At What Price Should I Buy a Stock?

Deciding at what price to buy a stock or other security is almost as hard as deciding whether to buy the security at all.  There are many different approaches for deciding at what price to buy a stock.  One of the ones I’ve seen discussed most often is dollar-cost averaging.  Other strategies include (1) buying the position on whatever day you decide to buy it and (2) setting a target price that is below the current trading price, among many others.  In this post, I’ll explain and compare these three strategies.

Dollar-Cost Averaging

Dollar cost-averaging is a strategy for buying stocks that is intended to reduce the risk that you will “buy high.”

How it Works

Here are the key steps for implementing this strategy:

  • Identify the security you want to buy.
  • Determine how much money you have to invest in that security.
  • Divide that amount into equal increments. In the examples below, I have split the amount into four increments.
  • Decide over what time period you want to make your purchases. In the examples below, I have illustrated a purchasing time period of four weeks.
  • Invest one increment at points in time evenly spaced over your selected time period. For example, let’s say you want to invest over four weeks.  You might buy the selected security every Wednesday in four equal pieces.  If you have $1,000 to invest, you would buy $250 of the selected security each Wednesday for four weeks.

The underlying premise of this approach is that you buy more shares of the selected security than if you happened to have bought the security on a day that the price is high.  Specifically, because you are buying the security in equal dollar amounts, you will buy more shares when the price is low and fewer shares when the price is high.  As such, your average purchase price will be low.

Simple Example

Here’s a simple example in which you invest a total of $4,800 in increments of $1,200 a week for four weeks.

Week Stock Price Shares Purchased
1 $10.00 120
2 8.00 150
3 12.00 100
4 9.25 130

In this example, you buy a total of 500 shares.  If you had bought all of your shares on at $10 (the first week price), you would have 480 shares ($4,800 / $10).  In this scenario, you will have 4% more shares ([500 – 480]/480 – 1) if you use dollar-cost averaging than if you bought all of your shares at the first week’s price.  4% more shares corresponds to 4% more money when you sell the security.  Although 4% may not sound like a large difference, it can add up over time as you buy and sell stocks.

To be clear, though, dollar-cost averaging isn’t always better.  If you had bought all of your shares at the Week 3 price of $8, you would have 600 shares or 20% more than if you used dollar-cost averaging.

Investing Strategies

Here are the three strategies for determining when to buy a security that I’ll use for illustration.

Strategy 1 – Invest Immediately

Invest all of your available money on the day you decide to make the purchase.

Strategy 2 – Dollar-Cost Averaging

Use dollar-cost averaging by buying ¼ of your money available on Wednesday of four consecutive weeks[1]. This strategy is similar to what happens when you buy securities in your employer-sponsored retirement account if you are paid weekly.  Every week, you employer takes some of your wages and invests it in the security you have selected.

Strategy 3 – Wait for Price Drop

Invest all of your available money after the stock price has dropped by 5%. Hold your money in cash while waiting for the price to decrease.

More Examples

I’ve created a few more simple examples to compare the strategies for deciding when to buy a security.  These examples are intentionally simple and therefore unrealistic.  Nonetheless, they are helpful in understanding the different strategies because of their simplicity.  In all of the examples, you have $1,000 to invest.

Smooth Increase

In the first scenario, the stock’s price goes up smoothly by 10% every year.  A graph of its price over two years would look like this.

The chart below focuses on the first month of the above chart and includes the purchases for Strategies 1 and 2 as dots.

Under Strategy 1 (big red dot), you buy all of your stock on the first day at $10 a share, so you are able to purchase 100 shares.

Under Strategy 2 (smaller green dots), you would buy $250 of stock on each of the first, eighth, fifteenth and twenty-second days.  The table below shows the prices on those days and the number of shares you buy.

Day Price Shares Bought
1 $10.00 25.00
8 10.02 24.95
15 10.04 24.90
22 10.05 24.88

The total number of shares you buy is 99.73.

Under Strategy 3, you never buy the stock because the price never decreases by 5%.

The table below compares the numbers of share bought under each strategy

Strategy Name Number Shares Bought Value in Two Years
1 Invest Immediately 100.00 $1,210
2 Dollar-Cost Averaging 99.73 1,203
3 Wait for Price Drop N/A 1,000

In this scenario, there is very little difference between the first two strategies, though you will buy more shares if you invest immediately. Any time you delay your purchases in this scenario, you are certain to pay a higher price which reduces the number of shares you can buy.  Under Strategy 3, because the price never decreases, you never buy the stock, so end up with the same amount of money with which you started.

Smooth Check Mark

The second illustration is stock whose price goes down smoothly for six months and then increases for the next 18 months.  A graph of its price would look like this.

The chart below focuses on the first six months of the above chart and includes the purchases for all three strategies as dots.

Under Strategy 1 (big red dot), you buy all of your stock on the first day at $10 a share, so you are able to purchase 100 shares.

Under Strategy 2 (smaller green dots), you buy $250 of stock on each of the first, eighth, fifteenth and twenty-second days.  The table below shows the prices on those days and the number of shares you buy.

Day Price Shares Bought
1 $10.00 25.00
8 9.98 25.05
15 9.96 25.10
22 9.94 25.15

The total number of shares you buy is 100.30.

Under Strategy 3, you buy 105.2 shares at $9.50 (5% below the initial price of $10) on day 177.

The table below compares the numbers of share bought under each strategy and the amount of money you will have at the end of two years.

Strategy Name Number Shares Bought Value in Two Years
1 Invest Immediately 100.0 $1,097
2 Dollar-Cost Averaging 100.3 1,100
3 Wait for Price Drop 105.2 1,154

In this scenario, the best strategy is to wait until the price drops by 5% which happens to be the minimum price over the two-year period.  The results of the other two strategies are very similar, though investing all of your money on the first day is the worst choice, as you buy stock during the period in which the price has fallen under the other two strategies.

Bumpy Increase 1

Next, we will look at two illustrations of what a stock price might actually look like.  Here is a graph of the first illustration.

The chart below focuses on the first month of the above chart and includes the purchases for Strategies 1 and 2 as dots.

Under Strategy 1 (big red dot), you buy all of your stock on the first day at $10 a share, so you are able to purchase 100 shares.

Under Strategy 2 (smaller green dots), you would buy $250 of stock on each of the first, eighth, fifteenth and twenty-second days.  The table below shows the prices on those days and the number of shares you buy.

Day Price Shares Bought
1 $10.00 25.00
8 9.83 25.43
15 9.88 25.30
22 9.80 25.51

The total number of shares you buy is 101.24.

Under Strategy 3, you don’t buy any shares because the price never falls by 5%.

The table below compares the numbers of share bought under each strategy

Strategy Name Number Shares Bought Value in Two Years
1 Invest Immediately 100.00 $1,144
2 Dollar-Cost Averaging 101.24 1,158
3 Wait for Price Drop 0.00 1,000

In this scenario, the best strategy is to buy your stock using Dollar-Cost Averaging (Strategy 2), but only by a small amount compared to using the Invest Immediately strategy.  You will have 1% more money than if in you invest it all on the first day and 13% more money than if you wait for the price to drop.

Bumpy Increase 2

The second realistic illustration is exactly the same as the first one with the exception that, in the first month, the price bounces around a bit above the initial $10 price rather than just below it.  The chart below focuses on the first month for this illustration and includes the purchases for Strategies 1 and 2 as dots.

Under Strategy 1 (big red dot), you buy all of your stock on the first day at $10 a share, so you are able to purchase 100 shares.

Under Strategy 2 (smaller green dots), you would buy $250 of stock on each of the first, eighth, fifteenth and twenty-second days.  The table below shows the prices on those days and the number of shares you buy.

Day Price Shares Bought
1 $10.00 25.00
8 10.21 24.49
15 9.88 25.30
22 10.31 24.25

The total number of shares you buy is 99.04.

Under Strategy 3, you don’t buy any shares because the price never falls by 5%.

The table below compares the numbers of share bought under each strategy

Strategy Name Number Shares Bought Value in Two Years
1 Invest Immediately 100.0 1,144
2 Dollar-Cost Averaging 99.04 1,133
3 Wait for Price Drop 0 1,000

In this scenario, the best strategy is to use the Invest Immediately strategy (Strategy 1), but only by a small amount compared to Dollar-Cost Averaging.  You will have 1% more money than if in you use Dollar-Cost Averaging and 14% more money than if you wait for the price to drop.

More Realistic Examples

Now that you have a better understanding of the three different strategies, I’ll turn to even more realistic scenarios.

  • The first of these scenarios will use the actual returns on the S&P 500 from 1928 through early 2020. This scenario is likely to be relevant when you are considering an investment in an index fund.
  • The second scenario is intended to be similar to an investment in an individual stock. To create the example, I took the S&P 500 times series and doubled the volatility.[2]

The daily stock prices are illustrated in the graph below.

Investment Horizons

To illustrate the impact of the different strategies, I looked at three different time periods over which you might hold the stocks – one year, five years and ten years.  If you are young and hold a stock until you retire, such as I have with some of the stocks I own, you might own the stock for 30 or 40 years.  I didn’t feel there was enough data available in the above time series to look at the impact on owning securities for more than ten years.  So, if you think you will be a very long-term investor, you will want to focus on the ten-year results.  Also, these analyses are not helpful to people who plan to own stocks over very short periods of time, such as some traders who might buy and sell a security in the same day.

Comparison of Realistic Results

The table below compares how much money you would have, on average across all possible starting dates for which data were available, at the end of each of the three time periods if you used each of the three strategies to buy $1,000 of an S&P 500 index fund.

Strategy One Year Five Years Ten Years
Invest Immediately 1,074 1,372 1,873
Dollar-Cost Averaging 1,074 1,373 1,877
Wait for Price Drop 1,022 1,181 1,485

 

The table below compares how much money you would have, on average, at the end of each of the three time periods if you used each of the three strategies to buy $1,000 of the illustrative stock.

Strategy One Year Five Years Ten Years
Invest Immediately 1,087 1,376 1,875
Dollar-Cost Averaging 1,087 1,379 1,880
Wait for Price Drop 1,077 1,330 1,772

 

Dollar-Cost Averaging vs. Invest Immediately

For both the S&P 500 and the illustrative stock, there are only very small differences (less than 0.3% for the one-year investment horizon and less than 1.3% for the longer investment horizons) in the average amount of money at the end of each of one, five and ten year between the Dollar-Cost Averaging and Invest Immediately strategies.

Wait for Price Drop

On the other hand, there is a larger difference between the average amount of money at the end of the three time periods if you use the Wait for Price Drop strategy and the average amount using either of the other two strategies.  For the S&P 500, you will have between 5% and 20% less money, on average, if you use the Wait for Price Drop strategy than if you use the Invest Immediately strategy, depending on your investment horizon.

For the more volatile illustrative stock, you will have between 1% and 5% less money, on average, if you use the Wait for Price strategy than if you use the Invest Immediately strategy.  With the higher volatility of the illustrative stock, it is more likely to have a 5% price drop.  There are therefore fewer scenarios in which you don’t get any investment return than there are using the S&P 500 prices.  As such, there is a smaller difference between the results of the Wait for Price Drop strategy and the other strategies for a more volatile security than for a more stable one.

Key Takeaways

As can be seen, the best strategy depends on the pattern and volatility of the security’s price.  Briefly:

  • For securities that have fairly smooth trends, there isn’t a lot of difference between the Invest Immediately and Dollar-Cost Averaging strategies.
  • For securities with more volatile prices, such as the two Bumpy Increase scenarios, the choice between the Dollar-Cost Averaging and Invest Immediately strategies can be a bit larger. However, there isn’t one that is better in all situations – Dollar-Cost Averaging was better in Bumpy Increase 1 while Invest Immediately was better in Bumpy Increase 2.  Because you can’t know whether your security’s price will follow a pattern closer to Bumpy Increase 1 or Bumpy Increase 2, neither strategy is preferred.
  • If you think that the price of the stock might trend down somewhat significantly or has a lot of volatility allowing the price to be significantly lower than the current price, waiting for a 5% (or other value you select) price decrease (Strategy 3) could be the best strategy. The drawback of this strategy is that there are a lot of scenarios in which you will never buy the security and then will get no return.

What Do I Do?

With all this information, you might wonder what I do.  I first need to provide a little background about my current investing situation, as it is likely to be different from yours.

I am retired, so am starting to spend my investments.  As such, I have a shorter investment horizon than I did when I was younger and in the saving mode.  I have a number of stocks and a few mutual funds that I have owned for many, many years and do very little trading of those positions.

Another portion of my money is in sector funds (index funds that focus on one segment of the economy, such as industrial companies, healthcare or technology) and a few large companies.  I tend to hold those securities for six months to two years.  The securities I am trading are closer in nature to the S&P 500 time series than even the hypothetical company with twice the volatility as the S&P 500.  As such, the Wait for Price Drop strategy doesn’t work for me.

With the very small differences between the Dollar-Cost Averaging and Invest Immediately strategies, I choose the Invest Immediately strategy because it is easier.  I have to place only one buy order instead of several orders.

Limit and Market Orders

As discussed in my post on stocks, there are different types of orders you can place when you want to buy a stock.  I always place limit orders.  A limit order allows me to buy a stock from the first person who wants to sell it to me at the price I have stated in the order.

The other type of order is a market order.  If you place a market order, you don’t get to set the price.  You buy the stock at whatever price it is trading at the moment you place the order.

There are risks to both types of orders.  If you place a market order and the price jumps up, you will buy the stock at the higher price.  If you place a limit order for a price below the current market price, you might never buy it similar to the Wait for Price Drop strategy.

A Compromise

To avoid the risk that I might buy a stock at a significantly higher price than I intend, I place a limit order with a limit that is about half way between the closing price and the low price from the previous day.  (I almost always place my orders over the weekend, so don’t have “up-to-the-minute” prices.)  This difference is often between 0.5% and 1% of the price.  By taking this strategy, I get a very small boost to my return by setting my limit below the market price but with very little risk that I won’t buy the stock because I have chosen the limit amount to be within a single day’s trading range.  The additional 0.5% to 1% doesn’t sound like a lot, but if I am able to increase my total return by that amount every year or two, it compounds quickly.

 

[1] There is nothing special about once a week for four weeks.  I did some testing of once a day for five days and found that there wasn’t a lot of difference in the number of shares bought, on average across a wide range of scenarios, from what the number using once a week for four weeks.  I also did some testing of what happens when you buy shares once a month for a year.  Across a wide range of realistic scenarios, you own fewer shares on average if you spread your purchases over a year as you purchase securities that you think will increase in price.  If the price of the security increases over the year, you will buy some of your shares at the higher price and own fewer shares.

 

 

[2] This note explains the nitty gritty details of how I adjusted the S&P 500 time series to create the second scenario.  I calculated the 200-day moving average of the daily closing prices of the S&P 500 from 1928 to early 2020.  The deviation is the actual closing price minus the moving average.  I doubled this deviation and added it back to the moving average to simulate prices for the hypothetical stock.

Don’t Panic! Just Plan It.

Don't Panic. Just Plan it.

Financial markets have been more turbulent in the past few weeks than has been seen in many years, probably more volatile than has happened since many of you started being financially aware. You may be wondering what actions you should take. With the sense of panic and urgency surrounding recent news, it often feels as if drastic action is necessary. If you have created a financial plan with key elements similar to those in many of my posts, inaction may be the best strategy for you!

As indicated elsewhere on this blog, I do not have any professional designations that qualify me to provide professional advice. In addition, my comments are provided as generalities and may not apply to your specific situation. Please read the rest of this post with these thoughts in mind.

Biggest Financial Risk from Recent News

I suspect that losing your job or losing business if you are self-employed is the biggest financial risk many of you face. Understanding your position within your company and how your company will be impacted by coronavirus, oil prices and other events will inform you as to the extent to which you face the risk of a lay-off or reduction in hours/salary.

If you think you might have a risk of a decrease in earned income, you’ll want to look into what options for income replacement are available to you, including state or federal unemployment programs, severance from your employers, among others. Another important step is to review your expenses so you know how you can reduce them to match your lowered income.  In addition, you’ll want to evaluate how long you can live before exhausting your emergency savings, with or without drastic reductions in your expenses. You may even want to start cutting expenses before your income is lowered and put the extra amount in your emergency savings.

Your Financial Plan & Recent News

In the rest of this post, I’ll look at the various components of a financial plan and provide my thoughts on how they might be impacted by the recent news and resulting volatility in financial markets.

Paid Time-Off Benefits/Disability Insurance

If you are unfortunate enough to get COVID-19 or are required to self-quarantine and can’t work from home, you may face a reduction in compensation. Your first line of defense is any sick time or paid time-off (PTO) provided by your employer. In most cases, your employer will cover 100% of your wages for up to the number of days, assuming you haven’t used them yet.

Once you have used all of your sick time/PTO, you may have coverage under short- or long-term disability insurance if provided by your employer or if you purchase it through your employer or on your own. Disability insurance generally pays between 2/3 and 100% of your wages while you are unable to work for certain causes, almost always including illness. It might be a good time to review your available sick time/PTO and disability insurance to understand what coverage you have.

Emergency Savings

Emergency savings is one of the most important components of a financial plan.  There are two aspects to your emergency savings that you’ll want to consider. The first is whether you have enough in your emergency savings.  The second is the risk that the value of the savings will go down due to financial market issues.

Do I Have Enough?

If you are laid off, have reduced hours or use up all, exhaust your sick time/PTO or get less than 100% of your wages replaced by disability insurance, you may have to tap into your emergency savings. The need to spend your emergency savings increases if you tend to spend most of your paycheck rather than divert a portion of it to savings.

I generally suggest one to six months of expenses as a target for the amount of emergency savings. In light of recent events and the increased risks lay-off and illness, I would focus on the higher end of that range or even longer. As you evaluate the likelihood you’ll be laid off, the chances you’ll be exposed to coronavirus and your propensity to get it, you’ll also want to consider whether you have enough in emergency savings to cover your expenses while your income is reduced or eliminated.

In certain situations, such as in response to the coronavirus, creditors will allow you to defer your payments.  You will then have the option as to whether to defer them or make those payments from your emergency savings./a>

Will it Lose Its Value?

I’ve suggested that you keep at least one month of expenses in emergency savings in a checking or savings account at a bank or similar financial institution. The monetary value of your emergency savings is pretty much risk-free, at least in the US. The only way you would lose any of these savings is if the financial institution were to go bankrupt. In the US, deposits in financial institutions are insured, generally up to $250,000 per person per financial institution, by the Federal Deposit Insurance Corporation (FDIC). For more specifics, see the FDIC web site. Similar protections may be available in other countries.

I’ve also suggested that you keep another two to five months of expenses in emergency savings in something only slightly less accessible, such as a money market account. There is slightly more risk that the value of a money market account will go down than a checking or savings account, but it is generally considered to be very small. Money market accounts are also insured by the FDIC. For more specifics, see this article on Investopedia.

As such, the recent volatility in financial markets are unlikely to require you to take action related to your existing emergency savings and could act as an opportunity to re-evaluate whether you have enough set aside for emergencies.

Short-Term Savings

Another component of a financial plan is short-term savings.  Short-term savings is money you set aside for a specific purpose. One purpose for short-term savings is expenses that don’t get paid every month, such as property taxes, homeowners insurance or car maintenance and repairs.   Another purpose for short-term savings is to cover the cost of larger purchases for which you might need to save for several years, such as a car or a down payment on a house.

Short-term savings are commonly held in money-market accounts, certificates of deposits (CDs) or very high quality, shorter term bonds, such as those issued by the US government. CDs and US government bonds held to maturity are generally considered to have very little risk. Their market values are unlikely to change much and the likelihood that the issuers will not re-pay the principal when due is small.

Thus, the recent volatility in financial markets is also unlikely to require you to take action related to your short-term savings.

Long-Term Savings

Savings for retirement and other long-term goals are key components of a financial plan.  If they are invested at all in any equity markets, your long-term savings have likely taken quite a beating. Rather than try to provide generic guidance on how to deal with the losses in your long-term savings, I’ll tell you how I’m thinking and what I’m doing about mine. By providing a concrete example, albeit one very different from most of your situations, my goal is to provide you with some valuable insights about the thought process.

Think about the Time Frame for My Long-Term Savings

As you may know, I’m retired and have just a little income from consulting. As such, my financial plan anticipates that I will live primarily off my investments and their returns. I have enough cash and bonds to cover my expenses for several years. As such, I’m not in a position that I absolutely have to liquidate any of my equity positions in less than three-to-four years.

For many of you, your most significant goal for long-term savings is likely retirement. As such, your time horizon for your long-term savings is longer than mine and you can withstand even more volatility. That is, you have a longer time for stock prices to recover to the recent highs and even higher.     In the final section of this post, I’ll talk about how long it has taken equity markets to recover from past “crashes” to help you get more perspective on this issue.

Know Your Investments

My view is that, if I wait long enough, the overall stock market will recover. It always has in the past. If it doesn’t, I suspect something cataclysmic will have happened and I will be focused on more important issues such as food, water and heat, than my long-term savings. For now, though, my view is that my investments in broad-based index funds are going to recover from the recent price drops though it may take a while and be a tough period until then. As such, I am not taking any action with respect to those securities. Once the stock market seems to settle down a bit (and possibly not until it starts going up for a while), I might invest a bit more of my cash to take advantage of the lower prices.

I have a handful of investments in stocks and bonds of individual companies. These positions have required a bit more thought on my part.   I already know the primary products and services of these companies and the key factors that drive profitability, as I identified these features before I purchased the stocks or bonds as part of my financial plan. I can now look at the forces driving the economic changes to evaluate how each of the companies might be impacted.

Example 1

I own some bonds that mature in two to three years in a large company that provides cellular phone service. As discussed in my post on bonds, as long as you hold bonds to maturity, the only risk you face is that the issuer will default (not make interest payments or re-pay the principal). With the reduction in travel and group meetings, I see an increased demand for technological communication solutions, such as cell phones. While the stock price of this company has gone down, I don’t see that its chance of going bankrupt has been affected adversely, so don’t plan to sell the bonds.

Example 2

One company whose stock I’ve owned for a very long time focuses on products used to test food safety. While the company’s stock price has dropped along with the broader market, I anticipate that people will have heightened awareness of all forms of ways of transmitting illness, including through food-borne bacteria and other pathogens. As such, I am not planning to sell this stock as the result of recent events.

Example 3

I own stock in an airline that operates primarily within North America. This one is a bit trickier. It looks like travel of all types is going to be down for a while. I’m sure that US domestic airline travel will be significantly impacted, but suspect it will not be affected as much as international or cruise ship travel. The reduction in revenue might be slightly offset by the lower cost of fuel, but that is probably not a huge benefit in the long term.

I’ve owned this company for so long that I still have a large capital gain and would have to pay tax on it if I sold the stock. At this point, I don’t think there is a high probability that this airline will go bankrupt (though I’m not an expert and could be wrong). I expect the price to drop more than the overall market average in the coming months, but also expect that it will recover. As such, I don’t plan to sell this stock solely because of recent events.   However, if this company had most of its revenue from operating cruise ships, was smaller, or had more foreign exposure, I would study its financials and business model in more detail to see if I thought it would be able to withstand the possibility of much lower demand for an extended period of time.

Summary

I have gone through similar thought processes for each of the companies in my portfolio to create my action plan. I will re-evaluate them as time passes and more information becomes available.

What We Can Learn from Past Crashes

Although every market cycle is different, I thought it might be insightful to provide information about previous market crashes. For this discussion, I am defining a market crash as a decrease in the price of the S&P 500 by more than 20% from its then most recent peak. I have identified 11 crashes using this definition, including the current one, over the time period from 1927 to March 14, 2020.

As you’ll see in the graphs below, the market crash starting at the peak in August 1929 is much different from most of the others. It took until 1956 before the S&P 500 reached its pre-crash level! Over the almost three years until the S&P 500 reached its low and then again during the recovery period (from the low until it reached its previous high), there were several crashes. I have counted this long cycle as a single crash, though it could be separated into several.

Magnitude of Previous Crashes

The table below shows the dates of the highest price of the S&P 500 before each of the 11 crashes since 1927.  It also shows the percentage decrease from the high to the low and the number of years from the high to the low.

Date of Market Peak

Price Change Years from High to Low

9/17/29

-86% 2.7

8/3/56

-21%

1.2

12/13/61 -28%

0.5

2/10/66 -22%

0.7

12/2/68

-36%

1.5

1/12/73

-48% 1.7

12/1/80

-27% 1.7

8/26/87

-34%

0.3

3/27/00 -49%

2.5

10/10/07 -57%

1.4

2/20/20 -27%

0.1

While they don’t happen all that often, this table confirms that the S&P 500 has suffered significant decreases in the past. What seems a bit different about the current crash is the speed at which prices have dropped from the market high reached just a few weeks ago. In the past, the average time from the market peak to the market bottom has been 1.4 years, but the range has been from 0.3 years to 2.7 years. While the 27% decrease in the S&P 500 from its peak on February 20, 2020 until March 14, 2020 is large and troubling, the average price change of 10 preceding crashes is -41% (-36% if the 1929 crash is excluded). As such, it isn’t unprecedented.

What Happened Next?

This table shows how long it took after each of the first 10 crashes for the S&P 500 to return to its previous peak. It also shows the average annualized return from the lowest price until it returned to its previous peak.

Date of Market Peak

Years from Low Back to Peak Annualized Average Return During Recovery

9/17/29

22.2 9.3%

8/3/56

0.9 29.8%
12/13/61 1.2

31.7%

2/10/66 0.6

55.3%

12/2/68 1.8

28.3%

1/12/73

5.8 12.0%

12/1/80

0.2 293.4%

8/26/87

1.6

28.1%

3/27/00 4.6

15.7%

10/10/07 4.1

22.9%

For example, it took 1.6 years after the market low price on December 4, 1987 (the low point of the cycle starting on August 26, 1987) for the S&P 500 to reach the same price it had on August 26, 1987. Over that 1.6-year period, the average annual return on an investment in the S&P 500 would have been 28%!

Because the values from the 1929 and 1980 cycles can distort the averages, I’ll look at the median values of these metrics. At the median, it took 1.7 years for the S&P 500 to reach its previous high with a median annualized average return of 28%.   There are obviously wide ranges about these metrics, but, excluding the 1929 crash, the S&P 500 never took more than 6 years to recover from its low. This time frame is important as you are thinking about the length of time until you might need to use your long-term savings.

After hitting bottom, the S&P 500 always had an average annual return of 12% or more over the recovery period, a fair amount higher than the overall annual average return on the S&P 500. Anyone who sold a position in the S&P 500 at any of the low points missed the opportunity to earn these higher-than-average returns – a reminder to not panic.

From Crash to Recovery

The graph below shows the ratios of the price of the S&P 500 to the price at the peak (day 0) over the 30 years after each of the first 10 market peaks in the tables above.

The light blue line that stays at the bottom is the 1929 crash. As you can see, by 30 years later, the S&P 500 was only twice as high as it was at its pre-crash peak. For all of the other crashes, the S&P 500 was at least four times higher than at each pre-crash peak, even though in many cases there were subsequent crashes in the 30-year period.

To get a sense for how the current crash compares, the graph below shows the same information for only the first 100 days after each peak. The current crash is represented by the heavy red line.

As indicated above, one of the unique characteristics about the current crash is that it occurred so quickly after the peak. The graph shows that the bright red line is much lower than any of the other lines on day 17. However, if you look at the light blue line (after the peak on September 17, 1929) and the brown line (after the peak on August 26, 1987), you can see that there were similarly rapid price decreases as occurred in the current crash, but they started a bit longer after their respective peaks.

Current Crash

We can’t know the path that the stock market will take going forward in the current cycle. It could halt its downward trend in a few days to a week and return to set new highs later this year. On the other hand, if other events occur in the future (such as the weather conditions that led to the dust bowl in the 1930s and World War II in the 1940s that exacerbated the banking issues that triggered the 1929 crash), it is possible stock prices could decline for many years and take a long time to recovery. Based on the patterns observed, this trend is less likely, but it is still a possibility.

As such, it is important as you consider your situation that you look at your investment horizon, your ability to live with further decreases in stock prices and your willingness to forego the opportunity to earn higher-than-average returns when the stock market returns to its pre-crash levels if you sell now, among other things.

Closing Thoughts

My goal in writing this post was to provide you with insights on how to view the disruptions in the economy and financial markets in recent weeks and plan your responses to them. My primary messages are:

  1. Don’t panic. While significant action may be the best course for your situation, do your best to make well-reasoned and not emotional decisions. Although you might want to sell your investments right away to avoid additional decreases in value, it isn’t the best strategy for everyone.
  2. Stick with (or make) a financial plan. Having a financial plan provides you with the ability to look at the impact of the uncertainties in financial markets and the overall economy on each aspect of your financial future separately, making the decision-making process a little easier.

 

Mutual Funds and ETFs

Mutual-Funds-and-ETFs

Mutual fund and ETFs (exchange-traded funds) allow you to invest in securities without having to select individual positions. Instead, the fund manager makes the decisions as to when to buy and sell each security. As such, a fund is an easy way for new or busy investors to participate in financial markets. This post will help you learn about the different types of funds, their pros and cons and other considerations of owning mutual funds and ETFs.

What is a Mutual Fund?

A mutual fund is pool of money collected from the investors in the fund. The investors own shares in the mutual fund itself, but not in the individual securities owned by the fund. However, other than closed-end funds discussed below, an investor’s return is his or her share of the returns of the aggregation of the returns of the individual securities owned by the mutual fund. That is, if, on average, the securities in the mutual fund issue dividends of 3% and appreciate by 2%, fund owners will receive a dividend distribution equal to 3% of the value of their share of the pool plus the value of their ownership share will increase by 2%.

Most mutual funds also issue capital gain distributions once or twice a year. If the mutual fund had a gain on the aggregate amount of securities sold in the year, it will often distribute the amount of the gain to investors as a capital gain distribution in proportion to their ownership shares in the pool.

Mutual funds can be purchased directly from the fund manager or through a broker. Most mutual funds are not traded on exchanges. Purchases and sales of mutual funds occur once a day, with all buyers and sellers receiving the same price which is equal to the net asset value of the underlying assets. (See below for more information and exceptions.)

What is an ETF?

Exchange-traded funds or ETFs have several characteristics in common with mutual funds:

  • They are pools of money collected from their investors.
  • Investors share in the returns of the aggregation of the individual securities.
  • ETFs can hold a wide range of securities, including stocks, bonds and commodities.

These are a few of the ways in which ETFs differ from mutual funds:

  • They are exchange-traded securities (as implied by their name), so they can be bought and sold any time the exchange is open. As such, the price you pay or receive when you buy or sell an ETF can vary over the course of a day.
  • While many mutual funds have a minimum investment requirement, most ETFs do not.

Types of Mutual Funds and ETFs

There are many features of mutual funds and ETFs that are important in determining the best funds for your portfolio. Almost all of these features apply to both mutual funds and ETFs.

Active vs. Passive Management

An actively managed fund has a fund manager who is responsible for selecting the securities that will be owned by the fund. The manager decides when to buy and sell each security.  By comparison, the securities owned by a passively managed fund are determined so that the performance of the fund tracks a certain basket of assets.

Index funds are a common type of passively managed funds.   An index fund is a mutual fund or ETF that has a goal of matching the performance of an index, such as the S&P 500, the Dow Jones Industrial Average or the Fidelity US Bond Index.

There are other passively managed funds whose trades are determined so as to produce returns similar to a certain segment of a market, such as a particular industry or region of the world, that may or may not have an index that measures those returns.

Securities Owned

Funds can own a wide variety of securities – everything from stocks and bonds to commodities, among others. As you are looking for a fund, you’ll want to decide what type of security you are seeking.

Geography

Most funds focus on a specific geography. Many mutual funds focus on US investments, while others purchase securities from within a region of the US, the whole world or segments thereof, such as the developed world excluding the US. While I hold most of my North American equity positions in individual companies, I use mutual funds to diversify my portfolio globally.

Market Segment

Just as funds focus on a specific geography, they sometimes invest in one or more market segments.   Some funds focus on a specific industry, such as natural resources or technology or financial companies. If you think a particular industry is going to benefit from trends in the economy, such as healthcare as the population ages, you might want to buy a fund that focuses on the healthcare industry. On the other hand, you might want to avoid healthcare stocks if you think that the healthcare industry might be at risk of significant disruption from changes in the government’s role in healthcare.

Other funds focus on the size of companies.  For example, an S&P 500 Index fund only buys positions in companies in the S&P 500 which, by definition, are large.  Other funds focus on middle-sized companies (middle-sized capitalization of mid-cap) or smaller companies (small-cap).

Another “industry” on which many funds focus is municipal bonds. These funds invest in bonds issued by municipalities. In many cases, interest from municipal bonds and municipal bond funds is not taxed by the Federal government or in the state in which the municipality is located. For example, if you buy a bond issued by the City of Baltimore, it is likely that it will not be taxed at all if you are a Maryland resident.

Appreciation vs. Dividends

Some funds focus on high-dividend investments, while others focus on appreciation in the value of the securities they own. You can learn the focus of a fund by looking at its details either in a summary or its prospectus. Funds that focus on high-dividend yields often have “high-dividend” in their name, but not always. The type of return targeted by funds you purchase will impact the specific securities owned by the fund. In addition, the type of return impacts the taxes you will pay (discussed below).

Growth vs. Value

Companies are often categorized between growth and value, reflecting the two primary reasons that stock prices increase. The stock price of a growth company is expected to increase because the company will increase its profits. By comparison, the stock price of value company is expected to grow because its valuation, often measured by the price-to-earnings or P/E ratio, is considered low and likely to return to normal.

Closed-end vs. Open-end Funds

Most funds are open-end funds. The price you pay for these funds is equal to the market value of the securities owned by the fund divided by the number of shares outstanding.   This price is known as the Net Asset Value. You can buy shares from and sell shares back to the fund owner at any time at the net asset value.

A closed-end fund differs in that the number of shares available is fixed when the fund is first created. When you buy and sell shares in a closed-end fund, the other party to the transaction is another investor, not the fund owner.  In fact, closed-end fund shares trade in the same manner as if the fund were a company. As such, the price is not the net asset value, but rather has a market value that reflects not only the net asset value but also investors views of the future performance of the fund.

I found Investopedia to have some great information about open-end funds and closed-end funds.

Advantages and Disadvantages of Mutual Funds and ETFs

The biggest advantage of mutual funds and ETFs is the ease with which you can diversify your portfolio, especially in asset classes or market segments with which you are unfamiliar. I think index-based ETFs are a terrific way for new investors to participate in markets. As I mentioned above, I use mutual funds for international stocks, as I don’t know enough about economies and market conditions outside the US, much less about individual companies, to make informed buying decisions.

A drawback to actively-managed funds is that they tend to underperform the market. That is, there are not many money managers who can consistently produce returns that exceed their target benchmarks. This difference is even greater when returns are reduced for fees paid by investors (discussed later in this post).

There are many sources for statistics about mutual fund returns. CNBC states that, in every one of the nine years from 2010 through 2018, more than half of actively managed large-cap funds produced returns less than the S&P 500. The same article also indicates that 85% of those funds underperformed the S&P 500 over a ten-year period and 92% underperformed over a 15-year period. As such, care should be taken when investing in actively managed funds. If you are looking for funds that will produce returns similar to broad market indices, such as the S&P 500, an index fund might be a better choice.

Income Taxes

There are four types of returns that are taxed when you own mutual funds or ETFs that hold stocks or bonds held in taxable accounts. Funds held in tax-deferred or tax-free accounts will have different tax treatment. The taxable returns on other types of funds will depend on the types of returns generated by the underlying assets.

Capital Gains

When you sell your ownership position in a fund, the difference between the amount you paid when you bought it and the amount you received when you sell it is a capital gain.   The taxation of short-term capital gains (related to securities owned for less than one year) is somewhat complicated in the US. Long-term capital gains are taxed in the same manner as dividends in the US, at 15% for most people. In Canada, capital gains are taxed at 50% of the rate that applies to your wages.

Interest

When you own a bond fund, interest paid by the issuers of the bonds owned by the fund is taxable in the year the interest payment was made. In the US and Canada, interest held in taxable accounts is taxed at the same rate as wages, except for certain municipal and government bonds which may be exempt from state or Federal taxes.

Dividends

Dividends paid by companies owned by a fund are taxable in the year the dividends payments are made. For most people in the US, there is a 15% Federal tax on dividends from investments held in a taxable account plus any state taxes. In Canada, dividends are taxed at the same rate as wages.

Capital Gain Distributions

Over the course of a year, a mutual fund may sell some of its assets. The capital gains earned from those assets are distributed to owners as capital gain distributions. Capital gain distributions are taxed in the same manner as capital gains.

Fees

There are generally three types of fees that can affect your returns on ETFs and mutual funds: front-end loads, operating expenses and commissions. Schwab identifies two other hidden costs that are a bit more obscure, so I’ll refer you to its post on this topic if you want more information.

Front-End Loads

Some mutual funds require you to pay a fee when you make a purchase. The fee is usually a percentage of your investment. For example, you would pay $10 for every $1,000 you invest in a fund with a 1% front-end load. If you purchased this fund, its total return on the underlying investments would need to be 1% higher over the entire period over which you owned it than the same fund with no front-end load for you to make an equivalent profit.

Funds that don’t have a front-end load are called no-load funds.

Operating Expenses

Mutual funds and ETFs, even those that are passively managed, have operating expenses. The operating expenses are taken out of the pool of money provided by investors. Every fund publishes its annual operating expense load, so you can compare them across funds. Funds with higher expense loads need to have higher returns on the underlying investments than fund with lower expense loads every year for you to make an equivalent return.

ETFs tend to have much lower operating expense loads than mutual funds. Similarly, passive funds tend to have lower operating expense loads than actively managed funds.

Commissions

If you purchase a mutual fund or ETF through a broker, you may pay a commission both when you buy the fund and when you sell it. A commission is a fee paid to the broker for the service it provides allowing you to buy and sell securities. Many brokers have recently reduced or eliminated commissions on many ETFs. If you purchase the mutual fund or ETF directly from the fund manager, you will not pay a commission.

Dividend Reinvestment

Many funds allow you to automatically reinvest distributions (i.e., interest, dividends and capital gain distributions). Although it includes all types of distributions, it is often called dividend reinvesting or reinvestment. It is a great way to ensure that all of your returns stay invested, as you don’t have to keep track of the payment dates on any distributions so you can reinvest them.

I have a few cautions about dividend reinvestment.

First, you want to reevaluate your choice of fund periodically. If you blindly reinvest all of your dividends and something changes that makes the fund a poor fit for your portfolio, automatic dividend reinvestment will cause you to have more money invested in something that you don’t want.

Second, you’ll want to be aware of the tax implications of dividend reinvestment – one of which is helpful and one of which requires some care – if you hold the fund in a taxable account.

Increased Cost Basis

As indicated above, when you sell a fund, you pay capital gains tax on the difference between your proceeds on sale and what you paid for the fund. The distributions that you reinvest are considered part of what you paid for the fund. You’ll need to take care to keep track of the amounts you’ve reinvested, as they increase your cost basis (the amount you paid) and decrease your capital gains tax.

Taxes on Distributions

Even if you reinvest your distributions, you need to pay taxes on them in the year in which they were paid. As such, if 100% of your distributions are automatically reinvested, you’ll need to have cash available from another source to pay the income taxes on the distributions.

Selecting Mutual Funds and ETFs

There are thousands of mutual funds and ETFs from which to choose. Here are my thoughts on how you can get started.

Set your Goals

  1. Determine what type of fund you are seeking. Are you trying to focus on a small niche or the broader market?
  2. Narrow down the type of fund that will meet your needs. Do you want an actively managed fund or a passive one? Are you interested in an open end or closed end fund?  Do you want the fund to look for growth companies or those with low valuations?

Identify Some Funds

  1. Once you’ve narrowed down the type of fund you’d like, you can use a screener to help you further narrow down your choices. Most large brokerage firms, as well as many independent entities, have mutual fund and ETF screeners. For example, Morningstar, a global investment-research and investment-services firm, has a free screener (after you sign up at no charge) at this link.
  2. Look at the ratings of the funds that are identified. The entity assigning the ratings usually expects higher rated funds to perform better than lower rated funds.
  3. Look at the historical returns. While past performance is never a guarantee of future performance, funds that have done well in the past and have consistent management and strategy may do well in the future.
  4. Read the details of the fund either on the fund manager’s web site or in the prospectus. Look to see if the objectives of the fund are consistent with your objectives. Make sure the types of securities the manager can purchase are in line with what you would like to buy. The names of some funds can be much narrower than the full range of securities the manager is allowed to buy. Find out if the fund management and objectives have been stable over time. Some funds can change their objectives on fairly short notice, potentially exposing you to risks you may not want to take or lower expected returns that you desire. To learn more about reading a prospectus, check out the article on Page 9 of this on-line magazine.
  5. Compare the fees among the funds on your list. If the underlying assets are similar and are expected to produce the same returns, funds with lower fees are more likely to provide you with higher returns (after expenses) than funds with higher fees. Don’t forget to look at both front-end loads and annual operating expense ratios.
  6. Select a strategy for buying your mutual funds or ETFs, such as dollar-cost averaging, waiting for a price drop or buying at the market price.

Make a Decision

  1. Buy a position in the fund(s) that best fit your requirements. As indicated above, you can buy most funds either through a broker (which can sometimes add a commission to your expenses) or directly from the fund manager.
  2. Last, but not least, be sure to monitor your positions to make sure that the fund objectives, holdings, management and fees remain consistent with your objectives.

Picking Stocks

Many investors create their own portfolios by picking stocks in individual companies. As discussed in my post on the basics of stocks, picking stocks in individual companies is one of several strategies for creating an investment portfolio. Alternatives to picking stocks in individual companies include buying mutual funds and exchange-traded funds. I’ll talk about those strategies in another post.

When I first started investing in the early 1980s, mutual funds were quite common but index funds and exchange-traded funds, while they existed, were not well known. I started my investment story by picking stocks in individual companies. One of the best books I’ve ever read on investing is One Up on Wall Street by Peter Lynch, originally published in 1989.

Confirmation of Independence: I have no affiliation with the author or publisher of the book I am reviewing. I do not receive any compensation for recommending it or if you purchase it.     I truly think it is a great source of investing information.

Lynch was the manager of a very successful mutual fund, the Fidelity Magellan fund, from 1977 to 1990. During that time, the fund had a 29.3% annual average return or more than twice the average return on the S&P 500 over the same time period. If you are considering picking stocks in individual companies, I recommend his book even though it is quite dated. It references companies and trends with which you may not be familiar, but the fundamental concepts are still relevant and it is a quick, easy read.

In this post, I’ll essentially provide an overview of some of the key points I learned from One Up on Wall Street and illustrate them with some personal examples when I can.

Picking Stocks in Companies You Know

One of the first concepts that Lynch introduces is that you are your own local expert. You are familiar with the business in which you work and shop. You are a consumer and you can observe trends in the area in which you live. By watching the world around you, you can identify possible investment opportunities, possibly even before the “market” or “experts” discover them. In many cases, if you identify a trend very early and invest in a company that will benefit from it, you can earn a much-higher-than-market-average return on your investment. In fact, Lynch points to this opportunity as giving individual investors a better chance of beating the market than professional investors who have to invest larger amounts so tend to purchase more mature companies.

Our Kids’ Choices

To illustrate what I mean by “invest in what you know,” I will use an experience we had with our children as an example. When they were in their early teens (probably around 2004 or 2005), we gave them each a very small amount of money to invest. Our son, who was very interested in trains and large equipment, chose the following companies:

  • Microsoft
  • John Deere
  • Canadian Pacific Railway
  • Canadian National Railway
  • ASV – a company that makes skid-steer loaders.

Our daughter, who was much more aware of what was happening in the retail space, chose the following companies:

  • Apple
  • Nordstrom
  • JC Penney
  • Target
  • One other company that I don’t recall.

How it Turned Out

I don’t remember exactly when we started this exercise, so have looked at the two- and five-year average annual returns starting on January 1, 2006. By using two-year returns, I have excluded the impact of the market decline in 2008 and early 2009. The five-year returns go through December 31, 2010, so include the market decline and part of the recovery.

The S&P 500 averaged a 4.5% increase per year during the two-year period and was essentially flat for the five-year period. By comparison, my daughter’s stocks increased at an annual average rate of 9% over the two-year period and 8% over the five-year period. My son did even better, with annual average returns of 15% over the two-year period and 9% over the five-year period.

What is even more impressive about my son’s returns is that his returns were dragged down significantly by a single company – ASV. When my son bought it, the company had its own patented suspension system for its tracks. As I recall, not too much later, it had a change in management. The new management decided to license the patent to Caterpillar. Unfortunately for ASV, Caterpillar’s much larger market share caused a large reduction in ASV’s sales that couldn’t be made up by the licensing fees. Over a several year period, ASV’s stock price went down by about one-third. This experience illustrates another lesson when looking a company’s fundamentals for investment decisions – carefully follow the decisions of any new management teams.

Without ASV, our son’s returns were much more impressive – 19% over the two-year period and 13% over the five-year period.

Don’t Invest in What You Don’t Understand

A related concept, but somewhat different one, is to avoid picking stocks in companies and sectors you don’t understand. Lynch has all sorts of great examples of why people buy stock in companies whose business they don’t understand – hot tips from a “rich uncle,” aggressive buy recommendations from a broker and so on and so forth.

Not understanding a company’s business can be everything from it having a very technical focus to not being familiar with its marketplace (i.e., to whom and how it sells its products) to being so diverse that it is hard to figure out what drives profits.   Essentially, his advice is that, if you can’t explain to someone what the company does in a few sentences, you shouldn’t buy its stock.

One Example of My Choices

I fell into that trap. We had a little extra money many years ago and decided to take some risk by making a very small investment in a private placement. When a company sells its stocks to a small group of investors and not the general public, it is called a private placement.

The two choices we were offered were a company that was marketing telemedicine to the Veterans Administration and a barbeque restaurant that was just opening its first locations. Our assessment was that the restaurant space was grossly overcrowded and that telemedicine would catch on quickly with the aging population and increases in technology. Not understanding that the telemedicine company didn’t actually have any customers or the challenges of getting a contract with the Veterans Administration, we made a very small investment in it.

Were we wrong! Many years later, we wrote off the entire value of the investment in the telemedicine company as it had become worthless. The restaurant was Famous Dave’s.

Ten Baggers

One of Lynch’s goals is picking stocks that are ten-baggers. These are companies whose stocks appreciate to at least 10 times what you paid for them in relatively short periods of time. By identifying trends in your local area, you are more likely to be able to earn the high returns associated with companies that start small and grow rapidly. As an example, consider the increases in Apple’s stock price.

The picture above shows the annual appreciation of Apple stock from 1981 through 2018. If you had owned the stock during any of the years circled in green, you would have more than tripled your money in two years. Not quite 10 times, but 3 to 5 times in 2 years is still a return anyone would envy. If you look at the returns in more recent circled in orange, you’ll see much more modest appreciation. The returns were still very attractive, but much lower than the earlier period.

Lynch points out the benefit of having just one ten-bagger in a portfolio with otherwise mundane performers. For example, if you invest the same amount in 9 stocks each having a total return of 5% per year, your total return in 5 years will be 27.6%. If you add a ten bagger to the mix, your total return increases to 115% or 16.5% per year.

Although our daughter didn’t have any ten baggers, her portfolio benefited from a similar effect. From 2006-2010, her three retail stocks had an annual average return of -1.6%. Apple, on the other hand, was almost a 4.5-bagger (its price at the end of 2010 was 4.4 times its price at the end of 2005). The addition of that one company to her portfolio increased her return from -1.6% to +8.2%!

Do Your Research

Once you’ve identified a company with an appealing product or service, it isn’t time to buy yet! Lynch suggests looking at the company’s financial statements and several financial metrics. I’ll talk about a few of them here.

Percent of Sales

The first thing to check is whether the new “thing” is big enough to have an impact on the profitability of the company. To illustrate, let’s look at two companies that make widgets. Company A makes primarily widgets, so 90% of its sales is from widgets. Company B makes a lot of things. Only 5% of Company B’s sales is from widgets. A new thingamabob has been designed that will double the sales of widgets with no impact on the profit margin (percent of sales cost that turns into profit). Company A’s profit will increase by 90%, whereas Company B’s profit will increase by only 5%. Because stock prices are driven in large part by estimates of future profitability, you would expect that Company A’s stock price would increase much more if it added thingamabobs to its widgets than Company B’s stock price.

Future Earnings

For many reasons identified by Lynch, stock prices don’t always move in line with earnings. Nonetheless, the more that earnings increase, the more that the stock price is likely to go up. Lynch suggests that you make sure you understand how a company plans to grow its earnings.

Ways to Increase Earnings

He identifies the following five ways for increasing earnings:

  • Reduce costs
  • Raise prices
  • Expand into new markets
  • Sell more product to existing markets
  • Revitalize, close or otherwise dispose of losing operations

If you plan to hold the company’s stock for a fairly short time, any of these ways of increasing earnings could provide nice returns. I tend to buy and hold my stocks for a long time (over 25 years in several cases), so I prefer companies whose growth strategies include expanding into new markets or selling more product to existing markets. The other three approaches tend to produce one-time increases to earnings that can’t be replicated over and over again.

Expanding into New Markets

One of the most common ways existing companies expand into new markets is through acquiring other companies. There are many companies that have grown very successfully through acquisition.

Berkshire Hathaway

One such company is Berkshire Hathaway, whose chairman is Warren Buffett. Over the past 40 years, Berkshire Hathaway has purchased such companies as Burlington Northern, Dairy Queen, and Fruit of the Loom, among others. The graph below shows the value of $1 invested in Berkshire Hathaway (stock symbol: BRK-A) since 1980 as compared to a $1 investment in the S&P 500.[1]

Clearly, Berkshire Hathaway has been highly successful in its acquisition strategy.

General Electric

Other companies have been less successful with their expansion and acquisition strategies. One such example is General Electric (GE). When I was young, I thought of GE as primarily manufacturing appliances and light bulbs. The graph below shows how the value of $1 invested in GE increased between 1962 and 2000 as compared to the same investment in the S&P 500.

Clearly, over that time frame, GE was very successful. In fact, my in-laws bought a few shares of GE for each of my kids when they were young (in the 1990s) because it was considered such a great, stable company.

Over the past 20 years, it has expanded its operations into loans, insurance and medical products and related services.   In hindsight, it appears that GE wasn’t sufficiently familiar with all of the business it entered or acquired.  It also used a lot of debt to finance its acquisitions and expansions.  As a result, its stock price suffered. The graph below shows how much a $1 investment in GE’s stock has changed over the past 20 years as compared to the S&P 500.[2]

Comparison

From 2000 to late 2019, Berkshire Hathaway’s stock price went up by a factor of almost 5 while GE’s stock price decreased by more than 50%. Interestingly, GE’s new CEO (hired in 2018) announced a transformation plan that includes selling several of its businesses, allowing it to focus primarily on “safely delivering people where they need to go; powering homes, schools, hospitals, and businesses; and offering more precise diagnostics and care when patients need it most.”[3]

You’ll want to make sure you understand which new markets a company plans to enter, think about whether management has sufficient experience or expertise to expand successfully and understand how much debt the company is using to finance these expansions.

P/E Ratio

The ratio of the price of a company’s stock to its annual earnings is known as the P/E ratio. A P/E ratio is one way to measure whether a company’s stock price is expensive. A rule of thumb mentioned by Lynch is that a stock is reasonably priced when its P/E is about the same as its future earnings growth rate. He acknowledges the important point that the future earnings growth rate isn’t ever known and that lots of experts spend a lot of time incorrectly estimating the earnings growth rate.

Nonetheless, you can at least look to see if a company’s P/E ratio is the right order of magnitude. For example, if you are looking at a company that slowly expands its sales in its current market, its earnings growth rate might be 5% to 7%. If that company’s P/E were 25, you’d know it was expensive. If the P/E ratio were 2, it might be an attractive buy. So, it isn’t necessarily important to know whether the company’s earnings growth rate is going to 5% or 7%, but rather whether it is likely to be 5% or 25%.

Schwab has an entire post on using the P/E ratio as part of stock analyses.

Debt/Equity Ratio

Companies can get cash from three sources to finance their operations – equity (selling shares of stock), borrowing and profits. Long-term debt is the amount of money that a company has borrowed, other than to meet short-term cash needs (such as through a line of credit). Long-term debt frequently is in the form of bank loans or bonds issued by the company.

The ratio of the amount of long-term debt to equity (the difference between assets and liabilities which is an estimate of the value of the company to the stockholders) is known as the debt-to-equity ratio. There are both advantages and disadvantages to a high debt-to-equity ratio. Let’s look at an example.

Company A has $100 of profit before interest (and ignoring taxes) and $60 of interest payments, for net income of $40 ($100 – $60). Company B is the same as Company A but it has no long-term debt, so its net income is $100. If profit before interest went down by 40%, Company B’s net income would also decrease by 40% to $60. Company A’s net income, though would go from $40 to $0 or a 100% decrease. The primary disadvantage of debt is that it magnifies the impact of bad news. The 40% decrease in profit before interest turned into a 100% decrease in net income for Company A with all its debt. This magnification is called leverage or debt leverage.

On the plus side, increases in profits are also magnified. If Company A’s profit before interest increased by 50% to $150, its net income would increase by $50 to $90. The percentage increase in net income in this case is +125% as compared to the +50% increase in Company B’s net income.

Other Metrics

Lynch discusses several other things to check on a company’s financial statements before making an investment.   I talk about one of them, the dividend payout ratio, in my post on investing for dividends. I’ll let you read One Up on Wall Street to learn more about the other metrics and to get Lynch’s views and examples on the ones I’ve discussed here.

Create Your Story

For every company in which you invest, Lynch recommends that you create a story. There are two parts to the story.

Two-Minute Story

First, you should be able to describe the company’s business in what I would call an “elevator speech.” That is, it is important to be able to explain to someone else what the company does and why you think it will grow all in two minutes. If your explanation takes longer, it is likely an indication that the company’s business is too complex to benefit from a trend you observe or you don’t fully understand its business.

Additional Details

Second, you’ll want to have a story for yourself that includes a bit more detail about what you think will cause earnings (and hopefully therefore the stock price) to increase. Is it one of the one-time actions, such as cutting expenses or increases prices, or a longer-term plan to increase sales?

If the former, you’ll want to monitor the progress of those actions. Are they being implemented? Have they been effective? Has their full impact been reflected in earnings and/or the stock price? If the company’s plans don’t come to fruition or they were successful and reflected in earnings, you’ll want to evaluate whether you want to continue to own the company’s stock or whether it is time to sell it.

If the latter, you’ll want to understand what steps the company plans to take to increase sales. You can then monitor the company’s progress towards those plans. If it doesn’t appear to be on track, it might be time to considering selling the stock and investing in another company.

Final Thoughts

As I re-read Lynch’s book in preparation for writing this post, I was reminded how many useful tidbits he provides in it. Interspersed among the anecdotes are lots of lists, checklists and guidance on everything from identifying a company in which to possibly invest to determining the company’s growth pattern to reading financials to designing your portfolio. If you plan to start picking stocks in individual companies, I highly recommend One Up on Wall Street by Peter Lynch as a good first book on the topic. If you are looking for a shorter source for similar information, I suggest this post from Schwab.

 

 

[1] Taken from Yahoo Finance, November 8, 2019.

[2] Taken from Yahoo Finance on November 8, 2019

[3] General Electric 2008 Annual Report, https://www.ge.com/investor-relations/sites/default/files/GE_AR18.pdf, p3.

Investing for Dividends

Investing for dividends is one of many strategies investors use to identify stocks for their portfolios. Among the strategies I identified in my post on what you need to know about stocks, this is not one that I have ever used.  So I reached out to one of my Twitter followers who uses it to get more information, Dividend Diplomats (aka Lanny and Bert) to get some real-life insights. With Lanny’s and Bert’s help, I will:

  • define dividends.
  • talk about the criteria that Lanny and Bert use for selecting companies and why they are important.
  • show some historical returns for dividend-issuing companies.
  • explain the tax implications of dividends on your total return.

What are Dividends?

A dividend is a cash distribution from a company to its shareholders. The amount of the dividend is stated on a per-share basis.  The amount of cash you receive is equal to the number of shares you own times the amount of the dividend. When companies announce that they are going to pay a dividend, they provide two dates.  The first is the date on which share ownership is determined (also known as the ex-dividend date).  The second is the date on which the dividend will be paid. For example, a company might declare a 15₵ dividend to people who own shares on May 1 payable on May 15. Even if you sell your stock between May 1 and May 15, you will get 15₵ for every share you owned on May 1.

When a company earns a profit, it has two choices for what to do with the profit. Under one option, the company can keep the profit and use it to support future operations. For example, the company might buy more equipment to allow it to increase the number of products is makes or might buy another company to expand its operations. Under the second option, the company distributes some or all of its profit to shareholders as dividends. My experience is that companies that are growing rapidly tend to keep their profits, whereas companies that can’t find enough opportunities to reinvest their profits to fund growth tend to issue dividends.

Dividend Diplomats – A Little Background

Lanny and Bert have been blogging for over 5.5 years and have been best friends for 7.  They both are pursuing the same goal of reaching financial freedom and retiring early to break the “9 to 5” chains.  They hope to achieve financial freedom through dividend investing, frugal living, and using as many “personal finance” hacks as possible to keep expenses low and bring in additional income. For more information about the Dividend Diplomats, check out their web site at www.dividenddiplomats.com.

Why Use the Investing for Dividends Strategy

As you’ll see in future posts, I have used several strategies for my stock investments, but have never focused on investing for dividends.

My Preconceived Notions

I have always considered investing for dividends as most appropriate for people who need the cash to pay their living expenses, such as people who are retired. I am retired, but currently have cash and some bonds that I use to cover my living expenses. As I get further into retirement, I will need to start liquidating some of my stocks or start investing for dividends.

Lanny’s & Bert’s Motivation

So, when I started reading about Lanny and Bert, I wondered why people who are still working (and a lot younger than I am) would be interested in investing for dividends.   Here’s what they said.

“There were a few different motivating factors.

Lanny had endured a very difficult childhood, where money was always limited and his family had struggled financially.   Due to this, he personally wanted to never have to worry about money, period.

Bert was not a dividend growth investor until he met Lanny.  Once he talked to Lanny, learned about dividend investing, and saw the math, he was sold and hasn’t looked back since.

Therefore, we are looking to build a growing passive income stream so we can retire early and pursue our passions.  Building a stream of growing, truly passive dividend income has always been a very attractive option to us.  We love the fact that dividend income is truly passive (outside of initial capital, we don’t have to lift a finger) and we are building equity in great, established companies that have paid dividends throughout various economic cycles.

Second, the math just makes sense.  It is crazy how quickly your income stream grows when you are anticipating a dividend growth rate of 6%+ (on average).  Lanny writes an article each quarter showing the impact of dividend increases and we have demonstrated the impact of dividend reinvesting on our site in the past. When you see the math on paper, it is insane. “

Lanny and Bert provided links to a couple of their posts that illustrate the math: Impact of Dividend Increases and Power of Dividend Reinvesting.

Lanny’s & Bert’s Strategy

Lanny and Bert developed a dividend stock screener that helps them identify undervalued dividend growth stocks in which to consider investing.  At a minimum, the companies must pass three metrics to be further considered for investment:

  • Valuation (P/E Ratio) less than the market average.
  • Payout Ratio Less than 60%. (Unless the industry has a higher benchmarked figure. i.e. oil, tobacco, utilities, REITs, etc., then they compare to the industry payout ratio.)
  • History of increasing dividends.

They don’t consider dividend yield until later in the process.  They never advocate chasing dividend yield at the risk of dividend safety. That is, they would rather a dividend that has very low risk of being reduced or eliminated (i.e., safety) than a higher dividend be unsustainable over the long term.

That’s why they don’t look at yield initially.  It allows them to focus on the important metrics that help them gain comfort over the safety of the dividend.  Here is a link to their Dividend Stock Screener.

Payout Ratio

Lanny and Bert mention that that one of their key metrics is a payout ratio. A dividend payout ratio is the annual amount of a company’s dividend divided by its earnings per share.  For more about earnings per share, check out my post on reading financial statements.

A dividend payout ratio of less than 1 means that a company is retaining some of its earnings and distributing the rest. If the ratio is more than 1, it means that the company is earning less money than it is paying out in dividends.

I worked for a company that had a payout ratio of more than 1. When I first started working there, the company had more capital than it could use. The company was returning its excess capital to its shareholders through the high dividend. After several years, the company’s capital approached the amount it needed to support its business. If it had cut its dividend to an amount lower than its earnings, the stock price might have decreased significantly. Instead, the company was sold. Had the company not been sold, its shareholders might have had both a decrease in future dividend payments and a reduction in the value of their stock at the same time.  This double whammy (dividend cut at the same time as a price decrease) is a risk of owning a stock in a dividend-issuing company especially those with high dividend payout ratios.

Performance – Lanny and Bert’s View

Lanny and Bert are not assuming they can do better than management or the market.  As noted above, they tend to focus on companies with a dividend payout ratio less than 60%.  This approach allows for all three of increasing dividends to shareholders, share repurchases, and internal growth for profit.  Also, this approach ensures the company is continuing to invest in itself as well.  You can’t pay a dividend in the future if you can’t grow, or even maintain, your current earnings stream.  Therefore, if revenues are stagnant or shrinking, the safety of the company’s dividend comes into question.  Companies “can” pay out a dividend that is larger than your earnings over the short-to-medium term.  However, it is not sustainable as was the case with the company for which I worked.

Historical Performance

I was curious about how stocks that met Lanny and Bert’s criteria performed. I have a subscription to the ValueLine Analyzer Plus. It contains current and historical financial data and stock prices about hundreds of companies. I looked at two time periods.  I first looked at the most recent year (November 2018 to November 2019).  Because I was curious about how those stocks performed in the 2008 crash, I also looked at the ten-year period from 2003 to 2013. I would have used a shorter period around the 2008 crash and the period thereafter, but didn’t save the data in the right format so had to look at time periods for which I had saved the data in an accessible manner.

How I Measured Performance

For both time periods, I identified all stocks for which the data I needed for the analysis were available at both the beginning and end of the period.  There were 1,505 companies included in the sample in the 2018-2019 period and 952 companies for the 2003 to 2013 period.

I then identified companies (a) whose dividend grew in each of the previous two fiscal years, (b) whose dividend payout ratio was less than 60% and (c) whose P/B ratio was less than the average of all of the companies in the same. That is, I attempted to identify the companies that met Lanny and Bert’s criteria. There were 332 companies in the 2018-2019 period and 109 companies in the 2003-2013 period that met these criteria.

ValueLine ranks companies based on what it calls Timeliness, with companies with Timeliness ratings of 1 having the best expected performance and those having a rating of 5 having the worst expected performance. Because I suspected that Bert and Lanny’s screen would tend to select more companies with favorable Timeliness ratings than those with poorer ones, I looked at both the overall results, as well as the results by Timeliness rating.

November 2018 – November 2019

In the most recent year, the stocks that met Lanny’s and Bert’s criteria had an average total return (dividends plus change in stock price) of 11% as compared to 8.5% for the total sample. That is, in the current market, dividend issuing companies meeting their criteria returned more than the average of all companies.

Interestingly, when I stratified the companies by Timeliness rating, it showed that for companies with good Timeliness ratings (1 and 2), the Lanny’s and Bert’s companies underperformed the group. For companies with two of the three lower Timeliness ratings (3 and 5), though, Lanny’s and Bert’s companies not only did better than the average of all companies in the group, but also did better than even the group of companies with a Timeliness rating of 1! It looks to me as if their approach might identify some gems in what otherwise appear to be poorer performing companies.

The chart below shows these comparisons.

2003 to 2013

Over the longer time period from 2003 to 2013, the companies meeting Lanny’s and Bert’s criteria didn’t do quite as well as the average of all companies. In this case, the stocks meeting their criteria had a compound annual return of 5% as compared to 7% for all stocks in the sample. Without more data, it is hard to tell whether the difference in return is the sample of dividend-issuing companies is small, because those companies didn’t fare as well during the Great Recession or something else.

I looked at the total returns by Timeliness rating and the results were inconsistent for both the “all stocks” group and the ones that met our criteria. A lot can happen in 10 years! Nonetheless, it was interesting to see that the dividend-yielding stocks that had Timeliness ratings of 5 in 2003 out performed all other subsets of the data. So, while these stocks didn’t have quite as high a total return over the 10-year period in the aggregate, there are clearly some above-average performers within the group.

Tax Ramifications of Dividends

One of the drawbacks of investing in companies with dividends, as opposed to companies that reinvest their earnings for growth, is that you might need to pay taxes on the dividend income as it gets distributed.

Types of Accounts

If you hold your dividend-yielding stocks in a tax-deferred (e.g., Traditional IRA or 401(k) in the US or RRSP in Canada) or tax-free (e.g., Roth IRA or 401(k) in the US or TFSA in Canada), it doesn’t matter whether your returns are in the form of price appreciation or dividends. Your total return in each of those types of accounts gets taxed the same. That is, if you hold the stocks in a tax-deferred account, you will pay tax on your total returns, regardless of whether it is interest, dividends or appreciation, at your ordinary income tax rate. If you hold the stocks in a tax-free account, you won’t pay taxes on any returns.

The only type of account in which it matters whether your return is in the form of price appreciation or dividends is a taxable account. In the US, most people pay 15% Federal income tax plus some additional amount for state income taxes on dividends in the year in which they are issued. They pay taxes at the same rate on capital gains, but only when the stock is sold, not as the price changes from year to year. In Canada, the difference is even greater. Dividends are taxed at your ordinary income tax rate (i.e., they are added to your wages) and capital gains are taxed at 50% of your ordinary income tax rate and only when you sell the stock.

Dividend Reinvestment

When you earn dividends from a company, you often have the option to automatically reinvest the dividends in the same company’s stock. This process is a dividend reinvestment plan. Lanny and Bert take this approach.

Dividend reinvestment plans are terrific ways to make sure you stay invested in companies that you like, as you don’t have to remember to buy more stock when the dividend is reinvested. The drawback of dividend reinvestment plans is that you will owe tax on the amount of the dividend, even if you don’t receive it in cash. If you reinvest 100% of your dividends, you’ll need to have cash from some other source to pay the taxes unless you hold the investments in a tax-free or tax-deferred account.

Illustration

Let’s assume you are a US investor subject to the 15% Federal tax rate and pay no state income tax. You have two companies you are considering. You expect each to have a total return of 8%. One company’s return will be 100% in dividends, while the other company issues no dividends. You plan to own the stock for 10 years. Your initial investment will be $1,000 and you will pay your income taxes out of your dividends, so you reinvest 85% of the dividends you earn each year.

At the end of the 10th year, you will have $1,931 if you buy the company with 8% dividends. If you buy the company with no dividends, your stock will be worth $2,159. After you pay capital gains tax of $174, you will have $1,985 or 2.8% more than if you buy stock in the company that issues 8% dividends.

If you pay Canadian taxes, the difference is even bigger because of the much lower tax rate on capital gains than dividends. Over the full ten-year period, you will end up with almost 11% more if you buy stock in the company with no dividends than if you buy stock in the dividend-issuing company.

As such, you’ll want to put as much of your portfolio of dividend-issuing stocks in a tax-deferred or tax-free account as possible to minimize the impact of taxes on your total return.

Reading Financial Statements

Reading financial statement guides many investors in their decisions to buy and sell stocks.   Investors who focus on financial fundamentals look at recent financial statements in the context of other trends to estimate how much a company’s future profit might grow.  High-dividend yield investors need to understand the company’s financial statements to evaluate the sustainability of current dividend payments into the future.

Before investing in the stock of individual companies, it is good to understand the basics of their financial statements. In this post, I’ll identify the important values in the income statement and balance sheet and discuss important ratios that investors use to evaluate financial performance.  This post provides the basics of how stocks work.  In future posts, I’ll illustrate how these values can be used to evaluate companies and their stock prices under different investment strategies.

McCormick

Every company’s financial statements will be slightly different because every business is different. For illustration, I will use excerpts from the financial statements in the McCormick 2018 Annual Report. McCormick sells spices under its own name, but also owns the French’s mustard, Club House crackers and Lawry’s seasonings brands, among others. To be clear, my selection of McCormick for illustration is not intended to be a recommendation.

In this post, I’ll explain the key line items in McCormick’s financial statements.  If you are interested in other line items, you can either ask me in the comments or by e-mail or do some research on your own.

Income Statement

An income statement presents a summary of the financial aspects of a company’s operations and other financial transactions that occur during the financial reporting period. Publicly traded companies are required to provide their income statements to financial regulators (e.g., the Security & Exchange Commission in the US) quarterly and annually in reports known as the 10-Q and 10-K, respectively.

Here is a picture of the income statement from the McCormick 2018 Annual Report.[1]   All of the numbers in the excerpts from McCormick’s financial statements are in millions.

Revenue is the money that a company receives for the goods and services it delivered during the year.  As you can see in its income statement McCormick had $5.4 billion in total revenues (net sales) in 2018.

Expenses

Expenses represents all the money that a company spends in the year, with one exception.

Depreciation

When the company purchases something that is expected to last for a long time, it is called a capital asset. Companies don’t include the full cost of capital assets in expenses in the year in which they buy them. Rather, they spread the costs of capital assets over several years. The amount spread to each year is called depreciation. The depreciation of capital assets is included on the Income Statement, not the actual cash expense.

Operating Expenses or Cost of Goods Sold

Operating expenses, sometimes called Cost of Goods Sold for sellers of products, are those that are directly related to the manufacture of products or provision of services sold in the year. For McCormick, these expenses were $3.0 billion in 2018.

General and Administrative (G&A) Expenses

G&A expenses, sometimes called overhead expenses, represent the cost to run the company and are not directly related to specific products or services. Some companies include research and development (R&D) expenses with G&A expenses while others show them separately. For McCormick, these expenses were about $1.4 billion, an amount I had to find in its Notes to Financial Statements.

Other Income/Expenses

There are many types of income and expenses that don’t relate to products and services and aren’t G&A expenses. These items are usually small relative to the other line items on the income statement. For McCormick, there are three line items that fall in the Other Income/Expenses category

  • Transaction and integration expenses of $22 million
  • Special charges of $16 million
  • Other income, net of $13 million

These amounts combine to a net total of $25 million (=$22 million + $16 million – $13 million) in 2018. Compared to the other revenue and expense items, all of which are measured in billions of dollars, these amounts are small, as expected.

Interest Expenses

Interest expense represents interest that the company pays on its debt.  McCormick’s had $175 million of interest expense in 2018.

Income Taxes

These expenses represent income taxes that the company pays to any federal, state or local governments. McCormick had a tax benefit of $157 million in 2018. By looking at the Notes to Financial Statements included in the Annual Report, I found that McCormick owed $183 million in taxes related to 2018 operations, but the reduction in the US Federal tax rate on corporations in early 2018 caused an adjustment to McCormick’s tax liabilities. The decrease in tax rate created a benefit of $340 million. The $157 million tax benefit on the income statement is equal to the $183 million for current operations offset by the $340 million reduction in future taxes. When looking at McCormick’s profits going forward, the $183 million of taxes for current operations is the more important number because the $340 million is a one-time adjustment.

Accrual Basis vs. Cash Basis

One of the hardest things for most people to understand about income statements is the difference between the values on the income statement and the cash the company receives and pays. The income statement is said to be on an “accrual” basis. Accrual amounts relate to goods and services delivered during the year, regardless of when the cash is actually received or paid.

To clarify, revenues on the income statement represent the amount of cash the company has or will receive for goods or services delivered in the year. If the company hasn’t received some of its compensation for goods or services by the end of the year, it creates an asset on its balance sheet for accounts receivable. If it receives the cash before it delivers the goods or services, it creates a liability for goods or services due to customers.

Similarly, the expenses on the income statement relate to the products or services delivered in the year. If a company has to pay for components of its products, for example, before it delivers them, it will create an asset on its balance sheet for inventory. If it hasn’t paid all of the bills related to products delivered in the year, it creates a liability on the balance sheet for accounts payable.

As you can see, many balance sheet items (discussed further below) are really differences between amounts accrued on the income statement and actual cash received or paid.

Measures of Profit

Companies have several measures of profit. They can be measured as either dollar amounts or percentages or revenues. In this post, I’ll put “%” after the type of profit when I’m referring to the profit as a percentage of revenue.

Gross Margin

The gross margin is calculated as revenues minus operating expenses. This line is labeled as “Gross profit” in the McCormick income statement. In 2018, McCormick’s gross margin was $2.4 billion and corresponds to 44% of revenues. It represents the amount of profit the company would have had if its only expenses were those directly related to products and services.

Operating Income

Operating income is calculated as the gross margin minus G&A expenses and some components of other income and expenses. For 2018, McCormick’s operating income was $903 million or 17% of revenues. It represents the amount of profit the company would have had if it didn’t have any interest expense or taxes. It is sometimes called EBIT or earnings before interest and taxes.

Pre-tax Income

Pre-tax income is calculated as operating income minus interest expense and some components of other income and expenses. For 2018, McCormick had $741 million of pre-tax income (also known as EBIT or earnings before income taxes) or 14% of revenues.

Net Income

Net income is the bottom-line profit after taxes. It is calculated as pre-tax income minus income taxes. For 2018, McCormick had net income of $899 million. Recall, though, that McCormick had a one-time benefit from the change in tax rate of $340 million, so its net income would have been $559 million on a “normalized” basis or 10% of revenues. This adjusted net income is a better value for estimating future profits, as McCormick won’t get the benefit of a tax rate change every year.

Other Comprehensive Income

There are some values that impact the net worth of a company that don’t appear in the calculation of net income, but rather appears either at the bottom of the Income Statement or on a separate schedule in the financials. These items are referred to as Other Comprehensive Income. They can include the impact of changes in foreign exchange rates, certain transactions or changes in valuation related to investments and changes in the value of pension plans. As with other income, Other Comprehensive Income is usually small relative to other values on the income statement. If it isn’t, you’ll want to read the Notes to Financial Statements to understand the sources of Other Comprehensive Income and how it might affect profitability and growth in the future.

Balance Sheet

A balance sheet shows everything that a company owns or is owed (assets) and owes (liabilities) on a particular date.  As I mentioned earlier that many balance sheet items represent the differences between what the company has accrued on its income statement and what it has actually paid or received in cash. The balance sheet also shows the difference between assets and liabilities, which corresponds to its net worth or shareholders’ equity.

Here is a picture of McCormick’s 11/30/18 balance sheet taken from its Annual Report.[2]

Assets

Assets represent the value of things the company owns and amounts it is owed. Current assets are assets that a company can sell and turn into cash within a year. They are usually reported separately on a balance sheet.

McCormick had $10 billion in total assets on November 30, 2018. As you can see, inventory was its largest current asset at $786 million. Inventory represents the amount already spent on products that are ready to be sold or are in the process of being manufactured.

McCormick’s largest assets overall are its $4.5 billion of goodwill and $2.9 billion of intangible assets. These assets appear on some companies’ financial statements but not others. As you look at the net worth of a company, you’ll want to understand these assets.

Goodwill is created when one company buys another for a price that is higher than the net worth of the acquired company. That difference between the price and the net worth is intended to represent the present value of future profits on the acquired business. Goodwill is generally reduced as the profits emerge. In 2017, McCormick’s bought RB Foods which includes the French’s mustard, Frank’s RedHot and Cattlemen’s brands. More than three-quarters of McCormick’s goodwill was created when it bought RB Foods.

In McCormick’s case, the intangible assets represent the value of its brand names and trademarks. Although not exactly correct, the amount can be thought of as the present value of the future profits McCormick thinks it will get as the result of owning the brand names and trademarks.

Liabilities

Liabilities represent money or the value of products or services a company owes to others. McCormick had $7.1 billion in liabilities on November 30, 2018. The largest of these liabilities was Long Term Debt of $4.1 billion. McCormick issued roughly $3.4 billion in debt to finance its acquisition of RB Foods in 2017.

Equity

Shareholders’ equity represents the difference between assets and liabilities. It represents what is known as the “book value” of the company. On November 30, 2018, Boeing’s shareholders’ equity was $3.2 billion.

Key Financial Ratios

When deciding whether to buy or sell stock in a company, there are a number of ratios that many investors consider. I’ve highlighted a few important ones in this section, using the McCormick financial statement excerpts from above for illustration. I note that I have used simplified versions of the financial statements and the calculations, so you will likely see published values for McCormick that differ a bit from those calculated here.

ROE or Return on Equity

Return on equity (ROE) can be approximated as Net Income for the year divided by Shareholders’ Equity at the beginning of the year. For McCormick, it is approximated for 2018 as the $899 million of net income divided by the $2,571 million of shareholders’ equity at the end of its 2017 fiscal year or 35%. That ROE is very high. Recall, though, that McCormick had a one-time tax benefit of $340 million in 2018. If we exclude that benefit as it won’t be repeated in the future, we get an adjusted ROE of 22%.

According to CSI Market[3], the average ROE for the total market for 2018 was around 13%. ValueLine, a source for lots of qualitative and quantitative information about companies, reports that the average ROE for companies in the food processing industry (in which McCormick falls) is about 15%.[4] As such, even McCormick’s adjusted ROE is higher than these averages.

P/E Ratio or Price/Earnings Ratio

The Price/Earnings or P/E ratio is the stock price divided by the earnings per share. McCormick had roughly 130 million shares of stock outstanding in 2018. As such, its earnings per share was about $7 (=$899 million/130 million shares). McCormick’s stock price on November 30, 2018 (the date of the financial statements) was $150, which corresponds to a P/E ratio of about 22.

According to ValueLine, the average P/E of companies in the food processing industry on October 31, 2019 was 23. By comparison, the average P/E for the market has been between 16 and 18 for the past year or so. As such, McCormick’s P/E is in line with its peers. If we adjust McCormick’s earnings to exclude the one-time tax benefit, its earnings per share would have been about $4.25 per share. When we divided the $150 stock price by this smaller number, the adjusted P/E is about 35 or much higher than its peers.

P/B Ratio or Price/Book Ratio

The Price/Book or P/B ratio is the stock price divided by shareholders’ equity (book value) per share. McCormick’s equity as of November 30, 2018 was $3,182 million. When divided by the number of outstanding shares, the book value per share was $24. The stock price divided by the book value is about 0.90. ValueLine indicates that the average P/B ratio on October 31, 2019 for the food processing industry was about 3.3 or much higher than McCormicks’ P/B ratio.

P/B Ratio > 1

When the P/B ratio is greater than 1, the difference between the stock price and the book value per share is the present value of future earnings estimated by investors. The higher the P/B ratio, the higher the value investors place on future earnings.

P/B < 1

When the P/B ratio is less than 1, it means that investors either think that the future earnings are going to negative (which doesn’t appear to be the case for McCormick) or they don’t think shareholders’ equity is fairly valued. In the case of McCormick, it could be that investors think that the goodwill and intangible assets might be overvalued or they might be concerned that the future reductions to income as the goodwill and intangible assets are reduced will have a significant adverse impact on earnings. If either of those is the case, investors may be adjusting the company’s book value (equity) in their analyses for their perceived overstatement of goodwill and intangible assets.

Within the group of investors who look at financial fundamentals for decision-making, there is a subset called “value investors.” Value investors look for companies whose stock price doesn’t full reflect the value of the company which is often determined by P/B ratios of less than 1.00. A value investor who was confident that McCormick could maintain its current profitability and that the company had fairly estimated its goodwill and intangible assets might find McCormick to be an attractive stock.

Debt-to-Equity Ratio

Both debt and equity are ways in which a company can get money to finance their operations – either when it issues bonds or new shares of stock. The sum of the two is sometimes called total capital.

The Debt-to-Equity ratio is the amount of long-term debt divided by shareholders’ equity and is a measure of the mix the company has chosen to use for financing its operations, growth or acquisitions. McCormick has a total of $4.1 billion of debt ($4.05 billion recorded as long-term debt plus $84 million reported as the portion of long-term debt on its balance sheet). The debt-to-equity ratio is 1.30 (=4.1/3.2).

The higher the debt-to-equity ratio, the more leveraged a company is said to be. To clarify, when there is a lot of leverage, its ROE will be much higher than if some or all of the debt were equity instead. For example, McCormick’s ROE for 2018 was 35%. If all of its debt had been equity instead, its ROE would have been 13% (=$899 million/[$3.2 billion + $4.1 billion]).   The opposite it true when a company has a negative ROE. If McCormick’s ROE in 2018 had been -10% based on its current leverage, it would have been only -4% if it had only equity capital instead of its current mix of debt and equity.

Tangible Equity/Total Equity

I wasn’t planning to talk about tangible equity in this post, but my choice of McCormick almost forces me to. If you recall, I pointed out earlier in this post that McCormick’s two biggest assets are Goodwill and Intangible Assets. If a company encounters financial difficulties, it sometimes has to reduce or write-off the value of any goodwill or intangible assets. When these assets are reduced, its total equity will be reduced by the same amount, after adjustment for income taxes. In addition, goodwill and intangible assets are reduced as the future profits are expected to be earned. As such, goodwill and other intangible assets cause future net income to be lower than it would otherwise be, even if there are no write-offs.

Tangible equity is equal to total equity minus goodwill minus intangible assets. Because these assets can’t be quickly turned into cash and can have their value reduced, many investors look at ratio of tangible equity to total equity. The total of McCormick’s goodwill and intangible assets was $7.4 billion. This amount is more than twice its shareholders’ equity. What this means is that McCormick’s book value would become negative if it were required to write-down more than half of its goodwill and intangible assets.  As long as everything goes as expected, though, McCormick will be just fine. As such, this ratio is a measure of the riskiness of the stock price.

Earnings Growth Rate

Another important metric that investors consider is the earnings growth rate. When considering when to buy a stock, investors try to estimate future earnings growth rates. In the estimation process, they often consider historical growth rates. The historical earnings growth rate is the ratio of this year’s net income to last year’s net income minus 1.00.

For McCormick, after adjustment for the one-time tax benefit, the earnings growth rate from 2017 to 2018 was 25% (=$559 million / $444 million – 1). From 2016 to 2017, it was a much more modest 2%.

Stock prices tend to reflect estimated future earnings as well as estimated future earnings growth rates. There are many investment analysts who estimate the future earnings growth rates for publicly-traded companies. Yahoo Finance and most large brokerage firms’ web sites include information about analysts’ estimates of future earnings growth rates. Also, some investors look at recent growth rates and trends in the markets in which companies operate to estimate the future earnings growth rates.

Investing Decisions

These ratios, along with others, are often used by investors to evaluate the financial condition of the company and the reasonableness of its stock price. For example, one rule of thumb is that stocks are fairly priced when the P/E ratio is less than the expected future earnings growth rate. I’ll take about this rule of thumb and other decision criteria in future posts in my series on investing in stocks.

[1] https://ir.mccormick.com/financial-information, 2018 Annual Report, p50.

[2] https://ir.mccormick.com/financial-information, 2018 Annual Report, p. 51.

[3] https://csimarket.com/Industry/industry_ManagementEffectiveness.php?&hist=4, November 7, 2019

[4] ValueLine Investment Analyzer, October 31, 2019.

What You Need to Know About Stocks

Stocks are a common choice for many investors.  There are two types of stocks – preferred and common.  Because most investors buy common stocks, they will be the subject of this post.  I’ll talk about what you need to know about stocks before you buy them, including:

  • Stocks and how they work.
  • The price you will pay.
  • The risks of owning stocks.
  • Approaches people use for selecting stocks.
  • How stock are taxed.
  • When you might consider buying stocks.
  • How to buy a stock.

What are Stocks?

Stocks are ownership interests in companies.  They are sometimes called equities or shares.  When you buy a stock, you receive a certificate that indicates the number of shares you own.  If you buy your investments through a brokerage firm, it will hold your certificates for you.  If you buy them directly, you will usually receive the certificate (and will want to maintain it in an extremely safe place as it is your only proof that you own the stock).  Some companies track their stock’s owners electronically, so you may not always get a physical certificate.

How Do Stocks Work?

Companies sell stock as a way to raise money.  The company receives the amount paid for the shares of stock when they are issued, minus a fee paid to the investment banker that assists with the sale.  The process of issuing stock is called a public offering.  The first time a company offers its shares to the public, it is called an initial public offering (IPO).

Stockholder-Company Interactions

After the stock has been sold by the company, the stockholder has the following interactions with the company:

  • It receives any dividends paid by the company.
  • It gets to vote on matters brought before shareholders at least annually.  These issues include election of directors, advisory input on executive compensation, selection of auditors and other matters.
  • It has the option to sell the stock back to the company if the company decides to repurchase some of its stock.

In addition to these benefits of owning stock, you also can sell it at the then-current market price at any time.

Why Companies Care About Their Stock Prices

Interestingly, after the stock has been sold by the company, future sales of the stock do not impact the finances of the company other than its impact on executive compensation.  That is, if you buy stock in a company other than when it is issued, you pay for the stock and the proceeds go to the seller (who isn’t the company)!

You might wonder, then, why a company might care about its stock price.  That’s where executive compensation comes in!  Many directors and senior executives at publicly traded companies have a portion of their compensation either paid in stock or determined based on the price of the company’s stock.  When the leadership owns a lot of stock or is paid based on the stock price, it has a strong incentive to act in a way that will increase the price of the stock.  As such, with appropriate incentive compensation for directors and executives, their interests are more closely aligned with yours (i.e., you both want the price of the company’s stock to go up).

What Price Will I Pay?

The price you will pay for a stock is the amount that the person selling the stock is willing to take in payment.  Finance theory asserts that the price of a stock should be the present value of the cash flows you will receive as the owner of a stock.

In my post on bonds, I explain present values.  They apply fairly easily to the price of a bond, as the cash flows to the owner of a bond are fairly clear – the coupons or interest payments and the return of the principal on a known date.

By comparison, the cash flows to the owner of a stock are much more uncertain.  There are two types of cash flows to the owner of a stock – dividends and the money you receive when you sell the stock.

Dividends

Dividends are amounts paid by the company to stockholders.  Many companies pay dividends every quarter or every year.  In most cases, the amount of these dividends stay fairly constant or increase a little bit every year.  The company, though, is under no obligation to pay dividends and can decide at any time to stop paying them.  As such, while many people assume that dividends will continue to be paid, there is more uncertainty in whether they will be paid than there is with bond interest.

Proceeds from the Sale of the Stock

The owner of the stock will receive an amount equal to the number of shares sold times the price per share at the time of sale.  This cash flow has two components of uncertainty to it.

  1. You don’t know when you will sell it. You therefore don’t know for how long you need to discount this cash flow to calculate the present value.
  2. It is impossible to predict the price of a stock in the future.

What are the Risks?

The biggest risk of buying a stock is that its value could decrease.   At the extreme, a company could go bankrupt.  In a bankruptcy, creditors (e.g., employees and vendors) are paid first.  If there is money left after creditors have been paid, then the remaining funds are used to re-pay a portion of any bond principal.  By definition, there isn’t enough money to pay all of the creditors and bondholders when there is a bankruptcy.  As such, the bondholders will not get all of their principal re-paid and there will be no money left after payment has been made to bondholders and creditors.  When there is no money left in the company, the stock becomes worthless.

Any of the following factors (and others) can cause the price of the stock to go down.

Economic Conditions Change

Changes in economic conditions can cause the interest rate used for discounting in the present value calculation to increase. When the interest rate increases, present values (estimates of the price) will go down.

Company Changes

Something changes at the company that causes other investors to believe that the company’s profits will be less than previously expected. One simple way that some investors estimate the price of a company’s stock is to multiply the company’s earnings by a factor, called the price-to-earnings ratio or P/E ratio.  Although P/E ratios aren’t constant over time, the price of a stock goes down when its earnings either decrease or are forecast to be lower than expected in the future. For more about P/E ratios and how a company calculates and reports on its earnings, check out this post

Increased Risk

Changes either in the economy or at the company can cause investors to think that the future profits of the company are more uncertain, i.e., riskier. When a cash flow is perceived to be riskier, a higher interest rate is used in the present value calculation.  This concept is illustrated in my post on bonds in the graph that shows how interest rates on bonds increase as the credit rating of the company goes down.  Recall that lower credit ratings correspond to higher risk.  The same concept applies to stock prices.  The prices of riskier stocks are less than the prices of less risky stocks if all other things are equal.

How Do People Decide What to Buy?

There are a number of approaches investors use to decide in which companies to buy stocks and when to buy and sell them.   I will discuss several of them in future posts.

Reasonable Price Investing

Reasonable price investors look at the financial fundaments and stock prices of companies to decide whether and when to buy and sell them.

Technical Analysis

Technical analysts, sometimes called momentum investors, look at patterns in the movement of the prices of companies’ stocks.  Day traders tend to be technical analysts whose time horizon for owning a stock can be hours or days.

High-Yield Investing

Some investors focus on companies who issue dividends.

Mutual Funds and Exchange-Traded Funds (ETFs)

Rather than invest in individual companies, some investors purchase either mutual or exchange-traded funds.  Under this approach, the investor relies on the fund managers to select the companies and determine when to buy and sell each position.

How are Stocks Taxed?

There are two ways in which stocks can impact your income taxes:

  • When you receive a dividend.
  • When you sell your ownership interest in the stock.

The total amount of the dividend is subject to tax.  The difference between the proceeds of selling the stock and the amount you paid for the stock is called a realized capital gain or loss.  It is gain if the sale proceeds is more than the purchase amount and a loss if the sale proceeds are less than the purchase amount.

In the US, realized capital gains and losses on stocks you have owned for more than a year are added to dividends.  For most people, the sum of these two amounts is taxed at 15%.  For stocks owned for less than a year, the realized capital gains are taxed at your ordinary tax rate (i.e., the rate you pay on your wages).

In Canada, dividends and half of your realized capital gains are added to your wages.  The total of those amounts is subject to your ordinary income tax rate.

When Should I Buy Stocks?

Understand Stocks

The most important consideration in determining when to buy stocks is that you understand how stocks work.  One of the messages I wished I had given our children is to invest only in things you understand.  If you don’t understand stocks, you don’t want to invest in them.

Understand the Companies or Funds

You also want to make sure you understand the particular company or fund you are purchasing.  One of the biggest investing mistakes I made was when I was quite young and didn’t understand the business of the company whose stock I owned.

My parents gave me some shares of a company called Wang Laboratories.  In the 1970s and early 1980s, Wang was one of the leaders in the market for dedicated word processors.  Picture a desktop computer with a monitor that’s only software was Microsoft Word, only much harder to use.  That was Wang’s biggest product.  At one time, the stock price was $42.  Not understanding that PCs were entering the market and would be able to do so much more than a dedicated word processor, I was oblivious.  As the stock started going down, I sold a few shares in the high $30s.  When the stock dropped to $18, I told myself I would sell the rest when it got back to $21.  It never did.  A year or so later, the stock was completely worthless. Fortunately, I was young enough that I had a lot of time to recover and learn from this mistake.

Be Willing and Able to Understand the Risks

You should also not buy stocks if you can’t afford to lose some or all of your principal.  Even though only a few companies go bankrupt, such as Wang, the price of individual stocks can be quite volatile.  As discussed in my post on diversification, you can reduce the chances that your portfolio will have a decline in value by either owning a large number of stocks or owning them for a long time.  Nonetheless, you might find that the value of your portfolio is less than the amount you invested especially over short periods of time when you invest in stocks.  If you want to invest in stocks, you need to be willing to tolerate those ups and downs in value both mentally and financially.

Market Timing

There is an old investing adage, “Buy low, sell high.”  In principle, it is a great strategy.  In practice, though, it is hard to identify the peaks and valleys in either the market as a whole or an individual stock.

People who invest over very short time frames – hours or days – often use technical analysis to try to identify very short-term highs and lows to create gains.  I anticipate that most of my followers, though, will be investing for the long term and not day trading.  While you will want to select stocks that are expected to produce a return commensurate with their riskiness, it is very difficult to time the market.

That is, my suggestion for new investors with long-term investment horizons (e.g., for retirement or your young children’s college expenses) is to buy stocks or mutual funds you understand and think are likely to appreciate whenever you have the time and money available to do so.  If you happen to buy a fundamentally sound stock or index fund just before its price drops, it will be difficult to hang on but it is likely to increase in the price by the time you need to sell it.

As Chris @MoneyStir learned when he reviewed the post I wrote about whether he should pre-pay his mortgage, a fall in the stock market right after he started using his extra cash to buy stocks on a monthly basis was actually good for him!  While he lost money at first on his first few month’s investments, the ones he made over the next several months were at a lower stock price and produced a higher-than-average return over his investment horizon.  The process of buying stocks periodically, such as every month, is called dollar-cost averaging.

How and Where Do I Buy Stocks?

You can buy stocks, mutual funds and ETFs at any brokerage firm.  This article by Invested Wallet provides details on how to open an account at a brokerage firm.

Once you have an account, you need to know the name of the company or its symbol (usually 2-5 letters that can be found using Google or Yahoo Finance, for example), how many shares you want to buy and whether you want to set the price at which you purchase the stocks, use dollar-cost averaging to purchase them over a period of time or buy them at the market price.

Limit Orders

If you determine you want to buy a stock at a particular price, it is called a limit order.  The advantage of a limit order is you know exactly how much you will pay.  The disadvantages of a limit order are:

  • You might pay more than you have to if the stock price is lower at the time you place your order.
  • You might not buy the stock if no one is interested in selling the stock at a price that is a low as your desired purchase price.

Market Orders

If you place a market order, you will buy the stock at whatever price sellers are willing to take for their stock at the moment you place your order.  In some cases, you may end up paying more than you want for a stock if the price jumps up right at the time you place your order.  The advantages of a market order are (1) you know you will own the stock and (2) you know you are getting the best price available at the time you buy the stock.

Transaction Fees

Many of the major brokerage firms have recently announced that they will no longer charge you each time you purchase or sell a stock.  Some firms charge you small transaction fees, such as $4.95, each time you place a buy or sell order.  Other firms have higher charges.  You’ll want to consider the fees when you select a brokerage firm.

Tax-Efficient Investing Strategies – Canada

Tax-Effective-Investing-Canada

You can increase your savings through tax-efficient investing. Tax-efficient investing is the process of maximizing your after-tax investment returns by buying your invested assets in the “best” account from a tax perspective. You may have savings in a taxable account and/or in one or more types of tax-sheltered retirement accounts. Your investment returns are taxed differently depending on the type of account in which you hold your invested assets. In this post, I’ll provide a quick overview of the taxes applicable to each type of account (since I cover taxes on retirement plans in much greater detail in this post) and provide guidelines for how to invest tax-efficiently.

The strategy for tax-efficient investing differs from one country to the next due to differences in tax laws so I’ll talk about tax-efficient investing strategies in the Canada in this post. For information about tax-efficient investing in the US, check out this post.

Types of Investment Returns

I will look at four different types of investments:

I will not look at individual stocks with little or no dividends. The returns on those stocks are essentially the same as the returns on ETFs and are taxed in the same manner.

The table below shows the different types of returns on each of these investments.

Type of Distribution: Interest Dividends Capital Gains Capital Gain Distributions
High dividend stocks x x
Mutual Funds x x x
ETFs x
Bonds x x

 

Cash Distributions

Interest and dividends are cash payments that the issuers of financial instruments (i.e., stocks, mutual funds or bonds) make to owners.

Capital Gains

Capital gains come from changes in the value of your investment. You pay taxes on capital gains only when you sell the financial instrument which then makes them realized capital gains. The taxable amount of the realized capital gain is the difference between the amount you receive when you sell the financial instrument and the amount you paid for it when you bought it. Unrealized capital gains are changes in the value of any investment you haven’t yet sold. If the value of an investment is less than what you paid for it, you are said to have a capital loss which can be thought of as a negative capital gain.

Mutual Funds

Mutual funds are a bit different from stocks and ETFs. They can have the following types of taxable returns.

  • Dividends – A mutual fund dividend is a distribution of some or all of the dividends that the mutual fund manager has received from the issuers of the securities owned by the mutual fund.
  • Capital gain distributions – Capital gain distributions are money the mutual fund manager pays to owners when a mutual fund sells some of its assets.
  • Capital gains – As with other financial instruments, you pay tax on the difference between the amount you receive when you sell a mutual fund and the amount you paid for it.

Tax Rates

The four types of distributions are taxed differently depending on the type of account in which they are held – Taxable, Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA).

Accounts other than Retirement Accounts

I’ll refer to accounts that aren’t retirement accounts as taxable accounts.   You pay taxes every year on dividends and realized capital gains in a taxable account, whereas you pay them either when you contribute to or withdraw from a retirement account. The table below shows how the different types of investment returns are taxed when they are earned in a taxable account.

Type of Investment Return Tax Rates
Interest & Dividends Same as wages
Realized capital gains & capital gain distributions 50% of capital gains and capital gain distributions are added to wages

The marginal Federal tax rate on wages, and therefore on interest and dividends, for many employed Canadian residents is likely to be 20.5% or 26%.

In a taxable account, you pay taxes on investment returns when you receive them. In the case of capital gains, you are considered to have received them when you sell the financial instrument.

TFSA Retirement Accounts

Before you put money into a TFSA, you pay taxes on it. Once it has been put into the TFSA, you pay no more income taxes regardless of the type of investment return. As such, the tax rate on all investment returns held in a TFSA is 0%.

RRSP Retirement Accounts

You pay income taxes on the total amount of your withdrawal from an RRSP at your ordinary income tax rate. Between the time you make a contribution and withdraw the money, you don’t pay any income taxes on your investment returns.

After-Tax Returns by Type of Account

To illustrate the differences in taxes on each of these four financial instruments, I’ll look at how much you would have if you have $1,000 to invest in each type of account at the end of one year and the end of 10 years.

Here are the assumptions I made regarding pre-tax investment returns.

Annual Pre-tax Investment Return % Interest Dividends Capital Gains
Stocks 0% 3% 5%
ETFs 0% 0% 8%
Mutual Funds 0% 3% 5%
Bonds 4% 0% 0%

Mutual funds usually distribute some or all of realized capital gains to owners. That is, if you own a mutual fund, you are likely to get receive cash from the mutual fund manager related to realized capital gains. Whenever those distributions are made, you have to pay tax on them. For this illustration, I’ve assumed that the mutual fund manager distributes all capital gains to owners, so they are taxed every year.

Here are the tax rates I used for this illustration.

Type of Income Tax Rate
Wages 26%
Interest & Dividends 26%
Capital Gains 13%

One-Year Investment Period

Let’s say you have $1,000 in each account. If you put it in a taxable account, I assume you pay taxes at the end of the year on the investment returns. If you put the money in an RRSP, I assume that you withdraw all of your money and pay taxes at the end of the year on the entire amount at your ordinary income tax rate. (I’ve assumed you are old enough that you don’t have to pay a penalty on withdrawals without penalty from the retirement accounts.)

The table below shows your after-tax investment returns after one year from your initial $1,000. Note that the pre-tax returns are the same as the returns in the TFSA row, as you don’t pay income taxes on returns you earn in your TFSA.

One-Year After-tax Investment Returns ($) Stocks Mutual Funds ETFs Bonds
Taxable $66 $66 $70 $30
RRSP 59 59 59 30
TFSA 80 80 80 40

This table below shows the taxes you paid on your returns during that year.

Taxes Paid Stocks Mutual Funds ETFs Bonds
Taxable $14 $14 $10 $10
RRSP 21 21 21 10
TFSA 0 0 0 0

When looking at these charts, remember that you paid income taxes on the money you contributed to your Taxable account and TFSA before you put it in the account.  Those taxes are not considered in these comparisons. This post focuses on only the taxes you pay on your investment returns.

Comparison Different Financial Instruments Within Each Type of Account

Looking at across the rows, you can see that, for each type of account, stocks and mutual funds have the same one-year returns and tax payments. In this illustration, both stocks and mutual funds have the same split between dividends and appreciation. Your after-tax return on ETFs is higher than either stocks or mutual funds. All of the ETF return is assumed to be in the form of appreciation (i.e., no dividends), so only the lower capital-gain tax rate applies to your returns.

In all accounts, bonds have a lower after-tax return than any of the other three investments. Recall, though, that bonds generally provide a lower return on investment than stocks because they are less risky.

Comparison of Each Financial Instrument in Different Types of Accounts

Looking down the columns, you can see the impact of the differences in tax rates by type of account for each financial instrument. You have more savings at the end of the year if you purchase a financial instrument in a TFSA than if you purchase it in either of the other two accounts for each type of investment.

The returns on investments in a taxable account are higher than on stocks, mutual funds and ETFs held in an RRSP.  You pay taxes on the returns in a taxable account at their respective tax rates, i.e., at 50% of your usual rate on the capital gain portion of your investment return.  However, you pay taxes on RRSP withdrawals at your full ordinary income tax rate.  Because the ordinary income tax rate is higher than the capital gain tax rate, you have a higher after-tax return if you invest in a taxable account than an RRSP for one year.  For bonds, the taxes and after-tax returns are the same in an RRSP and a taxable account because you pay taxes on returns in taxable accounts and distributions from RRSPs at your marginal ordinary income tax rate.

Remember, though, that you had to pay income taxes on the money you put into your account before you made the contribution, whereas you didn’t pay income taxes on the money before you put it into your RRSP.

Ten-Year Investment Period

I’ve used the same assumptions in the 10-year table below, with the exception that I’ve assumed that you will pay ordinary income taxes at a lower rate in 10 years because you will have retired by then. I’ve assumed that your marginal tax rate on ordinary income in retirement will be 20.5%.

Ten-Year After-Tax Investment Returns ($) Stocks Mutual Funds ETFs Bonds
Taxable $917 $890 $1,008 $339
RRSP 921 921 921 382
TFSA 1,159 1,159 1,159 480

Comparison Different Financial Instruments Within Each Type of Account

If you look across the rows, you see that you end up with the same amount of savings by owning stocks, mutual funds and ETFs if you put them in either of the retirement account options. The mix between capital gains, capital gain distributions and dividends doesn’t impact taxes paid in a tax-sheltered account, whereas it makes a big difference in taxable accounts, as can be seen by looking in the Taxable row.

In taxable accounts, ETFs provide the highest after-tax return because they don’t have any taxable transactions until you sell them.  As discussed above, I have assumed that the stocks pay dividends every year.  You have to pay taxes on the dividends before you can reinvest them, thereby reducing your overall savings as compared to an ETF.  You have to pay taxes on both dividends and capital gain distributions from mutual funds before you can reinvest those proceeds, so they provide the least amount of savings of the three stock-like financial instruments in a taxable account.

Comparison of Each Financial Instrument in Different Types of Accounts

Looking down the columns, we can compare your ending savings after 10 years from each financial instrument by type of account. You earn the highest after-tax return for every financial instrument if it is held in a TFSA, as you don’t pay any taxes.

For bonds, you earn a higher after-tax return in an RRSP than in a taxable account. The tax rate on interest is about the same as the tax rate on RRSP withdrawals. When you hold a bond in a taxable account, you have to pay income taxes every year on the coupons you earn before you can reinvest them. In an RRSP, you don’t pay tax until you withdraw the money, so you get the benefit of interest compounding (discussed in this post) before taxes.  In addition, I have assumed that your ordinary income tax rate is lower in retirement, i.e., when you make your RRSP withdrawals.

Your after-tax return is slightly lower in a taxable account than in an RRSP for the three stock-like investments. The ability to compound your returns on a pre-tax basis more than offsets the higher tax rate you pay in the RRSP.

Illustration of Tax Deferral Benefit

The ability to compound your investment returns on a tax-deferred basis is an important one, so I’ll provide an illustration. To keep the illustration simple, let’s assume you have an asset that has a taxable return of 8% every year and that your tax rate is constant at 26% (regardless of the type of account).

The table below shows what happens over a three-year period.

Returns and Taxes by Year Taxable Account RRSP
Initial Investment $1,000 $1,000
Return – Year 1 80 80
Tax – Year 1 21 0
Balance – Year 1 1,059 1,080
Return – Year 2 85 86
Tax – Year 2 22 0
Balance – Year 2 1,122 1,166
Return – Year 3 90 94
Tax – Year 3 23 0
Balance – Year 3 1,188 1,260

By paying taxes in each year, you reduce the amount you have available to invest in subsequent years so you have less return.

The total return earned in the taxable account over three years is $255; in the tax-deferred account, $260. The total of the taxes for the taxable account is $66. Multiplying the $260 of return in the tax-deferred account by the 26% tax rate gives us $68 of taxes from that account. As such, the after-tax returns after three years are $188 in the taxable account and $192 in the tax-deferred account.

These differences might not seem very large, but they continue to compound the longer you hold your investments. For example, after 10 years, your after-tax returns on the tax-deferred account, using the above assumptions, would be almost 10% higher than on the taxable account.

Portfolios Using Tax-Efficient Investing

It is great to know that you get to keep the highest amount of your investment returns if you hold your financial instruments in a TFSA. However, there are limits on how much you can put in TFSAs each year. Also, some employers offer only an RRSP option. As a result, you may have savings that are currently invested in more than one of TFSA, RRSP or taxable account. You therefore will need to buy financial instruments in all three accounts, not just in a TFSA.

Here are some guidelines that will help you figure out which financial instruments to buy in each account:

  • If there is a wide difference in total return, you’ll want to put your highest returning investments in your TFSA.
  • For smaller differences in total return (e.g., less than 2 – 3 percentage points), it is better to put instruments with more distributions in your RRSP and then your TFSA, putting as few of them as possible in your taxable account.
  • Instruments with slightly higher yields, but little to no distributions can be put in your taxable account.
  • You’ll want to hold your lower return, higher distribution financial instruments, such as bonds, in your RRSP. There is a benefit to holding bonds in an RRSP as compared to a taxable account. The same tax rates apply to both accounts, but you don’t have to pay taxes until you withdraw the money from your RRSP, whereas you pay them annually in your taxable account.

Applying Tax-Efficient Investing to Two Portfolios

Let’s see how to apply these guidelines in practice using a couple of examples. To make the examples a bit more interesting, I’ve increased the annual appreciation on the ETF to 10% from 8%, assuming it is a higher risk/higher return type of ETF than the one discussed above. All of the other returns and tax assumptions are the same as in the table earlier in this post.

Portfolio Example 1

In the first example, you have $10,000 in each of a taxable account, an RRSP and a TFSA. You’ve decided that you want to invest equally in stocks, mutual funds and ETFs.

You will put your investment with the lowest taxable distributions each year – the ETF – in your taxable account. The stocks and mutual fund have higher taxable distributions each year, so it is better to put them in your tax-sheltered accounts. Because they have similar total returns in this example, it doesn’t matter how you allocate your stocks and mutual funds between your TFSA and RRSP.

Portfolio Example 2

In the second example, you again have $10,000 in each of a taxable account, an RRSP and a TFSA. In this example, you want to invest $15,000 in the high-yielding ETFs but offset the risk of that increased investment by buying $5,000 in bonds. You’ll split the remaining $10,000 evenly between stocks and mutual funds.

You again buy as much of your ETFs as you can in your taxable account. The remainder is best put in your TFSA, as the ETFs have the highest total return so you don’t want to pay any tax on the money when you withdraw it. The bonds have the lowest return, so it is best to put them in your RRSP as you will pay less tax on the lower bond returns than the higher stock or mutual fund returns. As in Example 1, it doesn’t matter how you allocate your stocks and mutual funds between your TFSA and RRSP.

Risks of Tax-Efficient Investing

There is a very important factor I’ve ignored in all of the above discussion – RISK (a topic I cover in great detail in this post). The investment returns I used above are all risky. That is, you won’t earn 3% dividends and 5% appreciation every year on the stocks or mutual funds or 10% on the ETFs. Those may be the long-term averages for the particular financial instruments I’ve used in the illustration, but you will earn a different percentage every year.

If your time horizon is short, say less than five to ten years, you’ll want to consider the chance that one or more of your financial instruments will lose value over that time frame. If you had perfect foresight, you would put your money-losing investments in your RRSP because you would reduce the portion of your taxable income taxed at the higher ordinary income tax by the amount of the loss when you withdraw the money. Just as the government gets a share of your profits, it also shares in your losses.

The caution is that financial instruments with higher returns also tend to be riskier. If you put your highest return investments – the ETFs in my example – in your TFSA, their value might decrease over a short time horizon. If they decrease, your after-tax loss is the full amount of the loss. If, instead, you had put that financial instrument in your RRSP, the government would share 26% of the loss in my example.

In conclusion, if you plan to allocate your investments using the above guidelines, be sure to adjust them if your time horizon is shorter than about 10 years to minimize the chance that you will have to keep all of a loss on any one financial instrument.

Tax-Efficient Investing Strategies – USA

Tax-Effective-Investing-USA

You can increase your savings through tax-efficient investing.  Tax-efficient investing is the process of maximizing your after-tax investment returns by buying your invested assets in the “best” account from a tax perspective.  You may have savings in a taxable account and/or in one or more types of tax-sheltered retirement accounts.  Your investment returns are taxed differently depending on the type of account in which you hold your invested assets.  In this post, I’ll provide a quick overview of the taxes applicable to each type of account (since I cover taxes on retirement plans in much greater detail in this post) and provide guidelines for how to invest tax-efficiently.

The strategy for tax-efficient investing differs from one country to the next due to differences in tax laws so I’ll talk about tax-efficient investing strategies in the US in this post and in Canada in this post.

Types of Investment Returns

I will look at four different types of investments:

I will not look at individual stocks with little or no dividends.  The returns on those stocks are essentially the same as the returns on ETFs and are taxed in the same manner.

The table below shows the different types of returns on each of these investments.

Distributions by Investment Interest Dividends Capital Gains Capital Gain Distributions
High dividend stocks           x          x
Mutual Funds          x          x          x
ETFs          x
Bonds          x          x

Cash Distributions

Interest and dividends are cash payments that the issuers of the financial instrument (i.e., stock, fund or bond) make to owners.

Capital Gains

Capital gains come from changes in the value of your investment.  You pay taxes on capital gains only when you sell the financial instrument which then makes them realized capital gains.  The taxable amount of the realized capital gain is the difference between the amount you receive when you sell the financial instrument and the amount you paid for it when you bought it.  Unrealized capital gains are changes in the value of any investment you haven’t yet sold.  If the value of an investment is less than what you paid for it, you are said to have a capital loss which can be thought of as a negative capital gain.

Mutual Funds

Mutual funds are a bit different from stocks and ETFs.  They can have the following types of taxable returns.

  • Dividends – A mutual fund dividend is a distribution of some or all of the dividends that the mutual fund manager has received from the issuers of the securities owned by the mutual fund.
  • Capital gain distributions – Capital gain distributions are money the mutual fund manager pays to owners when a mutual fund sells some of its assets.
  • Capital gains – As with other financial instruments, you pay tax on the any realized capital gains (the difference between the amount you receive when you sell a mutual fund and the amount you paid for it) when you sell a mutual fund.

Tax Rates

The four types of distributions are taxed differently depending on the type of account in which they are held – Taxable, Roth or Traditional.  401(k)s and Individual Retirement Accounts (IRAs) are forms of retirement accounts that can be either Roth or Traditional accounts and are discussed in more detail in in this post.

Accounts other than Retirement Accounts

I’ll refer to accounts that aren’t retirement accounts as taxable accounts.   You pay taxes every year on dividends and realized capital gains in a taxable account, whereas you pay them either when you contribute to or make a withdrawal from a retirement account.  The table below shows how the different types of investment returns are taxed when they are earned in a taxable account.

Type of Investment Return Tax Rates
Interest Same as wages
Dividends, realized capital gains & capital gain distributions ·         0% if dividends, capital gains & capital gain distributions are less than $38,600 minus wages minus income from other sources.

·         15% up to roughly $425,000.

·         20% if higher

For many employed US residents (i.e., individuals with taxable income between $38,700 and $157,500 and couple with taxable income between $77,400 and $315,000 in 2018), their marginal Federal tax rate wages and therefore on interest is likely to be 22% or 24%.

In a taxable account, you pay taxes on investment returns when you receive them.  You are considered to have received capital gains when you sell the financial instrument.

Roth Retirement Accounts

Before you put money into a Roth account, you pay taxes on it.  Once it has been put into the Roth account, you pay no more income taxes regardless of the type of investment return unless you withdraw the investment returns before you attain age 59.5 in which case there is a penalty.  As such, the tax rate on all investment returns held in a Roth account is 0%.

Traditional Retirement Accounts

You pay income taxes on the total amount of your withdrawal from a Traditional retirement account at your ordinary income tax rate.  Between the time you make a contribution and withdraw the money, you don’t pay any income taxes on your investment returns.

After-Tax Returns by Type of Account

To illustrate the differences in how taxes apply to each of these four financial instruments, I’ll look at how much you would have if you have $1,000 to invest in each type of account at the end of one year and the end of 10 years.

Here are the assumptions I made regarding pre-tax investment returns.

Annual Pre-tax Investment Return % Interest Dividends Capital Gains
Stocks 0% 3% 5%
ETFs 0% 0% 8%
Mutual Funds 0% 3% 5%
Bonds 4% 0% 0%

Mutual funds usually distribute some or all of realized capital gains to owners.  That is, if you own a mutual fund, you are likely to get receive cash from the mutual fund manager related to realized capital gains in the form of capital gain distributions.  Whenever those distributions are made, you pay tax on them.  For this illustration, I’ve assumed that the mutual fund manager distributes all capital gains to owners, so they are taxed every year.

Here are the tax rates I used for this illustration.

Type of Income Tax Rate
Ordinary Income – This Year 24%
Dividends 15%
Capital Gains 15%

One-Year Investment Period

Let’s say you have $1,000 in each account.  I assume you pay taxes at the end of the year on the investment returns in your Taxable account.  If you put the money in a Traditional account, I assume that you withdraw all of your money and pay taxes at the end of the year on the entire amount at your ordinary income tax rate.  (I’ve assumed you are old enough that you don’t have to pay a penalty on withdrawals without penalty from the retirement accounts.)

The table below shows your after-tax investment returns after one year from your initial $1,000.  Note that the pre-tax returns are the same as the returns in the Roth row, as you don’t pay income taxes on returns you earn in your Roth account.

One-Year After-tax Investment Returns ($) Stocks Mutual Funds ETFs Bonds
Taxable $68 $68 $68 $30
Traditional 61 61 61 30
Roth 80 80 80 40

The table below shows the taxes you paid on your returns during that year.

Taxes Paid Stocks Mutual Funds ETFs Bonds
Taxable $12 $12 $12 $10
Traditional 19 19 19 10
Roth 0 0 0 0

When looking at these charts, remember that you paid income taxes on the money you contributed to your Taxable and Roth accounts and that those taxes are not considered in these comparisons.  This post focuses on only the taxes you pay on your investment returns.

Comparison of Different Financial Instruments in Each Type of Account

Looking across the rows, you can see that, for each type of account, stocks, mutual funds and ETFs have the same one-year returns and tax payments. In this illustration, all three of stocks, mutual funds and ETFs have a total return of 8%.  It is just the mix between appreciation, capital gain distributions and dividends that varies.  The tax rates applicable to dividends and capital gains are the same so there is no impact on the after-tax return in a one-year scenario.

In all accounts, bonds have a lower after-tax return than any of the other three investments.  Recall, though, that bonds generally provide a lower return on investment than stocks because they are less risky.

Comparison of Each Financial Instrument in Different Types of Accounts

Looking down the columns, you can see the impact of the differences in tax rates by type of account for each financial instrument.  You have more savings at the end of the year if you invest in a Roth account than if you invest in either of the other two accounts for each type of investment.  Recall that you don’t pay any taxes on returns on investments in a Roth account.

The returns on a taxable account are slightly higher than on a Traditional account for stocks, mutual funds and ETFs.  You pay taxes on the returns in a taxable account at their respective tax rates – usually 15% in the US for dividends and capital gains.  However, you pay taxes on Traditional account withdrawals at your ordinary income tax rate – assumed to be 24%.  Because the ordinary income tax rates are higher than the dividend and capital gain tax rates, you have a higher after-tax return if you invest in a taxable account than a Traditional account for one year.  For bonds, the taxes and after-tax returns are the same in a Traditional and taxable account because you pay taxes on interest income in taxable accounts and distributions from Traditional accounts at your marginal ordinary income tax rate.

Remember, though, that you had to pay income taxes on the money you put into your taxable account before you made the contribution, whereas you didn’t pay income taxes on the money before you put it into your Traditional retirement account.

Ten-Year Investment Period

I’ve used the same assumptions in the 10-year table below, with the exception that I’ve assumed that you will pay ordinary income taxes at a lower rate in 10 years because you will have retired by then. I’ve assumed that your marginal tax rate on ordinary income in retirement will be 22%.

Ten-Year After-Tax Investment Returns ($) Stocks Mutual Funds ETFs Bonds
Taxable $964 $931 $985 $349
Traditional 904 904 904 375
Roth 1,159 1,159 1,159 480

Comparison of Different Financial Instruments in Each Type of Account

If you look across the rows, you see that you end up with the same amount of savings by owning any of stocks, mutual funds and ETFs if you put them in either of the retirement account.  The mix between capital gains, capital gain distributions and dividends doesn’t impact taxes paid in a tax-sheltered account, whereas it makes a big difference in taxable accounts, as can be seen by looking in the Taxable row.

In taxable accounts, ETFs provide the highest after-tax return because they don’t have any taxable transactions until you sell them.  I have assumed that the stocks pay dividends every year.  You have to pay taxes on the dividends before you can reinvest them, thereby reducing your overall savings as compared to an ETF.  You have to pay taxes on both dividends and capital gain distributions from mutual funds before you can reinvest those proceeds, so they provide the least amount of savings of the three stock-like financial instruments in a taxable account.

Comparison of Each Financial Instrument in Different Types of Accounts

Looking down the columns, we can compare your ending savings after 10 years from each financial instrument by type of account.  You earn the highest after-tax return for every financial instrument if it is held in a Roth account, as you don’t pay any taxes on the returns.

For bonds, you earn a higher after-tax return in a Traditional account than in a taxable account.  The tax rate on interest is about the same as the tax rate on Traditional account withdrawals.  When you hold a bond in a taxable account, you have to pay income taxes every year on the coupons you earn before you can reinvest them.  In a Traditional account, you don’t pay tax until you withdraw the money, so you get the benefit of interest compounding (discussed in this post) before taxes.

Your after-tax return is higher in a taxable account than in a Traditional account for the three stock-like investments.  The lower tax rate on dividends and capital gains in the taxable account, even capital gain distributions, more than offsets the fact that you have to pay taxes on dividends and mutual fund capital gain distributions before you reinvest them.

Illustration of Tax Deferral Benefit

The ability to compound your investment returns on a tax-deferred basis is an important one, so I’ll provide an illustration.  To keep the illustration simple, let’s assume you have an asset that has a taxable return of 8% every year and that your tax rate is constant at 24% (regardless of the type of account).

The table below shows what happens over a three-year period.

Returns and Taxes by Year Taxable Account Retirement Account
Initial Investment $1,000 $1,000
Return – Year 1 80 80
Tax – Year 1 19 0
Balance – Year 1 1,061 1,080
Return – Year 2 85 86
Tax – Year 2 20 0
Balance – Year 2 1,125 1,166
Return – Year 3 90 94
Tax – Year 3 22 0
Balance – Year 3 1,194 1,260

By paying taxes in each year, you reduce the amount you have available to invest in subsequent years so you have less return.

The total return earned in the taxable account over three years is $255; in the tax-deferred account, $260.  The total of the taxes for the taxable account is $61.  Multiplying the $260 of return in the tax-deferred account by the 24% tax rate gives us $62 of taxes from that account.  As such, the after-tax returns after three years are $194 in the taxable account and $197 in the tax-deferred account.

These differences might not seem very large, but they continue to compound the longer you hold your investments.  For example, after 10 years, your after-tax returns on the tax-deferred account, using the above assumptions, would be almost 10% higher than on the taxable account.

Tax-Efficient Investing for Portfolios

It is great to know that you get to keep the highest amount of your investment returns if you hold your financial instruments in a Roth.  However, there are limits on how much you can put in Roth accounts each year.  Also, many employers offer only a Traditional 401(k) option.  As a result, you may have savings that are currently invested in more than one of Roth, Traditional or taxable accounts.  You therefore will need to buy financial instruments in all three accounts, not just in a Roth.

Here are some guidelines that will help you figure out which financial instruments to buy in each account:

  • You’ll maximize your after-tax return if you buy your highest yielding financial instruments in your Roth.  Because they generate the highest returns, you will pay the most taxes on them if you hold them in a taxable or Traditional account.
  • Keep buying your high-yielding financial instruments in descending order of total return in your Roth accounts until you have invested all of the money in your Roth accounts.
  • If two of your financial instruments have the same expected total return, but one has higher annual distributions (such as the mutual fund as compared to the stocks in the example above), you’ll maximize your after-tax return if you put the one with the higher annual distributions in your Roth account.
  • Once you have invested all of the money in your Roth account, you’ll want to invest your next highest yielding financial instruments in your Taxable account.
  • You’ll want to hold your lower return, higher distribution financial instruments, such as bonds or mutual funds, in your Traditional account. There is a benefit to holding bonds in a Traditional account as compared to a taxable account.  The same tax rates apply to both accounts, but you don’t have to pay taxes until you withdraw the money from your Traditional account, whereas you pay them annually in your taxable account.  That is, you get the benefit of pre-tax compounding of the interest in your Traditional account.

Applying the Guidelines to Two Portfolios

Let’s see how to apply these guidelines in practice using a couple of examples.  To make the examples a bit more interesting, I’ve increased the annual appreciation on the ETF to 10% from 8%, assuming it is a higher risk/higher return type of ETF than the one discussed above.  All of the other returns and tax assumptions are the same as in the table earlier in this post.

Portfolio Example 1

In the first example, you have $10,000 in each of a taxable account, a Traditional account and a Roth account.  You’ve decided that you want to invest equally in stocks, mutual funds and ETFs.

You will put your highest yielding investment – the ETFs, in your Roth account.  The stocks and mutual fund have the same total return, but the mutual fund has more taxable distributions every year.  Therefore, you put your mutual funds in your Traditional account and your stocks in your taxable account.

Portfolio Example 2

In the second example, you again have $10,000 in each of a taxable account, a Traditional account and a Roth account.  In this example, you want to invest $15,000 in the high-yielding ETFs but offset the risk of that increased investment by buying $5,000 in bonds.  You’ll split the remaining $10,000 evenly between stocks and mutual funds.

First, you buy as much of your ETFs as you can in your Roth account.  Then, you put the remainder in your taxable account, as the tax rate on the higher return from the ETFs is lower in your taxable account (the 15% capital gains rate) than your Traditional account (your ordinary income tax rate).  Next, you put your low-yielding bonds in your Traditional account.  You now have $5,000 left to invest in each of your taxable and Traditional accounts.  You will invest in mutual funds in your Traditional account, as you don’t want to pay taxes on the capital gain distributions every year if they were in your taxable account.  That means your stocks will go in your taxable account.

Risk

There is a very important factor I’ve ignored in all of the above discussion – RISK (a topic I cover in great detail in this post).  The investment returns I used above are all risky.  That is, you won’t earn 3% dividends and 5% appreciation every year on the stocks or mutual funds or 10% on the ETFs.  Those may be the long-term averages for the particular financial instruments I’ve used in the illustration, but you will earn a different percentage every year.

If your time horizon is short, say less than five to ten years, you’ll want to consider the chance that one or more of your financial instruments will lose value over that time frame.  With perfect foresight, you would put your money-losing investments in your Traditional account because you would reduce the portion of your taxable income taxed at the higher ordinary income tax by the amount of the loss when you withdraw the money.  Just as the government gets a share of your profits, it also shares in your losses.

The caution is that financial instruments with higher returns also tend to be riskier.  If, in the US, you put your highest return investments – the ETFs in my example – in your Roth account, their value might decrease over a short time horizon.  In that case, your after-tax loss is the full amount of the loss.  If, instead, you had put that financial instrument in your Traditional account, the government would share 24% (your marginal ordinary tax rate) of the loss in my example.

In conclusion, if you plan to allocate your investments using the above guidelines, be sure to adjust them if your time horizon is shorter than about 10 years to minimize the chance that you will have to keep all of a loss on any one financial instrument.

Should Chris Pay off his Mortgage?

Chris @Money$tir asked other financial literacy and financial independence (FI) bloggers, in a post on March 9, 2019, whether he should pre-pay his mortgage or invest the money. He provided his thought process and calculations. In this post, I will review his calculations and then show that his decision will be easier if he narrows his question and analysis. I will also provide my findings and analysis to help inform his decision.

Background

Chris’s post provides all of the background. You might want to read his post quickly to understand his calculations and other considerations before you read the rest of this post.

Briefly, he will have just under $310,000 left on his mortgage on July 1, 2019. His payments are $1,525 and he will have an additional $4,000 a month available to either pre-pay his mortgage or invest.

I followed up with Chris and learned that he expects to take the standard deduction on his tax return, so he will have no tax benefit from his mortgage interest. His marginal tax rate on ordinary income is 22%; on capital gains and dividends, 15%. I also confirmed that Chris does not have any pre-payment penalties associated with his mortgage.

Three Re-Payment Options

Chris suggested three options in his article, two of which involve making pre-payments. The three options are:

1. Make $1,525 a month in mortgage payments until his mortgage is fully re-paid in July 2045, while investing the remaining $4,000 at 8% per year.

2. Take a middle-of-the road option and make mortgage payments of $3,525 each month and invest the remaining $2,000. Under this option, his mortgage will be re-paid in 2027.

3. Pay $5,525 each month – $1,525 in scheduled payments and $4,000 in pre-payments – until his mortgage is fully re-paid in 2024.

Chris calculated his pre-tax savings using an 8% return through July 2045. The values he calculated are:

• Option 1 – $4,145,000
• Option 2 – $3,772,000
• Option 3 – $3,594,000

In his post, Chris indicated he is leaning towards Option 3 – pre-pay his mortgage as quickly as possible.

Chris’s Math

One of Chris’s questions is whether his calculations are correct. I re-created Chris’s calculations. While I did not get his ending balances exactly, my results were within a couple of percentage points, so I suspect we made slightly different assumptions regarding either the timing of the interest charges (beginning or end of month) and/or his exact mortgage balance. I’m quite comfortable that the calculations he performed are what he intended.

I also confirmed that increasing his payments by $2,000 or $4,000 a month shortens the time until his mortgage is fully re-paid as he indicated in his post.

Re-framing the Question

Many of Chris’s considerations relate to additional flexibility he will have after his mortgage is fully re-paid. I believe that Chris has not correctly separated the mortgage re-payment question from his other decisions – renting out his house and buying a new one, not having a mortgage if he decides to downsize, freeing up money for other purchases and so on. That is, as discussed below, he can use his first five years of savings in Options 1 and 2 to make the rest of his mortgage payments. By understanding that, he can independently decide to do with the $5,525 a month after five years doesn’t depend on his choice of payment option.

If Chris changes his calculations consistent with the re-framed question (i.e., looking at only the $5,525 a month for the first five years), he can eliminate all of the noise of these other questions as they will become independent of his mortgage decision. In his calculations, Chris has set aside $5,525 every month until his mortgage would be fully re-paid in 2045 if he made the minimum payments. Instead, I propose that he set aside $5,525 a month only until 2024 (and not after) – that is, only until his mortgage would be fully paid under Option 3. Except in certain situations discussed below, Chris will make his mortgage payments starting in August 2024 from the savings that accumulates from the money he saved up until then and not from his future income or other savings. That stream of payments, if invested in a hypothetical risk-free, tax-free financial instrument at 3.625% would exactly pay off his mortgage regardless of which of his three re-payment options he chooses.

By focusing on this shorter stream of payments until 2024, he can do whatever he wants with the $5,525 a month after his mortgage is paid off under all three re-payment options. As a result, his decision-making process can focus solely on the risks and rewards of his three re-payment options without any consideration of other, unrelated financial decisions.

My re-framed question does not eliminate one of his considerations – his peace-of-mind from not having a mortgage. Chris will need to include this subjective consideration in his decision-making process, along with the considerations regarding risk and rewards presented below.

My Math

There are four changes I made to Chris’s calculations:

1. I assumed that Chris set aside $5,525 a month from July 2019 through August 2024, rather than until 2045. In addition, except as noted below, after July 2024, he will make his remaining mortgage payments from the savings he has accumulated and not from his income. Therefore, starting in August 2024, he can use the $5,525 a month however he wants as I excluded it from my analysis.

2. I introduced the impact of income taxes. Chris will pay taxes on his investment returns which will make the first two options look less attractive than is shown in his analysis.

3. I quantified the risk Chris will assume by investing in the first two re-payment options.

4. I focused on Chris’s financial position not only in 26 years (when his mortgage would be paid off making the minimum payments), but also in 10 years (when he might want to down-size).

Three Investment Strategies

Chris’s first and second options assume he will invest in an S&P 500-like ETF returning 8%. His calculations do not quantify the riskiness of the S&P 500, though he does mention the risk in his subjective considerations. I will provide explicit insights on the risk. In addition, because Chris is concerned with the riskiness of the S&P 500, I also looked at two other options, for a total of three investment strategies:

1. Invest in 100% in stocks, such as an S&P 500 ETF.

2. Invest in 100% bonds, such as a bond fund. I used the Fidelity Investment Grade Bond Index (FBNDX), as a proxy.

3. Invest 50% in each of stocks (an S&P 500 ETF) and bonds (the Fidelity bond index).

Under all three strategies, I assumed the Chris would re-invest all interest, dividends and capital gains, after tax, and would not withdraw it except to make his mortgage payments.

In my analysis, I calculated Chris’s financial position as if stocks and bonds had the monthly returns observed historically for the 10-year periods starting on the first of each month from January, 1980 through October, 2008 (10 years before my time series ended). There are 345 overlapping 10-year periods. For the 26-year time frame, there are only 153 overlapping periods covered by the Fidelity bond index data. I therefore looked at only the S&P 500 investment option when doing the calculations of Chris’s financial position in 2045.

Timeline

The infographic below clarifies the key dates under all three options and provides a teaser of the results.

Option 1

Under Option 1, Chris will make payments of $1,525 a month to his lender from July 2019 to August 2024 from his income. He will also save $4,000 a month over the same time period. This time period is represented in green. From August 2024 until July 2045, he will withdraw $1,525 from the savings he accumulated in the first five years to pay his mortgage. This period of time is shown in orange. This use of debt to finance investments is discussed in more detail in my post on good and bad debt.

Option 2

Under Option 2, Chris will make payments of $3,525 a month to his lender from July 2019 to August 2024 (the green segment) from his income. He will also save $2,000 a month over the same time period. From August 2024 until December 2027 (the orange segment), he will withdraw $3,525 a month from his accumulated savings to pay his mortgage. He will have fully re-paid his mortgage by December 2027, so any leftover savings will remain invested until July 2045. This time period is represented in yellow.

Option 3

Under Option 3, Chris will make payments of $5,525 a month to his lender from July 2019 to August 2024 (the green segment) at which point his mortgage will be fully re-paid. Because he hasn’t put any money in savings, he will have no savings so nothing will happen related to the money from the green time period during the yellow time period.

Check-In Dates

The infographic also calls out July 2029 and July 2045. These are the two dates that Chris mentions in his post as being possible decision dates. In ten years (July 2029), he might want to sell his house and downsize. In July 2045, his mortgage will be fully paid if he makes his minimum payments and it offers another point at which to consider selling the house.

The infographic shows the balance of his mortgage and the average amount of his after-tax savings if he invests 100% in stocks. As will be discussed below, there is a lot of risk around this average and it is calculated using historical returns, so there is also uncertainty around it.

Summary of Findings

Here are the key findings of my analysis. They will be discussed in detail below.

● Chris’s time horizon is important in making his decision.

o If he plans to keep his house until 2045, the historical data indicate he is better off in three-quarters of the scenarios making his minimum payments and investing in stocks. The average values of his after-tax savings are shown in the infographic above and show that he will have more savings on average with lower monthly mortgage payments.

o If he plans to sell his house or use the money he has saved to fully re-pay his mortgage 10 years from now, the decision is not as clear cut and will need to consider his risk tolerance. Because Chris plans to continue to work for many years, he may be able to tolerate more risk than someone who plans to retire before their mortgage is fully re-paid.

● Chris’s investment mix is important in making his decision.

o If he plans to keep his house until 2045, the historical data indicate that he is better off investing 100% in stocks.

o If he plans to sell his house or use the money he has saved to fully re-pay his mortgage 10 years from now, the mix of investments will depend on his risk tolerance.

● The historical data indicate Chris’s downside risk is not significantly changed by the stock market possibly being near its peak.

Discussion

I will start by providing insights on Chris’s financial position on average across all of the time series of historical investment returns – first for the 10-year period and then for the full 26-year period. I will then discuss the riskiness of the options. The last part of this discussion will focus on how I evaluated his results if the stock market were at a peak.

Average Results – 10 Years

The table below summarizes Chris’s average financial position, based on the historical investment returns, in 10 years on July 1, 2029, the time frame he referenced as possibly wanting to downsize. The invested asset row shows the balance of his investments if he sells all of his positions on that date and pays the related taxes. The “net worth” row shows the average amount Chris will have left if he pays off the balance of his mortgage with his after-tax investments.

Payment Option 3 2 2 2 1 1 1
Mortgage Payment $5,525 $3,525 $3,525 $3,525 $1,525 $1,525 $1,525
Investment Option All 100% Bonds 50% Bonds/ 50% Stocks 100% Stocks 100% Bonds 50% Bonds/ 50% Stocks 100% Stocks
Invested Assets $0 $10,620 $25,515 $34,396 $248,941 $285,615 $324,269
Mortgage Balance 0 0 0 0 221,928 221,928 221,928
“Net Worth” 0 10,620 25,515 34,396 27,033 64,687 102,341

I use “net worth” in quotes because it includes only the assets emanating from the $5,525 per month for the next five years and only his mortgage balance as a liability. In addition, Chris will have his house, all of his other taxable savings, his retirement accounts, and so on and so forth. Because all of these other assets are the same regardless of which option he chooses for his mortgage re-payment, I have excluded them from the comparison.

The positive “net worth” numbers mean Chris will get to keep the entire proceeds of his house if he sells it in 10 years plus the positive “net worth.” If there were negative “net worth” numbers (which there are in the graphs below), Chris would need to use that portion of the proceeds from his house to contribute to the settlement of his remaining mortgage balance.

The farthest left column – paying off his mortgage as quickly as possible – is the option Chris indicated is his initial preference. Under this strategy, he will have saved no invested assets from the $5,525 a month for five years and have no mortgage balance, so would get exactly the proceeds of his house if he were to sell it then. The remaining columns show that, on average using the historical returns, Chris will have more savings than his mortgage balance if he makes his lower mortgage payments and invests the rest of his $5,525 per month than if he pre-pays his mortgage as quickly as possible.

The smaller his mortgage payment, the higher his “net worth” or the more he will have available in excess of his mortgage balance in 10 years. For example, Chris will have a “net worth” of $34,396 at the end of 10 years, on average using historical returns, if he pays $3,525 a month towards his mortgage and invests the rest in 100% stocks as compared to $102,341 if he pays $1,525 a month towards his mortgage and invests the rest in 100% stocks. Because the average historical after-tax returns on his investments are higher than Chris’s pre-tax mortgage interest rate, he will accumulate savings above the balance of his mortgage.

In addition, at the average, Chris is better off if he invests more heavily in stocks. For example, if Chris makes his minimum mortgage payments and sells his house in 10 years, he will have $27,033 in after-tax savings if he invests 100% in bonds as compared to $102,341 in after-tax savings if he invests 100% in stocks.

I also calculated the averages for the 100% stocks investment strategy using the longer time period (back to 1950). While the results are slightly less favorable, they show generally the same results as are shown in the 100% stocks columns in the table above.

Average Results – 26 Years

The table below summarizes Chris’s average financial position on July 1, 2045, based on the historical investment returns. As discussed above, I don’t believe there is enough historical data regarding bond returns to include those investment strategies in this analysis. This table therefore shows results only based on the 100% stocks investment strategy and is based on stock returns going back to 1950.

Mortgage Payment Option 3 2 1
Mortgage Payment $5,525 $3,525 $1,525
Investment Option 100% Stocks 100% Stocks 100% Stocks
Invested Assets $0 $84,534 $373,269
Mortgage Balance 0 0 0
“Net Worth” 0 84,534 373,269

This table shows that the smaller mortgage payments Chris makes, the higher his savings will be 26 years from now on average using the historical returns.

Risky Results – 10 Years

So far, I have focused on Chris’s average returns. I mentioned in my introduction that one of the aspects of his decision that Chris does not quantify is risk. By looking at his “net worth” under 345 different historical scenarios (i.e., the number of complete 10-year time periods in my historical data) regarding bond and stock returns, we can get a sense for the riskiness of Chris’s choices.

Box & Whiskers – 10 Years

The graph below is called a box and whisker plot. My post on risk provides additional information about these graphs. The boxes represent the 25th to 75th percentiles of Chris’s “net worth” at 10 years. That is, I put the 345 “net worth” results in order from smallest to largest. The 25th percentile is the 86 th one on the list; the 75th percentile, the 259th. The whiskers (lines sticking out from the ends of the boxes) represent the 5th percentile to the 95th percentile and correspond to the 17th and 328th in order from smallest to largest.

Taller boxes and wider spreads between the top and bottom of the whiskers represent more risk. The placement of the boxes up and down on the graph show the overall level of the results. That is, boxes that are higher on the graph have higher returns than boxes that are lower.

This graph shows Chris’s “net worth” after 10 years under each of the investment and re-payment strategies.

Chris’s Re-payment Option 3 – pay off his mortgage as fast as possible – is shown on the far left. Because he makes no investments under this option, there is no risk and he always has no savings at the end of 10 years. As either the percentage of investments in stock increases or the amount of savings increases (moving to the right on the graph), both the risk and level increase. That is, with more savings, the boxes are higher on the graph and taller (e.g., compare the $1,525/0% Stocks box with the $3,525/0% Stocks box). The same comparison can be seen as the percentage of stock increases, by looking at the $1,525/0% Stocks relative to the $1,525/50% Stocks and $1,525/100% Stocks.

The tops of the boxes, tops of the whiskers and average values (shown in the table above) are all clearly higher with lower mortgage payments and a higher investment in stocks. The bottoms of the boxes and bottoms of the whiskers are all lower, though, so those options have more risk.

Efficient Frontier – 10 Years

Making a decision from the box & whisker plot can be challenging. If Chris is willing to view his risk-reward trade-off as being between his average “net worth” and his worst “net worth,” he can narrow down his choices. The drawback of this approach is it considers only one point in the range of possible results for measuring risk.

The graph below is a scatter plot showing the different options. My post on financial decision-making provides more insights on this type of graph. The x-axis (the horizontal one) shows Chris’s average “net worth” in 10 years. The y-axis (the vertical one) shows the worst “net worth” result observed based on the historical returns. Points on this chart that are up (worst results aren’t as bad) and to the right (higher average result) are better than points that are lower or to the left.

I have drawn a dashed line, called the efficient frontier, that connects those strategies (dots) that are optimal in that there are no other dots that have a higher average with the same worst result or have a higher worst result with the same average. Using the worst result as the sole measure of risk would allow Chris to narrow his choices down to the four on the efficient frontier, depending on how much risk he is willing to take.

You’ll see that there are two orange dots on this graph. They represent the points using the S&P 500 returns going back to 1950, whereas the blue points all use data starting in 1980. What I found most interesting is that the worst results are the same for both time series, though the average results are somewhat lower using the longer time series. The worst results occurred using the time series starting in February 1999.

Risky Results – 26 Years

The graph below shows the box & whisker plot of Chris’s “net worth” in July 2045, using the historical returns.

The 25th percentile of Chris’s “net worth” under all three options is about $0. As such, in 75% of the historical scenarios, Chris will be somewhat to significantly better off making smaller mortgage payments than making larger payments.

The much clearer results shown in this chart as compared to the one at 10 years results from the benefits of diversification over time. That is, the longer time period over which Chris is invested, the less risk there is in his financial results. Diversification is one way a portfolio can be diversified. Investing in both stocks and bonds is another. My post on how diversification reduces investment risk discusses these concepts in more detail.

The scatter plot below shows that in the worst scenario, Chris ends up losing about $120,000 over 26 years if he is 100% invested in stocks. The trade-off is that in 75% of the historical scenarios, he will have at least some savings and more than $370,000 in savings on average.

Current Market Cycle

Another concern that Chris and others on Twitter expressed is that the stock market has been going up for many years and is at risk of going down significantly in the near future.

Selection of Prior Peaks

To address that concern, I have reviewed the historical stock market returns to find points that would correspond to the market being at a peak. The two graphs below show the cumulative returns on the S&P 500 since 1950. (I had to create two charts so that the ups and downs from older periods could be seen. Even then the first peak on the second chart is a little tough to see even though it includes the largest single monthly decline in the entire time period.)

The eight green circles correspond to important peaks in the market, similar to Chris’s concern about today’s market.

“Net Worth” After Prior Peaks

I looked at Chris’s “net worth” ten years after each of those peaks, as shown in the table below. Recall that the bond index data are available starting only in 1980, so we can’t look at any strategies that include bonds for the earlier peaks.

Mortgage Payment $5,525 $3,525 $3,525 $3,525 $1,525 $1,525 $1,525
Investment Option All 100% Bonds 50% Bonds/ 50% Stocks 100% Stocks 100% Bonds 50% Bonds/ 50% Stocks 100% Stocks
1/1/1962 $0 $4,528 $184
11/1/1965 0 -5,103 -62,533
11/1/1968 0 -36,596 -76,978
1/1/1973 0 -1,543 27,375
12/1/1980 0 44,331 61,920 79,509 99,120 138,282 177,444
8/1/1987 0 27,585 40,490 53,394 57,535 151,014 244,493
3/1/2000 0 -5,747 1,033 2,198 -13,435 -33,178 -52,922
6/1/2007 0 2,848 25,314 47,780 -8,634 62,814 134,263
Average – Last 4 0 17,254 32,189 45,720 33,646 79,733 125,819
Average – All 8 0 18,021 48,916
All Scenarios 0 10,620 25,515 34,396 27,033 64,687 102,341

In some of the time periods, particularly the ones starting on November 1, 1965 and November 1, 1968, Chris would have been better off pre-paying his mortgage as quickly as possible rather than investing. In others though, he would have been much better off making his minimum mortgage payments.

The average result for the most recent 4 “bad” time periods (third-to-bottom row) is slightly better than the average result across all possible time periods (bottom row). If all eight periods are included, Chris is better off making minimum payments, but not by as much as was observed in all scenarios.

Dollar Cost Averaging

In several of the “bad” periods (e.g., the ones starting on 12/1/1980, 8/1/1987 and 6/1/2007), Chris ends up with a very high “net worth” if he invests 100% in stocks. Although Chris buys some stocks at the peak of the market, he will also buy stocks as the prices go down (generally taking a year or two). The graphs above show that the market often re-bounds fairly rapidly after it has fallen. In these situations, Chris will achieve a high return on the stocks bought at or near the bottom of the market, thereby boosting his overall return.

Dollar cost averaging is the process of making regular investments regardless of the market cycle. It is a common investing approach and, although it may not be intentional, it is exactly what you do when you contribute to a 401(k) through payroll deductions. Dollar cost averaging lets you buy stocks at all levels, without timing the market, which can produce better total returns than trying to time the market and make your investment on a single day or just a few days a year. If Chris invests monthly, he is implementing a dollar cost average strategy.

Assumptions

The findings presented here depend on a large number of assumptions.

Investment Returns

I used historical monthly returns on the S&P 500 and the Fidelity Investment Grade Bond Index (FBNCX) downloaded from Yahoo Finance. I assumed that any dividends and distributions, reduced by any related income taxes, were immediately reinvested.

Yahoo Finance provides a Closing Price and an Adjusted Closing Price. I used the percentage changes in the Adjusted Closing Price to calculate the total return for each financial instrument. For the S&P 500, the Closing Prices and Adjusted Closing Prices were identical. For the Bond Index, they were not. I assumed that the difference in the percentage changes between the Adjusted Closing Price and the Closing Price were interest payments.

I assumed that Chris would fund any shortfalls from current income or other after-tax savings and that there would be no borrowing costs or additional taxes.

Income Taxes

I made several key assumptions about income taxes:

● All investments will be held in taxable accounts. Chris is already contributing the maximum amounts to his tax-sheltered retirement plans. In addition, he might encounter penalties if the withdrawals needed to make his mortgage payments did not meet the guidelines of the specific tax-sheltered account to which he made contributions. See my post on retirement plans for more details on such withdrawals.

● The interest payments from the Bond Index will be taxed at Chris’s marginal rate on ordinary income of 22%.

● Chris will pay tax at his marginal capital tax rate of 15% capital gains and losses when he sells his investments, either to make mortgage payments or withdraws the money at the end of 10 years or 26 years.

● Chris’s marginal tax rates won’t change over the time horizon of the analysis.

● There were no tax implications of borrowing.

Fine Print

Having been a consultant for over 20 years, I feel it necessary to touch on the many limitations on the findings of the analysis.

Variability

Most importantly, actual results will vary from those presented herein. I have used historical data as a proxy for what might happen in the future. However, it is unlikely that future results will exactly replicate any results previously seen. If any of the assumptions discussed above or otherwise made do not turn out to be appropriate to Chris’s situation, the findings may similarly be relevant to his decision-making process.

Economic Environment Differences

An important component of these differences is the interest rate environment. As shown in the chart below, interest rates (as measured by the 10-year Treasury in this chart) declined or were flat during almost the entire period from 1980 to the present – the time period for which data were available for the Bond Index.

It is more likely than not that interest rates will increase during the time horizon of this analysis. When interest rates increase, bond prices tend to decrease. If that were to happen, the findings based on historical bond returns likely overstate the results that might be observed in the future.

Data Used in My Analysis

I downloaded S&P 500 and the Fidelity bond index monthly returns from Yahoo Finance. Data were available for the S&P 500 going back to 1950, but only to 1980 for the Fidelity bond index. To the extent that these data are incorrect, the findings herein might also be incorrect (i.e., garbage in, garbage out).

Intended Use

The purpose of this analysis was to provide insights to help Chris make a more informed decision. It should not be interpreted as making a recommendation for any financial decision. The only information I have about Chris’s financial situation is what is outlined above and in his post. As such, there may be other aspects of his financial situation that cause this analysis to not apply correctly to his specific situation.

Lastly, the analysis may not be applicable to anyone else’s specific situation.