Sunday, August 28, 2011

Avoiding Moral Hazards in the Stock Market

A few weeks ago (before the debt ceiling debate and stock market dip) I wrote a post that explained that you should invest your money with the purpose to “make more money” and not to promote personal convictions or causes. In other words, do not consider outside “positive” factors when deciding where to invest your money.

However, I do believe that “negative” factors, based on moral or ethical standards, should be considered when making investment decisions. This may sound contradictory, but it is my personal standard. You are not going to agree with everything in this post. We are entering an area that mixes economics and morals and that is a smoky, gray, world. Keep in mind I am not telling you what to do or what to believe. This is how I approach this issue and my purpose here is to make you think about how you invest and hopefully improve the process and results.

Many moral/ethical factors can impact investment decisions. Most can be divided into three categories:

Vices: Alcohol, tobacco, gambling, etc.

Environmental Conduct: Pollution, off-shore drilling, oil spills, destroying the Rain Forest and now, fracking, etc.

Corporate Conduct: Child labor, corporate scandals, corporate policies, CEO conduct, etc.

There are other factors in addition to these, but you get the idea.

So how do I navigate these issues when investing? Because the situations are different, I will look at mutual funds and stocks separately.

Mutual Funds

Because most mutual funds invest in hundreds of companies and because many consumer and entertainment companies have diversified into many products and services, it is difficult to find a mutual fund that does not have something in it that is objectionable to someone. My solution to this is what I call “Don’t Look, Don’t Know”.

That’s right; treat it like a blind trust. Do take the time to research the fund. Know what the strategy is. Know what the performance has been. Look at the summary categories provided in the prospectus (Manufacturing – 23%, Consumer goods -16% etc.), but don’t look at the individual investments. It is too time consuming and you will drive yourself crazy. Is a fund that has 0.2% of its money in a company that derives 4% of its profit from something objectionable, toxic? I don’t know and I don’t want to know. If this is unacceptable to you, then there are those “clean”, socially responsible (I call them “gadget”) mutual funds. But as I stated a few weeks ago, the primary objective of these funds is to be “clean” of something first and make money second. And that makes me nervous as an investor.

It is important to track the performance of your mutual funds and how they are managed. One time I held a substantial investment in a “value” fund that was supposed to provide moderate returns with limited risk. In the late ‘90’s this fund started to rack up yearly returns of over 20%. This delighted me. Great returns with no risk! (This reminds me of the Seinfeld episode where the frozen yogurt is delicious, and Jerry, it’s non- fat). When the internet bubble burst in the early aughts (00’s), my value fund lost much of its value. It lost more than most other funds that were supposed to be riskier. It turns out that the fund manager had totally abandoned the stated strategy of the fund and had put lots of junk (bonds) in the fund’s trunk.

You should also review your mutual fund when you get those notices telling you that the fund manager has changed. If the fund was doing well (compared to similar funds) and the manger left the firm, that is a red flag. This probably means that the manager wasn’t paid enough and that the firm did not value his or her ability. Now the new manager will probably be paid less and be told, “Just manage the fund like Bill did and things will be fine. (How difficult can that be?). If this is the case, it may be time to move your money to another fund. Conversely if the fund is underperforming, the fund manager was not doing a great job and you may as well see if the new person can turn it around. But please keep watching it. Too many people put their money in mutual funds and then never look at it until a big correction occurs.

Individual Stocks

These are much easier to make decisions about. When I was considering dividend stocks to add to the “George Fund”, several consumer product companies that have strong profits and high dividends looked attractive. However, these companies make significant profits selling cigarettes to third-world countries. Because I enjoy sleeping at night, I decided not to buy stock in these companies. But remember, these decisions are based on personal convictions. So I am not saying you should not invest here or are wrong if you already do, however it is not a good investment for me.

So invest wisely and carefully, my friends.

George Fund Update

I finally made changes to the George Fund a few weeks ago. Even though I only ended up changing 20% of the fund, it was actually very difficult to pull the trigger on the sale of the old stocks and the buying of the new ones. When it was finished, I realized why. By taking these actions I had taken total ownership of the fund and this caused some anxiety. I thought about renaming it the “Don Fund”, but that didn’t seem right since 80% of the fund remained the same. From now on I will refer to it as the “GeoDon” Fund. Sounds very 21st century, now doesn’t it?

Seinfeld Frozen Yogurt Clip

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