We may just write a blog post about it.
Ashley Woodring, CFP®
“But international stocks are underperforming the S&P 500! Why are you buying international mutual funds in my account?”
We hear this question a lot. People often wonder why we include various sectors and asset classes in our portfolios, but the one that tends to get the most scrutiny is international equity. Many investors exhibit what is known as “home bias,” or the tendency to invest primarily in domestic securities, whether it stems from a nationalistic desire to “buy local” or simply the belief that international investing carries additional costs and complexities. Often, investors eschew international diversification to their detriment, as many studies have shown that the inclusion of international equities lowers portfolio volatility while increasing risk-adjusted return. However, these metrics are not what investors see – they see performance. They see that the return on their international fund is lower than the return on the S&P 500 and fear that it will be a drag on their returns forever. So why don’t we sell it?
Quite simply, we keep it for the diversification benefits. With Halloween just around the corner, perhaps an analogy will help. When you’re trick-or-treating, you knock on the door of every lighted house and collect as much candy as you can carry home. Then you dump it out on the floor and sort through it to revel in the spoils. Hopefully you’ll come home with lots of chocolate candy bars, M&Ms, Milk Duds, Junior Mints, and Reese’s cups. Then there might be a smattering of Smarties, Starburst, and Skittles, which are fine. Invariably there will be a few of those orange and black-wrapped peanut butter taffies, some chalky Dubble Bubble and a handful of Dum Dums – but that’s OK. A few crummy candies won’t ruin the night, since you have so much more of the good stuff. And you never know which houses are going to hand out what candy, so you have to hit them all. (And to the person handing out raisins, just stop. Don’t be that guy.)
Now imagine that your portfolio is a bag of Halloween candy. Even if you love Snickers, it would be pretty disappointing if your entire haul was nothing but Snickers – that would defeat the purpose of trick-or-treating, because you could simply go to the store and buy a bag. No, you want a wide variety from which to choose, based on changing moods and cravings! In a similar way, you need to diversify your investments so that the mood of the day doesn’t destroy your savings in one fell swoop. If your entire portfolio consists of the stock of one bank and the bank goes under, you lose all of your money. If you buy the stock of 5 different banks, but the entire banking industry hits a rough patch, your portfolio plummets…so you buy the stock of 40 different companies in different sectors and industries to spread the risk. But what if they’re all domestic companies and the domestic economy tanks? I think you see where this is going. Different investments zig and zag, moving in opposite directions simultaneously, which dampens the overall volatility of the portfolio.
You may not be a huge fan of Blow-Pops, but what happens if you fill your bag with Kit Kats and you’re suddenly in the mood for Sour Apple? What if you leave your bag in the sun and all the Kit Kats melt? It’s true that if particular sector (such as international equity) underperforms and you have it in your portfolio, you might get a lower return on your portfolio for that period. But when that sector rallies, you’ll be happy you had a couple of Blow-Pops in your bag.
Sarah DerGarabedian, CFA
A “short sale” refers to selling stock that you do not own with the hope of repurchasing it at a lower price later. It is a way for an investor to try and profit from their view that a particular investment is overvalued and likely to fall in price. This technique can be used on individual stocks, or on Exchange Traded Funds (“ETFs”) that represent anything from individual sectors to the overall market. While there are many successful investors who have done well on the short side, for most people this strategy doesn’t make a lot of sense due to the risks involved.
The mechanics of a short sale are as follows: An investor goes to their broker, borrows shares of a stock and sells them. The short sale proceeds are credited to the short seller’s account, less a fee for borrowing the stock. You must have a margin account in order to short stock. If the price of the shorted stock rises, the short seller will need eventually to borrow on margin to keep the position open.
The short seller receives interest on the short sale proceeds, although this is minimal currently since interest rates are low. In practice, this interest is often split with the buyer of the shares or the brokerage firm that is facilitating the short sale. The short seller must pay any dividends on the borrowed stock to the purchaser of the shares.
Risks of Short Selling:
Swimming Against the Tide –Since 1926, about 7 out of 10 years have been positive for the overall market. If you are short the overall market, chances are you will be in a losing position after a year.
Timing is Critical—Stocks can move quickly in either direction, and it is difficult to predict the future. If the event that you are betting on fails to materialize, or if the opposite happens, your losses can mount quickly. For this reason, short selling is more common among professional and institutional investors.
It can be Expensive to Maintain a Short Position— With today’s low interest rates, the combination of the borrowing cost and the dividends the short must pay to the long far outweighs the interest on the short sale proceeds that the seller is earning. For example, say you short 100 shares on Johnson and Johnson at $108 because you think Band-Aid sales are going to decline sharply. You receive proceeds of $10,800 and earn money market interest at 0.01%, or $10.80 per year. Your annual cost to carry the position is the 2.8% dividend, or $302.40 plus any borrowing costs charged by your broker. These additional costs can be quite high for stocks that are hard to borrow.
Limited Profits but Potentially Unlimited Losses–At most, any stock can go down 100% in value. However, there is no limit to how far a stock or the overall market can go up. If it goes up by enough to wipe out the equity in your margin account, the brokerage firm will buy-in the security at a loss and close the trade. Say you short a stock at $8/share. The most you can make is $8 if the company goes out of business and you are able to buy back the borrowed shares at $0. But what if good news comes out and the stock goes from $8 to $18? You just lost $10/share when your maximum theoretical profit was $8. In reality, few companies go out of business so your maximum profit is even more limited.
We believe that, rather than trying to profit on short-term price movements, our clients should place the equity portion of their investments in a diversified portfolio of quality companies with the potential for rising earnings and rising dividend income.
Bill Hansen, CFA
|as of Sept 30, 2014|
|DJ Industrial Average||15.29%||4.60%||1.87%||-0.23%|
|MSCI EAFE Index||4.25%||-1.38%||-5.88%||-3.84%|
|MSCI Emerging Markets||4.30%||2.43%||-3.50%||-7.41%|
|Barclays US Aggregate||3.96%||4.10%||0.17%||-0.68%|
|Barclays Intermediate US Gov/Credit||2.20%||2.22%||-0.03%||-0.51%|
Mark A. Lewis
Director of Operations
My father was ready for retirement. We had several discussions about picking the right time. Choosing when to retire is always a big decision. Conventional wisdom suggests the longer you wait, the better. You have more time to save and eliminate debt. Your Social Security benefit could be higher. On the other hand, how many people do you know who died before they could retire? There is something to be said for “getting out of the game” and enjoying your life.
We discussed a myriad of items. In the interest of brevity, let’s talk about two of them: finding the right insurance coverage and managing your time.
Health care is a big ticket item. No matter how well we take care of ourselves, our bodies will need more attention as we get older. Finding the right coverage is vital. Individuals over age 65 have Medicare Part A. Most people obtain supplemental insurance coverage since Part A does not pay for everything. Some plans are very expensive. Some plans provide minimal coverage at a reduced cost. Penalties can be incurred if one does not sign up for Medicare when required. And, if someone retires before age 65, coverage must be found to bridge the gap between the retirement date and Medicare eligibility.
I was overwhelmed. I arranged for my parents to meet with an insurance agent who specializes in Medicare plans.
Thanks to the draft, my dad spent a few years in the Army. His service gave him a permanent distaste for peeling potatoes. More importantly, it provided him with access to health care benefits. His previous employer’s insurance plan was awful, so he used the VA coverage as a supplement for years. He said the prescription drug discounts are good.
The agent found appropriate policies for both of my parents. My father’s supplemental policy needs were reduced by the VA coverage, whereas my mother needed increased coverage. It helped to have someone with Medicare knowledge guide them through the process. I highly recommend seeking help instead of trying to research it on your own.
She could not help us with the other problem: occupying my dad’s time. He is not a “lounge around the house” kind of guy. He must stay busy. He made a plan for the first year of retirement. He wanted to remodel the kitchen – build cabinets, replace the countertop himself, install new flooring, et cetera. He planned to tackle some home improvement projects at my house (yeah!). He wanted to get a dog which would give him a buddy and an excuse to get outdoors. Then, in about a year, he hoped to get a part-time job at a nearby home improvement store. He would be perfect for the job, and the store employs a lot of older workers.
He knew he could not be happy unless he was busy doing something. When considering retirement, it is very important to think about how one will occupy time previously spent working. We all have fantasies about what we would do. When faced with the reality of filling those hours, though, it can be a daunting task.
In the end, my father did retire. I saw an immediate “lightness.” He smiles and laughs easily. Plagued with ulcers and wicked reflux most of his life, his gastro issues have greatly improved. Retirement definitely agrees with him.
Someday, you may have the same conversations with your parents. My advice is to get help from people who know more than you – financial advisors, insurance experts, estate planning attorneys – whenever you encounter unfamiliar issues.
The same advice applies if you are considering retirement. There is more to the issue than whether or not you will have enough money. My parents and I spent almost a year talking about it. Just as you took time to find the right career or the right house, care should be taken with retirement planning too.
Of course, Parsec is here to guide you. Retirement matters are too complex to tackle alone.
Cristy Freeman, AAMS®
Senior Operations Associate