Understanding Investment Risk: Impact of Individual Stocks

This article was originally published in River Hill Magazine.

The fastest way to accumulate wealth is to buy the stock of the best company you can find, invest all of your available cash, and sit tight until you eventually need the money.  Most people do not follow this approach because they realize no one is able to predict the future with any degree of certainty, and they are uncomfortable with the investment risk. This concentrated strategy can be the fastest way to lose all of your wealth if you place a bad bet.

It is possible to reduce overall portfolio risk and volatility by creating a diversified portfolio.  From the chart below, total investment risk can be divided into unsystematic risk and systematic risk.

Unsystematic Risk

A truly diversified portfolio eliminates unsystematic risk. The first component of unsystematic risk is business risk.  Business risk is risk that is attributed to a particular industry, competitive threats, and regulatory constraints.  The second component of unsystematic risk is financial risk.  Financial risk is related to the financial health of the company itself, its level of debt, its cash flow, earnings, and profits.

When you purchase the stock or bond of a single company, unsystematic risk is an additional risk that you incur. The professional investment community generally agrees that a basket of at least 25 – 30 different stocks must be held in order to minimize or perhaps virtually eliminate unsystematic risk from a portfolio.  Keep in mind, however, that risk and volatility is the investor’s friend in a rising bull market.  Some investors are perfectly willing to take on higher risk with the hope of achieving higher returns.  A diversified portfolio will generally not lead to the highest returns over time, but should offer more stable and consistent returns than a portfolio that is not adequately diversified.

Systematic Risk

The second major category for investment risk is systematic risk.  The four types of systematic risk are purchasing power risk, interest rate risk, market risk, and exchange rate risk.  Purchasing power risk refers to the risk of inflation.  Stocks have proven to be a good long-term hedge against inflation.  It is prudent therefore for most investors to have at least some portion of stocks or stock funds in their portfolio.  Interest rate risk refers to changes in market interest rates.  When interest rates rise, bonds lose market value, and stocks quite often perform poorly as well.

Market risk is related to the behavior of the market in general.  In the long-run, the stock market is driven primarily by the growth of earnings.  In the short-run, the market can be driven by irrational and emotional factors.  Many individual investors do not realize how much the performance of a company’s stock is dependent with the behavior of the general market.  The statistical term for this is beta.  The best way to diversify against market risk is to hold different asset classes in your portfolio that behave differently (not highly correlated).  This strategy involves using a combination of cash, bonds, stocks and even other asset classes.  Within the major category of stocks, an investor can further diversify by choosing among small, large, growth, and value stocks.

The last type of systematic risk is exchange rate risk.  Exchange rate risk results from adding international investments to a portfolio.  It is impossible to eliminate systematic risk completely from a portfolio, but it can be reduced.

If your investment goal is to implement a strategy of lower volatility and reduce risk, then avoiding individual stocks in favor of using more broadly diversified funds should provide a smoother ride.

Christopher P. Parr CFPTM is a River Hill resident and President of Parr Financial Solutions Inc.- an independent, fee-only financial advisory firm:  www.ParrFinancialSolutions.com

Wall Street Journal – Giving the Gift of Money

Financial Gifts Can Provide Lasting Value to Recipients—and Save You Cash  

Christopher Parr was mentioned in this Wall Street Journal article by finance writer Liz Moyer on financial gift tax exemptions. “Erwin Freed says he and his wife, Carolyn, opened 529 college-savings plans for their three grandchildren four years ago with the help of their financial planner, Christopher Parr in Columbia, Md. They put $5,000 a year into each grandchild’s account.”

To read full article on “Giving the Gift of Money: Financial Gifts can Provide Lasting Value to Recipients – and Save you Cash” by Liz Moyer Click Here

Financial Advisor Magazine: Trust and Estate Documents & Planning

Christopher P. Parr was interviewed by Senior Editor Wayne Rasmussen for the Wealth Management & Estate Planning section of the May, 2012 issue of “Financial Advisor Magazine” about the perils of flawed language in trust documents.

The key takeaways from the interview are:

1. All estate documents should be reviewed and updated when your life situation changes, to make sure your wishes are current and represented effectively.
2. Be sure to plan for any potential contingency scenarios. Even the best intentions can go bad if a trust document is not well thought out and well written.
3. Trust language can be nuanced and often confusing. It is best to hire an attorney who specializes in estate planning issues and is not a legal generalist.
4. A good financial advisor can take a leadership role in helping families think through complex family issues and how to plan effectively for them.
5. Consider hiring a corporate trustee to provide trust administration services, when a financially competent family member who is also objective and unbiased is not readily available.

To read the full article please click this link: http://www.fa-mag.com/news/the-horror-10529.html

The Business Monthly: Gifting Appreciated Securities – A Win-Win Deal

Charitable contributions are an important part of many household budgets. It is quite common for families who budget carefully to base annual contributions to charities on a targeted percentage of gross household income. Charitable donations generally range between 1% to 10%. A typical percentage is perhaps 3%.

Most donees, however, overlook a gifting strategy that can provide significant economic as well as other benefits. This relatively simple strategy involves gifting appreciated shares of stock or mutual funds to your favorite charity in-lieu-of cash.

The most important economic benefit of gifting appreciated securities is that the donor reaps immediate tax savings. Assume a donor originally purchased 100 shares of stock at $10.00 per share net cost (including transaction charges) for a total cost basis of $1,000. With the help of the recent extended bull market, the market value of those shares could have easily doubled over the past 3-5 years to $20.00 per share or $2,000. By donating these shares, your favorite charity will receive the average market value of the shares on the date of receipt. The donor will get credit for the same $2,000 donation on Schedule A, although the original out-of-pocket cost was $1,000. By gifting the shares, the donor avoids having to pay tax on the $1,000 capital appreciation ($2,000 market value of gift less $1,000 original cost). In this example, the donor avoided the 20% long-term capital gains tax ($200) as well as brokerage transaction costs that would have been incurred to eventually liquidate those shares.

A second advantage of gifting appreciated securities is that this technique can be used to periodically rebalance your portfolio. If you are fortunate to own shares of a high-flying stock and are concerned about a potential “crash”, gifting appreciated shares in a timely manner can alleviate this problem. There is no extra cash outlay on your part since you planned to donate the same dollar amount to charity anyway.

Another reason to rebalance your portfolio could be that a particular stock prudently represented 2-3% of your portfolio at the time of original purchase, but has swelled to10% of your total nest egg by outperforming the rest of your portfolio handily during the past few years. Your portfolio risk has increased significantly. Perhaps you have too many eggs in one basket. This is a nice problem to have, but rebalancing may be prudent strategy to reduce risk.

A third example of gifting appreciated shares as part of a portfolio rebalancing strategy is to reduce the exposure of an income generating asset in a taxable portfolio in favor of a more tax-efficient holding.

A final advantage of gifting appreciated securities applies to those who contribute weekly/frequently. Religious organizations are the example that quickly comes to mind. Since gifting securities are drawn from investments instead of income, monthly cash flow can be improved. This technique is particularly beneficial for those who are self-employed and have irregular income streams. It can also benefit those who for whatever reason, fall behind in their annual pledges, or happen to “come-up-short” between pay periods. Since securities contributions are made in one lump sum, eliminating the need to tediously write that weekly check also saves time. Some organizations offer “the convenience” of automated payroll deductions for contributions. Gifting appreciated securities is a superior strategy since it involves pre-tax (capital gains) funds rather than after-tax cash.

When considering gifting securities, here are a four potential pitfalls:
1. Do not donate securities that have depreciated (suffered a loss in value). It makes more sense to gift cash instead.
2. To achieve maximum tax advantages, do not gift securities that are held in tax-deferred retirement accounts.
3. Consider gifting appreciated securities for donations of at least $500. This arbitrary requirement is due to the time and paperwork required to process, and potential benefit.
4. Be sure to identify specifically in a letter to the brokerage custodian which shares of a particular holding that you intend to gift. This is particularly important for mutual fund accounts that have reinvested dividends. Gift the shares with the lowest tax-basis.

In conclusion, by gifting appreciated securities in-lieu-of cash, your favorite charity still wins as you intended, but the donor also wins at the expense of Uncle Sam. To initiate a gift of appreciated securities, contact your favorite charitable organization, your brokerage firm, or your financial adviser for assistance.

This is an updated post of an article that originally appeared in the May 1999 issue of The Business Monthly.

Copyright © by PARR Financial Solutions, 2011

Please feel free to contact us if you have any questions or comments.

The Business Monthly: How to Weather Stock Market Turbulence

Safe to say that with a fair amount of monumental events happening throughout 2011, investors experienced the upsides and downsides of stock market turbulence. Throughout the years I have developed a few ways to weather stock market turbulence and reduce volatility through diversification.

Weathering Stock Market Turbulence

I recommend that investors take these five steps to weather the stock market turbulence:

1. Distinguish financial resources required to meet short-term goals from long-term goals.
2. Understand your portfolio liquidity needs and cash-flow requirements.
3. Be aware of how volatile your investment portfolio has behaved in percentage terms relative to the risk of the overall stock market.
4. Modify your investment plan by reducing your exposure to stocks if your needs have changed, or you are uncomfortable with the current volatility of your portfolio.
5. Stick to your long-term investment plan if you have sufficient financial resources to meet immediate needs and you can accept a higher-degree of risk with funds targeted to fund long-term (> 3-5 years) needs.

Diversify: Reducing Volatility by Understanding Correlations

An investment strategy practicing broad diversification can pay-off with reduced downside volatility. One-way to accomplish this is by carefully selecting different types of investments (technically referred to as “asset classes”) that have low correlations. Correlation is a statistical measure of how different investments behave relative to each other. It can range from +1.00 to -1.00. A correlation of +1.00 indicates perfect correlation. For example, rain and umbrellas have a correlation close to +1.00. Rain and sun have a correlation closer to -1.00 (but not absolutely -1.00 as an analytically-minded engineer would surely be quick to point-out). The correlation between rain and a cow is perhaps 0.00 and implies that these two items are uncorrelated and have nothing to do with each other.

This is an updated post of an article that originally appeared in the May 2001 issue of The Business Monthly.

Copyright © by PARR Financial Solutions, 2011.

Please feel free to contact us if you have any questions or comments.

Dental Products Report: Christopher P. Parr Among “2011 Best Financial Advisors for Dentists”

BALTIMORE, MD — Christopher P. Parr, president of Columbia-based Parr Financial Solutions, Inc., has been recognized by Dental Products Report as one of “2011 Best Financial Advisers for Dentists”. The list includes 77 advisers nationwide. Advisors were selected based on certifications, over a decade of experience with a depth of knowledge about a broad range of financial issues, and a clean regulatory disciplinary track record.

According to Dental Products Report editors Ken Krizner and Bob Feigenbaum, “We felt it was important to offer this listing because, like most other professionals, dentists can find it difficult and time-consuming to concentrate on their personal finances by themselves. Delegating personal finances to a professional adviser can bring value to one’s long-term future. Trustworthiness is critical to the relationship.”

Dental Products Report is the leading independent, unbiased information source for North American dentists on clinical applications of new products, equipment, materials, and technology. The publication, launched in 1968, reaches more than 150,000 dentists in office-based practice nationwide.

Parr Financial Solutions, Inc. provides fee-only financial planning and independent wealth management services to clients locally as well as throughout the U.S. Services cover the spectrum of personal financial planning issues including retirement planning, estate planning, and professional portfolio management. The firm specializes in helping clients transition smoothly into retirement.

For more information, visit www.ParrFinancialSolutions.com

George Johns, CFP® joins Columbia Wealth Management Firm

BALTIMORE, MD — Christopher P. Parr, president of Columbia-based Parr Financial Solutions, Inc., is pleased to announce George A. Johns, CFP® joined the firm as Financial Advisor and Director of Client Services. According to Parr, “George Johns is looking forward to working as a fee-only advisor providing objective, unbiased advice to clients that is not contingent on the sale of financial products. We are very fortunate to have George on our team.”

Mr. Johns holds a BS degree in Information Systems Management from the University of Maryland University College and completed his financial planning studies with the College for Financial Planning in Denver, Colorado. Prior to joining Parr Financial Solutions, he spent seven years in the Private Wealth Management group of SunTrust Bank delivering comprehensive financial planning services to high net worth clients. Mr. Johns also spent several years with T. Rowe Price working with corporate retirement plans as well as individual investors.

Parr Financial Solutions, Inc. provides fee-only financial planning and independent wealth management services to clients locally as well as throughout the U.S. Services cover the spectrum of personal financial planning issues including retirement planning, estate planning, and professional portfolio management. The firm specializes in helping clients transition smoothly into retirement.

For more information, visit www.ParrFinancialSolutions.com