Investing for Dividends

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

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

What are Dividends?

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

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

Dividend Diplomats – A Little Background

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

Why Use the Investing for Dividends Strategy

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

My Preconceived Notions

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

Lanny’s & Bert’s Motivation

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

“There were a few different motivating factors.

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

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

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

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

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

Lanny’s & Bert’s Strategy

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

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

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

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

Payout Ratio

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

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

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

Performance – Lanny and Bert’s View

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

Historical Performance

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

How I Measured Performance

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

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

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

November 2018 – November 2019

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

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

The chart below shows these comparisons.

2003 to 2013

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

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

Tax Ramifications of Dividends

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

Types of Accounts

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

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

Dividend Reinvestment

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

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

Illustration

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

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

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

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

Reading Financial Statements

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

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

McCormick

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

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

Income Statement

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

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

Revenue

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

Expenses

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

Depreciation

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

Operating Expenses or Cost of Goods Sold

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

General and Administrative (G&A) Expenses

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

Other Income/Expenses

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

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

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

Interest Expenses

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

Income Taxes

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

Accrual Basis vs. Cash Basis

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

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

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

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

Measures of Profit

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

Gross Margin

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

Operating Income

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

Pre-tax Income

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

Net Income

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

Other Comprehensive Income

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

Balance Sheet

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

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

Assets

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

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

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

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

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

Liabilities

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

Equity

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

Key Financial Ratios

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

ROE or Return on Equity

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

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

P/E Ratio or Price/Earnings Ratio

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

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

P/B Ratio or Price/Book Ratio

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

P/B Ratio > 1

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

P/B < 1

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

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

Debt-to-Equity Ratio

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

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

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

Tangible Equity/Total Equity

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

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

Earnings Growth Rate

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

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

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

Investing Decisions

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

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

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

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

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

What You Need to Know About Stocks

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

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

What are Stocks?

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

How Do Stocks Work?

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

Stockholder-Company Interactions

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

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

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

Why Companies Care About Their Stock Prices

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

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

What Price Will I Pay?

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

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

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

Dividends

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

Proceeds from the Sale of the Stock

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

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

What are the Risks?

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

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

Economic Conditions Change

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

Company Changes

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

Increased Risk

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

How Do People Decide What to Buy?

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

Reasonable Price Investing

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

Technical Analysis

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

High-Yield Investing

Some investors focus on companies who issue dividends.

Mutual Funds and Exchange-Traded Funds (ETFs)

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

How are Stocks Taxed?

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

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

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

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

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

When Should I Buy Stocks?

Understand Stocks

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

Understand the Companies or Funds

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

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

Be Willing and Able to Understand the Risks

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

Market Timing

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

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

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

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

How and Where Do I Buy Stocks?

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

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

Limit Orders

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

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

Market Orders

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

Transaction Fees

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

Tax-Efficient Investing Strategies – Canada

Tax-Effective-Investing-Canada

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

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

Types of Investment Returns

I will look at four different types of investments:

  • 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.

Investment Diversification Reduces Risk

Diversification-2

Investment diversification is an important tool that many investors used to reduce risk. Last week, I explained diversification and how it is related to correlation.   In this post, I’ll illustrate different ways you can use investment diversification and provide illustrations of its benefits.

Investment Diversification: Key Take-Aways

Here are some key take-aways about investment diversification.

  • Diversification reduces risk, but does not change the average return of a portfolio. The average return will always be the weighted average of the returns on the financial instruments in the portfolio, where the weights are the relative amounts of each instrument owned.
  • The smaller the correlation among financial instruments (all the way down to -100%), the greater the benefit of diversification. Check out last week’s post for more about this point.
  • Diversification can be accomplished by investing in more than one asset class, more than one company within an asset class or for long periods of time. One of the easiest ways to become diversified across companies is to purchase a mutual fund or exchange traded fund.  Funds that focus on one industry will be less diversified than funds that includes companies from more than one industry.
  • Diversification reduces risk, but doesn’t prevent losses. If all of the financial instruments in a portfolio go down in value, the total portfolio value will decrease.  Also, if one financial instrument loses a lot of value, the loss may more than offset any gains in other instruments in the portfolio.
  • A diversification strategy can be very risky if you purchase something without the necessary expertise to select it or without understanding all of the costs of ownership.

I’ll explain these points in more detail in the rest of the post.

Diversification and Returns

The purpose of diversification is to reduce riskIt has no impact on return.  The total return of any combination of financial instruments will always be the weighted average of the returns on the individual financial instruments, where the weights are the amounts of each instrument you own.  For example, if you own $3,000 of a financial instrument with a return of 5% and $7,000 of a different financial instrument with a return of 15%, your total return will be 12% (={$3,000 x 5% + $7,000 x 15%}/{$3,000+$7,000} = {$150 + $1,050}/$10,000 = $1,200/$10,000).  Similarly, two instruments that both return 10% will have a combined return of 10% regardless of how correlated they are, even -100% correlation.

Investment Diversification among Asset Classes

When investing, many people diversify their portfolios by investing in different asset classes. The most common of these approaches is to allocate part of their portfolio to stocks or equity mutual funds and part to bonds or bond mutual funds.

Correlation between Stocks and Bonds

Two very common asset classes for personal investment are bonds and stocks. Click here to learn more about bonds, including a comparison between stocks and bonds.  Click here to learn more about stocks.

 

The Theory

The prices of stocks and bonds sometimes move in the same direction and sometimes move in opposite directions.  In good economies, companies make a lot of money and interest rates are often low.  When companies make money, their stock prices tend to increase.  When interest rates are low, bond prices are high.[1]  So, in good economies, we often see stock and bond prices move in the same direction.

However, from 1977 through 1981, bond prices went down while stocks went up.  At the time, the economy was coming out of a recession (which means stock prices started out low and then rose), but inflation increased. When inflation increases, interest rates tend to also increase and bond prices go down. [2]

Correlation of S&P 500 and Interest Rates

Over the past 40 years, interest rates have generally decreased (meaning bond prices went up) and stock markets increased in more years than not, as shown in the graph below.

The blue line shows the amount of money you would have each year if you invested $100 in the S&P 500 in 1980.  The green line shows the interest rate on the 10-year US treasury note, with the scale being on the right side of the graph.  Because bond prices go up when interest rates go down, we anticipate that there will be positive correlation between stock and bond prices over this period. If we looked at a longer time period, the correlation would still be positive, but not quite as high because, as mentioned above, there were periods when bond prices went down and stock prices increased.

Historical Correlation of Stocks and Bonds

I will use annual returns on the S&P 500 and the Fidelity Investment Grade Bond Fund to illustrate the correlation between stocks and bonds.  The graph below is a scatter plot of the annual returns on these two financial instruments from 1980 through 2018.  The returns on the bond fund are shown on the x axis; the returns on the S&P 500, the y axis.  Over this time period, the correlation between the returns on these two financial instruments is 43%.  This correlation is close to the +50% correlation illustrated in one of the scatter plots in last week’s post.  Not surprisingly, this graph looks somewhat similar to the +50% correlation graph in that post.

Stock and Bond Returns and Volatility

Recall that diversification is the reduction of risk, in this case, by owning both stocks and bonds.  The table below sets the baseline from which I will measure the diversification benefit.  It summarizes the average returns and standard deviations of the annual returns on the S&P 500 (a measure of stock returns) and a bond fund (an approximation of bond returns) from 1980 to 2018.  The bond fund has a lower return and less volatility, as shown by the lower average and standard deviation, than the S&P 500.

Bond Fund S&P 500
Average 0.6% 0.8%
Standard Deviation 1.6% 4.3%

 

Diversification Benefit from Stocks and Bonds

The graph below is a box & whisker plot showing the volatility of each of these financial instruments separately (the boxes on the far left and far right) and portfolios containing different combinations of them.  (See my post on risk for an explanation of how to read this chart.)

In this graph, the boxes represent the 25th to the 75th percentiles.  The whiskers correspond to the 5th to 95th percentiles.  As the portfolios have increasing amounts of stocks, the total return and volatility increase.

Diversification Benefit from Stocks and Bonds – A Different Perspective

These results can also be shown on a scatter plot, as shown in the graph below.  In this case, the x or horizontal axis shows the average return for each portfolio.  The y or vertical axis shows the percentage of the time that the return was negative. (See my post on making financial decisions for an explanation of optimal choices.)

There are three pairs of portfolios that have the same percentage of years with a negative return, but the one with more stocks in each pair has a higher return.  For example, about 24% of the time the portfolios with 30% and 50% invested in bonds had negative returns.  The 30% bond portfolio returned 8.9% on average, whereas the 50% bond portfolio returned 8.5% on average.   Therefore, the portfolio with 30% bonds is preferred over the one with 50% bonds using these metrics because it has the same probability of a negative return but a higher average return.

How to Pick your Mix Between Stocks and Bonds

The choice of mix between stocks and bonds depends on how much return you need to earn to meet your financial goals and how much volatility you are willing to tolerate.  A goal of maximizing return without regard to risk is consistent with one of the portfolios with no bonds or only a very small percentage of them.  At the other extreme, a portfolio with a high percentage (possibly as much as 100%) of bonds is consistent with a goal of minimizing the chance of losing money in any one year.  The options in the middle are consistent with objectives that combine attaining a higher return and reducing risk.

Other Asset Classes

There are many other asset classes that can be used for investment diversification.  Some people prefer tangible assets, such as gold, real estate, mineral rights (including oil and gas) or fine art, while others use a wider variety of financial instruments, such as options or futures.  When considering tangible assets, it is important to consider not only the possible appreciation in value but also the costs of owning them which can significantly reduce your total return.  Examples of costs of ownership include storage for gold and maintenance, insurance and property taxes for real estate.  All of the alternate investments I’ve mentioned, other than gold, also require expertise to increase the likelihood of getting appreciation from your investment.  Not everyone can identify the next Picasso!

Investment Diversification across Companies within an Asset Class

One of the most common applications of diversification is to invest in more than one company’s stock. It is even better if the companies are spread across different industries.  The greatest benefit from diversification is gained by investing in companies with low or negative correlation.  Common factors often drive the stock price changes for companies within a single industry, so they tend to show fairly high positive correlation.

Diversification across industries is so important that Jim Cramer has a segment on his show, Mad Money, called “Am I Diversified?”  In it, callers tell him the five companies in which they own the most stock and he tells them whether they are diversified based on the industries in which the companies fall.

To illustrate the benefits of diversification across companies, I have chosen five companies that are part of the Dow Jones Industrial Average (an index commonly used to measure stock market performance composed of 30 very large companies). These companies and their industries are:

American Express (AXP) Financial Services
Apple (AAPL) Technology
Boeing (BA) Industrial
Disney (DIS) Consumer Discretionary
Home Depot (HD) Consumer Staples

 

Correlation Between Companies

The graph below shows the correlations in the annual prices changes across these companies.

The highest correlations are between American Express and each of Boeing and Disney (both between 50% and 55%).  The lowest correlation is between Apple and Boeing (about 10%).

The graph below shows a box & whisker plot of the annual returns of these companies’ stocks.

All of the companies have about a 25% chance (the bottom of the box) of having a negative return in one year.  That is, if you owned any one of these stocks for one calendar year between 1983 and 2018, you had a 25% chance that you would have lost money on your investment.

Adding Companies Reduces Risk

The graph below shows a box & whisker chart showing how your volatility and risk would have been reduced if you had owned just Apple and then added equal amounts of the other stocks successively until, in the far-right box, you owned all five stocks.

The distance between the tops and bottoms of the whiskers get smaller as each stock is added to the mix. If you had owned equal amounts of all five stocks for any one calendar year in this time period, you would have lost money in 19% of the years instead of 25%.  The 25th percentile (bottom of the box) increases from between -5% and 0% for each stock individually to +14% if you owned all five stocks.  That is, 75% of the time, your return would have been greater than +14% if you had owned all 5 stocks.

As always, I remind you that past returns are not necessarily indicative of future returns. I used these five companies’ stocks for illustration and do not intend to imply that I recommend buying them (or not).

Investment Diversification Doesn’t Prevent Losses

The above illustration makes investing look great!  Wouldn’t it be nice if 75% of the time you could earn a return of at least 14% just by purchasing five stocks in different industries?  That result was lucky on my part.  I looked at the list of companies in the Dow Jones Industrial Average and picked the first five in alphabetical order that I thought were well known and in different industries.  It turns out that, over the time period from 1983 through 2018, all of those stocks did very well.  Their average annual returns ranged from 19% (Disney) to 40% (Apple).  The Dow Jones Industrial Average, by comparison, had an average return of 10%.  That means that most of the other stocks in the Average had a much lower return.

Being diversified won’t prevent losses, but it reduces them when one company experiences significant financial trouble or goes bankrupt.  Here’s a recent example.

Pacific Gas and Electric

Pacific Gas and Electric (PG&E) is a California utility that conservative investors have bought for many, many years.  I’ve added it to the box & whisker plot of the companies above in the graph below.

PG&E’s average return (10%) is lower than the other five stocks and about equal to the Dow Jones Industrial Average.  Its volatility is similar to Boeing and Disney as shown by the height of its box and spread of it whiskers being similar to those of the other two stocks.

However, on the day I am writing this post, PG&E declared bankruptcy.  PG&E has been accused of starting a number of large wildfires in California as the result of allegedly poor maintenance of its power lines and insufficient trimming of trees near them.  Here is a plot of its daily stock price over the past 12 months.

In the year ending January 26, 2019, PG&E’s stock price decreased by 72%.  From its high in early November 2018 to its low in January 2019, it dropped by 87%.

How to Reduce the Impact of Another PG&E

Although diversification can’t completely protect you from such large losses, it can reduce their impact especially if you are invested in companies in different industries.   If the only company in which you owned stock was PG&E, you would have lost 72% of your savings in one year.  If, on the other hand, you had owned an equal amount of a  second stock that performed the same as the Dow Jones Industrial Average over the same time period (-6%), you would have lost 39%.  The graph below shows how much you would have lost for different numbers of other companies in your portfolio.

This graph shows how quickly the adverse impact of one stock can be offset by including other companies in a portfolio.  In a portfolio of five stocks (PG&E and four others that performed the same as the Dow), the 72% loss is reduced to about a 20% loss.  With 20 stocks, the loss is reduced to 10% (not much worse than the -6% for the Dow Jones Industrial Average).

Investment Diversification Over Time

Another way to benefit from diversification is to own financial instruments for a long time. In all of the examples above, I illustrated the risk of holding financial instruments for one year at a time. Many financial instruments have ups and downs, but tend to generally follow an upward trend.  The volatility and risk of the average annual return of these instruments will decrease the longer they are held.

20-Year Illustration

For illustration of the diversification benefit of time, I have used returns on the S&P 500. The graph below shows the volatility of the average annual return on the S&P 500 for various time periods ranging from one to twenty years.

To create the “20 Years” box and whiskers in this graph, I started by identifying all 20-year periods starting from 1950 through the one starting in 1997.  I calculated the average annual return for each 20-year period.  I then determined the percentiles needed to create this graph.  The values for the shorter time periods were calculated in the same manner.

The average return over all years is about 8.8%.  Because we are using data from 1950 to 2018 for all of these calculations, the average doesn’t change.

The benefits of long-term investing are clear from this graph.  There were no 20-year periods that had a negative return, whereas the one-year return was negative 25% of the time.

More Complicated Example

My post about whether Chris should pay off his mortgage provides a bit more complicated application of the same concepts. In that case, Chris puts money into the account for five years and then withdraws it for either the next five years or the next 21 years. The longer he invests, the more likely he is to be better off investing instead of paying off his mortgage.

A Caution about Individual Stocks

As a reminder, it is important to remember that this concept applies well to financial measures such as mutual funds, exchange-traded funds and indexes.  It also applies to the financial instruments of many companies, but not all.  If a company starts a downward trend, especially if it is on the way to bankruptcy, it will show a negative return no matter how long you own it.  If you choose to own stocks of individual companies, you will want to monitor their underlying financial performance (a topic for a future post) and news about them to minimize the chance that you continue to own them through a permanent downward trend.


[1]The price of a bond is the present value of the future interest and principal payments using the interest rate on the date the calculation is performed.  That is, each payment is divided by (1+today’s interest rate)(time until payment is made). Because the denominator gets bigger as the interest rate goes up, the present value of each payment goes down.    I’ll talk more about this in a future post on bonds.

[2]An explanation of the link between inflation and interest rates is quite complicated.  I’ll write about it at some point in the future.  For now, I’ll just observe that they tend to increase at the same time.

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.