What’s The Four Factors℠?
When I speak with clients, I like to remind them that every investment has positive and negative attributes, depending on your goal. Over the years, I developed The Four Factors℠. These four factors can and should be used to analyze every investment in your portfolio and other holdings.
The Four Factors℠ are: Growth/Yield, Liquidity, Fees and Volatility. Every investment option can be analyzed for each of the four factors.
An example would be investing in raw land. There’s no yield, but there is growth depending on the local real estate market. The fees would be transaction costs paid to a realtor, interest and fees on any loans and taxes, if any. Volatility would be low, because there’s no valuation day to day. Liquidity would be low, because it’s very difficult to turn the land into cash without along process and more transaction costs.
Digging Deeper
We can dig deeper on each of the factors, too.
Take Fees, for instance. Some people believe they are paying 1.25% to have their mutual fund portfolio professionally managed. But that’s only part of the story. Doing deeper analysis, we may discover that the mutual funds inside your “wrap account” also have management fees and kick-backs to the large corporation who shall not be named. You can add another 1% in fees. Don’t even get me started on 401k plans and hidden fees. Feh!
Let’s dig deeper on volatility. Everybody loves the upward volatility. When the stocks you picked off of the CNBC ticker go up 10% in a month, you feel like the prettiest girl at the dance. When they go belly up like Bear Stearns, you feel like Jim Kramer in December of 2008. And that’s the issue, with volatility. The higher the risk, the higher the potential reward and the bumpier the ride to get to that pie in the sky. We’ve found from academia, that certain asset classes have higher or lower volatility. Historically, volatility correlates with growth rates over long periods of time.
Let’s Make a Deal
You know what, I’ll stop there. Books could be written on each of The Four Factors℠. But here’s a point that needs to be made: we can trade some of one or more factors to get a little more of another.
I explained in our webinar, that oftentimes you must trade one or two factors to get another two factors. In the raw land illustration, you may have high growth expectations and enjoy the low volatility. But you gave up some higher fees and taxes and a high barrier to liquidity to get potential growth and low volatility.
Now let’s look at something you may own: a 3-month government bond.
- Volatility: Volatility is low if held to maturity. Why, because ‘Murica! Which is to say that it’s backed by the wealthiest country in history.
- Fees: Fees are not part of the government bond, but there may be a commission to be paid to your brokerage firm. Either way, fees are very low.
- Liquidity: You are only trapped for 3 months until you get your principal back. If you’d like to sell before that, the bond may be more or less popular. You may sell for more or less than you bought it.
- Growth/Yield: Not so great. In September of 2017, the 3-month paid a whopping 1.05%.
Now most of us invest for growth or yield. So, if you want more from your government bond, what do you do. You make a deal. You can more than double your yield to 2.24%. All you must do is purchase a 10-year Treasury. But what have you given up for this double? Liquidity if you hold it for ten years. Low Volatility if you plan on selling it in a rising interest rate environment. In the words of Walter White, “Perhaps you should tread lightly.”
While I enjoy giving hypothetical examples, it’s only to explain a concept. What I prefer is providing this type of analysis to potential clients who could benefit from it. If that’s you, contact us to see if we can help you.