I read online about some advisers suggesting derivatives. What are your opinions?
First, let’s explain derivatives. A derivative is essentially a promise to convey ownership of the asset on which it is based, called the underlying asset or the underlying instrument. It does not represent ownership of the asset itself. When you buy a derivative, you’re not buying something tangible, like a commodity or shares of a company. Instead, you’re betting on how the financial instrument or asset that underlies it will perform. It’s a bit like betting on a horse race; you’re not buying the horse, you’re betting on how well the horse will do. The underlying asset/instrument is often something whose price fluctuates dramatically or frequently. Those changes also affect the price of derivatives based on that asset, but not necessarily in the same way or to the same degree. The investment community in recent years has developed increasingly sophisticated derivative instruments designed to address specific needs.
Two types of common derivatives are options and futures. Purchasing an option gives you the right (but not the obligation) to buy or sell a specific asset at a specific price by a specific time. An option typically falls into one of two categories: calls, which convey the right to buy the underlying asset, and puts, which convey the right to sell the underlying asset. You can buy or sell both puts and calls. Like options, futures contracts are traded on exchanges and represent an agreement to deliver an underlying asset–typically, a commodity, a quantity of a given currency, or a financial instrument–at a specific time for a specific price. However, a futures contract represents a legal obligation to transfer the underlying asset; unlike an option buyer, who can decide whether to exercise the option, the buyer of a futures contract has no choice but to take delivery.
Derivatives can be used to help hedge against specific risks involved in owning the underlying asset. For example, the risk that a commodity’s price will rise or fall unexpectedly, or the risk that a corporate borrower will default on a bond. Derivatives are a zero-sum game, because for every investor who gains on a contract another participant has an equivalent loss. Money isn’t being made. It is just shifted from one person to another.
We feel that derivatives are not for the layman investor. Often you’ll be betting against companies with much more sophisticated investors—a game you are likely to lose.
I have a 401k plan at work, and they are mapping funds from the old plan to a new plan. I am not sure how similar these funds are. What would be the best way to find out this information? Also, with the market not being in a very stable environment at the moment, what would be your advice on how best to tackle this situation?
When an employer changes 401(k) plan vendors, typically, participants will be notified of a blackout period where you cannot make changes to your plan. This allows the vendors and third-party administrators to transfer funds.
Since not every fund option is available from every vendor, most map your existing investments to like investments. For example, if you have a Large Cap fund, it will likely be mapped to the new vendor’s Large Cap option. Once this is done and the blackout period has ended, you can, generally, go into the plan administrator’s website and make changes to your investments. Your plan administrator should furnish you with research reports and past performance of all your investment options. You can then compare your previous investment options to the mapped options, and evaluate your past performance, fees, etc.
We feel investments in a 401(k) plan should also follow our Ten Year Rule, where any money needed within the next 10 years should be in fixed investments. If you will need to begin pulling money from your 401(k) within the next 10 years, you may consider shifting some of your investments to intermediate bond funds. Likewise, we feel any money you do not need within 10 years should be invested in mutual funds that invest in common stock. Your allocation between Large Cap, Small Cap, Internationals, etc. depends on your individual risk tolerance and time horizons.
We believe it can benefit investors to discuss their 401(k) options with their financial adviser at least once a year to make sure the asset allocation is still in line with their financial goals.