Investing 101: August 2020

Taxable Brokerage Accounts 

Paul R. Ruedi, CFP® 

In our past four columns we covered tax-advantaged accounts such as 401(k)’s and IRA’s, but perhaps the most available and widely used type of investment account is the typical “taxable” brokerage account.  The purpose of a brokerage account is to hold investments, in the same way a bank account holds dollars.  They can hold stocks, bonds, mutual funds, ETFs, and some can be approved for even more exotic investment vehicles, like options.  Anyone can open one - they don’t need to be sponsored by an employer or government institution.   

Brokerage accounts are often referred to as “taxable” accounts because they receive no special tax treatment.  Any time an investment is sold for a gain, taxes are owed on that gain in that year.  It is the same with taxable dividends and interest – any income earned in a taxable account will be subject to taxes in the year it was earned.   

That does not necessarily mean a taxable brokerage account is a bad place to hold investments. In many ways it is more flexible than accounts that receive special tax treatment because you can withdraw money without penalty at any time, compared to tax-advantaged accounts like 401(k)’s and IRA’s that a person generally must wait until age 59.5 to withdraw from.  For this reason, taxable brokerage accounts may be a useful account for those planning to retire before they can withdraw from their tax-advantaged accounts. 

There are no income limitations for contributing to a taxable brokerage account, and no limit to how much you can contribute in any given year.  A wealthy person who would be phased out of making contributions to a Roth or has more savings than the maximum 401(k) contribution could find a brokerage account to be a very useful savings tool for those extra dollars. 

Many large brokerage firms like Charles Schwab, Fidelity, and Vanguard allow you to open an account online with no fee involved and you generally don’t need a ton of money to do so.  Once your account is open you can then put money in the account, perhaps transferring from a checking or savings account.  Once the money is in the account, it can be invested in stocks, bonds, or whatever the investor chooses.  Investments can be sold at any time, and the funds can usually be withdrawn in as little as 3 days after an investment is sold.  It is important to remember to account for the taxes that will be owed on the gains when something is sold, and perhaps set aside the amount of taxes owed in cash. 

 

What is a REIT?

By David Ruedi, CFP®

Real Estate Investment Trusts or "REITs" for short are companies that own real estate. Like mutual funds, REITs pool money from many investors and use it to invest in a portfolio of real estate investments. They can be an excellent option for investors who want diversified exposure to many real estate investments but don't have real estate expertise or time to manage properties.

There are many types of REITs. Some may own specific types of properties, like apartment buildings, retail real estate, office buildings, warehouses, or hotels. Some may be more diversified and hold a combination of different types of real estate.

Many REITs are regulated by the Securities Exchange Commission (SEC) and trade publicly on major exchanges and can be bought and sold similar to stocks. These REITs, called "publicly-traded REITs," are the most liquid, a fancy way of saying it is easy to pull your money out. There are also what are called "public non-traded REITs" that must register with the SEC but aren't traded on national exchanges. As such, they are less liquid, and should generally be approached with extreme caution.

The benefit of adding real estate to your investment portfolio stems from the fact that it's not perfectly correlated to the stock market. In layman's terms, sometimes stocks zig while real estate zags, which can smooth out the fluctuation of your overall portfolio. Many index funds, particularly "total market" index funds, already include REITs. If the funds you invest in already contain REITs, you don't necessarily need to buy a separate REIT fund unless you want extra exposure to real estate.

One downside of REITs is that they have to be structured to pay out at least 90% of the taxable income they create to shareholders each year. That means they pay out a lot of taxable income taxed at ordinary income tax rates to investors each year. For this reason, REITs are best held in a retirement account such as an IRA, Roth IRA, or 401(k) if possible, since investors don't owe taxes on the income they receive from their investments each year within these types of accounts.

My recommendation for people looking to purchase REITs mirrors my advice for mutual funds: keep costs low, and make sure it is adequately diversified with a large number of properties and different types of properties. I generally recommend REIT index funds because they provide diversified exposure to a large number of REITS and have meager costs. If you aren't sure if REITs are an excellent addition to your portfolio, you may want to talk to a financial advisor.

 

Emergency Funds

Ryan Repko, CFP®

When people ask me how they should invest the first few thousand dollars they have saved up, I generally have to give some not-so-fun advice: you should set it aside in cash as an emergency fund. Though setting aside cash is seemingly less fun than growing your wealth in the stock market, it is an essential step in building a financial foundation that cannot be skipped over. People are generally more motivated to invest, or pay off debt faster, but it simply doesn’t make sense to take on either of these goals until an emergency fund is built, because an unexpected expense could have you selling your investments (possibly at a loss) or letting debt stack up.

In my studies for the CERTIFIED FINANCIAL PLANNER™ exam, the CFP Board emphasized the importance of setting aside an emergency fund with 3-6 months of non-discretionary expenses. Non-discretionary expenses are those expenses which you could not eliminate. Typical examples include food, housing costs such as rent or a mortgage, car payments, student debt, bills such as electric, gas, water, and your phone bill. By contrast, discretionary expenses are those you could forego in the event of a financial emergency. Examples include eating out at restaurants, your favorite drink at Starbucks, non-essential clothing purchases, and entertainment expenses.

Though the textbook recommendation is to have 3-6 months of non-discretionary expenses set aside in cash, the amount a person will need will vary based on their expenses, level of responsibility for others, and ability to find replacement work. A single adult with no debt, who has a job that could easily be replaced if lost, may only need three months of nondiscretionary expenses in cash. By contrast, a primary breadwinner for a family of four, that works in a specialized role and is responsible for car payments and a mortgage, could justify holding more than 6 months of expenses in cash.

An emergency fund should be invested in the safest way possible, which is likely a savings account at a reputable bank. Your emergency fund should never be invested in the stock market, nor should it be in bonds, due to the fact that these types of investments fluctuate in value, and there is a substantial risk of loss. If you simply cannot stomach placing your money in a bank account, then the only suitable alternative for investing your emergency fund would be through a reputable money market fund. If you need help identifying how much money you should have saved up in an emergency fund, seek out the help of an impartial financial advisor.

 

Chasing Performance Often Ends Poorly 

Paul R. Ruedi, CFP® 

Globally diversified investing can be challenging for many reasons.  By spreading your money around to many different types of stocks, you inevitably “miss out” on returns relative to investing in whatever the best performing group of stocks happened to be at that time.  When it is a lesser-known group of stocks like those in emerging markets or small companies outperforming, people don’t tend to notice.  But when seemingly “obvious” investment choices, like the large U.S. company stocks in the S&P 500 or large tech stocks in the Nasdaq shoot the lights out relative to a globally diversified stock portfolio, watch out.  It can be very tempting for investors to abandon disciplined diversification for what has worked over the past few years, and often at the very worst time to do so. 

Though history doesn’t always exactly repeat itself, it often rhymes.  So I think it is helpful to think back to the 1990s when this same situation happened.  Leading up to what we now refer to as the “tech bubble” or “dot-com bubble” the S&P 500 and particularly the tech stocks in Nasdaq experienced a huge rally.  From 1995 to its peak in March 2000, the Nasdaq index quintupled in value.  Investors piled in, chasing the performance of the hottest stocks of the day.  The Nasdaq proceeded to fall 78% over the next two years, giving up all of the gains of the prior 5 years. 

The S&P 500 followed the strong returns of the late 90s with a poor performance streak that stretched an entire decade!  The S&P 500 fell 49% between the beginning of the year 2000 and the end of 2002 as the tech bubble burst.  This was a rough start to a period that was so bad for the S&P 500 it would also receive its own name: “the lost decade.” Over the entire decade that spanned 2000-2009, the value of $100,000 invested in an S&P 500 index fund would have declined in value to approximately $90,000. For comparison, that same $100,000 invested in the Vanguard Global Index Fund would have had an ending balance of approximately $170,000.  Of course, as we must always mention, past performance is not an indicator of future results. 

Moral of the story, performance differences like this are common and cyclical.  Investors who are tempted to abandon a globally-diversified stock portfolio for the recently better-performing S&P 500 or Nasdaq Index should consider the experience of investors who did that at the end of the 90s as a cautionary tale. 

 

Can I Pick the Best Stocks?

Paul R. Ruedi, CFP®

When I tell people I am a financial advisor, the most common reactions I get are questions about which stocks to invest in, or stories about the best stock picks the person I am talking to ever made. When household name companies like Amazon and Apple have such strong performance, it can make stock picking look deceptively easy.

The performance of the broad stock market is always driven by a handful of star performers. Naturally, there is a huge temptation for investors to try to only buy those best companies. I always hate to break this news, but you likely can’t pick the best performing stocks beyond just random luck. If it is any consolation, the professionals can’t either.

The reason it is so hard to pick stocks and outguess the market is because the market does such a good job of incorporating all available information people could possibly use to make investment decisions. Millions of investors pour through all the available information about companies and make buying and selling decisions based on that information. Because of this, the stock market incorporates any and all information into stock prices more or less instantly. If information comes out that would positively impact a stock’s price, prices immediately rise to reflect that. If bad news comes out, prices will immediately fall.

By the time you have heard about something, the information you are acting on has already been incorporated into market prices. This is why it is so hard to “beat the market” by picking the best stocks. Even the professionals have a very hard time doing so.

According to research from Dimensional Fund Advisors, over the twenty-year period that ended December 21, 2019 only 22% of actively managed equity (stock) mutual funds beat their benchmark. That means 78%, a huge majority of actively managed mutual funds, actually squandered value with their stock picking activities. Of the funds that existed at the beginning of the 20-year period studied, 59% did such a bad job they were shut down, and no longer existed by the end of the study.

The only way to ensure you own the best performing stocks that drive the performance of the stock market is through a constant commitment to broad diversification. By owning everything all the time, you will inevitably own whichever stocks are on a hot streak at that particular time. If you are thinking about investing a material portion of your wealth in just a few stocks based on information everyone already knows, you should probably think twice.