A Guide To Risk Warnings And Disclaimers

Risk is fundamental to the investment process, but remains a concept that is not particularly well understood by most regular investors. For this reason, risk warnings - those vaguely worded, fine print disclaimers at the bottom of any investment documents and websites - are extremely important for both buyers and sellers.
Unfortunately, although there are many warnings out there, they often remain unread or are not sufficiently explicit. An investor needs a fairly substantial level of experience and sophistication to know what is really meant, or an advisor needs to take the time to explain it to the investor carefully in person. Yet, all too often, these conditions do not prevail. Sometimes, sellers obviously prefer to keep people in the dark in order to make a sale. In this article, we will take a look at the nature of risk warnings in order to figure out what gets the message across properly, and what still leaves investors not truly knowing what they could be getting into. (For the basics of investor risk, read Determining Risk And The Risk Pyramid and Risk Tolerance Only Tells Half The Story.)


Where Do These Warnings Appear and Why?
Mainly for legal reasons, firms generally publish some kind of warning in their brochures and on internet sites. The objective is not only to explain to the investor the nature of the risks involved in the particular kind of investment being offered, but also to ensure that there can be no legal comeback. The warnings are either in a separate internet link, or in a brochure. In the latter case, it may vary from a rather small footnote to a pretty explicit and large-print explanation of what can go wrong. The length tends to vary from one sentence to a couple of pages.


Examples of Written Warnings
Let's look at some actual written examples of how investors are warned of what might happen to their money. We will see what the firms say and just how useful it is.


Example - Too vague"An investor may get back less than the amount invested. Information on past performance, where given, is not necessarily a guide to future performance."
Or
"The capital value of units in the fund can fluctuate and the price of units can go down as well as up and is not guaranteed."


Warnings like these are very common, regrettably. The problem with these is that there is no quantification and the warning does not really hit home. Can you lose 5% or 25%? There is a big difference between the two. It is unlikely that this warning alone will ensure that the unwary investor knows what could potentially happen to his or her money.


Example - Not easily understood by non-experts
"The investments and services offered by us may not be suitable for all investors. If you have any doubts as to the merits of an investment, you should seek advice from an independent financial advisor."


This certainly warns people to be careful, but how many investors really understand what is meant by "suitability" or would bother to double-check? And if the investor trusts the seller, he will think he is being careful. The odds of an investor actually going to an advisor are low. 


Example -  Relativity and context given
"You should be aware that certain types of funds might carry greater investment risk than other investment funds. These include our Smaller Companies, Pacific Growth and Japan funds."


Now we are moving in the right direction. You can see from this that the same company has other, safer investments, which you may prefer. This is no longer a token warning, and points clearly to lower-risk alternatives. 


Example - The losses can be BIG


"Investment in the securities of smaller companies can involve greater risk than is generally associated with investment in larger, more established companies that can result in significant capital losses that may have a detrimental effect on the value of the fund."


What is good about this one is that the investor is warned that the losses can be substantial. This is still not quantified, but the point that the investment is not for the faint at heart is clear enough.


Example - Now that's a warning!


"You should not buy a warrant unless you are prepared to sustain a total loss of the money you have invested plus any commission or other transaction charges."


No need for vast experience or a vivid imagination. It is quite clear that you can lose the lot.


Criteria for a Good Risk Warning
There are several criteria that a warning should fulfill if it is to get the right message across:


Quantification: 
Although this is not always possible, investors should have some idea as to the proportion of their money that they could lose.  


Warnings should be easy to follow:
 Any risk warning should be easy to understand. If you don't understand what the risk warning is telling you, don't assume that the investment is right for you just because you trust the seller. An inexperienced investor could easily be advised to buy anything, ranging from a basic stock fund to a highly complex packaged product. (To get your feet wet in complex products, read The Barnyard Basics Of Derivativesand Understanding Structured Products.)


Signing is important for both parties:
 If an investor has to sign the warning, this demonstrates its importance to him or her, and provides good protection to the firm. However, never sign anything your don't understand.


Internet warnings: 
On the internet, it is all too easy to click away a warning and carry on with the deal. In a perfect world, the link and entry would be very clear and the investor prompted to take the warning seriously. This is not a perfect world, however, and it's up to investors to make sure they read the disclaimer before continuing.


Personal explanations: 
These are the only way many investors will really understand the risks of a given investment. If the print warning does not meet your criteria, seek out personal advice. The explanation should be clear and give sufficient detail so you know what you could lose, and how, and what other products might be more or less suitable and appealing. The seller should also make a note of how the warning was presented and, if possible, get the investor to sign this too.


Ask Until You Are Sure
As a private investor, you need to request verbal and/or written information and explanations until you are sure you understand the warnings. Don't stop until you are fully aware, in quantitative terms, of what you stand to gain and lose, and what other potential investments there are with different risk/reward ratios. (For related reading, see Is Your Broker Acting In Your Best Interest? and Understanding Dishonest Broker Tactics.)


Conclusion
It is essential that investment risk warnings be clear and sufficient not only to provide legal protection, but also to ensure that the message truly gets home. Firms and advisors should only sell products with a warning that conveys the real level of risk in no uncertain terms; unfortunately, what should be done and what is common practice are two different things. As an investor it's crucial to know how much of your money you could lose and what circumstances could cause this to occur. If you are uncomfortable with the risks of the investment, remember there are always lower-risk alternatives.


For another angle on fine print, see Footnotes: Start Reading The Fine Print.

Get A Hold On Mishandled Accounts

Investors often look to professionals to help them navigate the markets and provide a certain level of service, but there are times when they may feel that an account is being mishandled. As tempting as it may be to find someone to blame for monetary losses, they are often the result of market conditions and investors must be prepared for such risks. However, arbitration or other avenues may be warranted if evidence suggests that a broker recommended an unsuitable investment, committed fraud, or charged excessive commissions by "churning" the account. In this article, we'll help you to decide whether your account has been mishandled and if you do need to act on the complaint. (To learn more, see Paying Your Investment Advisor - Fees Or Commissions?)


Your First Steps

If you feel that your broker has not acted in your best interest, try to exhaust all possible remedies with the investment company. After quantifying the loss, schedule a meeting with the primary contact at the investment firm to have an extensive discussion, and listen to the broker's side of the story. If this process does not yield adequate information, escalate the complaint to the next level of management until some type of resolution is reached. This may include various outcomes, including simply waiting for the markets to improve to ending all discussions and proceeding with legal action. 


If the dispute is with a broker, you probably already agreed to settle through arbitration when you began working with the firm. In this case, the Financial Industry Regulatory Authority (FINRA), formerly the National Association of Securities Dealers (NASD), would handle the arbitration process from start to finish. The group's dispute resolution forum helps resolve matters between investors and securities firms, as well as industry-related issues between individual registered representatives and their firms. (To learn more, see Broker Gone Bad? What To Do If You Have A Complaint and When A Dispute With Your Broker Calls For Arbitration.)

If You Need Legal Representation

As with any potentially lucrative legal proceeding, many legal advisors offer free consultations. Consulting an attorney opens up an outside perspective and can help confirm the appropriate forum for resolving a dispute. This is a good time to begin building a short list of potential litigators, should the need arise. If an arbitration path is appropriate, the list will shrink, as more attorneys handle court cases than arbitration.


While the entire process is simplified in order for any one who has a grievance to file a claim and proceed, the majority of customers pursue their claims in conjunction with a legal team that includes at least one attorney and an expert witness. It is also a good time to set reasonable expectations with potential outcomes and time frames. Do not count on large settlements that include punitive damages, as such generous judgments are rarely rendered. Be prepared to wait months or even years before the arbitration date is set. Depending on the size of the claim and the legal participants, anticipate that arbitration that is not completed in the originally scheduled time frame may be postponed to accommodate participant and panel members' schedules.
The Arbitration ProcessThe table below presents the number of cases handled by FINRA on an annual basis. Typically, the caseload increases in years following volatile financial markets where investors have suffered losses. Caseloads hit historically high levels in 2003, approximately two years after what the tech bubble burst and the stock market plunged. 

Year	Cases
2002	7,704
2003	8,945
2004	8,201
2005	6,074
2006	4,614
2007	3,238

If arbitration appears to be the best course of action, visit the FINRA website and search pending cases with the investment firm or registered representative in question. The listing will provide a summary and itemization of any pending or closed cases against the firm and its representative or advisor. It will not, however, include every issue or any cases that expunged the record as part of the settlement. 

If the search is for a registered investment advisor (RIA) rather than someone who works for a brokerage firm, you will be redirected to the Securities And Exchange Commission (SEC) website, or possibly to a state-sponsored site if the advisor is state licensed. If the search is for a registered representative or a brokerage firm, FINRA's BrokerCheck program will search data from the Central Registration Depository (CRD) registration and licensing database, which gathers data reported on industry registration and licensing forms. BrokerCheck reports professional background information on currently registered brokers, registered securities firms and previously registered parties. One section provides vital information regarding events reported at the CRD, which is required by the securities industry registration and licensing process. Any number of financial disclosures can be listed here, including bankruptcies or unpaid liens. The listing might also contain formal investigations, customer disputes, disciplinary actions and criminal charges or convictions.

Filing a Complaint

If you determine that the portfolio was mishandled, the next step is to file a complaint. FINRA suggests doing so as soon as possible to avoid a delay in arbitration or mediation. Mediation, which can serve as a supplement or replacement for arbitration depending on the outcome, is a voluntary process in which both parties can settle their disputes in a non-binding format. For most claims under $25,000, the process is resolved primarily through written statements filed by each party to FINRA. At any point the claimant, respondent, or arbitrator may request a hearing. These smaller cases can be assigned to a single arbitrator and may settle fairly quickly. 

Claim amounts greater than $25,000 are usually assigned to a three-person arbitration panel. Because they typically settle in-person and involve more formalities, they tend to take longer. FINRA offers a complete online claim filing process, and this is where most investors get bogged down. While FINRA has streamlined the process for the layman to follow, it is still a legal proceeding with required documents such as the "statement of claim".  Many frustrated investors will pursue the services of an attorney at this point. 

Evaluate Your Progress

This stage of the process is a good time to step back, evaluate your progress, and set time frames and expectations. Keep in mind, however, that the relationship between you and the representative or advisor has changed. While customers sometimes stay with the company against which they have filed claims, most do not. Depending on the claim or loss, they have probably moved to another firm, liquidated their holdings or made other arrangements. The process from this point on becomes a legal proceeding, although it is slightly less formal than a typical court proceeding; you should view this process as a resolution-in-progress. 

Conclusion

FINRA provides a framework for licensing, registration, education, monitoring and policing of the brokerage community to ensure the public receives the best service. While the vast majority of financial service professionals provide excellent service, some accounts are mishandled and FINRA has the process available for anyone to pursue what he or she believes is a valid claim. It is important to remember that all decisions made by either the sole arbitrator or the combined panel are binding and that the judgments are enforceable, as they would be in a court. Finally, consider that while the investor has every right to pursue a claim, doing so carries costs such as filing fees, arbitration and/or mediation fees, and if the panel decides a case is frivolous, legal and other costs will apply. 

ADRs: Invest Offshore Without Leaving Home

It was April 1927. Calvin Coolidge was president, and noteworthy events that die-hard historians or baseball fans may recall include the Italian anarchists Saccho and Vanzetti receiving their death sentences and Babe Ruth hitting the first of his 60 home runs, - a single-season record at the time. For investors, a third event in April 1927 has proved equally important and far more profitable: the debut of American depositary receipts (ADRs). (Read What Are Depositary Receipts? for background reading on this common type of security.)

An ADR represents ownership of shares in a foreign company, but it can be bought and sold just like any U.S. stock, allowing investors to diversify their portfolios with foreign assets, but skip the hassle of a foreign brokerage account. Sound intriguing? Find out how these securities work and what they can add to your portfolio.

History of the ADR and Current Stats
John Piermont Morgan (yes, that J.P. Morgan), launched the first ADR for the U.K.'s Selfridges Provincial Stores Limited, the famous retailer now known as Selfridges Plc. Even the audacious J.P. Morgan probably had no idea of the trend he was touching off. As of mid-2008, there were more than 2,250 depositary programs representing more than 1,800 companies from over 70 countries listed on global stock exchanges. According to the Bank of New York Mellon, in the first half of 2008, 52 billion shares of ADRs changed hands, representing a value of $2.07 trillion.

Benefits of ADR Investing
Some benefits of ADR investing are clear. First, many international markets, especially emerging markets, have higher GDP growth rates than the United States or Europe. While the American stocks in your portfolio may be stagnating, holding a few ADRs has the potential to provide you with solid returns during downturns in domestic markets. Your broker and the financial media are always advocating diversification; ADRs represent a great avenue to diversify your portfolio. (Read Going International to learn about this and other ways to diversify your portfolio with foreign stocks.)

Another benefit investors can realize through ADR investing is favorable currency conversions for dividends and other cash distributions. For example, if you own shares of a European ADR and the euro is strong against the dollar, a dividend increase will be that much more rewarding because the dividend payment has to be converted to dollars. (Read more in The Impact Of Currency Conversions.)

The most obvious benefit of ADRs is that they make international companies that investors would normally have to pay a premium for (or perhaps be unable to buy at all) more accessible. If you want to buy 100 shares of Petrobras, the Brazilian oil giant, all you need to do is call your broker or log onto your online brokerage account. There's no need to find a distant relative living in Brazil to execute the trade for you.

Perils and Pitfalls
As buyers of ADRs, we treat them as we would any other securities purchase: we want to profit. However, there are issues that can arise with ADRs that aren't always germane to domestic stocks. Let's use a 2008 geopolitical conflict to highlight a potential peril. Say you own some shares of a Russian oil ADR, and neighboring country Georgia's military is able to knock out a couple hundred miles of pipeline. As far-flung as it seems, this scenario could come to bear, especially in a developing nation. The same goes for political unrest. It's probably best to identify dictators and not invest in companies based in nations that are ruled by these leaders, as these countries are more prone to political strife. (Due diligence is key to not getting burned by an unfamiliar investment. Read Due Diligence In 10 Easy Steps to learn what to look for.)

Of course your ADR investments are subject to some of the same risks as your domestic investments, including credit, currency and inflation risk. These should be taken into account, regardless of the state of the market. There are some markets, such as Australia and Canada, where the local currencies are tied directly to commodity prices. If gold or oil is going up, this contributes to a rise in those currencies. Of course, when those commodities fall, the currencies fall in tandem. This is just one more factor an investor needs to take into account. (Read Investing Beyond Your Borders for more risks associated with investing overseas.)

There are levels of ADRs on U.S. markets. For example, a Level I ADR trades over the counter and as such, is highly speculative. Those shares probably aren't liquid and, what's worse, information on the company is scant. Keep in mind that many countries don't require their public companies to report results quarterly like the U.S. does. For better or worse, Level I issues are the fastest-growing segment of the ADR market, according to the Bank of New York Mellon.

Thinking of buying that Chinese solar company that trades 20,000 shares a day at $1.50? It's probably best to wait for it to graduate to the Nasdaq or NYSE. Level II and III ADRs are where investors want to be. These are the ADRs that trade on major U.S. exchanges and must uphold the same general reporting rules and SEC regulations as American-based corporations. (IFRS are poised to change some aspects of international reporting. Read International Reporting Standards Gain Global Recognition to learn more.)

Tax Treatment of ADRs
Tax treatment of ADRs by the IRS is generally the same as for domestic investments. Investors are subject to the same capital gains and dividend taxes at the same rates. There is a little twist, however: many countries will withhold taxes on dividends paid. While the American investor must still pay U.S. income tax on the net dividend, the amount of the foreign tax may be claimed by the investor as a deduction against income or claimed against U.S. income tax. Investors are encouraged to consult a professional tax or investment advisor to make sure they are recording (and paying taxes on) their ADR investments properly. (Read more about capital gains and dividend taxation in Dividend Facts You May Not Know.)

Conclusion
Investors should look beyond the confines of the U.S. borders in an effort to diversify and maximize returns. Many investors ignore the foreign-equity asset class entirely, and this is not beneficial to their portfolios. ADRs are one way to diversify your portfolio and help you achieve better returns when the U.S. market is in a slump.

Why Being A Copycat Investor Can Get You Hurt

While some investors are trailblazers and do their own research, many investors attempt to mimic the portfolios of well-known investors, such as Warren Buffett of Berkshire Hathaway, in the hope of being able to cash in on those investors' world-class returns. But copying another investor's portfolio, particularly an institutional investor's portfolio, can actually be quite dangerous. So, before you jump on the copycat bandwagon, get to know the pitfalls of this approach to investing.

An Inability to Adequately Diversify Holdings
It is not uncommon for a major institutional investor, such as a mutual fund, to own more than 100 stocks in a given portfolio. Even Berkshire Hathaway (Warren Buffett's investment vehicle), which has a tendency to invest in fewer stocks as opposed to more, owns shares in some 38 (as of June 30, 2008) different public companies! (Read Build A Baby Berkshire and Warren Buffett's Best Buys to learn more about investing like Warren Buffett.)

Institutional investors like Warren Buffett are able to spread their risk over a number of companies so that if one particular company, sector, industry, or even country hits a rough patch, there are other investment holdings that may pick up the slack. Unfortunately, most individual investors have neither the funds, nor the financial wherewithal to ever achieve such diversification. (See what can happen when diversification goes too far in The Dangers Of Over-Diversification.)

So what do investors do when they realize that they cannot maintain as many positions as an institutional investor?

Usually, the individual investor will copy or mimic a small portion of the institution's holdings (that is, heavily invest in some holdings and ignore others entirely). Unfortunately, this is where trouble can occur – especially if one or more of those core holdings heads south.

An individual investor's inability to adequately mimic an institution's diversification profile and mitigate risk is a major reason why many individuals fail to outperform major mutual funds - even if they maintain similar holdings. (To find out more about institutional sponsorship as a gauge of stock quality, read Institutional Investors And Fundamentals: What's The Link?)

Different Investment Horizons
Many people like to refer to themselves as longer-term investors, but when it comes down to it, most investors want to see results in the first 12 to 24 months that they own a particular stock.

In fact, according to an often-cited November 2001 study by Gavin Quill (a senior vice president and director of research studies at Financial Research Corporation, a financial services research and consulting firm), mutual fund holding periods in 2000 were only about three years! That is well shy of the more than 30 years that Berkshire Hathaway has owned shares of Washington Post Company. In other words, on average, institutions seem to have much more patience than their individual-investor counterparts do. (Read more about how investing for the long haul can benefit you in Long-Term Investing: Hot Or Not?)

In short, even if individual investors achieve diversification similar to the institutions they are looking to mimic, they might not be able afford or have the patience to sit on a given investment for five or 10 years, as they may need to tap into the funds to buy a home, to pay for school, to have children or to take care of an emergency situation, and doing so may adversely impact their investment performance.

Institutional Knowledge/Research
In spite of regulations meant to level the playing field between individuals and institutions (such as Reg FD, which outlines a company's disclosure responsibilities), institutions often employ teams of seasoned industry analysts. These trained experts typically have many contacts throughout the supply chain and tend to have more frequent contact with a given company's management team than the average individual investor. (Read more about the role of Reg FD in Defining Illegal Insider Trading.)

Not surprisingly, this gives the institutional analysts a far better idea of what is going on at a company or within a given industry. In fact, it is almost impossible for the individual to ever gain the upper hand when it comes to such knowledge. (Learn more about Wall Street analysts in Three Kinds Of Analysts And What You Need To Know About Them.)

This relative lack of knowledge about future earnings potential, opportunities for growth, competitive forces, etc. can adversely impact investment results. In fact, a lack of knowledge is another major reason why many individual investors tend to underperform mutual funds over time. (You can piece together your own analysis if you have the right information. Read Do-It-Yourself Analyst Predictions to find out how.)

This is compounded by the fact that analysts can sit and wait for new information ,while the "average Joe" has to work and attend to other matters. This creates a lag time for individual investors, which can prevent them from getting in or out of investments at the best possible moment.


Keeping Tabs on Institutions Is Tough
Even if an individual has enough money to adequately diversify him- or herself, the willingness to hold positions for an extended period of time and the ability to accurately track and research multiple companies, it is difficult to copy the actions of most institutions.

Why? Because, unlike Berkshire Hathaway, many mutual funds buy and sell stocks with great vigor throughout a given quarter.

In fact, take T. Rowe Price as an example. According to the company's website, its Capital Opportunity Fund (which invests primarily in domestic securities) has a turnover rate of 63.5 as of July 31, 2008. That's big.  This makes positions like these are hard to mimic because even if you had access to databases that track institutional holdings the information is usually updated on a quarterly basis.

What happens in between? Frankly, those looking to mimic the institution's portfolio are left guessing, which is an extremely risky strategy, particularly in a volatile market. (Learn some ways you can keep track of institutional investment activities in Keeping An Eye On The Activities Of Insiders And Institutions.)

Trading Costs Can Be Huge, and Treatment May Vary
By definition, institutions such as mutual funds have more money to invest than the average retail investor. Perhaps not surprisingly, the fact that these funds have so much money and conduct so many trades throughout the year causes retail brokers who service these accounts to fawn over them.

Funds often receive favorable treatment. In fact, it's not uncommon for some funds to be charged a penny (or in some cases a fraction of a penny) per share to sell or purchase a large block of stock – whereas individual investors will typically pay 5-10 cents per share.

In addition, even though there are rules to prevent this (and time and sales stamps that prove when certain trade tickets were entered), institutions often see their trades pushed ahead of those of retail investors. This allows them to realize more favorable entry and exit points. (Read Patience Is A Trader's Virtue and A Look At Exit Strategies for a discussion of setting entry and exit points.)

In short, the odds are that the individual, regardless of his or her wealth, will never be able to garner such preferential treatment. Therefore, even if the individual was able to match an institution in terms of holdings and diversification, the institution would probably spend fewer dollars on trades throughout the year, making its investment performance, on a net basis, better overall. (Learn where you may be paying more than you think in The Hidden Costs Of Investing.)

Bottom Line
While it may sound good in theory to attempt to mimic the investment style and profile of a successful institution, it is often much harder (if not impossible) to do so in practice. Institutional investors have resources and opportunities that the individual investor cannot hope to match. Retail investors may benefit more, in the long run, from an investment strategy more suited to their means.

Coping With Inflation Risk

Inflation, although not as dramatic as a market crash, can be even more devastating in the long run, steadily eroding the value of a portfolio year after year. Moreover, it is prone to flare-ups, which can make its effects especially acute. These effects include:
Reduction of purchasing power
Disruptions to stock and bond markets, which may cause volatility
Devaluation of income on interest-bearing securities
Squeezing of the profit margins of certain types of stocks
From an investment standpoint, this means inflation is a risk to be managed and balanced against more obvious forms of risk, such as volatility and loss of principal. (To read more about inflation basics, see All About Inflation.)

Historical Examples of Inflation
Inflation is the increase in the price of goods, services, commodities and/or wages. A look at past inflation numbers illustrates what inflation is capable of doing.


According to the widely recognized Ibbotson compilation of data, inflation in the United States averaged 3% annually from the beginning of 1926 through the end of 2007. As is often the case though, long-term averages do not reflect the extremes along the way that can also be instructive in understanding inflation.


While inflation averaged 3% during those 82 years, there were 10 years in which inflation was negative, meaning that prices, in aggregate, actually declined. At the other end of the spectrum, there were four years in which inflation increased at a double-digit rate.


These extremes, which tend to come in bunches, often have a cumulative effect. For example, during the 10 years ending in 1935, inflation decreased at a rate of 2.6% per year. As a result, an item that 10 years prior sold for $100 cost $77.10 in 1935 - a substantial decline in price. On the other hand, during the 10 years ending in 1982, inflation averaged 8.7% annually. Consequently, an item that 10 years prior cost $100, more than doubled in price to $229.65 by 1982.

Even with these extremes, the American economy has never experienced the true extent of inflation risk. Hyperinflation, which occurred in Germany during the 1920s and still crops up from time to time in isolated developing economies, can rapidly devalue a currency and cause economic chaos.

Portfolio ImpactsFor investors, the portfolio impacts of inflation can be discussed in terms of the long-term, overall impact, and the short-term disruptions on specific asset classes.

In the long term, inflation erodes a portfolio's purchasing power. At an average inflation rate of 3% per year, the value of a portfolio is cut in half every 23 years or so.

In this respect, the impact of inflation is every bit as severe as that of a market crash - and even more devastating in the long run. Historically, U.S. stock market crashes are always followed by a recovery, even if it is a long and painstaking one. In contrast, because periods of deflation (negative inflation) are rare, the effects of inflation tend to be permanent.

Thus, investors cannot ignore inflation risk, which unlike other forms of risk, cannot be avoided simply by investing conservatively (or not at all). Even cash held in the safest vault in the world is subject to the steady erosion of purchasing power as a result of inflation.

What You Can Do to Protect Your PortfolioTherefore, the first step toward fighting inflation is to be constructively invested. The challenge of this is that in the short term, periods of inflation are disruptive to all sorts of financial assets. During the highest 10-year period for U.S. inflation, from January 1, 1973, through December 31, 1982, the following were the cumulative real returns (overall returns adjusted for inflation) for stocks, bonds and T-bills:

January 1, 1973, through December 31, 1982
Asset Class	Cumulative Real Return
Stocks	-16.85%
Long-Term U.S. Bonds	-23.73%
T-Bills	-1.93%

Looking at longer-term data, however, adds a very different perspective: 

January 1, 1926, through December 31, 2007
Asset Class	Cumulative Real Return
Stocks	+882.37%
Long-Term U.S. Bonds	+572.35%
T-Bills	+72.28%

Some critical takeaways from this data include:

When inflation was at its most extreme, none of the major investment asset classes were able to keep up with the rate of inflation

The effects of extreme inflation were felt most severely by bonds

While T-bills came closest to keeping up with inflation at its most extreme, they offered the weakest long-term return (both before and after inflation) 

(Keep reading about real returns in What You Should Know About Inflation and Curbing The Effects Of Inflation.)

Commodities and Inflation

Commodities (oil, grains, metals, etc.) are often touted as a portfolio hedge against inflation. There is some logic to this, as commodity prices tend to rise during periods of inflation, and in turn, rising commodity prices can be a key root cause of inflation. (To read more about commodities, see Commodities That Move The Markets and Commodities: The Portfolio Hedge.)

Unfortunately though, there are some risks associated with investing in commodities:

They have no income or earnings stream; as a result, they have no inherent value beyond their market prices, which are totally dependent on the perceptions of other investors.

They are prone to periods of speculation, which causes volatility. This is especially true during inflationary periods, meaning commodities might be at their most risky just when they seem most appealing.

They are not a perfect inflation hedge.

First of all, there are many types of commodities, not all of which will rise equally during inflationary periods. Inflation can be driven by particular commodities (ex. oil), which may actually dampen the price of other commodities.

Second, not all inflation affects commodities. For example, wage inflation can impact the price of finished goods and services without increasing the price of commodities.

Commodities are good hedges for people and businesses subject to very specific risks based on particular commodities, or for sophisticated investors with a detailed perspective on inflation. However, commodities are not good mainstream portfolio investments for the average investor.

Portfolio Construction

Given its profound impact, inflation has to be addressed by any long-term investment portfolio. While there are no perfect hedges against inflation, there are some rational investment responses to inflation concerns:

A long-term perspective is critical. In the short-run, no asset class is a perfect inflation hedge, but because the effects of inflation are most devastating on a cumulative basis, long-term returns matter most.

Stocks play a crucial role. While stocks may be more subject than other asset classes to loss of principal, they can help a portfolio combat the effects of inflation. This is not simply because they offer the highest returns over time. Fundamentally, stocks represent businesses that are actively adjusting to prevailing conditions, so the earnings stream of a well-diversified portfolio can adapt over time to the inflationary environment.

Bonds are most sensitive to high inflation. In some respects, a U.S. government bond may seem like an iron-clad investment, but while its principal and interest are guaranteed, the future purchasing power of that principal and interest can be significantly reduced by inflation.

The above are general observations, but as always, specific market conditions can change the equation. For example, when stocks are highly overvalued, their future returns (and thus their inflation-fighting power) are likely to be diminished. Conversely, because bonds tend to fall in price in response to signs of inflation, their yields may rise to the point at which they represent an attractive premium over inflation. Therefore, investors should target long-term portfolio weightings according to the long-term trends described above, but should also be alert to market extremes which can skew those trends.

To read more about constructing your portfolio, see Portfolios Rise From Oblivion To Omnipresence and A Guide To Portfolio Construction. 

Who's Looking Out For Investors?

In the financial services industry, consumers pay a fee for a service and expect a certain level of security in return. When an investor pays a broker to handle his or her accounts, the broker is obligated to act in that investor's best interests. This obligation is not only moral, but also arises from the rules set forth by the industry's various regulatory agencies. The problem is that if an account is mishandled, most consumers have no idea where to turn until it's too late. 


Examples of mishandling range from churning to suitability to fraud. Churning is an unethical practice employed by some brokers to increase their commissions by excessively trading in a client's account. Suitability relates to the types of investments chosen for the account and whether they are appropriate for a particular investor, while fraud can encompass a wide range of behaviors with varying levels of severity. 


So who is looking out for the average investor? 
Is it the Financial Industry Regulatory Authority (FINRA), the state regulatory agencies, the Securities and Exchange Commission (SEC), the Office of the Comptroller of the Currency (OCC) or the Federal Reserve Board (FRB)? The answer is all of the above, but each in its own way. Read on to learn more.


FINRAFor most consumers, FINRA, the agency that governs business between brokers, dealers and the investing public, is the first line of defense in the event of a problem associated with an investment account.


When an investor opens an account at a U.S.-based brokerage firm, the fine print in the lengthy account-opening document typically stipulates that consumers give up their rights to pursue the brokerage company in a venue outside arbitration. Under FINRA's rules, however, the consumer maintains the right to pursue arbitration. As a result, the lion's share of consumer complaints against brokerages is fielded by FINRA and is usually arbitrations.


Arbitrations are basically court-like settings where judges are replaced by a panel of peers. Cases are presented by claimants (plaintiffs), with or without their attorneys, and are defended by respondents (defendants), who typically have attorneys. 


The process begins by filing a claim with FINRA, which then notifies all parties involved that proceedings have begun. Arbitration is designed to be simple in order to accommodate the average consumer lacking legal expertise and allow him or her to file a claim without the need to hire an attorney. The forms are written in plain language so as not to discourage someone from filing. 


However, while the initial filing can be processed without an attorney, it is widely suggested that the claimant (plaintiff) hire an attorney as he or she will encounter a barrage of deep-pocketed legal defense maneuvers once the claim is filed. There is no shortage of legal services available for claimants, and many attorneys will take cases on contingency, especially if there is a large potential settlement and what they feel is a good chance of winning.


While the arbitration process is effective and orderly, consumers pursuing a case should be prepared for the same time lags they would experience with a typical state or federal court case. The filing process can take up to one year and proceedings after the initial filing can take years. 


Because the process can take a significant amount of time and resources, it is highly recommended that consumers that have been treated unfairly exhaust all measures for handling grievances directly with their broker or investment manager prior to filing a complaint with FINRA. (For further reading, see Investigating The Securities Police.)


State Regulatory AgenciesWhile FINRA fields the majority of complaints from investors, there are other lines of defense with overlapping powers. For instance, each state has its own regulatory agency to police the in-state activities of the securities industry. While a state's regional jurisdiction is defined by its own state lines, its professional jurisdiction varies. 


Typically, the state polices a variety of financial services providers ranging from credit unions to broker dealers. State agencies also cover investment advisors that fall below the requirement for filing with the SEC (less than $25 million under management). Here, the coverage that state agencies provide is similar to the SEC's duties of licensing, filing and auditing. Regulatory overlap is usually avoided as registered investment advisors only register under one agency or the other. 
The state typically gets involved early in an investigation and then cooperates with the SEC as the investigation deepens. While effective, the state agencies are not usually as well staffed as FINRA or the SEC and have to cover a larger caseload per investigator. 


The SECThe glue that holds the investor protection system together is the SEC, which arose from the ashes of the 1929 stock market crash and was crafted around the Securities Act of 1933 and the Securities Exchange Act of 1934. The SEC governs the self-regulatory organizations (SROs) that reach down to the consumer, and its jurisdiction is far reaching, covering four main divisions: 


corporate finance
market regulation
investment management
enforcement


The SEC's responsibilities have become ever more challenging with the advent of computer-based crimes and the increasing complexity of financial products and transactions, but its primary purpose is still to protect the individual investor by watching over the investment management industry and ensuring that public companies provide sufficient financial and other information to the public to allow investors to make informed decisions. 


With the new challenges in the marketplace, there has been a call to increase the flexibility of the SEC's power. However, despite years of discussions about consolidating regulatory bodies or appointing a finance czar, there are no concrete plans in the pipeline. (Learn more about how this regulatory body protects the rights of investors in Policing The Securities Market: An Overview Of The SEC.)


The OCC and the FedThere are two other regulatory bodies spoken of frequently, the less common Comptroller of the Currency (OCC) and the famous (or infamous) Federal Reserve Board (FRB). While both of these bodies are very active in watching out for investors, their activities are focused on banking and financial services at a higher level, and their involvement in individual cases is rare.


Conclusion
Each of these regulatory bodies looks out for investors in its own way, and each has its specific duties with some overlap. The regulatory organizations have become increasingly sophisticated to accommodate increasingly complex investment transactions and products, but are challenged each year as new issues arise. These organizations are designed to protect consumers, so if you have a problem that you aren't able to resolve directly with your broker, take advantage. Remember, just like your local police, the regulatory agencies won't know about any issues unless you contact them.

Understanding The Time Value Of Money

Congratulations!!! You have won a cash prize! You have two payment options:


A. Receive $10,000 now


OR 


B. Receive $10,000 in three years 


Which option would you choose? 


What Is Time Value?
If you're like most people, you would choose to receive the $10,000 now. After all, three years is a long time to wait. Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive. So at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later. 


But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn't it? Actually, although the bill is the same, you can do much more with the money if you have it now because over time you can earn more interest on your money.


Back to our example: by receiving $10,000 today, you are poised to increase the future value of your money by investing and gaining interest over a period of time. For Option B, you don't have time on your side, and the payment received in three years would be your future value. To illustrate, we have provided a timeline:

If you are choosing Option A, your future value will be $10,000 plus any interest acquired over the three years. The future value for Option B, on the other hand, would only be $10,000. So how can you calculate exactly how much more Option A is worth, compared to Option B? Let's take a look. 


Future Value Basics
If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the future value of your investment at the end of the first year is $10,450, which of course is calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount: 

Future value of investment at end of first year: = ($10,000 x 0.045) + $10,000 = $10,450

You can also calculate the total amount of a one-year investment with a simple manipulation of the above equation: 




Original equation: ($10,000 x 0.045) + $10,000 = $10,450
Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450
Final equation: $10,000 x (0.045 + 1) = $10,450
The manipulated equation above is simply a removal of the like-variable $10,000 (the principal amount) by dividing the entire original equation by $10,000. 


If the $10,450 left in your investment account at the end of the first year is left untouched and you invested it at 4.5% for another year, how much would you have? To calculate this, you would take the $10,450 and multiply it again by 1.045 (0.045 +1). At the end of two years, you would have $10,920:

Future value of investment at end of second year: = $10,450 x (1+0.045) = $10,920.25

The above calculation, then, is equivalent to the following equation:

Future Value = $10,000 x (1+0.045) x (1+0.045)

Think back to math class and the rule of exponents, which states that the multiplication of like terms is equivalent to adding their exponents. In the above equation, the two like terms are (1+0.045), and the exponent on each is equal to 1. Therefore, the equation can be represented as the following:

We can see that the exponent is equal to the number of years for which the money is earning interest in an investment. So, the equation for calculating the three-year future value of the investment would look like this:

This calculation shows us that we don't need to calculate the future value after the first year, then the second year, then the third year, and so on. If you know how many years you would like to hold a present amount of money in an investment, the future value of that amount is calculated by the following equation:

Present Value Basics

If you received $10,000 today, the present value would of course be $10,000 because present value is what your investment gives you now if you were to spend it today. If $10,000 were to be received in a year, the present value of the amount would not be $10,000 because you do not have it in your hand now, in the present. To find the present value of the $10,000 you will receive in the future, you need to pretend that the $10,000 is the total future value of an amount that you invested today. In other words, to find the present value of the future $10,000, we need to find out how much we would have to invest today in order to receive that $10,000 in the future.


To calculate present value, or the amount that we would have to invest today, you must subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we can discount the future payment amount ($10,000) by the interest rate for the period. In essence, all you are doing is rearranging the future value equation above so that you may solve for P. The above future value equation can be rewritten by replacing the P variable with present value (PV) and manipulated as follows:

Let's walk backwards from the $10,000 offered in Option B. Remember, the $10,000 to be received in three years is really the same as the future value of an investment. If today we were at the two-year mark, we would discount the payment back one year. At the two-year mark, the present value of the $10,000 to be received in one year is represented as the following:

Present value of future payment of $10,000 at end of year two:

Note that if today we were at the one-year mark, the above $9,569.38 would be considered the future value of our investment one year from now.


Continuing on, at the end of the first year we would be expecting to receive the payment of $10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of a $10,000 payment expected in two years would be the following:

Present value of $10,000 in one year:

Of course, because of the rule of exponents, we don't have to calculate the future value of the investment every year counting back from the $10,000 investment at the third year. We could put the equation more concisely and use the $10,000 as FV. So, here is how you can calculate today's present value of the $10,000 expected from a three-year investment earning 4.5%:

So the present value of a future payment of $10,000 is worth $8,762.97 today if interest rates are 4.5% per year. In other words, choosing Option B is like taking $8,762.97 now and then investing it for three years. The equations above illustrate that Option A is better not only because it offers you money right now but because it offers you $1,237.03 ($10,000 - $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you receive from Option A, your choice gives you a future value that is $1,411.66 ($11,411.66 - $10,000) greater than the future value of Option B. 


Present Value of a Future Payment
Let's add a little spice to our investment knowledge. What if the payment in three years is more than the amount you'd receive today? Say you could receive either $15,000 today or $18,000 in four years. Which would you choose? The decision is now more difficult. If you choose to receive $15,000 today and invest the entire amount, you may actually end up with an amount of cash in four years that is less than $18,000. You could find the future value of $15,000, but since we are always living in the present, let's find the present value of $18,000 if interest rates are currently 4%. Remember that the equation for present value is the following:

In the equation above, all we are doing is discounting the future value of an investment. Using the numbers above, the present value of an $18,000 payment in four years would be calculated as the following:

Present Value

From the above calculation we now know our choice is between receiving $15,000 or $15,386.48 today. Of course we should choose to postpone payment for four years! (For related reading, see Anything But Ordinary: Calculating The Present And Future Value Of Annuities.)

Conclusion
These calculations demonstrate that time literally is money - the value of the money you have now is not the same as it will be in the future and vice versa. So, it is important to know how to calculate the time value of money so that you can distinguish between the worth of investments that offer you returns at different times.

To read more on this subject, see Continuously Compound Interest.