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.

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 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.

Annual Retirement Savings Targets

Once you know how much you want to save for retirement, you need a plan for building that savings.  Your annual retirement savings target depends on your total savings target, how many years you have until you want to retire and how much risk you are willing to take in your portfolio.  In this post, I’ll provide information you can use to set targets for how much to contribute to your retirement savings each year.

Key Variables

There are several variables that will impact how much you’ll want to target as contributions to your retirement savings each year.  They are:

  • Your total retirement savings target.
  • How much you already have saved.
  • The number of years you are able to contribute to your retirement savings.
  • How much risk you are willing to take in your portfolio.
  • The impact of taxes on investment returns between now and your retirement. That is, what portion of your retirement savings will be in each of taxable accounts, tax-deferred retirement savings accounts and tax-free retirement savings accounts.  For more information on tax-deferred and tax-free retirement savings accounts, check out this post.  I provide a bit more insight on all three types of accounts in these posts on how to choose which assets to buy in which type of account in each of the US and Canada.

Some of these variables are fairly straightforward.  For example, you can check the balances of any accounts with retirement savings that you already have and you can estimate (within a few years, at least) how many years until you retire.

Other variables are more challenging to estimate.  For example, I dedicated a whole separate post to the topic of setting your retirement savings target.

Your Risk Tolerance

Your risk tolerance is a measure of how much volatility you are willing to take in your investments.  As indicated in my post on risk, the more risk you take the higher your expected return but the wider the possible range of results.  My post on diversification and investing shows that the longer period of time over which you invest, the less volatility has been seen historically in the annualized returns.

Here are a few thoughts that might guide you as you figure out your personal risk tolerance.

  • If you have only a few years until you retire, you might want to invest fairly conservatively. By investing conservatively, you might want to invest in money market or high-yield savings accounts that currently have yields in the 1.75% to 2% range.
  • If you have five to ten years until you retire or are somewhat risk averse (i.e., can’t tolerate the ups and downs of the stock market), you might want to invest primarily in bonds (discussed in this post) or bond mutual funds. Depending on the maturity, US government bonds are currently yielding between 1.5% and 2% and high-quality corporate bonds are currently returning between 2.5% and 4%.
  • If you have a longer time period to retire and/or are able to tolerate the volatility of equities (discussed in this post), you might invest in an S&P 500 index fund or an index fund that is even more risky. These funds have average annual returns of 8% or more.

As can be seen, the more risk you take, the higher the average return.  As you are estimating how much you need to save each year for retirement, you’ll need to select an assumption about your average annual investment return based on these (or other) insights and your personal risk tolerance.

Taxability of Investment Returns

In addition to considering your risk tolerance, you’ll need to adjust your investment returns for any taxes you need to pay between the time you put the money in the account and your retirement date.  For this post, I’ve assumed that your savings amount target includes income taxes, as suggested in my post on that topic.  If it does, you only need to be concerned with taxes until you retire in estimating how much you need to save each year.

In the previous section, you selected an average annual investment return.  The table below provides approximations for adjusting that return for Federal income taxes based on the type of financial instruments you plan to buy and the type of account in which you hold it.

US – Taxable

Canada – Taxable

All Tax-Deferred & Tax-Free Accounts

Money Market

Multiply by 0.75

Multiply by 0.75

No adjustment

Bonds and Bond Mutual Funds

Multiply by 0.75

Multiply by 0.75

No adjustment

Equity Mutual Funds

Multiply by 0.85

Multiply by 0.87

No adjustment

Equities and Index Funds

Multiply by 0.85

Multiply by 0.87

No adjustment

Further Refinements to Tax Adjustments

You’ll need to subtract your state or provincial income tax rate from each multiplier. For example, if you state or provincial income tax rate is 10%, you would subtract 0.10 from each multiplier. For Equities and Index Funds, the 0.85 multiplier in the US-Taxable column would be reduced to 0.75.

The assumptions in this table for equities and index funds in particularly and, to a lesser extent, equity mutual funds, are conservative.  Specifically, if you don’t sell your positions every year and re-invest the proceeds, you will pay taxes less than every year.  By doing so, you reduce the impact of income taxes.  Nonetheless, given all of the risks involved in savings for retirement, I think these approximations are useful even if they cause the estimates of how to save every year to be a bit high.

Also, the tax rates for bonds and bond mutual funds could also be conservative depending on the types of bonds you own.  The adjustment factors shown apply to corporate bonds.  The tax rates on interest on government bonds and some municipal bonds are lower.

Calculation of After-Tax Investment Return

From the table above, it is clear that calculating your after-tax investment return depends on both the types of investments you plan to buy and the type of account in which you plan to hold them.  The table below will help you calculate your overall after-tax investment return.

Investment Type

Account Type

Percent of Portfolio Pre-tax Return Tax Adjustment

Product

Money Market, Bonds or Bond Mutual Funds

Taxable

0.75

Equity Mutual Funds, Equities, Index Funds

Taxable

0.85 if US; 0.87 if Canada

All

Other than Taxable

1.00

Total

There are three assumptions you need to enter into this table that reflect the types of financial instruments you will buy (i.e., reflecting your risk tolerance) and the types of accounts in which you will hold those assets in the Percent of Portfolio column.  These assumptions are the percentages of your retirement savings you will invest in:

  • Money markets, bonds or mutual funds in taxable accounts.
  • Equities, equity mutual funds and index funds in taxable accounts.
  • Tax-deferred or tax-free accounts (IRAs, 401(k)s, RRSPs and TFSAs).

For each of these three groups of assets, you’ll put the average annual return you selected from the Risk Tolerance section above in the Pre-Tax return column.  You also may need to adjust the multipliers as discussed above.

Once you have filled in those six boxes, you will multiply the three numbers in each row together to get a single product in the last column of each row.  Your weighted average after-tax investment return will be the sum of the three values in the last column.

Illustration of Weighted Average Return Calculation

I have created an illustration in the table below.  For this illustration, I have assumed that you will invest 50% of your portfolio in bonds and 50% in equities.  You are able to put 60% of your portfolio in tax-deferred and tax-free accounts.  Although not consistent with my post on tax-efficient investing, you split your bonds and stocks between account types in the same proportion as the total.  As such, you have 20% of your portfolio in taxable accounts invested in each of bonds and equities.  The 60% you put in your tax-deferred and tax-free accounts goes in the All Other row.

Investment Type

Account Type

Percent of Portfolio Pre-tax Return Tax Adjustment

Product

Money Market, Bonds or Bond Mutual Funds

Taxable

20% 3% 0.75

0.5%

Equity Mutual Funds, Equities, Index Funds

Taxable

20% 8% 0.85 if US; 0.87 if Canada

1.4%

All

Other than Taxable

60% 5.5% 1.00

3.3%

Total

5.2%

I’ll use a pre-tax return on bonds of 3% and equities of 8%.  Because the All Other category is 50/50 stocks and bonds, the average pre-tax return for that row is the average of 3% and 8% or 5.5%.

I then calculated the products for each row.  For example, in the first row, I calculated 0.5% = 20% x 3% x 0.75.  The weighted average after-tax investment return is the sum of the three values in the product column or 5.2% = 0.5% + 1.4% + 3.3%.  The 5.2% will be used to help estimate how much we need to save each year to meet our retirement savings target.

Annual Savings Targets

By this point, we have talked about how to estimate:

  • Your total retirement savings target
  • The number of years until you retire
  • An after-tax investment return that is consistent with your risk tolerance and the types of accounts in which you plan to put your savings

With that information, you can now estimate how much you need to save each year if you don’t have any savings yet.  I’ll talk about adjusting the calculation for any savings you already have below.

I assumed that you will increase your savings by 3% every year which would be consistent with saving a constant percentage of your earnings each year if your wages go up by 3% each year.  For example, if you put $1,000 in your retirement savings this year, you will put another $1,030 next year, $1,061 in the following year and so on.  In this way, your annual retirement savings contribution will be closer to a constant percentage of your income.

Annual Savings/Total Target

The graph and table below both show the same information – the percentage of your retirement savings goal that you need to save in your first year of savings based on your number of years until you retire and after-tax annual average investment return.

After-tax Return

Years to Retirement
5 10 15 20 25 30 35

40

2%

17.6% 7.8% 4.6% 3.0% 2.1% 1.6% 1.2% 0.9%

3%

17.3% 7.4% 4.3% 2.8% 1.9% 1.4% 1.0% 0.8%

4%

16.9% 7.1% 4.0% 2.5% 1.7% 1.2% 0.9% 0.6%

5%

16.6% 6.8% 3.7% 2.3% 1.5% 1.0% 0.7%

0.5%

6% 16.3% 6.5% 3.5% 2.1% 1.3% 0.9% 0.6%

0.4%

7% 16.0% 6.2% 3.2% 1.9% 1.2% 0.7% 0.5%

0.3%

8% 15.7% 6.0% 3.0% 1.7% 1.0% 0.6% 0.4%

0.3%

As you can see, the more risk you take, the less you need to save on average.  That is, as you go down each column in the table or towards the back of the graph, the percentage of your target you need to save in the first year gets smaller.  Also, the longer you have until you retire (as you move right in the table and graph), the smaller the savings percentage.  I caution those of you who have only a few years until retirement, though, that you will want to think carefully about your risk tolerance and may want to use the values in the upper rows of the table corresponding to lower risk/lower return investments, as there is a fairly high chance that your savings will be less than your target due to market volatility if you purchase risky assets.

How to Use the Table

First find the percentage in the cell with a row that corresponds to your after-tax investment return and a column that corresponds to your time to retirement.  You multiply this percentage by your total retirement savings target.  The result of that calculation is how much you need to save in your first year of saving.  To find out how much to save in the second year, multiply by 1.03.  Keep multiplying by 1.03 to find out how much to save in each subsequent year.

Earlier in this post, I created an example with a 5.2% after-tax investment return.  5.2% is fairly close to 5%, so we will look at the row in the table corresponding to 5% to continue this example.  I have calculated your first- and second-year savings amounts for several combinations of years to retirement and total retirement savings targets for someone with a 5% after-tax investment return below.

Years to Retirement

Savings % from Table (5% Row) Total Retirement Savings Target First-Year Savings Amount Second-Year Savings Amount

5

16.6% $500,000 $83,000 $85,490

15

3.7% 2,000,000 74,000

76,220

30 1.0% 500,000 5,000

5,150

40 0.5% 1,000,000 5,000

5,150

The first-year savings amounts in this table highlight the benefits of starting to save for retirement “early and often.”   It is a lot easier to save $5,000 a year than $75,000 or $85,000 a year.  By comparing the last two rows, you can see the benefits of the extra 10 years between 30 years of savings and 40 years of savings.  With the same starting contributions, on average, you end up with twice as much if you save consistently for 40 years than if you do so for 30 years.

Adjusting for Savings You Already Have

The calculations above don’t take into account that you might already have started saving for retirement.  If you already have some retirement savings, you can reduce the amount your need to save each year.

The math is a bit complicated if you don’t like exponents, but I’ll provide a table that will make it a bit easier.  To adjust the annual savings calculation for the amount you already have saved, you need to subtract the future value of your existing savings from your total retirement savings target.  The future value is the amount to which your existing savings will grow by your retirement date.  The formula for future savings is:

where n is the number of years until you retire.  The annual return is the same return you’ve been using in the formulas above.  If you don’t want to deal with the exponent, the table below will help you figure out the factor by which to multiply your current amount saved.

After-tax Return

Years to Retirement
5 10 15 20 25 30 35

40

2%

1.10 1.22 1.35 1.49 1.64 1.81 2.00 2.21

3%

1.16 1.34 1.56 1.81 2.09 2.43 2.81 3.26

4%

1.22 1.48 1.80 2.19 2.67 3.24 3.95 4.80
5% 1.28 1.63 2.08 2.65 3.39 4.32 5.52

7.04

6% 1.34 1.79 2.40 3.21 4.29 5.74 7.69

10.29

7% 1.40 1.97 2.76 3.87 5.43 7.61 10.68

14.97

8% 1.47 2.16 3.17 4.66 6.85 10.06 14.79

21.72

Illustration of Adjustment for Existing Savings

Let’s say you have $50,000 in retirement savings, 25 years until you retire and have selected an annual return of 5%.  You would use the factor from the 5% row in the 25 years column of 3.39.  You multiply $50,000 by 3.39 to get $169,500.

If your total retirement savings target is $1,000,000, you subtract $169,500 and use an adjusted target of $830,500.  Using the same time to retirement and annual return, your annual savings target is 1.5% of $830,500 or $12,458.  This annual savings amount compares to $15,000 if you haven’t saved any money for retirement yet.

Caution

Having been subject to Actuarial Standards of Practice for most of my career (which started before the standards existed), I can’t finish this post without providing a caution.  All of the amounts that I’ve estimated in this post assume that you earn the average return in every year.  There aren’t any financial instruments that can guarantee that you’ll earn the same return year in and year out.  As mentioned above, riskier assets have more volatility in their returns.  That means that, while the average return is higher, the actual returns in any one year are likely to be further from the average than for less risky assets.

As such, you should be aware that the amounts shown for annual savings will NOT assure you that you will have your target amount in savings when you retire.  I suggest that, if possible, you set a higher target for your total retirement savings than you think you’ll really need or save more each year than the amounts resulting from these calculations. You don’t want to be in the situation in which my friend found herself at age 59 starting over financially.

 

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:

  • Individual stocks with high dividends
  • Mutual funds
  • Exchange-traded funds (ETFs) with no dividends
  • Bonds

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:

  • Individual stocks with high dividends
  • Mutual funds
  • Exchange-traded funds (ETFs)
  • Bonds

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.

What is Diversification and How Does it Work?

One of the key concepts used by many successful investors is diversification.  In this post, I’ll define diversification and explain how it works conceptually.  I explain different ways you can diversify your investments and provide illustrations of its benefits in this post.

What is Diversification?

Diversification is the reduction of risk (defined in my post a couple of weeks ago) through investing in a larger number of financial instruments.  It is based on the concept of the Law of Large Numbers in statistics. That “Law” says that the more times you observe the outcome of a random process, the closer the results are likely to exhibit their true properties.  For example, if you flip a fair coin twice, there are four sets of possible results:

 

First flip Second flip
Heads Heads
Heads Tails
Tails Heads
Tails Tails

 

The true probability of getting heads is 50%.  In two rows (i.e., two possible results), there is one heads and one tails.  These two results correspond to the true probability of a 50% chance of getting heads.  The other two possible results show that heads appears either 0% or 100% of the time.  If you repeatedly flip the coin 100 times, you will see heads between 40% and 60% of the time in 96% of the sets of 100 flips.  Increasing the number of flips to 1,000 times per set, you will see heads between 46.8% and 53.2% of the time in 96% of the sets.  Because the range from 40% to 60% with 100 flips is wider than the range of 46.8% to 53.2% with 1,000 flips, you can see that the range around the 50% true probability gets smaller as the number of flips increases.  This narrowing of the range is the result of the Law of Large Numbers.

Following this example, the observed result from only one flip of the coin would not be diversified. That is, our estimate of the possible results from a coin flip would be dependent on only one observation – equivalent to having all of our eggs in one basket.  By flipping the coin many times, we are adding diversification to our observations and narrowing the difference between the observed percentage of times we see heads as compared to the true probability (50%).   Next week, I’ll apply this concept to investing where, instead of narrowing the range around the true probability, we will narrow the volatility of our portfolio by investing in more than one financial instrument.

What is Correlation?

As discussed below, the diversification benefit depends on how much correlation there is between the random variables (or financial instruments). Before I get to that, I’ll give you an introduction to correlation.

Correlation is a measure of the extent to which two variables move proportionally in the same direction. In the coin toss example above, each flip was independent of every other flip.

0% Correlation

When variables are independent, we say they are uncorrelated or have 0% correlation. The graph below shows two variables that have 0% correlation.

In this graph, there is no pattern that relates the value on the x-axis (the horizontal one) with the value on the y-axis (the vertical one) that holds true across all the points.

100% Correlation

If two random variables always move proportionally and in the same direction, they are said to have +100% correlation.  For example, two variables that are 100% correlated are the amount of interest you will earn in a savings account and the account balance.  If they move proportionally but in the opposite direction, they have -100% correlation.  Two variables that have -100% correlation are how much you spend at the mall and how much money you have left for savings or other purchases.

The two charts below show variables that have 100% and -100% correlation.

In these graphs, the points fall on a line because the y values are all proportional to the x values. With 100% correlation, the line goes up, whereas the line goes down with -100% correlation.  In the 100% correlation graph, the x and y values are equal; in the -100% graph, the y values equal one minus the x values. 100% correlation exists with any constant proportion.  For example, if all of the y values were all one half or twice the x values, there would still be 100% correlation.

50% Correlation

The graphs below give you a sense for what 50% and -50% correlation look like.

The points in these graphs don’t align as clearly as the points in the 100% and -100% graphs, but aren’t as randomly scattered as in the 0% graph.  In the 50% correlation graph, the points generally fall in an upward band with no points in the lower right and upper left corners.  Similarly, in the -50% correlation graph, the pattern of the points is generally downward, with no points in the upper right or lower left corners.

How Correlation Impacts Diversification

The amount of correlation between two random variables determines the amount of diversification benefit.  The table below shows 20 possible outcomes of a random variable.  All outcomes are equally likely.

The average of these observation is 55 and the standard deviation is 27.  This standard deviation is measures the volatility with no diversification and will be used as a benchmark when this variable is combined with other variables.

+100% Correlation

If I have two random variables with the same properties and they are 100% correlation, the outcomes would be:

Remember that 100% correlation means that the variables move proportionally in the same direction.  If I take the average of the outcomes for Variable 1 and Variable 2 for each observation, I would get results that are the same as the original variable.  As a result, the process defined by the average of Variable 1 and Variable 2 is the same as the original variable’s process.  There is no reduction in the standard deviation (our measure of risk), so there is no diversification when variables have +100% correlation.

-100% Correlation

If I have a third random variable with the same properties but the correlation with Variable 1 is -100%, the outcomes and averages by observation would be:

The average of the averages is 0 and so is the standard deviation!  By taking two variables that have ‑100% correlation, all volatility has been eliminated.

0% Correlation

If I have a fourth random variable with the same properties but it is uncorrelated with Variable 1, the outcomes and averages by observation would be:

The average of the averages is 54 and the standard deviation is 17.  By taking two variables that are uncorrelated, the standard deviation has been reduced from 27 to 17.

Other Correlations

The standard deviation of the average of the two variables increases as the correlation increases.  When the variables have between -100% and 0% correlation, the standard deviation will be between 0 and 17. If the correlation is between 0% and +100%, the standard deviation will be between 17 and 27.  This relationship isn’t quite linear, but is close.  The graph below shows how the standard deviation changes with correlation using random variables with these characteristics.

Key Take-Aways

Here are the key take-aways from this post.

  • Correlation measures the extent to which two random processes move proportionally and in the same direction. Positive values of correlation indicate that the processes move in the same direction; negative values, the opposite direction.
  • The lower the correlation between two variables, the greater the reduction in volatility and risk. At 100% correlation, there is no reduction in risk.  At -100% correlation, all risk is eliminated.
  • Diversification is the reduction in volatility and risk generated by combining two or more variables that have less than 100% correlation.

5 Steps to Begin Your Investing Journey

Riley is a senior financial analyst at a Fortune 500 company with a CPA and M.S. in Applied Economics who aspires to help young professionals navigate the sometimes-murky waters of finance.  He is also the author of the blog, Young and The Invested, which is dedicated to growing an online community for young professionals looking to improve their financial literacy and develop strategies to reach financial independence. In this guest post, he will provide 5 steps to help you begin your investing journey.

The oldest rule in investing is also the simplest: “Buy low, sell high.”  While it seems blindingly obvious and begs the question of why anyone would want to do anything else when investing, you might be surprised how hard it is to put into practice.

Investing is a discipline which plays not only on astute analysis and remarkable luck but also on people’s behavioral responses.  Holding onto your stocks during periods of intense market volatility takes a lot of courage and isn’t what the human brain is wired to withstand.

But how do you approach investing if you don’t have a background in it? Without much prior experience, it’s tough to say. There’s an ocean of information out there and sorting through it requires deliberate, thoughtful reflection when piecing together what you’ve read.

When it comes to growing your wealth and working toward financial independence, investing is an important tool.  Through investing, you can buy assets which, hopefully, grow in value, whether it is a home, a retirement account, stocks, or bonds.

Let’s walk through some simple steps on how you can begin your investing journey.

First, Invest in Yourself

This past summer, I attended a wedding with my wife and her family where my brother-in-law approached me with a conversation about investing.  He wanted to know how he could replicate the performance seen by the world’s greatest investors.  

Essentially, he wanted to turn a small sum of money into an account balance with two commas in quick fashion.

If only I knew the sure-fire way to make that path my own reality.  If I did, we wouldn’t have driven to the wedding in a rented subcompact.

I cautioned him those investors are truly gifted and the exception to the norm.  But what I then told him is the common trait these legendary financiers share: following a systematic and disciplined approach to investing.

I told him regardless of investing style, timeframe, or philosophy, they all have discipline, transact based on logical, informed thinking and do not let emotions drive their decisionsThese are the most important elements required for investing success.  But don’t just take my word for it, many folks seem to agree[1],[2],[3],[4].

The aforementioned investing strategies are merely a means to an end and come later.  Any investor starting out should develop these core principles and learn to stick to them during times of good and bad.

Develop Your Investing Approach

As I explained this to my brother-in-law, I could see his disappointment in my not knowing any shortcuts to overnight investing success.  However, we launched into a discussion around how he could develop his own disciplined investing approach by first becoming a student of markets.

Knowing that this discussion could become overly cumbersome in just one conversation, I decided to share only introductory steps.

Investing isn’t easy but, at the same time, it shouldn’t be seen as a frightening endeavor. If done wisely and consistently, investing can separate retiring comfortably at a reasonable age from working into your golden years out of necessity.

So, with that thinking, I will do the same here.  Short of a formal education in finance, my five high-level steps for gaining familiarity with investing in the market are as follows:

1 – Read a Lot About the Market

Sounds logical, right?  You’d be surprised by how many people I’ve heard say they got into a stock simply because so-and-so recommended it.

This person winds up not doing a lick of due diligence before investing.  This person didn’t know what was happening in the market, nor anything about the company beyond it being a hot stock tip.

To counteract this, I suggest first beginning by reading reputable sources that discuss markets (e.g., MarketWatch, the Financial Times, the Wall Street Journal, Reuters, Yahoo Finance, among others). As you read more, I suggest approaching every article with a heavy dose of skepticism.

This will make you more likely to piece together content from multiple sources and form your own thinking about markets and the companies in them.

As an exercise, take a moment to read this article about the earnings estimates for public companies.  After you’ve read it, what were the main, salient points that stood out to you?  I found the following to be most important:

  • Many investors seem to think lackluster stock market movement during this quarter’s earnings announcements indicates peaking corporate profits. When companies announce record earnings and markets barely move, it must mean expectations were high and future earnings don’t look to get any better.
  • Analysts, or those people who follow stocks and publish opinions on them, disagree, and are increasing their profit projections at the highest rate in 6 years. This is where the skepticism should come into play.  This conflict means someone is wrong, but who?  Perhaps both are right and yet both are wrong.  The truth likely lies somewhere in between.
  • A growing economy and corporate tax reform have benefited companies but trade war activity makes for an uncertain outlook. To illustrate uncertainty, reporting companies have seen the most volatile trading in two years immediately after announcing earnings results. However, it appears this trading reaction could be the result of poor understanding of the effects of the recent tax reform legislation and clouds the visibility for accurately forecasting future earnings.  Therefore, the volatility merely highlights poor forecasting abilities, not necessarily anything indicative of market direction.
  • A lot of positive developments exist to push markets higher but looming risks serve to temper optimism usually present with such strong earnings growth. Bottom line: there doesn’t appear to be a strong case for a plummeting market but neither for a sustained rally.

As you read more pieces like this, reflect after each one and begin to piece together content from what you’ve read.  Building this understanding won’t happen overnight.

2 – Start Looking into Individual Companies

Naturally, you will come across individual companies.  You should identify companies consistently performing well or making strides to improve.  I recommend starting your journey by researching five companies you admire and understand (preferably in different industries) and cultivating ideas about the strategies of each firm, their competitive advantages, and the core value they provide.

If you don’t believe any of these items to be durable over time, I would suggest moving on.  Recognize what sets these companies apart from their peers, the prospects for the markets in which they operate (e.g., growing market vs. declining market), and how the market values them. 

Cast aside companies if you uncover something you don’t like. Don’t let sunk costs guide your thinking.  Even if you are wrong in not liking the company, there are many other companies out there about which you don’t uncover anything you don’t like.  Investments in these companies will be less risky.

Ultimately, a stock represents a piece of a company, so sustainable profitability is an important factor.  You really want to assess how profitable these companies can be, because before you decide how much to pay for a stock, you need to understand how much money that company makes. 

If the company makes a lot of money consistently, you will likely have to pay more to acquire the stock.

3 – Take Action

At this point, if you’ve gotten a decent handle on the overall market’s activity and analyzed a set of attractively-valued companies you think stand out from the rest, it’s your time to pull the trigger. 

There are a number of retail brokers you may use to invest in individual stocks (e.g., Interactive Brokers, TD Ameritrade, Charles Schwab).

4 – Continue Following the Companies and Markets

By doing your due diligence, you will be able to follow these companies and see if they continue to perform as you expect. If a company makes a decision you don’t agree with or think will adversely impact its value going forward or the environment in which that company operates changes in a way that is adverse to the company, you might consider cutting your losses short and moving on.

5 – Keep It Simple, Invest in ETFs

Investing is hard.  It’s more art than exact science.  By writing this step-by-step guide, my goal is not to simplify the act of investing.  In fact, what I want to convey as clearly as possible is just how difficult it is to invest in individual stocks.

Investing is so much more than following some rules of thumb.  Getting an edge is difficult so you shouldn’t develop irrational self-confidence and think you have an investing edge when you really don’t.

Usually, being humble and saying to yourself that you don’t really know can be great to steady your decision-making.

If you don’t have confidence in selecting individual companies to outperform the market, another strategy is to use exchange traded funds (ETFs) to invest.  You can consider investing in low-cost ETFs through brokerages (e.g., Vanguard) or robo-advisors (e.g., Betterment).

Personally, I use both of those services to hold my ETFs.  I prefer Betterment because it automates my ETF holdings based on scientific research matched to my stated financial goals.

For example, I have a Roth IRA account with the stated financial goal of growing money through retirement in about 30 years.  Because of this goal, Betterment chooses to hold a diverse portfolio of 90% ETFs ranging from small cap value to globally diversified ETFs.

I recommend that you start your investing journey with ETFs, especially when you can hold these investments for long periods of time.  This allows the last real-edge in investing to work its magic: time in quality investments.

When Investing, Doing Less is More

I think about smart investing in a way that minimizes mistakes instead of pursuing maximum gains.  I don’t like taking on uncompensated risk

A portfolio requires a healthy balance of risk and reward as well as exposure to many different investments.  I keep the following items in mind when investing:

  • Steer clear of all avoidable risks. Don’t take on unnecessary risk when the probability of a better investment outcome doesn’t exist
  • Be cautious and highly skeptical of your conclusions and whether you feel you possess some edge. It is much more likely you don’t have one when compared to the deep pockets spending endless time and money seeking the next edge
  • Minimize the number of times you touch your portfolio. High portfolio turnover in search of better investments often leads to negative consequences for your returns
  • Avoid big mistakes. You stand to gain a lot more by doing nothing than thinking you have some edge (when you really don’t) and acting upon it

When investing, doing less is more.  Therefore, I recommend investing through low-cost ETFs.

Investing well can produce very rewarding experiences you share with those you love.  For me, it allowed me to buy my first home and now to grow the assets necessary to purchase my next one together with my wife to start our family.

In general, developing your own disciplined investing approach based on rational, informed decision-making can lead to financial independence.

Learning how to invest wisely at a young age will have you maximize your youth by allowing compounding to work to your benefit.  Do yourself a favor and invest in yourself by following these five steps to begin investing.


A big thanks to Riley for writing this post. He makes many important points to consider as you get started with investing. I invited to write a guest post on investing, as I haven’t written much on that topic yet. I greatly appreciate his rounding out the breadth of topics covered on our blog.

 

Retirement Savings/Saving for Large Purchases

In my previous post, I presented the first part of a case study that introduced Mary and her questions about what to do with her savings. In this post, I will continue the case study focusing on retirement savings and saving for large purchases. 

Case Study

To help set the stage, I created a fictitious person, Mary, whose finances I use for illustration.

  • Mary is single with no dependents.
  • She lives alone in an apartment she rents.
  • She makes $62,000 per year.
  • Mary has $25,000 in a savings account at her bank and $10,000 in her Roth 401(k).
  • Her annual budget shows:
    • Basic living expenses of $40,000
    • $5,000 for fun and discretionary items
    • $10,000 for social security, Federal and state income taxes
    • $4,000 for 401(k) contributions
    • $3,000 for non-retirement savings
  • Mary has $15,000 in student loans which have a 5% interest rate.
  • She owns her seven-year-old car outright. She plans to replace her car with a used vehicle in three years and would like to have $10,000 in cash to pay for it.
  • She has no plans to buy a house in the near future.
Mary's-Savings-Infographic

Her questions are:

  • Should I start investing the $25,000 in my savings account?
  • Should I have a separate account to save the $10,000 for the car?  
  • What choices do I have for my first investments for any money I don’t set aside for my car?
  • Should I pay off some or all of the principal on my student loans?

I talked about a framework for thinking about her savings and setting aside money for expenses she doesn’t pay monthly and emergency savings here.  In this post, I’ll focus on the rest of her savings.  I answer her questions about student loans here

Designated Savings

Designated savings is the portion of your investable asset portfolio that you set aside for a specific purchase, such as a car or home. Mary would like to buy a car for $10,000 in three years.  She needs to designate a portion of her savings for her car.

As part of her savings framework, Mary

  • Will set aside $13,000 for emergency savings.
  • Has $12,000 in her savings account after setting aside the $13,000 for emergency savings.
  • Included $3,000 a year for non-retirement savings in her budget, some of which she can use for her car.

Mary has decided she will use $5,500 as the start of her designated savings to replace her car. After reading this post, she has decided to pay cash for a car, rather than borrow or lease,  She will add half of her $3,000 of non-retirement savings each year to bring the total available balance to $10,000 in three years.  If Mary’s car becomes unrepairable sooner, she can use some of the money in her emergency savings, but will want to replenish that account as soon as she can.

Considerations for Investment Choices

When I’m saving money for a large purchase, such as a car or a down payment on a house, I’m willing to invest in something less liquid than a savings account or a money market account. That is, I don’t have to be able to access the money on a moment’s notice.  

I do, however, want a similar level of security.  It is very important to me that the market value of my investment not go down as I don’t want to risk my principal.  Because I tend to have time frames that are less than one year for these types of purchases, I tend to put my designated savings in certificates of deposit. 

Certificates of Deposit and Treasury Bills

In Mary’s case, she has three years.  She might consider longer-term certificates of deposit (CDs) or short-term government bonds. (Click here to learn more about bonds.) A CD is a savings certificate, usually issued by a commercial bank, with a stated maturity and a fixed interest rate.  

A treasury note is a form of a bond issued by the US government with a fixed interest rate and a maturity of one to 10 years.  A treasury bill is the same as a treasury note, except the maturity is less than one year.  When the government issues notes, bills and bonds (which have maturities of more than 10 years), it is borrowing money from the person or entity that buys them.  The table below shows the current interest rates on CDs and treasury bills and notes with different maturities.

Maturity CD[1] Treasury[2]
1-3 Months 2.32% 2.3%
4-6 Months 2.42% 2.5%
7-9 Months 2.56% N/A
10-18 Months 2.8% 2.7%
1.5–2.5 Years 3.4% 2.8%
3 Years N/A 2.85%
5 Years N/A 2.9%

When thinking about whether to buy CDs or Treasury bonds, Mary will want to consider not only the differences in returns, but also the differences in risk.  

Risks of Owning a Bond

Bonds have two key inherent risks – default risk and market risk

  • Default risk is the chance that the issuer will default on its obligations (i.e., not pay you some or all of your interest or principal).  Treasury notes, bills and bond issued by the US are considered some of the safest bonds from a default perspective.  I’m not aware that the US government (or Canadian government for that matter) has ever not paid the interest or repaid the principal on any of its debt. 
  • Market risk emanates from changes in interest rates that cause changes in the market values of bonds.  As interest rates go up, the market values of bonds go down.  All bonds come with a maturity date that is almost always stated in the name of the bond.[3]   If you buy a bonddon’t sell it until it matures and the issuer doesn’t default, you will get the face amount (i.e., the principal) of the bond no matter how interest rates change.  Thus, if you hold a bond to maturity, you eliminate the market risk

In summary, using certificates of deposit or Treasuries held to maturity can increase your investment return relative to a savings account without significantly increasing the risk that you’ll lose the money you’ve saved.  

Mary’s Decision

Because she can buy them easily at her bank or brokerage firm and they are currently yielding more the Treasuries with the same maturity, Mary has decided to buy 2.5-year CDs, earning 3.4%, with the $5,500 she has set aside to buy her car.

Long-term Savings – What to Buy

Mary has $6,500 in her savings account that isn’t needed for her emergency savings or her replacement car. She wants to start investing it or use it to pay down some of her student loans.  I’ll talk about her student loans next week.

Mary doesn’t want to spend a lot of time doing research, so is not going to invest in individual securities.[4]  Instead, she is looking at mutual funds and exchange-traded funds (ETFs).  A benefit of these funds over individual securities is that they own positions in a lot of companies so it is easier for Mary to diversify[5]her portfolio than if she bought positions in individual companies.

Mutual Fund and ETF Considerations

Briefly, here are some of the features to consider in selecting a mutual fund or an ETF.  I note that you may not have answers to a lot of these questions, but they should help you get started in your thinking[6].

  • The types of positions it holds and whether they are consistent with your investment objectives. Is the fund concentrated in a few industries or is the fund intended to produce the same returns as the overall market (such as the S&P 500 or Dow Jones Industrial Average)?  Does it invest in larger or smaller companies?  Does the fund focus on growth or dividend-yielding positions?  Is it an index fund or actively-traded?
  • The expense load.  All mutual fund and ETF managers take a portion of the money in their funds to cover their expenses.  The managers make their money from these fees.  Funds are required to report their expenses, as these reduce your overall return on investment.  There are two types of expense load – front-end loads and annual expenses.  If you buy a fund with a front-end load, it will reduce your investment by the percentage corresponding to the front-end load when you buy it.  Almost all funds have annual expenses which reduce the value of your holdings every year.  Although funds with lower expense loads generally have better performance than those with higher loads, there may be some funds that outperform even after consideration of a higher expense load.
  • Historical performance.  Although historical performance is never a predictor of future performance, a fund that has a good track record might be preferred to one that has a poor track record or is new.  As you review returns, look not only at average returns but also volatility (such as the standard deviation).  A fund with higher volatility should have a higher return.

Mutual Funds and ETFs – How to Buy

You can buy mutual funds directly from the fund management company.  You can also buy mutual funds and ETFs through a brokerage company.  If you buy them through a brokerage company, you will pay a small transaction fee but it is often easier to buy and sell the funds, if needed.  Holding these assets in a brokerage account also lets you see more of your investments in one place.

Mary’s Decision

Mary decides to invest in an S&P 500 index fund (a form of exchanged-traded fund that is intended to track S&P 500 returns fairly closely).  Since 1950, the total return on the S&P 500 corresponds to 8.9% compounded annually.  It is important to understand that the returns are very volatile from month-to-month and even year-to-year, so she might not earn as much as 8.9% return over any specific time period.[7]

Retirement Savings – What Type of Account?

As Mary thinks about her long-term savings, she not only wants to decide how to invest it, but also in what type of account to put it – a tax-sheltered retirement savings account or a taxable account she can access at any time[8].  In addition, she needs to think about how much she needs in total to retire and how much she will need to set aside each year.

Retirement Account Contribution Limits

In the US for 2018, she is allowed to contribute $18,500 ($24,500 after age 50) to a 401(k) plus $5,500 ($6,500 after age 50) to an Individual Retirement Account.  

In Canada, the 2018 maximum contribution to group and individual Registered Retirement Savings Plans (RRSPs) combined is the lesser of 18% of earned income or $26,230.  The 2018 maximum contribution to group and individual Tax-Free Savings Accounts (TFSAs) is $5,500.  If you didn’t make contributions up to the limit last year, you can carry over the unused portion to increase your maximum contribution for this year.

In Canada, there are no penalties for early withdrawal from a RRSP or TFSA as long as the withdrawal is not made in the year you make the contribution, so it is easy to take advantage of the tax savings.  If you make the withdrawal from an RRSP, you need to pay taxes on the withdrawal.  In the US, there is a 10% penalty for withdrawing money from a 401(k) or IRA before the year in which you turn 59.5. As such, the choice of putting your money in a 401(k) or IRA needs to consider the likelihood that you’ll want to spend your long-term savings before then.

Returns: Taxable Account vs. Roth IRA/TFSA

Mary has decided she won’t need the money for a long time.  She will decide how much to put in her retirement account and taxable accounts after she looks at her student loans.  Mary’s savings is considered after-tax money.  As such, she can put it in a Roth IRA or TFSA.  She will not pay taxes on the money when she withdraws it.  If she didn’t put the money in a Roth IRA or TFSA, she would have to pay income taxes on the investment returns.[9]  If she puts it in a Traditional IRA or RRSP, the amount of her contribution will reduce her taxable income but she will pay taxes on the money when she withdraws it. This graph compares how Mary’s money will grow[10]over the next 30 years if she invests it in a Roth IRA or TFSA as compared to a taxable account.  

Savings comparison, Roth vs Taxable savings

As you can see, $4,000 grows to just over $30,000 over 30 years in a taxable account and just over $50,000 in a Roth account assuming a constant 8.9% return and a 20% tax rate.

Key Points

The key takeaways from this case study are:

  • You may need to save for large purchases over several years.  The amount you need to set aside today as designated savings for those purchases depends on how much they will cost, when you need to buy them and how much of your future budget you can add to those savings.
  • Certificates of deposit are very low-risk investment instruments that can be used for designated savings.  
  • Treasuries with maturity dates that line up with your target purchase date can also be used for designated savings.  By holding bonds to maturity, you eliminate the market risk.
  • Mutual funds and ETFs require less research and more diversification than owning individual companies (unless you own positions in a very large number of companies).  These instruments are an easy way to get started with investing.

Your Next Steps

This post talks about Mary’s situation.  Here are some questions you can be asking yourself and things you can do to apply these concepts to your situation.

  1. Identify the large purchases you want to make.  These purchases can include a car, an extravagant vacation or a house, among other things.  For each purchase, estimate when you will want to spend the money and how much they will cost. 
  2. Determine how much of your savings you can set aside for these large purchases.  Look at your budget to make sure you can set aside enough money to cover the rest of the cost.  If you can’t, you’ll need to either make changes to your aspirations or your budget.  In my budgeting series starting in a few weeks, I’ll dedicate an entire post to what to do when your expenses are more than your income.  
  3. Decide whether to start a relationship with a brokerage firm.  Last week, I provided a list of questions to help you get started if you do.
  4. Look into options for your designated savings.
    • What are the returns offered by your bank or, if you have one, brokerage firm, on certificates of deposit with terms corresponding to when you need your designated savings? 
    • How do Treasury returns compare to certificates of deposit?
  5. Decide how much of your long-term savings you want to put into retirement accounts and how much will be left for other savings.  I put as much as I could into retirement accounts, but always made sure I had enough other savings for large purchases that I hadn’t identified in enough detail to include in designated savings.  If you want to retire before the year you turn 59.5, you’ll also want to keep enough long-term savings out of your retirement accounts to cover all of your expenses until that year. 
  6. Decide whether you want to start investing your long-term savings in mutual or exchange traded funds or in individual stocks.  If mutual or exchange traded funds, take a look at the list of questions above.

[1]https://www.schwab.com/public/schwab/investing/accounts_products/investment/bonds/certificates_of_deposit, November 17, 2018.

[2]www.treasury.gov, November 17, 2018.

[3]Some bonds have features that allow the issuer to re-pay the principal before the maturity date.  For this discussion, we will focus on bonds that do not give the issuer that option.  These bonds are referred to as “non-callable.”  Bonds that can be re-paid before the maturity date are referred to as callable bonds.

[4]For those of you interested in investing in individual equities, a guest blogger, Riley of Young and The Invested (www.youngandtheinvested.com), will write about how to get started with looking at individual companies right after the first of the year.

[5]Portfolio diversification is an important concept in investing.  I’ll have a few posts on this topic in the coming months.

[6]If you are interested in more information on selecting mutual funds, I found a nice article at https://www.kiplinger.com/article/investing/T041-C007-S001-my-9-rules-for-picking-mutual-funds.html

[7]This volatility is often referred to as the risk of a financial instrument and is another important concept in investing. Look for insights into the trade-off between risk and reward coming soon.

[8]I’ll cover retirement savings more in a future post.

[9]Income taxes on investments are somewhat complicated.  For the illustrations here, I’ll assume that Mary’s combined Federal and state tax rate applicable to investment returns is 20% and that all returns are taxable in the year she earns them.  There are some types of assets for which that isn’t the case, but identifying them is beyond the scope of this post.

[10]For illustration, this graph shows a constant 8.9% return.  Over long periods of time, the S&P 500 has returned very roughly 8.9% per year on average.  The returns vary widely from year-to-year, but for making long-term comparisons a constant annual return is informative even though it isn’t accurate. 

Investment Options in Retirement Savings Plans

All investment decisions are a trade-off between risk and reward. In this post, I’ll focus on how risk and reward affect your decision among the investment options in your employer-sponsored retirement plans.

If you look at returns over very long periods of time, well diversified, riskier investments tend to produce higher returns with lower risk. For most of these investments, “a very long period of time” is somewhere between 10 and 30 years. That doesn’t mean that the riskiest investments will always outperform the less risky investments in every 10 or 20 year period, but, if you look at enough of them, they generally will on average.

When I Take More Risk

Very briefly, three characteristics I use to help decide whether I want to lean towards a more or less risky investment are:

    • With only a small amount to invest, I will tend to be purchase less risky investments than if I have a larger amount because I have less of a cushion and I want to protect it.
    • When I know I will need the money very soon, I invest in less risky investments (or possibly keep it in a savings or checking account). With longer time periods, riskier investments have more time to recover if they have a large decline. If I need the money soon, I might not have enough money for my purchase if the values declined.
    • If I have almost as much money as I need for a purchase that isn’t going to be made for a while (for example when I had enough money saved for my children’s college education), I will purchase less risky investments as I don’t need a high rate of return to meet my objectives and also want to protect my savings.

     

  • If you aren’t comfortable with the concept of risk, I suggest looking at my post on that topic.

    Common Choices

    Commonly available investment options in employer-sponsored retirement plans are listed below. I have put them in an order that roughly corresponds to increasing risk.

    • Money market funds – Money market funds invest in what are considered short-term, liquid (easily sold) securities. They are similar to, but slightly riskier than, interest-bearing savings accounts.
    • Stable value funds – A stable value fund usually buys and sells highly-rated corporate or government bonds with short to intermediate times to maturity. The return on a stable value fund is the sum of the changes in the market value plus the coupon payments on the bonds held by the fund.   Because stable value funds tend to buy bonds with shorter times to maturity than typical bond mutual funds, they often have lower returns and be less risky.
    • Bond Mutual Funds – Bond mutual funds buy and sell bonds. The return on a bond mutual fund is the sum of the changes in the market value plus the coupon payments. Although they don’t track exactly, the market values of bonds tend to go down when interest rates go up and vice versa.
    • Large Cap Equity Mutual Funds – These funds buy and sell stocks in large companies, often defined as those with more than $10 billion of market capitalization (the total market value of all the stock it has issued).
    • Small Cap Equity Mutual Funds – These funds buy and sell stocks in smaller companies.
    • Foreign Equity Mutual Funds – These funds buy and sell stocks in foreign companies. Every foreign equity fund is allowed to define the countries in which it invests.   You’ll want to look to see in what countries your fund options invest to evaluate their level of risk.
    • Emerging Market Equity Mutual Funds – These funds buy and sell stocks in companies in countries that are considering emerging markets. Morocco, the Philippines, Brazil and South Africa are examples of currently emerging markets.
    • Retirement Date Funds – These fund managers buys bond mutual funds and equity mutual funds.  Each fund has a range of retirement dates associated with it.  The fund manager selects the allocation between bond funds and stock funds based on its evaluation of the amount of mix you should take given the length of time to retirement.  The key advantage of a retirement date fund is that you don’t have to make any decisions – the fund manager does it all.  The disadvantages of retirement date funds include the fact that they ignore your personal risk tolerance, they don’t consider other assets you may own outside the retirement date fund and some of them have fairly high fees, since the retirement date fund manager receives a fee on top of the fees charged by the mutual funds selected by the fund manager.

    Other Choices

    Some employers offer index funds which are variations on equity mutual funds. An index fund’s performance tracks as closely as possible to a major stock market index. The Dow Jones Industrial Average, the Standard & Poors (S&P) 500 or the Russell 2000 are examples of indices. The first two indices have risk and return characteristics somewhat similar to large cap equity mutual funds. The Russell 200 is more closely aligned with a medium or small cap equity mutual fund.

    Increasingly, employers are offering Target Retirement Date Funds as an option. The fund manager not only selects the individual securities that will be owned by the fund, but also chooses the mix between equities and bonds.   In theory, the number of years until the target retirement dates for that fund determines the mix of investments. For example, a fund with a target retirement date range of 2021 through 2025 might be invested more heavily in bonds than a fund with a target retirement date range of 2051 through 2055. People who are close to retirement are often more interested in protecting their investments (i.e., want less risk). On the other hand, people who don’t plan to retire for many years are often more willing to take on additional risk in exchange for higher returns. You can accomplish the same mix yourself using bond funds and equity funds, but some people prefer to let the fund manager make that decision.

    Some employers allow or require you to invest in company stock in their defined contribution plans. Many of these employers consider an investment in the company’s stock as an indication of loyalty. I view it as a very risky investment option. I discuss the benefits of diversification in this post. If your investment portfolio is diversified, it means that a decline in value of any one security will not adversely impact the total value of your portfolio too severely. If you purchase your employer’s stock, you are investing in a single company rather than investing in the larger number of companies owned by a mutual fund. In a really severe situation, you could lose your job and the stock value could drop significantly, leaving you with much smaller savings and no salary. As such, you take on much less risk if you select a mutual fund than company stock.

    How I Decided

    As I made my 401(k) investment selections, I thought about what other investments I had, if any, and used the 401(k) choices to fill in the gaps. That is, I used my 401(k) investment selections to increase my diversification. When I was young, I selected two or three funds that had US exposure to each of small and large cap equities. As I had more money both in and out of my 401(k), I still selected two or three funds, but invested in at least one fund with foreign or emerging market exposure to further diversify my holdings.

    Fine Print

    As a reminder, I am not qualified to give investment advice for your individual situation. Nonetheless, I can provide insights about the types of investment options I’ve seen in employer-sponsored retirement plans. I’ll describe the characteristics of most of these investment vehicles in more detail in later posts, but want to touch on them now as many of you will be making employee benefit elections before then.