Basic Principles of Investing

The text below is provided for informational purposes only. It is not investment advice; you must do your own due diligence before making any investments. By reading beyond this point, you agree to hold the owner of this website harmless for your investment decisions.

Top-line Thoughts
 ●  Pick a diversified asset allocation (not just stocks vs. bonds, but subcategories of these).
 ●  Use asset allocation to rebalance periodically (a form of “buy low, sell high”)
 ●  Use dollar cost averaging to make regular investments, when possible
 ●  Invest for the long-term; do not try to time the market
 ●  Use low-cost funds (e.g. index funds)
 ●  Consider tax implications, particularly when you get older

Asset Allocation
Diversification in your investments is important for reducing risk.  Putting all your eggs in one basket is inherently risky.  Asset allocation refers to dividing your money into different investment types.  It does not mean just dividing your money between a number of different stocks.  Doing so still means you are 100% invested in the US stock market, and in any case, you can get that type of diversification in stocks by buying a broad-based mutual fund (like a large-cap index fund).  You want to divide your money into different sectors.

The types of stocks or funds to consider include large-cap, mid-cap, small-cap, foreign, emerging markets, etc.; real estate (real estate investment trusts, known as REITs), bonds (corporate bonds, “junk” bonds, municipal bonds, core bond funds, and treasury bills), precious metals, and commodities.  Within the category of stocks are sectors (e.g., technology, financial, health, manufacturing, consumer products; etc.  Some categories or sectors will do well when others are not, so having a good mix among these sectors will reduce overall risk and help your money to grow.

Most advice I’ve read says that asset allocation is more important that exactly which investments you choose within each sector.

Target Percent to Invest in Stocks vs. Bonds
Stocks are riskier than bonds.  They tend to fluctuate more on a day-to-day basis and are hit harder when the economy takes a downturn (like in a recession) or when investor mood sours on the long-term or short-term direction of the economy.  On the other hand, stocks will produce higher returns over the long run.  So, having a mix of stocks and bonds is a good strategy to get high long-term returns yet preserve your investments.

The right mix depends on your risk tolerance.  If you are conservative/risk adverse, then you want more bonds than stocks (maybe 25% stocks, 75% bonds) because capital preservation may be more important to you than the rate of return.  If you are willing to tolerate some risk to get higher long-term returns, then a higher percentage of your investments should be in stocks.  If you are aggressive, then you may want a high percentage of stocks and not much in bonds.

Your future earning potential relative to the amount you are investing is an important factor as well because it is related to your ability to recover from a drop in the market.  If you are young, then you can afford to take more risks because most of your best earning years are ahead of you.  As you get closer to retirement age, you may want to take fewer risks because you will not have very many years left to recover from a setback. 

The amount to invest in stocks vs. bonds is a personal assessment that depends on a lot of factors.  Generally, you want to avoid having to sell your stock investments under duress when there is a downturn in the market, say during a recession which may last 2-3 years before stocks recover.  If you are working, saving for retirement through your employer’s 401K plan, and have some savings for emergencies, then you are less likely to have to sell under duress and may be willing to risk a higher percentage in stocks. If you are retired and have no sources of income beyond social security and income from your investments, you probably want to be more conservative.

The rule of thumb for the mix of stocks and bonds used to be to subtract your age from 100 to determine the percent of your investments that should be in stocks.  Because people are living longer, many financial advisors are recommending that you use 110 or even as high as 125 as the amount from which to subtract your age.  For example, if you are 40 years old and use 110 for subtraction, you would put 70% of your investment money in stocks and the rest in bonds or held in cash.  If you want to be more aggressive, then you can subtract from 125 and put 85% in stocks and the rest in bonds or cash.

These types of rules of thumb are based on the idea years that the older you are, the fewer years you have ahead of you to recover from a market downturn.  It may apply to many people, but may not apply to you. You have to consider your personal situation and it is up to you to decide on a reasonable mix of stocks and bonds.

Once you have decided on an asset allocation strategy and invested your money accordingly, you should look at how your money is actually invested every 6 months or so.  The reason is that, as expected, some of your investments will do better than others over this time interval, and your portfolio may no longer be allocated in your intended proportions.  If so, then it is a good idea to “re-balance” by selling some assets and buying others to get back to your intended allocation ratios.  The advantage of doing this, aside from keeping your risk profile the way you want it, is that you are selling assets that have increased in value and buying others that have risen less or even dropped in value.  Hence, this is a sell-high, buy-low strategy that can really help if you do it regularly.

Your 401K or 403b program may have built-in re-balancing features.  You specify a target asset allocation and a frequency for rebalancing and it will do it automatically.  There are some fees you may incur in re-balancing, but they tend to be small.  The reason is that some funds offered in your retirement program may charge a fee if you sell shares that were held for a short time (usually, less than a month).  Because you will be rebalancing every 6 months, and your investments will grow over time, only a small part of your overall shares will be subject to fees, and the cost is small relative to the benefits of rebalancing.

Dollar Cost Averaging
Dollar cost averaging is a technique that is useful when you plan to make periodic investments, such as to a 401K or 403b (tax-deferred) retirement account or into an investment account.  The idea is to invest the same amount per month (whether you contribute weekly, bi-weekly, or monthly, the idea is the same).  For example, suppose you invest $200 monthly into a mutual fund that is worth $25 per share.  You will buy 8 shares each time if the price stays the same.  If the fund increases in value to $40 per share, then you are only buying 5 shares per month.  If it drops to $20 per share, then you will be buying 10 shares per month.  With this strategy, you buy fewer high-priced shares and more low-priced shares over a long period of time, which reduces the average cost per share that you pay.

Value Cost Averaging
Value cost averaging also uses periodic investments, but focuses on the growth rate of the money invested.  For example, suppose you have $2000 in your investment account and you want it to increase by $200 per month.  If the value goes up to $2050 over the first month, then you add $150 the next month to reach the target of $2200.  If the value drops to $1950, then you would need to add $250 to reach your target of $2200.

Value cost averaging may produce better returns in the long run compared with dollar cost averaging, but depends on your ability to make the required contribution when the value of your account falls in relation to your target amount.

Rates of Return
Looking over many years, stocks have returned close to 7% annual returns after adjusting for inflation and dividends.  The “Rule of 72” is a good guide to how many years it will take to double your money.   Divide your annual rate of return as a percentage into 72 and that is the number of years it will take, on average, to double your money relative to inflation.  So, stocks should double in value in a little over 10 years (72 / 7).  Note that this calculation applies to the long-term and results can vary a lot over shorter periods.  Still, if you are investing for the long-term, it is good to keep in mind.

Stock prices tend to be driven by earnings.  Stocks that have a record of revenue/sales growth and earnings growth, and/or have a record of annual increases in dividend payouts, should do well.  Right now, the average price-to-earnings ratio (P/E ratio, a general measure of how highly valued a stock is) for the S&P 500 is around 25.  Higher P/E ratios indicate that a stock may be overvalued and lower values suggest the stock may be undervalued.  The current average P/E is high relative to historical averages (16 is the average since 1900), and some people are suggesting this is a warning sign that stocks are overvalued and a downturn could be on the horizon.  I would continue to watch that ratio, but also consider that bonds are at historic lows and most people are going to stay in the stock market to get some form of decent return.  A good alternative may be to consider a higher percentage in international stocks, which on average may have a lower P/E ratio (some are very low – Russia and China are a little over 7; some are even higher than the US – e.g., UK and Italy).

Bond rates are low right now, so it is hard to get much return on them.  Getting around 2-4% is what you can expect, depending on the types of bonds (see below). 

We have had a long bull market in stocks (almost 10 years), but that could change and we could have a sell-off and reduction in stock values at some point.  Short-term fluctuations always occur and, for the most part, I would advise ignoring them and focusing on the long-term.  The stock market tends to move in spurts and if you get nervous about the market and you “go to cash” to be conservative, you may miss a big upward leg. Generally, The Bear recommends that you stick with your asset allocation unless there are fairly clear signs that the economy is heading into a recession.  Having some cash, though, is not a bad idea so that, if the market does decline significantly, you have money on hand to “buy low”.

Stocks tend to do better (increase in value) when interest rates are low because bonds and other safe investments offer low rates of return.  Right now, interest rates are low and the economy is growing, so stocks should do well in the near term.  I’ll talk more about bond investments later, but generally speaking, bond prices tend to decline as interest rates rise.  It sounds a bit paradoxical, because you would think higher interest rates would make bond investments more valuable, and that is true, but there is more to it – see the bond section.  The bottom line is that we are in a period of historically low interest rates, and the Fed has been slowly and cautiously increasing them, so bond investing may be risky right now.

Tax Considerations
For your 403b and any IRAs (Roth or regular), you do not have to worry about tax consequences of trading. All taxes are deferred until you take them out (except for Roth IRAs, which are not taxed on withdrawal). These tax considerations only apply to your investment accounts.

Generally, you need to think about short-term versus long-term capital gains in your investments and about dividend income. Short-term gains (or losses) are gains from assets that are sold less than one-year from purchase. So, if you bought a stock or shares in a mutual fund on December 1, 2019 and you sell before December 1, 2020, you will incur a short-term gain. Short-term gains are treated as ordinary income and are taxed at your marginal income tax rate.

[Marginal income tax rate refers to the tax on your next $1 of income.  You need to be aware of what it is because we use a graduated income tax system, with the marginal rates increasing as your income increases.  See post on Tax Consequences.]

Long-term gains are treated differently.  If you sell more than a year after purchase, you incur long-term gains.  There is a maximum tax rate on long-term gains which, for most people, is 15% (very high income earners will pay 20%).  You do not pay any taxes on long-term capital gains, however, unless you are in the 25% marginal tax bracket or higher.

Most mutual funds, and a good number of individual stocks, will generate dividend income.  Dividend income is divided into Ordinary Dividends and Qualified Dividends.  Whether dividends are qualified or ordinary depends on how long the stock is held.  Because mutual funds buy and sell shares continually, they tend to generate a mix of the two.  Qualified Dividends are taxed as if they are long-term capital gains, as described above.  Ordinary dividends are taxed as ordinary income and will be taxed at your marginal income tax rate.

Generally, long-term gains are preferable to short-term gains, emphasizing the value of investing for the long-term.  On the other hand, if you are in a low tax bracket, the consequences of incurring short-term gains are fairly minor (15% tax rate).  When you are in a higher tax bracket (the top on is close to 40%), then you have to worry more about the difference between short- and long-term capital gains.

Most people use a first-in, first-out (FIFO) approach for selling stocks or mutual funds.  If you sell them all, it does not matter, but if you sell part of your asset (say 50 out of 100 shares), then FIFO will tend to increase the number of shares that are subject to long-term gains, with the more favorable tax consequences, if you are a long-term investor (for day traders, FILO [first-in, last-out] may be more advantageous). 

If you are close to the one-year period and are concerned about the tax consequences of short-term gains, then it may be advantageous to wait until the one-year period passes before selling to lock in the lower tax rate; again, this consideration depends on your tax bracket.  On the other hand, it is better to have a short-term gain than to incur a loss, so do not worry about tax consequences if you think the stock is headed south and there is good reason to sell.

There are various types of bond funds you can consider:
 ●  Short-term, intermediate-, and long-term bond funds
 ●  Bond index funds
 ●  Government bond mutual funds
 ●   High-grade bond funds
 ●  High-yield/low-grade (junk) bond funds
 ●  International and global bond funds
 ●  Tax-exempt and state tax-exempt bond funds

I mentioned above that bonds tend to decrease in value as interest rates rise.  All bonds have an interest rate and a term.  For example, you may buy a bond for $1000 that has a 2.5% interest rate and a 30-year term.  You will earn $25 for every year that you hold the bond.  The price of the bond, however, will vary over this 30-year period depending on current interest rates.  Suppose interest rates rise to 4% annually.  If someone buys a brand new bond with a 4% interest rate, then they will earn $40 per year.  Why, then, would they want to buy your bond?  It would only make sense to buy your bond if you decrease the price so that they will get a 4% annual return (e.g., to $625 = $1000 x 2.5% / 4%).  So, the value of your bond will go down if interest rates rise.  On the other hand, you can always hold it to the end of your 30-year period (maturity date) and continue to receive your annual $25.  At the end of the period, the bond will again be worth $1000 regardless of current interest rates, because the bond issuer is required to pay back the face value at the date of maturity. 

In the same way, if interest rates decline, then the value of the bond will increase. If the current interest rates drop to 2%, then your 2.5% bond is more attractive than a new $1000 bond, and its value will go up accordingly. Thus, the value of the bond is a combination of the face value, the nominal interest rate compared with the current interest rate, and the time to maturity.

The first bullet above refers to short-term, intermediate-term, and long-term bond funds.  Short-term bond funds are less susceptible to changes in the interest rate because the time to maturity is short.  The downside, though, is that they tend to pay lower interest rates.  Long-term bonds tend to pay higher interest rates, but are more susceptible to changes in interest rates.  A bond index fund will tend to have a mix of these, and you hope that the fund manager can take account of all of these factors to produce a reasonable rate of return without undue risk.

Government bonds (Treasury bonds or T-bills) are one of the safest investments you can make. T-bills are backed by the US government and the risk of default is minimal (it has never happened). Current rates, however, are low compared with historical averages. A 30-year T-bond pays around 2.33%, and that is not adjusted for inflation. If you buy short-term T-bills, then the rate will be lower; the current 1-year T-bill pays 1.56%. If you want to preserve your money while earning a low rate, the 1-year T-bill is fine because even if interest rates go down, you will get your full value back in a year. I am not necessarily advocating buying T-bills; you can instead invest in a mutual fund that trades in T-bills, if you want this type of safe investment.

Bonds have ratings, depending on how credit-worthy the bond issuer is.  The two main rating systems are Standard and Poor’s and Moody’s.  “Investment Grade” bonds are ones that are rated BBB- or higher by S&P or Baa3 or higher by Moody’s.   These tend to be bonds issued by corporations or by municipal governments (states or cities) to borrow money.  You will want a greater proportion of your bond investments to be investment grade because they are safer and pay reasonable rates.

Non-investment grade bonds, also called “junk bonds”, pay higher interest rates but are somewhat riskier.  Mutual funds that invest in junk bonds are often masked as “high-yield” bond funds.  The term “junk bond” seems derogatory, and if you buy individual bonds that are not investment grade, you may be taking a bit of a risk.  Buying into a junk-bond/high-yield fund, however, is not as risky because you are spreading the risk over a wide-variety of bonds, few of which would actually default.  So, having some high-yield bond funds can be a good thing if you are looking for a higher rate of return and can stand some level of risk.

International bond funds are a category that has only come to my attention recently.  They used to pay a lower rate of return, but that is changing, particularly with regard to “emerging markets”.  Bonds from China and India, for example, may pay a higher rate of return.  So, having some international bond funds can be another way to obtain a higher rate of return.

Depending on your income tax bracket, may want to invest in municipal bonds or funds.  Income from municipal bonds and funds are exempt from federal tax and may also be exempt from state taxes, but generally pay a lower interest rate.  If you are in a high tax bracket, your after-tax return may be higher with municipal bonds than with other types of bonds.

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