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The Dangers of Using Derivatives in Investing

dangers of using derivatives in investingIn the context of investing, leverage means using additional money that’s taken out as a loan to invest into a product that is expected to produce higher returns. If someone takes a bank loan of 4% interest to create a coffee shop that can produce 20% return within the year, they will have made successful use of leverage.

There are also other forms of leverage available such as using options and futures within the stock market. By buying these derivatives, an individual can create a stake in a company that amplifies a bet times 100. Someone can purchase a call on Apple (AAPL) stock at $200 and when the price increases by 10%, they can cash in on the call for a sizable profit (representing 100% gain – the cost of the call). The potential to produce substantial returns by the use of derivatives may explain the proliferation of “options or future(fx) traders” out there. It’s a way to get involved in the stock market with relatively low sums of money and potentially produce significant income. While the potential for higher income is available, there are multiple risks that become present once you introduce derivatives into your investment portfolio.

1. Derivatives amplify your potential for profit…and loss.

Sure, you can make a lot more money with derivatives but you now also have the potential to lose a lot more money. If you’re wrong on a specific bet, then you could end up with a derivative that is worthless. The potential for your portfolio to go to 0 becomes much more steeper. Even if you are using derivatives in a way that is meant to lower the risk of short-term volatility, you pay extra for that type of insurance. If you end up being wrong even 3-5 times in a row, which can be very easy to do, you may find out that your entire portfolio gets wiped out.

2. Once you take a major loss, your psychology will highly encourage you to continue…much like that of a gambler.

Assuming at some point you do lose a major portion of your money by taking a higher risk bet on a derivative, that type of loss will incentivize you to take even riskier bets. Once your portfolio is down 40%, you would need to make 66% on your money to hit break-even point again. With a need to hit break-even again, you’d realize that the fastest way to get back there again is an even bigger risk. This type of psychological reasoning keeps you in the game until you have no chips left to play.

3. Once you take a major gain, your psychology will be influenced to take risky decisions as well.

Let’s assume you gain 40% or even 100% within a very short time period. The risk and bet you have taken will prop up your psychology to become more confident and take even bigger risks, as you might reason that it will continue to be that easy. After increasing your money by however much, you may find that you get attached to that larger number. Then, assuming you lose a good sum on a wrong bet (which would be inevitable the longer you are “playing the stock market”), you become incentivized to play out the psychological dynamics discussed in #2.

4. Derivatives can expire over time ranging from a few days to years, introducing a market timing element to the investing.

Because there is an expiration date on the derivative, you not only have to be right but you need to be right about when it will happen. The timing aspect of derivatives can cause a rushed feeling within your psychology, causing you to take bets that backfire inappropriately. Time works against you when it comes to derivatives, which is unlike buying and holding securities for the long-term (longer holding periods is associated with increased returns).

Thus, there are many potential dangers to using derivatives in investing. For a long-term investor who desires to increase their earnings without the influence of nefarious psychological tendencies, a simple buy and hold approach would suffice.

How To Avoid Taxation On Your Investments

In America, we run on a ‘progressive tax’ system. This means that your tax rate will increase for each dollar that you are making. You won’t be taxed more on your “base amount” but you will be taxed extra for each additional dollar. Let’s say you are making $50k in wages a year for example. While each additional dollar you make will get taxed at 25%, parts of your original $50k will be taxed at 10% and 15%. The table below should explain this relatively well.

2015-Income-Tax-Brackets

While you are in the lower income tax brackets, you won’t be taxed as much. But taxation can become a problem for you once you reach 28%, 33% and even 25% marginal tax. The solution in these cases would require special tax-advantaged strategies that help you avoid having atleast a quarter taken out of every dollar you make.

4 ways to avoid taxation on your investments.

Growth Stock Funds

Instead of putting money into stock funds or stocks that return hefty dividends, and therefore, cause taxation, you can invest in growth stock funds. Growth stocks don’t give dividends and instead reinvests the company’s profits back into the company in hopes of continued and higher growth. This means that the value of your fund can keep growing without you being taxed for a long time. You will usually only get taxed when you sell, triggering capital gain taxes. However, if you are very intentional about when you sell, you can save alot of money in the long-term. For example, selling growth stock funds in retirement when your taxable income will likely be much lower will potentially save you thousands of dollars in taxes.

Municipal Bond Funds

While bonds offer relatively high dividends, the taxation of those dividends is treated just like any other ordinary income. However, if you were to buy public state municipal bond funds, you would be able to get decent dividends while avoiding state and federal taxation. While these bonds can offer great cash flow for high-income earners, it is important to note how inflation may erode the long-term value of the income without a growth hedge.

IRA / 401k

A very common option for many people to save for retirement, putting money away into an IRA (individual retirement account) or a 401k (a type of defined contribution plan) can help save a sizable amount of money from tax. When you contribute to a traditional IRA or 401k, money is taken away from your paycheck before your money is subject to tax and placed into these retirement accounts. This removes sizable money from taxation. With a Roth IRA or 401k, the contributions are taxed immediately but you won’t be taxed on the growth later on. There are disadvantages with these accounts such as not being able to access the money till 59.5 in age or later. However, this can be a great option for most people who should be saving for retirement in the first place anyway.

Tax Loss Harvesting

This is a relatively advanced investing technique. I highly suggest staying away from this unless you really know what you’re doing or if you find a robo-advisor that does this for you. At TFP, our investing partner Betterment For Advisors allows tax loss harvesting for clients.

Tax Loss Harvesting works by selling a security that has suffered a loss, which triggers a capital gains loss. Having a capital gains loss can be a good thing because it offsets capital gains, meaning less taxable income. While you shouldn’t actively search for capital gains loss, being able to take advantage of opportunities when they arise can be profitable. Assuming you don’t collide with wash sales rules which would remove your capital gains loss benefit and assuming that you maintain your asset allocation, this can cause gains with substantial impact in the long run. You could potentially take up to $3000 per year in tax deductions from income with this type of strategy.

These are four ways to avoid taxation on investments.

Investments Explained Simply

investments explained simply

Investments Explained Simply

It’s surprising how many people know nothing about investments like stocks and bonds, even though these types of financial instruments are serious catalysts for the growth of the overall economy. I’m going to explain the world of stocks and bonds in the simplest ways that I can.

Stocks

Stocks are basically pieces of companies. You can own pieces of google, apple, amazon and your other favorite businesses by purchasing stocks. Typically, businesses that are as big as these have millions of shares (another term for stocks). When you purchase a stock, you’re not just buying something that you expect to magically increase in value with time, but you’re buying a piece of a business that you expect to do well.

There are two ways you make money with stocks. Sometimes this business you buy will return their profits back to shareholders (you, the owner of the stock share). When you get money for owning stocks, that is called a dividend. The other way you can make money from a stock is when you sell it. The business might be more valuable within a year, causing the stock price to rise higher. When you sell the stock, you realize profits, or capital gains. Dividends and capital gains are the two ways you make money with stocks.

Stocks can be very volatile. The value of a stock can fall completely down to zero if the business fails but it can also rise meteorically if it is doing well. It’s not uncommon for some individual stocks to fall 10-60% within a day and go right back up again. Stocks can be very good for long-term growth of your money but can be risky in the short-term because of its volatility. For this reason, you should not invest in stocks unless you expect to be in the market for at least 5 years.

Bonds

Bonds are basically contracts where you give a “loan” to companies. So, for $1000, you can buy a bond from companies, or even the government. The government and companies will use that money you loan them to fund their projects, while you get a promise to get paid a certain percentage each year.

Assuming the company agreed to give you back 4% of the 1000 every year for 10 years, you’d receive 40 dollars every year for owning that bond. You will typically get paid that total amount in pieces on a semi-annual basis, $20 two times a year. By the end of the 10 years, the government or company will give you back your original amount, the $1000.

Bonds that are qualified as investment grade are typically less risky than stocks. You will get paid for as long as the company is alive, even if it is doing poorly. The only way you may not get paid is if the business goes out of business and doesn’t have enough money to distribute to lenders (you). This is different from stocks – if your stock went down to zero, you are entitled to nothing. But a company going bankrupt means you still have claims to the money you lent them. Usually bonds are good for cash flow – you get paid money directly more consistently than with stocks which you may have to sell to benefit from as much.

Mutual Funds

You may have heard a lot about mutual funds a lot but what exactly are they? Imagine mutual funds are a grocery cart of stocks or bonds that you hire someone to pick out for you. They’ll do the hard work of figuring out the best items (stocks/bonds) to put in. You can even get specialized baskets of stocks/bonds, like one that only picks the largest companies, or one that picks the smallest, high-potential companies. Mutual funds automatically diversify your portfolio compared to individual stocks and bonds by investing in multiple companies. If you had put a large portion of your money into just one stock (would you believe how many business owners put all their eggs into one business basket?), then you are susceptible to the risk that the business goes bust and you lose all your money. By diversifying between multiple stocks or bonds, your money has less risk of volatility while stabilizing the return potential of your money.

Mutual funds employ the use of stock picking managers, meaning it is an “active” fund. Many investors buy mutual funds with an expectation that this grocery cart of stocks or bonds will do better than anything they could pick out on their own. Typically, to have someone manage your investments on an active basis, mutual funds can take up to 1% a year or more away from your returns. This can be a poor choice that eats into your returns over the long term, compared to “index funds”, which I will discuss next.

Index Funds

Index funds are a type of mutual fund. The difference is that this grocery of stocks or bonds are made to copy the market. Instead of having someone pick out the investments on an “active” basis, a broad range of many stocks or bonds are put into a basket without much thought put into it.

The S&P 500 for example, is a very popular benchmark index fund that you will see mentioned in the investment world. It’s a collection of 500 biggest companies in the stock market. No sophisticated stock picking there at all yet everyone follows the S&P 500. They follow it because it represents the “market”. The S&P 500 is typically seen as a general measure of how the entire market is doing overall.

But why would anyone be interested in any index fund if they can get a manager to pick stocks for them? Doing as well as the “market”, or basically everyone else sounds unappealing to some.

However, studies have shown that index funds, funds that follow the market in a “passive” style, often do better than general mutual funds that are managed by an active manager.

This is partly because mutual funds typically charge up to 1% in fees every year while index funds charge extremely low prices that can go as low as 0.05%. To put this into perspective, imagine you had $500k to either put into a mutual or index fund. You would get charged $5000 per year on a mutual fund that charges 1% per year, while an index fund might charge 0.10%, which would only cost $500. Because you automatically save $4500 every year, this can make a huge difference on your long-term investment returns. For this reason, index funds are extremely popular in many investment management portfolios.

ETFs

Exchange-traded Funds, are increasingly popular investments and deservedly so. If index funds are a grocery basket of stocks and bonds, imagine that an ETF is an agreement that breaks apart that grocery basket index fund into many little pieces. ETFs feature a similar portfolio style as index funds with its passive investing, with the added benefit of lower prices.

As an example, the S&P 500 index fund currently costs over $2400 in mid-2017. The SPDR ETFs, which copies the S&P 500, can cost as little $15-100+. Buying just one ETF that costs $50 means you are indirectly investing in potentially hundreds of different stocks and bonds, which may normally cost thousands to do directly. This makes ETFs a very accessible investment vehicle that naturally diversifies your portfolio beyond the risk you would normally take from buying just a few expensive stock or bonds.

As a final point, diversification between different stocks and bonds will lower your risk but it will also stabilize your return potential, meaning that you will likely produce less returns for mitigating the risk. However, consider that investment management is about helping you reach your goals within the safest manner possible rather than chasing an absolute high return without regard to risk. Many investors make the mistake of chasing high potential returns without factoring in the risk they take to do it. When investing, make sure that you are not taking more risk than necessary and that your investment strategy is in line with your goals.

By reading this, you should be able to understand the basics of investing. Let me know if you have questions.

Liked This Post? Here’s my recommendation on which investing platforms are the best to use.

The Spending Habits of Each MBTI Type

Spending Habits Of Each MBTI Type

Each MBTI personality type sees life a little differently when it comes to money and tends to develop different habits when it comes to spending. If you haven’t taken the MBTI test yet, take it here, but be warned that your test result may not necessarily be accurate for your true personality type.

These are the habits of each MBTI type when it comes to spending money.

ISTJ:

ISTJs are classic nest-builders. They tend to be frugal and spend little on luxury goods compared to other types. They can have a tendency to spend large amounts on a few image items such as expensive cars, clothing or other items, but will be cheap for the most part everywhere else. ISTJs are very motivated to provide a “good life” for their loved ones.

ISFJ:

ISFJs are also good at saving. They don’t require much from their financial purchases to be satisfied with life but do like to spend on a few social displays of wealth such as eating out at restaurants with friends, clothing, etc. ISFJs are typically very reserved with money, more so than the ISTJ.

ESTJ:

Typically very good savers, very financially-focused ESTJs can develop a reputation for being cheap. Unhealthy ESTJs can become prone to accumulating excessive wealth to achieve their desire to be seen as high status. Work makes ESTJs happy, so money is not typically needed to spend. More healthier ESTJs will adapt to the spending habits of their friends but they will always have a knack for cutting costs where required.

ESFJ:

ESFJs tend to be good savers as well, however, they may be susceptible to becoming very focused on showing off their wealth depending on the values they grew up with. If they were exposed to an environment that public consumption of wealth was valued, then they could be likely to spend high amounts on clothing, dining out and travel to meet their esteem needs for being “high status” in society.

INTJ:

Very future-oriented, INTJs are often frugal and generally won’t spend above what they make. However, they will spend high amounts on items they feel are important to them after extensive analysis, more than other types would even consider. INTJS can become very susceptible to randomly high spending because of stress if they aren’t careful.

ENTJ:

ENTJs are great at producing income, which can create a lackadaisical attitude towards saving for them. ENTJs work hard so they can play hard, making money with the clear incentive to spend freely on what they want. Unlike other types, they are the most consistent with their beliefs about why they are making money and their actions. ENTJs are willing to invest high amounts within themselves for large returns.

INFP:

INFPs are carefree about money in general. Which will lead to their spending habits to often be very reflective of the environment they are in. If they grew up in a money-conscious household, they will also be money-conscious but if they don’t have the right people to guide them, then they can end up taking risks beyond what they can handle.

ENFP:

Similar to INFPs, ENFPs are also generally carefree when it comes to money. For ENFPs, money takes form as an expression of their zest for life, and they don’t believe they’ll need it to have a good life either. While some other types will have trouble figuring out what they’d want to spend on if they had money, ENFPs have an endless list of ideas that they can come up with to spend things on.

INTP:

INTPs see life as an endless amount of possible experiences to have which they wish to experience some day. Frugal in general, their spending will typically go towards funding new experiences, which can take on expensive tastes. INTPs are able to scale back their spending lifestyles more than most people if they have to, but if faced with large amounts of money, may find themselves spending more exuberantly than they should be.

ENTP:

ENTPs take life one day at a time usually. This can make them great at producing income, however, their ability to save for the future will usually come second to spending on things they want now. Generally, ENTPs will spend as much as they make, leaving little to no savings but they can also be very savvy with their purchases given the right attitude.

ESTP:

ESTPs are very focused on having the most fun that they can in life. Their spending will be very high for events (typically with many friends) including traveling and dining out. Generally, ESTPs are able to make good income but their spending habits may lead to trouble continuing their adventurous lifestyle. Big risk-takers, they make huge investments in themselves that may not fall through but will pay off if it works.

ESFP:

ESFPs can be very resourceful when it comes to spending in general but also be inefficient sometimes. ESFPs can find themselves falling prey to their emotions when it comes to purchases that they highly desire, even though they know it’s a logically bad decision. ESFPs usually like to spend often but in small bursts.

ISTP:

ISTPs have a strong desire to experience life in its full capacity. This makes them very interested in traveling and new experiences with dining along with other material luxuries. However, this can lead to them making brash decisions regarding their finances and spending much more than they should be. ISTPs can be prone to taking big risks with their money.

ISFP:

ISFPs have fine-tuned aesthetic tastes and are generally interested in expressing their identity to people with money. This can lead to high spending on clothing especially along with dining out with friends. More reserved than ESTPs however, ISFPs will scale back when required.

ENFJ:

ENFJs don’t care about money much similar to their ENFP counterpart, but are generally more controlled and aware of their expenditures. ENFJs love to have a good time with friends and will find that they don’t need money to do so like others. ENFJs generally don’t plan to become rich but they’ll have a modest amount of savings to spend when they want.

INFJ:

INFJs are generally good savers but when surrounded by peers who are spending more exuberantly, they may feel tempted to spend more. Although they will generally not join along, they may sometimes make bad decisions randomly as a result of stress and momentary carelessness. INFJs don’t care about money much but it is something that they do seriously think about when making career decisions.

Hopefully, you found the spending habits of each MBTI Type insightful.

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