This is the fourth and final guest post by Nathan Bush on 12 investing concepts.
CONCEPT EIGHT—FIXED INCOME (BONDS)
Unlike stocks, which are ownership in a company, bonds are a debt obligation that is owed to you. You can expect a return of the principal as well as Interest on the principal. The word Bonds is used interchangeably with Fixed Income in lots of financial literature because it is the main instrument in portfolio construction. Government Bonds are considered to be RISK FREE and therefore pay the least interest. Corporate bonds are riskier and therefore pay higher interest. Certificates of Deposits are less liquid and therefore pay more interest. Money Market accounts are the most liquid, therefore less interest. Cash is absolutely liquid, no interest. Some bonds are bought at a discount (EE Bonds) and only pay full value if held to maturity. Others are bought at Par and pay regular interest (coupons). Municipal Bonds are generally tax-exempt and therefore pay less interest. Some bonds (TIPs & I-Bonds) are inflation protected. There is a difference in interest depending on the duration of the bond.
As you can see, there are many types of bonds and bond funds.
More about Target Date Funds. These Balanced Funds have both stocks and bonds in the fund. The theory behind these funds is that younger investors should be more aggressive (more stocks than bonds) and as they approach retirement, they should become more conservative (less stocks more bonds). For example, a 30 year old in 2015 might buy a target date fund for his retirement in 2050 at age 65. The fund company might start you out in 2015 with a 90/10 asset/allocation and then adjust the A/A periodically to be at 20/80 by the year 2050. This is the one fund portfolio.
The main reason to have bonds in your portfolio is to add stability to the total. Bonds are much less volatile than stocks and even tend to go up when stocks go down. Stocks can and do swing in value sometimes as much as 50%; bonds swing in value very slowly in small increments.
Stocks let you eat well. Bonds let you sleep well.
CONCEPT NINE—ALTERNATIVE INVESTMENTS
Anything that you can invest in other than stock or a bond is an Alternative Investment. Examples could be real estate, commodities, gold coins, antiques, collector cars, stamps & coins, artwork, farmland. The expectation is for price appreciation, maybe rent, maybe interest, maybe crop production income, maybe oil or timber royalties. Generally, these alternative investments are not considered part of your investment portfolio, because of an inability to rebalance or partially liquidate.
Rents and Royalties could be considered in an “Equivalent Value” calculation, much like social security with a “present value” of cash flow calculation, for asset allocation purposes. If one is receiving consistent cash flow, it is “Bond-Like” and therefore you might consider reducing the bond portion of your investment portfolio. “That’s all I’m going to say about that” – Forrest Gump.
CONCEPT TEN—TAX ADVANTAGED ACCOUNTS
Investments accounts that are treated differently for tax purpose fall into three major categories: (1) Taxed When Withdrawn, (2) Taxed Before Deposited (but never again) and (3) Conditionally Taxed.
(1) Taxed When Withdrawn—These are the most common tax advantaged accounts. Examples are 401Ks (for corporate employees), traditional IRA’s (Individual Retirement Accounts), 403Bs (for teachers and academics), and 457s (for government employees). They are administered by the employer, who deposits part of your salary (perhaps partially matched) into an account at a financial institution. The money is excluded from current income tax, and while it is there, it grows tax-free. When it is withdrawn (should be in retirement) it is taxed as “Ordinary Income”. There are restrictions on how much you can contribute per year, penalties for early withdrawal, requirements for minimum distributions (RMD’s), and some limits on what you can invest in within the account. These accounts can be “rolled over” from one employer to another or to a different type of account. There are different requirements, restrictions, and limits but they all work basically the same. Untaxed money is deposited into an account, it grows untaxed, and it is taxed when withdrawn.
(2) Taxed Before Deposited (Never Again)—(Roth IRA’s). These are established by individuals who have “earned income” on which they pay taxes in the year earned. Some of that already-taxed money is deposited into the account. There are limits on the amount that can be deposited and limits on withdrawals before age 59.5, but the best part is neither the money nor its earnings are ever taxed again, not even by the inheritors of the estate. Untaxed money in 401K’s or traditional IRA’s can be “rolled over” into a Roth IRA but is taxed at “ordinary income” rates at the time of rollover.
(3) Conditionally Taxed Accounts—There are other types of accounts such as Health Savings Accounts (HSAs), Coverdale or 529 Educational Saving Accounts that are hybrids of the two above. Untaxed money is deposited, and it grows untaxed. IF used for the intended purpose, it is never taxed. IF NOT used for that purpose, then it is taxed.
All three of these types of accounts (and others such as ROTH 401K’s, Individual 401K’s, SEPs) can be extremely advantages to an investor.
A set of examples:
Tom (age 45) puts $10,000 in a 401K; it grows at a rate of 10% for about 15 years to a total $40,000. Tom withdraws the $40K and pays tax of 15% ($6,000), net of $34,000. Jerry (age 45) pays $1,500 tax on $10,000 and puts the remaining $8,500 into a ROTH; it grows at 10% for 15 years to a net of $34,000.
Mary (age 45) puts $10,000 in an HSA; it grows at 10% for 15 years to $40,000. If it is use for medical expense, there is no tax. However, if she spends it elsewhere, she has to pay taxes of 15% ($6,000). Net either $40,000 or $34,000.
Sally (age 45) does not use any kind of tax-advantaged account. She just puts her net of tax $8,500 in a brokerage account. It grows at 10% each year but she has to pay taxes on each years’ “interest or earnings” so the net growth (Approximately 8.5%) is significantly less than the three examples above. It would take an extra 2 years for the $8,500 to grow to $34,000.
All of these examples are very simple and use rounding and estimates and approximations, but the basic takeaway is that it is mostly a matter of when you pay the taxes and the tax-free growth. A better example would be differing tax rates at different stages of life. (Tom and Jerry would probably be paying a higher tax rate at 45 as opposed to in retirement at 65). The length of time over which the compounding takes place and the amount of money are also important factors.
CONCEPT ELEVEN—THE MIRACLE OF COMPOUNDING
Most people do not realize what a powerful force compounding is, even though it is a simple concept. The Rule of “72” is a rough estimation for calculating compounding. Simply stated, if you divide the interest RATE into 72 you get the number of years it takes for the original investment to double in value. For example, an original investment at a 10% rate would double in 7.2 years (72 / 10 = 7.2). A real world example: Susie makes $1,000 babysitting the summer of her tenth birthday, she puts it in a Schwab Roth account and buys an S&P 500 Index, and it doubles every 7.2 years (average rate of 10%). Age 17.2 = $2,000, age 24.4 = $4,000, age 32.6 = $8,000, age 38.8 = $16,000, age 46 = $32,000, age 53.2 = $64,000, age 60.4 = $128,000, age 67.6 = $256,000, age 74.8 = $512,000, age 82 = $1,024,000. Susie passes away at age 89.2 and now her $1,000 babysitting money has grown to over $2,000,000. She wills the $2mill to her granddaughter who must start taking the money out of the Roth (tax-free) presumably at a rate about equal to the growth rate. This compounding effect is truly a Miracle. “Compound interest is the Eighth Wonder of the World. He who understands it, earns it…he who doesn’t …pays it”—Einstein.
PORTFOLIO is the collection of investable assets, from which you expect to earn a return on investment. Keep in mind that any investment is RISKY. The risk can be mitigated by DIVERSYING your assets. Always keep an EMERGENCY FUND available so as not to have to dip into your main portfolio. The best type of security to invest in is an INDEX FUND, which can be as few as one fund or several as long as they are arranged in a simple, easy to understand COUCH POTATO LIKE manner, which will minimize FEES and expenses (cost matters). The assets within these funds should be both EQUITIES (stocks) and FIXED INCOME (bonds). Stocks are for growth and bonds are for stability or ballast. The mix is your asset/allocation. Any ALTERNATIVE INVESTMENTS should not be considered part of your investable assets but their generated income could be used as justification for an altered asset/allocation much like social security. This couch potato like group of index funds should be placed in TAX ADVANTAGED account or accounts which will enhance the COMPOUNDING effect.