Sunday, March 17, 2013

The Most Treacherous Bridge in the World

Only a Hope to Trust:
One of my favorite scenes in the Lord of the Rings films is the flight over the bridge of Khazad-dûm. Our heroes have traveled through the dark for days, hoping to trust that the light of Gandalf's staff would shield them from the evil dwelling in the shadows. As the companions’ grim journey through the mines nears the end, they are approached by a being so foul, so terrifying, that the entire chamber seems to be simultaneously lit aflame and filled with the blackness of its presence: the Balrog of Morgoth.

“This foe is beyond any of you. Run!” Gandalf cries. The nine heroes race through twist and turn, hardly daring a backwards glance at the malevolent presence that pursues them. Finally they reach the bridge. The bridge of Khazad-dûm arches through the shadow like a warped backbone, fearsome and challenging. Beneath the bridge falls a void, unfathomable in depth, filled with the mysteries of the enemies of Middle Earth – yet to cross this overpass is the only source of reprieve from the monstrosity charging behind them.

This is often how people feel about investing.

Many sources site that the most treacherous bridge in the world crosses the Hunza River in Pakistan. The Hussaini Hanging Bridge (pictured below) was built decades ago as a way for mountain locals to cross into town. In Jan. 2010, a landslide struck the Hunza valley, causing locals to race the rising river to cross the bridge.  Those that did not make it across the river were forced to flee their flooding homes and take refuge in the mountains until help arrived.

Hopefully our financial decisions are not as extreme as crossing an old bridge, abandoning our homes, or being chased by a Balrog - but it can often feel that way. On one side of the bridge lies dire straits (not the band, which would not be terrifying but, in fact, awesome) and on the other side are security and peace of mind.

Choose Your Eggs Wisely:

Last week, I wrote about a couple of metrics (P/E and PEG) that can help remove these fears about investing and minimize guesswork. So what are some other ways to reduce risk without feeling like you are watching a slug climb a mountain? Investing needs to be fun, right? Want to know why mutual funds ultimately climb over the long run? Diversification.

The beauty of modern investing is in the flexibility we as investors have. Does it not still blow anyone’s mind that we can purchase a company whilst sitting at home in our jammies? *Side note: sometimes I wonder if we are becoming numb to the grandeur of technology. Anyway, the size of your portfolio no longer limits the diversification you can attribute to your account. ETFs (Exchange-Traded Funds) are a perfect example of this. An ETF is a fund that holds a variety of assets (such as stocks, commodities, and bonds) and trades openly on the market just like a stock.

In 2008, the SEC voted unanimously to pass three new rules which would “increase investor choice by eliminating a barrier to entry for new participants in this fast-growing market, while preserving investor protections.” What they did redefined modern investing. In 2008, the SEC…

a)      Eliminated the need for ETFs to gain approval from the SEC to trade individual shares of the fund.
b)      Eliminated the need for ETFs to gain approval to trade outside NAV (Net Asset Value). NAV is an entity’s assets minus liabilities – in this case the entity is the ETF.
c)      Allowed ETFs to purchase >3% of another investment company’s shares.
Go SEC! Essentially what this did was open the doors to a brave new world of possibilities regarding ETFs. ETFs were no longer limited to mimicking major indices, and investors were given a vast pool of options from which they could choose. The new legislation made them subject to market sentiment on the fund as a whole as opposed to just the individual assets that made it up. Now the market has exchange-traded funds that range from precious metals (such as DBP) to information technology (such as VGT) instead of simply tracking the DJIA.

A New Way to Trade:

While ETFs still have management fees associated with them, they are typically not as large as mutual funds. Additionally, there is not a minimum investment to purchase shares and these funds are far more liquid than traditional index funds. If you are not sitting on a pile of cash – as very few of us are – this is an awesome way to diversify without being “nickel n’ dimed” out of an investment. So don’t let the Balrog sneak up on you while all your savings are stuck in your local branch’s 0.002% interest savings account – the power of compounding doesn’t really apply at those rates. Diversifying will provide the safety net so you can feel confident crossing this financial bridge. More of the differences between ETFs and mutual funds here.

Next week: How do I choose the right ETF and do some funds do better in different types of accounts?

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