Harold Evensky CFP® , AIF® Chairman
Having the option to sell an investment whenever you want and getting all of your money back is not the same thing.
Dr. Elizabeth Boone is a surgeon, a long-time friend and client. I’d been looking forward to chatting with Elizabeth about how my alma mater just trounced hers in basketball.
Receptionist: Hello, Harold; it’s Dr. Boone on 88.
HE: Hello, Elizabeth. Did you see the game?
EB: Forget it, Harold. Our best rebounder was out with a broken collarbone, the referees had to use braille to read the scoreboard, and our coach had the flu. Besides, I’ve got a problem.
HE: Sorry, Elizabeth. What’s up?
EB: I need some advice for my mom.
EB: She just received an inheritance from my aunt’s estate and she’s asking me how to invest it. I told her CDs are safe, but right now the rates are so low that she’d get more return if she buried her money in the backyard. She doesn’t have to pay much in the way of taxes and since she mostly needs income, her broker suggested one of those government bond funds and preferred stock that pay high dividends. I wanted to check with you to make sure that was all right.
HE: Good grief!
EB: Excuse me?
HE: Elizabeth, I’ve heard this same story about six zillion times. Let me ask you a few questions: first, how worried would your mom be about principal fluctuation?
EB: What on earth does principal fluctuation mean?
HE: Will your mom be worried if the value of her fund goes up and down, as long as her income is fairly steady?
EB: I don’t even need to ask her. She and Dad had big tax-free bond portfolio years ago. When interest rates went up, they’d watch their bond prices go down with each statement! I thought they’d die from bleeding ulcers. Harold, I also had lots of those long-term bonds and I still have the ulcers. Never again! You know how I feel about that. You’re the one who restructured my portfolio.
HE: Okay, Elizabeth, okay. Just checking. Second question: how carefully have you or your mom checked into the suggestion of government funds and preferreds?
EB: Pretty well, Harold. You know my mom—she’s sharp. She asked a lot of good questions of the broker and jotted down the answers. Let me read you the gist of how the conversation went:
Broker: Mrs. E., based on what you’ve said, you want income and safety, right?
Mrs. E.: Right.
Broker: Well, I think we should split your investment between our government fund and a portfolio of well-selected preferred utility stocks.
Mrs. E.: Mr. Broker, this is almost all of my money and you’re right, I’m really concerned about safety and income. How safe are these investments?
Broker: Mrs. E., the preferred stocks we’ll buy are all from highly rated companies—real blue chips—and the government fund invests in bonds guaranteed by the United States government. We’re talking safety!
Mrs. E.: What happens if I need my money?
Broker: Why, Mrs. E., don’t you worry, there are safe investments.
HE: That’s it? That was their conversation?
EB: Mom also said he was really comforting. He even got up from his desk and walked over and patted her shoulder and said, “These investments are exceptionally safe and you can sell whenever you want. Just call me and I’ll put in an order and you’ll have your money in a week.” Then he said, “Now, if you’ll just sign here—”
HE: But she didn’t sign, right? Tell me she didn’t sign and I’ll be a lot happier.
EB: Mom told the broker she wanted to talk to me first. She asked him to mail some information and I have it now.
HE: Let me guess. The prospectus on the government fund says “guaranteed by the federal government.” And the brochure has American flags all over it.
EB: You know this fund?
HE: No, but I do recognize the marketing strategy. And the rating sheets for the preferred stocks he wants her to buy say that the company balance sheets are so strong they could win an Olympic weight-lifting championship.
EB: Something like that. So we should go ahead? I started to tell her to go ahead, but remembering those great tickets I got you to the big game, I figured you owed me a bit of free advice.
HE: Elizabeth, I’ll give you the free advice, and I won’t even mention the current price of the other four hot tips I talked you out of.
EB: Touché! So what’s your diagnosis?
HE: I don’t think you want me to give you a lecture on good financial planning. Suffice it to say your mom shouldn’t do anything but put the money into a money market account until she reviews her entire financial situation, including her needs for cash flow and emergency reserves, tax planning, insurance, and her estate planning as well as her Social Security and pension income. All of those will make a difference in deciding what she should buy.
EB: All that?
HE: When you do a diagnosis, do you just give advice off the cuff based on what the patient says she wants, or do you probe a little bit?
EB: I probe a lot. What kind of a doctor do you think I am?
HE: A good one. So you can see my point. But if you want me to diagnose your mom from afar, then let me at least introduce you to two important ideas that will help you evaluate the investments Mr. Broker suggested: liquidity and marketability—the big L and M.
EB: I need to write this down so I can tell Mom.
HE: Don’t get hung up on the fancy words—focus on the concepts. Both liquidity and marketability refer to attributes of investments. You’ve heard me say that investments don’t have morals; they’re not good or bad. They have attributes, and those might be right or wrong for you or your mom, just as an antibiotic might be good for a patient with an infection but not so good for helping a patient who’s in a lot of pain.
EB: Maybe you should leave the medical analogies to me.
HE: Liquidity measures how easily your investment can be converted into cash whenever you want to, no matter what’s happening in the economy or to the stock or bond market, without losing any of your original investment. Marketability measures how easy it is to sell an investment when you want to. With me so far?
EB: I’m not sure. Those sound the same.
HE: You’re right; they do. Both relate to converting your investment to cash. Both measure how fast and how easy it is to do that. And neither is good nor bad. The problem is that they’re not the same.
EB: So tell me how they’re different.
HE: There’s one big difference. Liquidity refers to getting the full amount of your original investment back at any time. Marketability is about getting fair market value when you sell. And there’s the catch! You know yourself from your ulcer experiences with the bond funds that full amount and fair market value are often very different.
EB: So if the market goes down, and Mom tells the broker she wants her money back—
HE: The amount she gets could be less than she invested originally. And she’s back on ulcer medicine—or worse. She could be in danger of running out of money.
EB: So she wants something liquid, right? What kinds of investments are liquid?
HE: The most common liquid investments are checking and savings accounts, money market funds, Treasury bills, and that wad of cash she was going to bury in the backyard.
EB: And marketable investments are?
HE: There are lots of marketable investments. The list includes stocks and bonds, mutual funds, and government bond funds. Got it now?
EB: I think so, but so what?
HE: So knowing what you know now, take another look at that government fund with the flags on the brochure and the preferreds with their balance sheets on steroids. Suppose your mom wanted to sell her government fund or preferred in a few years. How much would she get back?
EB: I guess I really don’t know. How could I?
HE: You can’t unless you have a working crystal ball. You don’t have one, do you?
HE: I always ask, because I hope that one day I’ll find someone who has one and I can ask to borrow it for a while.
So we know the government fund is secure from a credit standpoint, and for now let’s assume the preferred stock issuers remain in good financial shape. But with both investments, you still have interest rate risk. That’s what the broker should have talked about, and probably would have, if he or she wasn’t so focused on making the sale.
EB: You mean the risk that interest rates will go up?
HE: Exactly. The broker is selling your mom two investments paying a fixed interest rate. Right?
HE: When interest rates go up, people can go out on the market and buy investments with fixed rates higher than what you mom is getting. So do you think anybody would want to buy her investment, with a lower yield, at the price she paid for it?
HE: You’re right. To take an extreme example, let’s say she buys a bond with a twenty-year maturity today and gets a fixed 4 percent, and ten years from now, interest rates have gone up to the point where a bond with the same credit rating, and ten years to maturity, by the same issuer, is paying 8 percent. If she wanted to sell her bonds, she would be offered about $7,000 for her $10,000 investment. She’d lose money and get an ulcer.
EB: Okay, but she still has the preferred stocks, right?
HE: Let’s talk about those. From the talk about interest rate risk, you can see that the longer the maturity of the investment, the more interest rate risk you’re taking. Rates probably aren’t going to double in one year, but they just might in ten. And during twenty years, you have no idea what’s going to happen, right?
HE: So tell me: what is the maturity date on the preferred stocks the broker was recommending?
EB: I don’t know. Ten years?
HE: What if I told you it was thirty? Would you be comfortable then?
EB: Not very, no.
HE: What if I told you it was 100?
EB: That would make me extremely uncomfortable.
HE: And if I said that those investments would mature in a thousand years, what would you say to me?
EB: I’d say you were joking.
HE: Actually, I was underestimating. The answer is that those preferred stock investments never mature.
HE: Not even when the Earth crashes into the sun. So your mom is subject to a seriously whopping interest rate risk. And it gets worse.
EB: How can it possibly?
HE: If you own a bond issued by the company selling the preferred stock and the company fails to pay on its bond obligation, it files bankruptcy. Guess what that same company does if it can’t pay on your preferred stock?
HE: It sends an apology letter.
EB: So maybe the broker’s advice wasn’t as great as I thought it was. Mom says he was really nice.
HE: I’m sure he’s a very nice person who pets his dog. But the bottom line for your mom is that those government bond funds and preferreds may have a good story, and they pay what today seems like an attractive rate, but they come with a boatload of risks and they are, irrevocably, not liquid. They certainly may play a role in many portfolios but not 100 percent of your moms.
EB: So what do I do? What would you recommend?
HE: First, let me ask: why didn’t your mom buy CDs?
EB: I told you. Those one- and two-year CDs just don’t pay enough.
HE: Did you look at the five-year CDs?
EB: Actually, we did. They were a little more attractive, but mom’s afraid to buy anything locked up for more than a few days.
HE: Elizabeth, that’s exactly the point! She was confusing liquidity with marketability.
EB: Yet again, I don’t follow you.
HE: It’s not that complicated. Tell me: if your mom purchased a five-year CD today and in three years she needed her money, what would happen?
EB: Actually, we asked about that. They said if we liquidated early, they would charge a six-month interest penalty.
HE: And that means?
EB: Mom would get her investment back and a little less interest than she had expected.
HE: Right; she would get her entire initial investment back and maybe even a little interest. Sounds like a liquid investment. Not very locked up, is it?
EB: Not when you put it that way.
HE: Your mom needs to be sure not to be misled by marketing that confuses liquidity with marketability. “Getting your money back” isn’t the same as getting all of your money back.
EB: Okay, I’ll talk to her.
HE: Maybe she can come to the game with us.
EB: What game?
HE: The game you’re going to get me tickets to, the one where your leading rebounder is going to be out, and our coaching staff has checked with the local institute for the blind to bring in some qualified referees.
EB: I’ll see what I can scare up. Thanks, Harold.
HE: I’m glad I could help.
This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.