by Neil Jesani
International - Funds that invest outside the U.S. come in three basic flavors. The first, international funds, typically buy stocks in larger companies from relatively stable regions like Europe and the Pacific Rim. Global funds do likewise, but they can also invest heavily in the United States. Emerging market funds invest in riskier regions, like Latin America, Eastern Europe and Asia.
As anyone knows, the stock market can be volatile. We will go into more detail concerning stocks in our next chapter. We will examine the history of the stock market return since the inception of the Dow Jones, S&P and NASDAQ indexes.
Bonds
A bond is a debt investment in which an investor loans money to an entity (typically corporate, or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Companies, municipalities, states and sovereign governments use bonds to raise money and finance a variety of projects and activities. Owners of bonds are debtholders, or creditors of the issuer.
When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing other debts, they may issue bonds directly to investors instead of obtaining loans from a bank. The issuer produces a bond that contractually states the interest rate that will be paid and the time at which the loaned funds must be returned.
Typically bonds are issued for 2 to 30 years’ maturity. The general movement in the interest rate causes the volatility in the price of the bonds.
Real Estate
Real estate is property comprised of land and the buildings on it as well as the natural resources of the land. Although the media often refers to the “real estate market” from the perspective of residential living, real estate can be grouped into three broad categories based on its use: residential, commercial and industrial. Examples of residential real estate include undeveloped land, houses, condominiums and townhomes. Commercial real estate consists of office buildings, warehouses and retail store buildings. Industrial real estate is typically factories, mines and farms.
For an investment or home purchase, real estate is the one investment that you can leverage to get more than what your money would normally buy. Say you wanted to buy a house worth $1,000,000. With good credit, you can obtain a mortgage for this building by putting $200,000 down and having a bank lend you the balance. If the property were to increase in value 10%, it would be worth $100,000 more than when you purchased it, giving you a 50% return on your $200,000 down payment (minus your interest payments and other related expenses).
Cash
Cash in its physical form is known as money. Cash usually includes bank accounts and marketable securities, such as government bonds and banker’s acceptances. Although cash typically refers to money in hand, the term can also be used to indicate money in banking accounts, checks or any other form of currency that is easily accessible and can be quickly turned into physical cash without losing any of the principle.
Commodities
A commodity is a basic good used in commerce that is interchangeable with other commodities of the same type. Commodities are most often used as inputs in the production of other goods or services. The quality of a given commodity may differ slightly, but it is essentially uniform across producers.
Some traditional examples of commodities include grains, gold, beef, oil and natural gas. More recently, the definition has expanded to include financial products such as foreign currencies and indexes. Technological advances have also led to new types of commodities being exchanged in the marketplace, such as cell phone minutes and bandwidth. The sale and purchase of commodities is usually carried out through futures contracts on exchanges that standardize the quantity and minimum quality of the commodity being traded.
Cash-Value Life Insurance
This is the type of life insurance policy that pays out upon the policyholder’s death, and also accumulates value during the policyholder’s lifetime. The policyholder can use the cash value or account value as a tax-sheltered investment (the interest and earnings on the policy are tax-deferred and can be taken out tax-free), as a fund from which to pay for retirement, fund college expenses, purchase a house or for any other purpose, or they can pass the benefits to their heirs. Whole life, variable life and universal life are all types of cash-value life insurance. Cash-value insurance is also known as permanent life insurance because it provides coverage for the policyholder’s entire life.
Comparison of Various Asset Classes:
Following is the comparison of six main asset classes by the average long term return, risk category, liquidity and tax-efficient yield:
Asset Class
Long Term Return
Risk
Liquidity
Taxable or Tax-free
Stocks
7%
Very High
Very Low
Taxable
Bonds
4%
Low
Medium
Taxable
Real Estate
6%
High
Very Low
Taxable
Cash
2%
No Risk
Very High
Taxable
Commodities
6%
Very High
Very Low
Taxable
Whole Life Insurance
4.5%
Low
Medium
Tax-free
S&P Index Universal Life Insurance
6.86%
Low
Medium
Tax-free
Asset Allocation by Ray Dalio
Ray Dalio is the founder of the world’s biggest hedge fund firm, Bridgewater Associates, which managed $160 billion in assets. He is the 79th richest man in the world as of January 2019, according to Bloomberg. He has been investing since he was 12 years old when he bought $300 of Northeast Airline stock. He tripled his investment when the airline merged with another company.
Ray is famous for his “All Weather Portfolio” investment philosophy and hedge fund, one of the largest hedge funds in the world. He refined this concept as a way to balance out the different pros and cons of each type of investment. This “All Weather Portfolio” has produced around 10% return with average loss of just under 2%, and the worst was just under 4%. He explains that you need 30% of your investment portfolio in stocks (for instance, the S&P 500 or other indexes for further diversification in this basket). Another necessary component is long-term government bonds. He suggests a breakdown of 15% in intermediate term bonds (7 to 10 years in maturity) and 40% in long-term bonds (20 to 25 in maturity). The stability of the bonds counters the volatility of the stocks.
He wants you to round out the portfolio with 7.5% in gold and 7.5% in commodities. As he says, “You need to have a piece of that portfolio that will do well with accelerated inflation so you would want a percentage in gold and commodities. These have high volatility because there are environments where rapid inflation can hurt both stocks and bonds.”
Lastly, you have to actively keep balancing the portfolio. This means that when one segment does well, you must sell a portion of it and reallocate its proceeds back to the original allocation. This should be done at least annually and if done properly can actually increase the tax efficiency of the investments.
While I agree wholeheartedly with Mr. Dalio’s philosophy and asset allocation, my only enhancement would be to use general account-based cash value life insurance as an alternative to long-term bond allocation. It creates tax-efficiency, while adding death benefits into the equation. As we will see, there are significant tax savings and other aspects of life insurance that can round out a solid investment plan.
Second Factor Affecting Return: Taxation of Investments
Understanding taxation of your investments is crucial to maximizing returns. Due to the complexities of both investing and U.S. tax laws, many investors don’t understand how to manage thei
r portfolio to minimize their tax burden. We’ll talk further about this in the twelfth chapter, but here we are simply discussing the tax efficiency during the accumulation phase of your money.
Tax efficiency is a measure of how much of an investment’s return is left over after taxes. The more that an investment relies on investment income rather than a change in its price to generate a return, the less tax-efficient it is to the investor. Different asset classes like stocks and bonds are taxed differently in the United States and often play much different roles in the investor’s portfolio. Historically, investors purchased bonds to provide an income stream for their portfolios, and bonds have generally enjoyed lower volatility or risk than stocks. The interest income from most bonds is taxable (municipal bonds which are a tax-efficient vehicle at the Federal tax level are an exception) and, therefore, are tax-inefficient to the investor in a higher tax bracket. Stocks are often purchased to provide a portfolio with growth or gains in their capital, as well as a current income stream from dividends.
Tax-efficiency is within reach of most investors. If you want to keep more of your investment earnings and stay out of a higher tax bracket, choose investments that offer the lowest tax burdens relative to their interest income or dividend income. You may also want to consider your opportunities for investing tax-free. Cash Value Life Insurance and Annuities enjoy special tax advantages and should be part of your investment portfolio. Given the market’s persistent volatility, your decisions regarding tax-efficient investing may spell the difference between reaching your financial goals and falling short.
Third Factor Affecting Return: Expenses of Investments
This is a complex topic. There are fees in any type of investment. Some methods are very clear-cut in their fees. For instance, if you are buying property, many of the fees are laid out for you. Now if you are obtaining a mortgage, some of the bank fees are spelled out and some are part of the interest you pay back to the bank. The same thing is true on something simple like a CD. The bank is certainly charging you, but it is hidden by the interest that they are not paying you.
In just about every type of investment mentioned in this chapter, there are various charges that are either spelled out or hidden. Sometimes you pay them upfront and in other instances, they come off the earnings. There could be an annual fee. In fact, there seems to be as many types of fees as there are investments, so look over your paperwork carefully, or have an expert nearby who can help.
These are questions you need to ask if you are about to put your money into something. Some of the fees can get quite expensive and have a bearing on what you actually make on that investment. Say you put $10,000 into a stock fund and your first year return was 8% ($800). If that particular fund had various fees associated with it that added up to $200, then you only end up with $600. If you are in the 37% tax bracket, there goes another $222. You are now down to a $378 net return. (By the way, if anyone is showing you what an investment earns, they rarely, if ever, factor in the expenses and the taxes.)
We will get into a bit more of the specific taxes and expenses for the various investment categories, but that is something that you need to closely monitor. An investment might look good on paper, but your earnings could be eroded before you even get to spend them.
As we start talking about the specifics of each investment, please keep in mind everything we have already covered. Having that perspective will help you see how each one fits into the big picture. Since you want to be invested in each category to some degree, it is good to be familiar with their highlights.
You probably realize at this point that investing your money is not as easy as picking a bank or a stock or a mutual fund. You might have thought that once you did that, you only needed to give it a quick review every now and then. The people that think like that are the ones who have paid the government more in taxes than they should have and did not have, quite as big of a nest egg at retirement as they could have.
Summary
As you begin to put a strategy together, remember these key points:
1. Don’t lump your money into ONE basket,
2. Pick the right asset classes for you,
3. Regularly rebalance the portfolio,
4. Choose indexed funds for your stock, gold and commodities allocation,
5. Choose investment grade government and municipal bonds, cash rich whole life/fixed annuity for your fixed income allocation.
Your investment portfolio is not meant to be stagnant. Just as you keep up on the latest innovations for whatever business you are in, you need to do the same with your money. You don’t need to be an expert; you can hire professional help. However, you should know what your money is doing, and be aware of new methods or plans that can complement your portfolio.
CHAPTER 6
Know the Real Return on Stocks
“Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.”
Warren Buffett
I
n the previous chapter, you saw an overview of stocks. In its simplest form, a stock represents ownership in a company. The more shares you own, the greater your equity in that particular business. You can make money on a stock based on its appreciation and the amount of a dividend the stock pays out to its holder. Conversely, there may be no dividends and a stock can drop in value below what you paid for it.
The concept of stock ownership goes back to the Roman Empire. Just as the government does now, the Romans contracted their services out to private companies. Somebody had to make the swords and shields! These government contractors were similar to modern corporations in a couple of aspects. They issued shares called partes for large investors and particulae, which were small shares that acted like today’s over-the-counter shares. Apparently, the Romans experienced the same highs and lows that today’s stock market experiences. The Roman orator Cicero even spoke about “shares that had a very high price at that time.”
Over the centuries, this concept went through evolution and refinement, which still goes on today. In fact, we will see how some relatively new tweaks to the stock market turned it into the behemoth we have now.
As shown earlier, there are different types of stocks. This might be one of the more complicated investments we have. Without clear guidance or putting the time in to learn about stocks, it is easy to make a wrong decision. Very often, you might think you are looking at two stocks that seem similar, but you are actually comparing apples and oranges. In general, remember that shares represent a fraction of ownership in a business. A business may declare different types (or classes) of shares, each having distinctive ownership rules, privileges, or share values. Ownership of shares may be documented by issuance of a stock certificate. A stock certificate is a legal document that specifies the amount of shares owned by the shareholder, and other details of the shares.
Stock typically takes the form of shares that are either common stock or preferred stock. Common stock typically carries voting rights exercised in corporate decisions. Preferred stock does not carry such voting rights, but the holder is legally entitled to receive a certain level of dividend payments before any dividends can be issued to other shareholders. “Convertible preferred stock” is preferred stock that includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually any time after a predetermined date.
That is the basic framework of stocks. You can purchase stocks as individual shares in a particular company, or you can buy shares in a fund. A stock fund consists of a number of individual stocks. The concept behind them is that you are spreading your money out over a variety of companies, so that no one poorly performing stock can flush all of your money down the drain. It is another example of “not putting all of your eggs in one basket.” Any dividends or money made by selling stocks in the fund goes back into the fund and is used to pay shareholders of the fund. Of course, if the fund experiences an overall loss,
the shareholders share in that too.
Many times, these funds have a theme. A “tech fund” specializes in technology stocks. You can have a fund investing in stocks that are more conservative, while a “rapid growth” fund goes after something a little more speculative. You can have funds that are full of purely domestic stocks and international funds that invest overseas. Like almost everything having to do with stocks, you have to look carefully at the makeup of a fund you are thinking about investing in.
The appeal of the stock market is that it is the major financial investment talked about the most. The media uses it as a barometer of how the economy is doing. Investment advisors tout its overall growth and sustainability as a place to put your money. When compared to what banks offer in interest these days, it seems like a no brainer to jump into the stock market where “real money” can be made.
To help explain some of the stock market’s history, it is good to have impartial statistics. MeasuringWorth.com is a nonprofit with two missions. The first is to make available to the public the highest quality and most reliable historical data on important economic aggregates, with particular emphasis on nominal (current-price) measures, as well as real (constant-price) measures. The second is to provide carefully designed contrasts (using these data) that explain the many issues involved in making value comparisons over time. The advisors of MeasuringWorth.com represent some of the finest universities of the United States and Great Britain, such as Harvard, Stanford, Oxford, Northwestern, etc. The nonprofit is not connected to any institution and as their website describes, it “strives to give arbitrary service for calculating relative worth over time.”
First, we are going to look at historical market data from them. The annual growth rate of the “Dow Jones Industrial Average” (DJIA) between its inception on February 16, 1885 and February 28, 2019, is 5.14%. The growth rate of the “S&P 500” since its inception on March 4, 1957 to February 28, 2019, is 6.92%. The growth rate of the “NASDAQ” since its inception on February 5, 1971 until February 28, 2019 is 9.42%.
