It’s fairly easy to look around the world and recognize places where uncertainty reigns. Not wars or disasters, but political uncertainty, the kind that depresses investors.
Run away? Not really. Investing when news is bad can be a great strategy. Take Brazil, for instance. Its main stock market index is up 66% so far this year.
That’s much better than the S&P 500, up just a bit more than 8% so far this year.
Despite the largely positive glow of the Rio Summer Olympics, Brazil has real problems. They just ousted an elected president, albeit peacefully. Huge numbers of ordinary Brazilians feel they’ve been left behind as the country’s elite have prospered.
Brazil is a big oil driller, and the price of oil has tanked globally. The list goes on.
Yet here we are, watching their stocks zoom higher. So why doesn’t everyone just buy Brazilian stocks and let it go? Because the performance this year follows a whopping 41% decline last year.
How many long-term investors could take that kind of emotional ride year after year? Not many. Even if you diversify and buy a Brazilian stock index fund, there’s no guarantee that next year won’t be another cliff dive into oblivion.
Investing in stocks means you have to be able to handle the swings that can occur. Most American investors remember perfectly well the dread they felt in 2008 when the U.S. stock market crumbled to bits.
We’re back and setting new highs, but the climb out of that hole has been long and stressful.
The dilemma of investing remains the same, whether you’re talking foreign or domestic stocks. Most of the growth in your portfolio is going to come from stocks. The long-term data proves it.
Yet most of the volatility in your investments is going to come from stocks, too. When stock prices move up sharply, we rejoice. But then we brace for the downdraft that can follow.
Where investors get into trouble is market timing, attempting investing when news is bad and then getting out when news is good.
Zigging when they zag sounds great, the ultimate money-making strategy. And it can work from time to time. More often than not, though, investors pay a big price for trying.
Softening the blows
What’s the solution? Portfolio investing instead. Yes, buy Brazil, and Russia and China, too, but remember that the volatility of those places will be a challenge. Accept only as much of that risk as you can stand.
By maintaining a diversified portfolio, you can soften the emotional blows. But there’s another advantage, too.
Sticking to your portfolio will help you do more investing when news is bad. Rebalancing allows you to load up on stocks as they fall in price and sell off those gains when recoveries occur.
Nobody can predict what will happen next, nor should they even try. The cost of being wrong is far too high. Yet you can participate in those good times just by following a simple, well-conceived plan.
An asset or investment is underwater if the market value falls below what the owner paid for it.
The purpose of owning an investment is to earn income from it, sell it in the future at a higher price and perhaps both.
Yet investors who purchase an investment might find that others are unwilling to pay more for that investment later on. The underwater investment must be sold at a loss or held.
Being underwater on an investment is mostly a problem if you are forced by circumstances to sell it for less than you paid, say to raise cash or to pay taxes.
However, income generated by the investment, such as from dividends, interest or rent, is considered part of the investment’s total return. That income offsets the potential loss of a lower market price for the investment itself.
Most people know the term underwater from their experience with residential real estate. Nevertheless, any investment can be described as being underwater.
For instance, options traders use the term to explain the valuation of a contract they hold that would be worthless if it expired that day.
That doesn’t mean the contract is worthless, but it does affect the price. There is no guarantee that the contract will generate a profit before the expiration date arrives, so a potential buyer might be less interested in purchasing it.
A stock or mutual fund investment, meanwhile, would be considered underwater if the market price falls below the price paid.
Nevertheless, many stocks pay a cash dividend every quarter. Investors who buy dividend-paying stocks often take a falling price as a signal to buy more in order to lower the average price paid for a long-term, income-generating investment.
A home that’s underwater can be distressing if the difference is significant. Yet if the homeowner does not intend to move and the cost of the mortgage is not onerous, it usually is better to live in the home and wait for the housing market to recover.
The cost of renting a comparable home could be higher than the combined cost of the mortgage, interest and taxes, for instance. Unlike a renter, a homeowner builds equity in a house by paying the mortgage down steadily, irrespective of the current market value of the property.
For the securities investor, too, being underwater is not necessarily a signal to sell. It can be an opportunity increase a position in a good investment.
If a sale is warranted, however, there still could be a tax advantage. The IRS allows investors to balance losses and gains on their tax return, a practice known as tax-loss harvesting.
Average savings numbers can be misleading, to say the least. Consider this thought experiment. Five people are standing in a room and Bill Gates walks in.
Before, the average savings of those five people was likely well under $50,000. After, that group of five people is suddenly worth billions — on average. Gates, one of the wealthiest people in the world, throws the curve skyward.
Something similar happens in retirement research. On average, or mean as statisticians call it, the American family has set aside $95,776.
The other way of looking at things is median. If you line up 12 values in rank order — say numbers of cats owned by a dozen individuals — and pick the middle number, that’s the mean.
That middle person, the person who owns more cats than half the group and less than the other half, might own six, but also it might also be three or seven. It’s not the average but the middle number, however that breaks out.
Considered as a median, the retirement savings total collapses to $60,000. Where did more than $35,000 go?
The fact is, a lot of people have saved nothing or very little. Taken as a long string of dollar amounts per family, the median is a lot lower than the average. That $60,000 number, for instance, counts only families that have at least some retirement savings.
Let’s drop the other shoe. What about all families, regardless of how much they have saved. Then the average savings falls to a measly $5,000 per family.
That’s the number you often see in the media, by the way, blaring headlines that say “Half of all Americans have saved nothing!” or “Most people couldn’t pay for a medical emergency” and so on.
While that’s true, it’s also true that some people will inherit money. They have Social Security coming as well and in some cases a pension, which tends to go uncounted. Others, of course, are totally stuck.
But let’s focus on the first figure: $95,776. Does that mean if you have more you’re doing fine and if less you’re in trouble?
Far from it. First, consider your Social Security income in retirement. Now compare that income against your actual cost of living today.
If the numbers are far apart, time to focus on private savings. How much you need is a matter of closing the gap between Social Security and your actual cost of living.
Let’s assume that you have that $95,000 saved for retirement. If you have a cost of living of $50,000 a year and expect Social Security to generate about $20,000, then you have a clear $30,000 income hole to file.
At a 4% withdrawal rate, which experts deem sustainable over time, you will need $750,000 by retirement to make up the difference.
Now what matters most is time. If you are relatively young, $95,000 is a great start. You add just $5,000 a year invested at a market rate of return and you’ll get there in under 24 years.
If you are older, say just 10 years from retirement, you shouldn’t try to get a higher return. The risk of loss is too great.
Instead, save more and soon. A couple maxing out their 401(k)s at $18,000 a year and making the extra $5,000 a year in catch-up contributions each will make it in just under a decade.
The point is to find your real number and work backward from there. Don’t rely on misleading averages to set your personal retirement course.
The kiddie tax is a tax on investment income received by a minor child from an investment controlled by a parent.
A parent with a high tax rate on his or her investments might be tempted to transfer those investments into the names of children in a bid to lower the tax rate on that income. The kiddie tax is meant to discourage that idea.
The kiddie tax falls on unearned investment income received by children under 18 and full-time students between the ages of 19 and 23. The income must be above a specific dollar threshold and is adjusted by the child’s own earned income, say from a part-time job.
Investment income above the threshold is taxed at the parent’s highest marginal tax rate, often a higher rate than the parent would have otherwise paid.
Previously, the rule applied to only children under 14, thus the name “kiddie tax.”
The tax affects only people with significant investments in taxable accounts who might consider transferring that wealth to their minor children. Most people do not run afoul of the rule because they save money into tax-deferred retirement accounts instead.
However, there is nothing wrong with giving your kids money and investments while you are alive. In fact, the government allows you to make ample annual tax-free gifts to children.
Those gifts can be up to $14,000 to each child each year. The gifting is counted against the parents’ lifetime inheritance tax exemption of well over $5 million for each spouse, a number most taxpayers never come near in any case.
Usually, such gifts are made to adult children who then control those assets. You can give money to a minor child, too. Under the Uniform Gift to Minors Act the investments you transfer to a minor are put into a trust.
A trust is used because a child is unlikely to be in a position to make decisions about the money. Otherwise, it might appear that you are making a gift to avoid taxes on investments you intend to control.
Nevertheless, there are tax advantages to gifting to a minor, if you file correctly. Always consult a tax professional before making any decisions about making gifts.
We live in a world that’s predicated on taking action. You want a job, go knock on doors. You find someone attractive, express your interest.
No pain, no gain, as they say in the gym. But what if the biggest investment mistake you make is the one thing that works in all of your other endeavors in life?
What if taking action is the problem, not the solution?
There’s a lot of data to back up this idea. As John Bogle, the founder of the Vanguard Group, famously put it, “Don’t do something, just stand there!”
Bogle is talking about the remarkably high premium that gets attached to taking action on your investments when action is not warranted. Truth be told, that’s close to all the time.
The bulk of the gains you will experience in an investment portfolio will happen whether you do something or not. Stocks have a propensity to rise over time. Dividends are paid out quarterly and reinvested with no effort, if you set them up that way.
If you’re in a workplace retirement plan and use your 401(k) or 403(b) properly, that’s automatic, too. An amount of cash comes out of your check on a pre-tax basis. The company likely adds a matching amount.
And it gets invested into your portfolio with every pay period, all year. If you buy even dollar amounts, you get the advantage of dollar-cost averaging. When stocks dip you get more for your money, essentially.
Owning the cashflow and growth that comes from the stock market is exactly what Bogle means by “just stand there.” He absolutely detests trading and finds it a huge waste of time and money.
In part, that’s because of the costs of trading, which sap your total return over time. The other problem is the likelihood that you will guess wrong and end up buying at a higher price while selling at a lower price.
Three simple steps
Buy high, sell low. See what’s wrong with the picture?
The only actions you need to take for long-term investing are these three steps. They are easy and anyone can do them. If you can operate a computer and type some numbers, no need to watch CNBC or hit up your friends for stock ideas.
In fact, the less you do that, the better. Here are the three steps:
And that is it! If you can manage these three steps, you will get a better annualized return than 99% of your friend and better than 90% of those highly paid Wall Street traders taking fees out of your account.
Couldn’t be simpler or cheaper, so long as you just stand there.
Net asset value (NAV) is the total value of the investments owned by a mutual fund after subtracting costs, expressed in dollars per share.
Investment companies own dozens or hundreds of individual company stocks, bonds and other investments on behalf of their clients. The amounts and values of each holding in a given fund can vary daily.
Fund companies also have costs associated with doing business, such as salaries, bonuses and marketing, as well as fees they charge their clients for investment management.
Investors in mutual funds buy units or shares in the fund. Since the underlying investments in a fund can be numerous and complex, the value of a single share is calculated at the end of the trading day and published. That number is the fund’s net asset value.
Net asset value is most useful for understanding the current “fair value” of a mutual fund, minus costs and ignoring the unknowable value of a given fund manager’s investment skills.
Net asset value clears up two very complicated problems in valuing a mutual fund: How much in investments do they own, and how much do they spend on running the fund?
Mutual fund managers don’t normally want to share information on how much they own of specific investments. Divulging their chosen mix of stocks and bonds could put them at a disadvantage when trading and result in losses if the information gets out.
Funds also don’t share specific data on their cost of doing business. They are required to disclose fees, of course, but accurately applying fee ratios to an entire fund can be difficult for outside investors.
Assets and liabilities
Net asset value solves both problems. A single number capture assets and liabilities and gives investors a starting point for deciding whether to buy or sell a fund.
In practice, if you buy a fund during the trading day the price you will get will be the net asset value published at the end of that day, after trading hours.
However, if you invest in closed-end fund, it’s possible to buy the fund during the trading day as you would a stock, while the price fluctuates.
As a result, the price you pay for a closed-end fund could be higher or lower than the current net asset value of the fund. This suggests that you are paying a premium for — or getting a discount on — the fund’s investment assets and, presumably, on the skill of the fund’s managers.
If you ask a a high school student today what they want to do for a living, you’ll probably get a shrug and a smile. And that’s okay.
Career planning guesswork is like investing guesswork; they exist for the same reason. It’s amazing how quickly the economy changes, and how utterly unpredictable those changes can be.
Entire industries exist today that nobody saw coming, extremely technical jobs but also careers around marketing, managing and selling technical products and services.
We still buy cars, but we also lease them and share them, too. We still buy houses but now we install high-tech smart home systems and wire them for Internet. Today’s job titles are incomprehensible to people whose careers peaked 10 years ago. Consultant? Consultant in what?
The answer is consultant in whatever the next client needs done. Skills are deployed to a problem, then the worker moves on to the next challenge, often at a completely different firm.
For a young person just getting out of college, none of this is surprising. Coming into a field with no experience also means having no preconception of what’s “normal” for a new job. You go with the flow.
People find investing guesswork for the same reasons. The companies that make up the major stock market indexes change every few years, for sure, but that’s just the large-cap consumer brands most people know by name.
Consider how different the small-cap stock world can be year in and year out. Companies raise capital, make some noise in the press, launch a product and then, maybe nothing. Or maybe a world-changing idea happens.
Google used to be tiny; now it’s huge and spinning out new firms as a holding company called Alphabet. Apple grew, virtually fell apart, then restarted to great success. How many dozens of biotechs and web startups have come and gone during those years?
Avoid investing guesswork
You can’t know the future, either in your career or investing. But you can make some simple moves to insulate yourself from unexpected change. For a career, that’s retraining and building new skills.
For investing, it’s avoiding the guesswork and owning index funds instead. An index fund always holds the largest, most recognized companies, year in and year out.
Diversification is an important way to reduce investing risk, of course, but it doesn’t help to buy a load of companies that no longer lead in their sector or, worse, could be shut out of future growth opportunities.
Investing guesswork is reduced by indexing, since indexing allows you to buy everything but also be assured that you own all of the better companies, no matter what the economy throws at you in six months or six years.
Preferred stock is a type of investment that provides both income and the possibility of growth.
Most investors in companies buy common stock. Bondholders also are invested in a company’s future. A bond must be paid back with interest. That happens only if the company stays in business and prospers.
A third type of investment, preferred stock, provides an income stream like a bond and the growth potential of a common stock, plus additional advantages.
For instance, preferred stock is given priority when dividends are paid. If dividends are suspended, payments accumulate and get paid out first, before common stock dividends resume.
If a company goes under, preferred stock owners are given a higher claim on the company’s assets. They are behind bondholders but ahead of common stock investors.
Many large U.S. corporations are mature businesses. They generate steady earnings cash that is not easy to reinvest. Their markets are crowded or they face heavy regulation. Two examples are telecoms and utility companies.
Investors want growth or income from an investment. Small-cap firms can be counted on for growth. Large-cap companies, while more stable, tend to grow more slowly.
If a company is large and profitable, its bonds can be oversubscribed. High demand means the bonds pay a low rate of interest. Preferred stock thus allows the investor to enjoy a more attractive dividend payout while receiving some of the protections a bond investor would require.
Preferred stock has two important features to understand: convertibility and call provisions.
Convertibility means that a preferred stock holder can convert preferred stock shares into common stock. This can be good if the common stock price rises significantly over the years, since convertible shares are more likely to track along with the common stock price.
A call provision means that the company has the right to call back the stock after a given date. This could happen if interest rates fall and the company wants to reduce its cost of capital through refinancing.
Every industry has a catchphrase that explains it all. For the tech business, one of the better quotes you hear is that “software is magic.”
There’s a lot to unpack there, but serious investors should think of software as the ultimate high-efficiency tool. It really is magical to have the kind of investing power that once only elite investment funds employed.
Consider for a moment the simple index fund. It’s just a collection of investments, right? But under that is software that tracks hundreds, even thousands of investments, and keeps them weighted correctly for the fund’s goal, which is to accurately track an entire stock market index.
You could not do this any other way expect by using software. Just imagine the work involved in trading, clearing and rebalancing hundreds of stocks every day by yourself!
Now consider that the best retirement portfolio is one that has a multitude of investment types — stocks, bonds, foreign securities, real estate and others. Index funds not only keep each asset class on track but in combination they can be adjusted to your personal level of risk tolerance.
Now software is edging into what used to be an entirely human domain, measuring risk.
Risk comes in two very different flavors: market risk and behavioral risk. It’s pretty easy to manage market risk. If your investments must be liquidated in the short- to medium-term, your portfolio should own less stock and more income-producing investments and cash.
If your income needs are farther out, say 10 years or more, then stocks are the better choice, since that’s where you get inflation-beating growth. The price of that outcome is volatility, the up and down movement of stocks in any given time frame.
Thus we run into the second problem, which is behavioral risk. If you can manage to “turn off” the stock market in your mind and go about your day, this kind of risk disappears.
Most people can’t. They try to ignore their investments, but the media makes sure they pay attention, usually only after markets fall sharply. That sets off a cycle of engagement that grows more frantic until the emotional investor feels that immediate action is required.
Usually, taking action is a huge mistake. Selling at a low point means locking in permanent losses that cannot be recovered. You feel better because the bleeding has stopped, then stocks recover and you feel immediately worse.
Again, software saves the day. Running a portfolio with online software allows you to better understand how the ups and downs of the market are actually opportunities in disguise. Rebalancing your investments give you a chance to realize gains when they happen and reinvest them in a timely fashion.
Over the years, that simple, repetitive action is what makes a portfolio thrive and compound into a truly great retirement.
By eliminating the drudge work and removing the risk of emotional trades, software gives you peace of mind and power over the randomness of investing.
It’s magic that anyone can use to be a better investor and retire without worry.
A tax bracket is a range of personal income subject to a federal or state tax rate.
People often talk about their individual tax bracket, but the reality is a bit more nuanced. For instance, if you file taxes jointly, say as a married couple, your tax bracket is determined by your combined incomes.
Even more misunderstood is how the IRS applies taxes to your income. Congress sets ranges of income with specific tax rates and the IRS then applies those tax rates to each level.
Thus the first several thousand dollars you earn in a year is subject to a 10% tax rate, then the next big band is taxed at 15% and so on, up to the highest current tax rate. The higher rates apply only to dollars earned above the previous bracket.
The table below shows 2016 projected tax rates, according to the IRS:
So when people say “My tax bracket is 25%,” the reality is that a given rate applies to perhaps only the last few thousand dollars one earns in that year. Your “effective” tax rate is a mix of all of these income bands in a stack minus deductions, so the actual tax rate you pay will be lower.
The reason the IRS has a tax bracket for each income band is to assure that U.S. taxes are progressive, that is, that people are taxed according to their ability to pay.
A single tax rate on income or on a good or service is considered a regressive tax system. Taxes on gasoline, for instance, hit everyone at the same rate per gallon, regardless of ability to pay.
Figuring out your personal tax bracket can be difficult, yet the goal of the IRS is to ensure that everyone who is liable for federal taxes pays them and that the playing field is somewhat level.
There are, however, many ways to reduce your tax bill by lowering your taxable income, such as exemptions, deductions and tax credits.
Cut your income, cut your taxes
For instance, saving money into a tax-deferred individual retirement account (IRA) or 401(k) retirement plan at work will reduce your income in the year that you save. That kind of dollar-for-dollar decline in current income is very valuable because the money you save is subtracted from the top, where rates are higher.
For instance, if you have an income of $78,000 a year and put $18,000 into a 401(k), your taxable income is now $60,000 instead. After taking the personal exemption, deductions and tax credits, it might fall to $50,000.
This means that $28,000 of your income is not taxed this year, while the remaining income is taxed at a lower rate than your total annual income would at first suggest.
Similarly, using your income to fund a health savings account (HSA), pay mortgage interest or claiming a tax credit to pay for child care can lower your income year after year.
The goal of a tax preparer is to find every opportunity possible to reduce your taxable income and thus keep more of your earnings in the lower brackets, driving down your effective tax rate — what you actually pay in taxes.