Friday, May 18, 2018

What To Do When Your Investments Lose Money

In February, almost a year's pay vanished from my accounts.  It went up in smoke, disappeared, and gave me nothing in return.  What should I do about it?  What should I not do?

Move My Investments to Something Safer!

When the market goes down, many people, particularly inexperienced investors or those who do not really understand the stock market, just want out.  They are afraid that even more of their wealth will disappear and they decide to head for the safety of a bank account, but often all this does is locks in a loss.

If your investment is losing money or not making as much money as you would like, you need to consider several questions:
  • Why is my investment losing money?  What would need to change in order for it to make money?
  • What is the purpose of this investment?
  • What are the other options?

Let's look at those questions with respect to some investments I've discussed on this blog.

Peer-to-Peer Lending

When I started investing via Lending Club and Prosper, average returns near 8%, at least when the economy was good, appeared do-able, though I was aware that if there was an economic downturn, defaults would likely rise. I thought it was worth the risk, and at first it seemed like those would be good investments.  Then I noticed the returns dropping, and reading various blogs and other information available online I realized I was not alone--many investors were having all their interest for a month eaten up by defaults.  So, on to the analysis:

  • Why is my investment losing money?  My investment is losing money because Lending Club and Prosper's rates are too low for the risk the borrowers pose.  When it became apparent that more people wanted to invest in their notes than wanted to borrow money, Lending Club and Prosper lowered their interest rates/loosened their standards to attract more borrowers.  Since Lending Club and Prosper make their money servicing the loans rather than investing in them, it is to their advantage to write more loans.  As an investor, I have no control over the underwriting of the loan and no expertise that would allow me to design a meaningful filter to check Lending Club or Prosper's underwriting. 

  • What is the purpose of this investment? I invested in these notes because I wanted income and wanted some liquidity.  They are still providing limited liquidity--each day I have the choice to re-invest money paid to me, or to withdraw it.  As an example, this week I will be withdrawing $155 from Lending Club and $131 from Prosper, and those are sums that have accrued this week.  However, last year my interest only exceeded the amount lost to defaults by a small amount, so this investment is not providing the income expected.

  • What are the other options?  The traditional income investment is bonds and/or bond funds.  They provide income and liquidity.  Yes they can go up and down in price (and lately bond funds have been decreasing in value) but they have a longer history than peer-to-peer lending and there are professionals on both sides of the bond transactions, whereas with peer-to-peer lending the party with the knowledge to properly price those notes has more interest in the loans being made than in them being paid. 

  • Conclusion:  I'm withdrawing money from Prosper and Lending Club.  I'm not saying I'll never invest with them again, but the odds are against it. I think buying a diversified bond fund is safer and the income more predictable.  While my overall return now is better than what most bond funds pay, the economy is good.  If a downturn occurs, I expect defaults to rise and right now, my account can't take more bad news and remain profitable.

The Stock Market

All of my investment accounts are worth less than they were two months ago.  I made lots of money in the stock market last year; am I going to lose it all this year?  Who knows?

  • Why is my investment losing money?  The talk of tarrifs is what the professionals blame last week's problems on.  Whatever the problem is, I have a lot of company.  Most stocks and mutual funds were down about the same percent as I was.

  • What is the purpose of this investment?  The purpose of investing in the stock market is long term growth.  Statistically speaking no other investment has outpaced inflation over the long term.  However, historically speaking the stock market has had its ups and downs.  The market may be down this month for whatever reason, but there is no reason to think that it won't eventually go up again.  Since this is money meant for long-term growth, I can afford to wait.

  • What are the alternatives?  Bonds, bank accounts, real estate.  Long-term all pay less than stocks. 
  • Conclusion:  Selling stocks because of a market decline just locks in losses.  Market declines are going to happen, but long term, the market, as a whole, is a winner.  Market declines are good times to buy stock if you have extra cash sitting around.

My Shares in XYZ

If you own shares in XYZ (fictitious company) and they fall, then it is time to look at XYZ.

  • Why is my investment losing money? me, but the market has a whole as dropped about the same as XYZ.  Well, it is likely that when the rest of the market recovers, so will XYZ.  If you want more XYZ this could be a good time to buy.

    XYZ just got sued in a big case.  XYZ just changed CEOs--the last one went to jail. No one is buying XYZs products and they've laid off half their workforce.  The price of XYZ has decreased because the value of the company has decreased.  If you believe the company's prospects are good despite this news, hang on for a bumpy ride.  If you have no reason to believe the market is wrong, then get out while you still have some value.
  • What are the alternatives?  There is a whole stock market full of alternatives
  • Conclusion:  If an individual stock falls, find out why.  Use the answer to that question to help you decide whether your money would best be deployed elsewhere.
The trick, of course, is to realize whether your losses are the result of an ordinary market downturn or whether your losses were caused by a problem with the investments.  Most advisors suggest NOT watching your investments too closely because it makes you want to take actions that, all things considered, are not in your best interest.  Nevertheless you should be aware of how your investments are peforming compared to the market as a whole as well as similar invesments, and if yours are consistently underperforming, you should be willing to change. 
*Part of Financially Savvy Saturdays on brokeGIRLrich.*

Friday, May 4, 2018

Why I Will No Longer Invest Via Lending Club

I've written several posts about my foray into Peer-to-Peer Lending via Lending Club and Prosper, and in the past few weeks I've read several (probably sponsored) articles encouraging people to invest via these platforms.   After reading a bunch of blog posts several years ago, investing some money on these platforms seemed like a good idea.  Now, after about three years, I am in the process of withdrawing my money and I do not advise anyone to put their money into these platforms.  Why?

The Reward Does Not Compensate for the Risk

Bank accounts don't pay much, but you know you aren't going to lose money.  You can lose everything investing in the stock market, but you can also double or triple your money, or more.  The upside of bonds is limited, but the risk of your investment being worthless can be limited by investing in high-quality bonds.  After investing via Lending Club and Prosper for three years, I have no trouble saying that the rewards do not compensate the average investor for the risk being taken.

Default Risk

Both Lending Club and Prosper warn investors to expect defaults--that's the nature of unsecured loans.  Some people will pay them; some people will not.  The unfortunate fact is that lenders have to make enough money off those who do pay to compensate for those who do not.  

At different times, the overall default rate increases or decreases due to the overall economic health of the country.  When times are bad, more people lose their jobs and when people lose their jobs, unsecured loans are the first payments skipped.  The rates charged for loans have to consider not only what the rate is likely to be today, but what will likely happen if the economy tanks.  I'm not earning enough today to convince me that I wouldn't lose money if the economy tanks.  Too many people are defaulting now--in April my average balance with Lending Club was about $9,200 and, after defaults, I earned $6.89.  Since unemployment is low and the economy is basically doing well, I have to believe I'd lose money if we move toward a recession.  

Lending Club publishes statistics about its overall portfolio and about what returns can be expected.  You can see them here. When I started investing via Lending Club, the norm from which it was hard to stray if you had a reasonable sized portfolio was about 8%; now it is about 5%.

Underwriting Risk

Before investing via Lending Club and Prosper, I did my homework.  I read articles.  I read the statistics on their websites.  Everything was showing average returns in the 8% range.  With returns in good times in that range, I figured there was room for some defaults in bad times.  Then something changed.  Interest rates went down and underwriting standards were made less stringent, which resulted, of course, in more defaults.  

The big difference between Lending Club and your local bank or payday lender is that the bank and payday lender are loaning out their own money. If you don't pay back your loan, they lose money.  If a Lending Club borrower defaults, Lending Club doesn't suffer the loss, the investors do.  Lending Club makes their money via origination fees and via service fees (they take a small percentage of each loan payment).  It is in Lending Club and Prosper's best interest to facilitate as many loans as possible.

There are two ways the conflict between investors and the platforms comes into play.  First, as noted above, is when the platform lowers interest rates or credit qualifications in order to increase loan volume.  The second is when the platform solicits current borrowers to refinance loans at a lower rate.  The platform gains an origination fee.  The borrower (hopefully) saves money.  The investor loses because the high-interest loan is paid off early and therefore with less interest.  Also the 1% service fee on the lump sum repayment can consume several months interest.  

Lack of Knowledge

I am not an expert on underwriting loans.  As a matter of fact, I know very little about it.  When loans are offered on Lending Club and Prosper, certain data points are made available to investors, but I lack the ability to analyze that data to determine in the offered interest rates are sufficient.  Banks and their computers do not have that problem, and more and more of the loan volume on Lending Club and Prosper are being purchased via computer by institutional investors.  I have a hard time believing those computers will not skim the cream of the loans, and I can't even identify the cream.

You used to be able to find blog articles about "filtering" Lending Club or Prosper loans--searching the offered loans for those meeting certain criteria that historically (short as "history" was) had done better than average--and then purchasing those loans.  NSR Invest offers a tool that allows you to back-test your strategy--to see if filtering out certain loans or looking for others would have increased your return on investment IN THE PAST.  The problem is that Lending Club and Prosper can (and do do change the rules at any time.  Unless you have a very good understanding of how the criteria for rating loans now compares to the criteria used in the past,  you can't use a back test tool to do anything except to see what might have happened in the past.  

My experience with Peer-to-Peer Lending has convinced me that loaning money to other people is a business best left to those with expertise.  Do you agree?  

*Part of Financially Savvy Saturdays on brokeGIRLrich.*

Friday, April 27, 2018

Mutal Funds, ETFs, Closed End Funds--What's the Difference?

One key rule in investing is to not put all your eggs in one basket--or all your money in the stock of one company.  No matter how great the company, no matter how long it has been in existence or how well known it is, it could fail--case in point:  Sears.  While Sears has not yet filed for bankruptcy (at the time of this writing), "word on the street" is that it is coming.  Sears has been a retailing giant since the 1800's and sent packages through the mail long before Amazon came into existence. 

The problem with buying a large number of investments is that researching them and following them takes too much time, even if you have learned how to do it.  Yes, there are investment geeks out there who love reading annual reports, who know what PEG, PE and EPS mean, and who revel in uncovering stocks no one else has heard of, but most of us would rather go to the beach, and outsource the job. Of course investment companies have seen the need and developed products to meet that need.  Today we are going to take a look at three types of products you can buy that basically pool your money with that of other investors to buy shares in many companies.

Open-Ended Mutual Funds:

Open-ended mutual funds are still the most common type of pooled investment vehicle, but Exchange Traded Funds are making headway.

With an open-ended mutual fund, a custodial company develops a plan stating the types of things in which it will invest, as well as the long-term goals.  This plan, which is described in a Prospectus gives investors some idea of what they are buying--is it stocks, or bonds?  Big companies, or little?  Is the goal current income or increasing share price?  Are people picking the investments or is a computer matching an index?

An initial share value is established and as investors send in money, the fund managers invest it per the prospectus.  If the initial share value is $10 and your money gets there the first day, you purchase one share for every $10 you invest.  As the purchased investments appreciate (get more valuable) or decrease in value, each share price adjusts proportionately.  Every day at the end of the day the NAV or Net Asset Value per share is computed.

With open-ended mutual funds, investors can buy more every day, and new shares are created, priced at the same NAV as the old ones are that day.  As more money comes into the fund, the fund managers invest it.  If more investors want to withdraw funds than contribute, then the fund managers have to sell assets, whether or not they think doing so at this time is wise.  As money comes in, the managers have to invest it per the prospectus--for example, if the prospectus limits cash to 10% of the fund assets then once cash reserves exceed 10%, they have to be invested per the prospectus, regardless of whether the managers believe it is the ideal time to buy those investments.  

Open-end mutual funds are the most common investment offered by 401(k) plans.  There are thousands of funds with a variety of investing styles and goals.  Mutual fund investments are made by dollar amount, not by share amount, and most fund companies require an initial minimum investment. 

Exchange-Traded Funds:

Exchange Traded Funds are similar to open-ended mutual funds, except that while mutual funds are valued at the end of the day and everyone who buys and sells shares that day gets the same price, ETFs are valued minute by minute as the value of the owned stocks change.  If you buy an ETF for $10 per share in the morning, I may be able to buy the same ETF for $9.00 per share in the afternoon--or it may cost me $11.00.  

Because the price of the shares fluctuate throughout the day, ETFs are purchased by shares, not by dollar amounts, so you only need the cost of one share to start an investment. They also can be bought or sold almost instantaneously, depending on your broker, so if you want to time the market, or set stop-loss or limit orders you can.  Some brokers charge a commission for buying or selling ETFs, though generally if you purchase directly from the managing company, there is no sales commission.

Closed-End Funds:

A closed end mutual fund is one in which a limited number of shares are sold.  If someone who owns shares in a closed-end fund wants to sell them, they are sold on the stock exchange for whatever price can be obtained, which may be the same, more, or less than the proportionate value of the fund assets.

For example, FundA may be, for simplicity sake, invested 1/4 in ABC, 1/4 in DEF, 1/4 in GHI and 1/4 in JKL today.  The NAV of the shares is $10.00, so each share of FundA represents $2.50 of each company.  Tomorrow, there is really bad news about ABC and the price drops by 20%, and the other companies' price remains the same.  Now, the NAV of the shares of FundA is $9.50.  If FundA was an open-ended mutual fund, and it received my order for shares tomorrow, I would pay $9.50 per share--and that' s what you would receive if you wanted to sell.  However, with a closed-end fund, if I wanted to buy shares in FundA, I would have to go to the stock exchange, and pay the going rate, just as if I was buying the underlying stocks.  It is not uncommon for closed end funds to sell at a noticible discount or premium to the NAV.  If more people want to buy FundA, then the price goes up; if "everyone" wants to sell, the price goes down--however, there are still the same number of shares of FundA in existence, and each share is still invested in ABC, DEF, GHI and JKL.

For fund managers, the advantage of closed-end funds is that they have a set amount of money with which to work.  With open-ended funds, if there is a large in-pouring of assets, then fund managers may have trouble investing it in companies in which they believe and in accordance with the fund prospectus.  Closed-end funds don't have that problem.  In the same way, if too many people want to withdraw money from open-ended funds, the managers can be forced to sell assets when the value is down.  With closed-end funds, the investor might suffer a loss in that situation, but the fund as a whole would not.  

Investors benefit because without having to manage funds coming into and out of the fund, the operating expenses of a closed-end fund are less than that of an opened ended one.  Further, if you are looking for income, closed end funds tend to pay shareholders regularly--passing on both the dividends paid by the underlying stocks and the capital gains earned when stocks within the portfolio are sold.  

I own a few shares in a closed-end fund--Liberty All Star Equity Fund (USA), which is a large cap fund.  Its major holdings include Adobe, Visa, Amazon and Alphabet.  You can read more about it here.   Liberty tries to pay out 2.5% of the Net Asset Value of the fund each quarter to shareholders, which means it is good for those who want income.  Today it is selling for 6.99% less than the NAV.  On the other hand, a sister fund focused more on growth is currently trading at 6.6% more than the NAV.  

I am due to collect a distribution of $0.17 per share.  My shares cost an average of $6.29 each, and closed today at $6.25.  The current Net Asset Value per share is $6.72  

So, is buying this fund a guaranteed 10% return annually?  No.  If the fund does not have enough earnings to cover the distribution, it makes up the deficit by returning capital to the shareholders; in effect giving you some of your money back, which of course lowers the NAV (and probably the market price) of the shares.  Still, if you want to know that on four days of the year, you will receive a check for more or less an amount of money, closed end funds may work for you.

Overall, USA's annualized performance over the last ten  years has been 8%, which is slightly less than the 9.62% return of Vanguard's Total Stock Market Index Fund, and slightly more than the Lipper Large Cap Core Average, which the fund considers to be its benchmark.  
Disease Called Debt