Copyright 2011 by Morris Rosenthal
All Rights Reserved
Self Directed Retirement And Long Term Income Investing
My fun investing flowchart, makes more sense than most bankers.
Fund Investing And Brokerage Accounts
Note that these steps correspond with decision points on the flowchart and are reached directly by clicking on the diamond symbols. The text below cannot be read sequentially.
Self Directed? Do you handle all of your investments directly and invest in whatever you think is best, or do you rely on professional money managers? Self directed investing means you are either moving funds from your savings into riskier asset classes, or you have received some sort of lump some to invest, perhaps from sale of an asset, inheritance, a settlement or through taking over funds that were previously managed by professional money managers. The easiest way to gain access to a broad range of investment opportunities at the lowest possible fees is to open an online brokerage account. The most popular of these at the moment is E-Trade, which took over my old favorite, BrownCo, but Ameritrade, Fidelity, and many other options exists. Online brokerages insist on a minimum deposit to open an account, usually a few hundred dollars for a regular taxable account or an IRA brokerage account, and may charge fees for writing checks against the account, or making making multiple withdrawals. The worst brokerage I ever dealt with was Charles Schwab, which established quarterly fees soon after I opened the account, and then charged a fee for closing the account to move the money elsewhere. I was traveling at the time the instituted the fee, and by the time I got back and figured it out a few months later, Schwab screwed me out of $120 just to get my funds moved. This unethical practice triggered a class action lawsuit, of which I was part, and I certainly don''t intend to ever deal with Schwab again.
On the whole, online brokerage accounts all work pretty much the same way, and I say that having had a half dozen of them for both taxable and retirement investing over the years. The main figure of merit is how much they charge per trade. Anything in the $5 to $10 range for basic trades is fair, I'm leary of the free options (though I've never tried one), anything above $10 I feel it's just the bank making windfall profits on our backs. There are usually fees for more complex transactions, an extra $5 for a limit order, stop loss, etc, but the basic trading fee gives you access listed equities (stocks) and mutual funds, plus a dizzying array of Exchange Traded Funds (ETF's), Exchange Traded Commodities (ETC's) and Exchange Traded Notes (ETN's). Exchange Traded Funds now exist for most investment styles you can imagine, but they started out as basic index funds, tracking a broad index such as the DOW, S&P or Nikkei, with the trading done by computer to keep the fund in balance with the index. The fees for a good Index ETF are lower than the fees for the best managed Index ETF, plus the Exchange Traded Funds can be traded like stocks in your brokerage account at any point of the day, where the price is the price at the moment of the transaction as opposed to a settling price at market close. I don't see any reason to own a managed index fund rather than an index ETF, unless you have money in a retirement account where trading ETF's isn't an option.
But there are much more complicated versions of ETF's, ETC's and ETN's, that are based on derivatives, futures, debt contracts, or even structured as limited partnerships with complicated tax consequences. Sometimes you can shelter yourself from having to think about tax consequences by holding the more complex instruments in retirement accounts, but other times, you may be jeopardizing the tax free status of the entire retirement account by doing so. I've contacted the IRS a couple times to ask specific questions about retirement account investments, but they see their job here as strictly enforcement. You have to go to a lawyer or an "investing professional" for advice on investing in the more complex exchange traded investment vehicles, and that professional advice won't necessarily do you a bit of good if the IRS gets a court ruling changing the status of particular strategies.
For example, all of the leveraged exchange traded vehicles may turn out to be improper investments for retirement accounts, yet Americans own them en-masse since they can be traded just like stocks in a retirement brokerage account. If their status changes, everybody who owns these instruments may be forced to liquidate their retirement accounts, pay a penalty, and then pay income tax on the whole value of the accounts that year. I suspect this would be politically unacceptable and Congress would step in, but you can't count on it. Likewise, some ETF's are actually structured as limited partnerships, and issue a K-1 to report the partnership profit or loss for the year. This profit or loss may have nothing to do with your actual profit or loss, depending on when you traded, yet you may have to report it to the IRS even if it's held in a retirement account. I spend several days reading IRS documents for the rules on this stuff, it seemed to depend on the amount of the profit (over $1,000 was a problem), but on the whole, it's safer for the individual investor to simply stay away from any products structured as partnerships in tax free accounts. If you absolutely feel you need the exposure, it may be better to trade futures contracts on the underlying ETF, but I've never done this myself and I'm no tax expert.
Work, 401K, TIAA CREF? If you have the opportunity to participate in an employer sponsored retirement plan that matches funds and you don't, you're an idiot. If you drain the money from your 401K the first time you're out of work because you want to keep up your lifestyle, you'll pay a penalty, income tax on the withdrawal, AND you're an idiot. Most private companies abandoned defined benefit plans for defined contribution plans back in the 1980's. The defined contribution plans are less valuable on the whole, but they are much, much better than nothing, and if you don't participate, you're an idiot. TIAA CREF is traditionally very well run, and any of the basic options should result in market comparable returns over the course of your working life.
Familiar with Nikkei history? There's an important object lesson in the the Japanese stock market for anybody investing in equities. Japan's market peaked at almost 40,000 points in the late 1980's. Since then, it has gone up and down, but is currently at a level of around 10,000, one quarter of the value of more than two decades ago. People who invested in the Japanese stock market for retirement in their 40's intending to retire in their 60's are still working and falling further and further behind. Investment advisors are fond of pointing to the long run, but they don't like to point out that people who invest during the run-up to a bubble would have done better to keep their cash under the mattress. The American stock markets, indeed, most of the world's stock markets,differ from the Nikkei only in the peak level of their bubbles. Stocks will certainly go up at some point during the next week, the next year, and the next ten years, but they will also go down at some point during the next week, next year, and next ten years. You can't assume that buying and holding, an excellent strategy when markets are rising, will be of any more use to American investors over the next two decades than it's been to the Japanese over the last two decades.
Income Investing? If you are investing for income, with the idea of generating a stream of cash that will pay your bills in retirement, the main options are dividend paying stocks, bonds, and investment trusts, like REITs (Real Estate Investment Trusts). All of these have pluses and minuses. For starters, stocks that pay high dividends often do so because the underlying value of the shares has been falling or under performing the market. In some cases, this is an indication that the company is on it's way towards bankruptcy or government conservatorship (think CitiBank or GM). Other companies, such as public utilities, may pay strong dividends over time but have very stable share prices, meaning you can't look for capital gains. Companies that get into trouble will often lower their dividends, at which point it's usually too late to sell out without taking a big hit on the share price.
Bonds are a relatively safe investment for both returns and capital preservation providing you buy the actual bonds, and not mutual funds. Bond mutual fund investing has soared out of control over the past decade, and bond funds have so outperformed both the stock market and their own expectations that you can expect decades of stagnation. As soon as the Federal reserve begins raising interest rates, or as soon as investors finally come to perceive that it's inevitable, the value of shares in bond funds will begin to plummet, and you'll lose tens of percentage points of your investment. If, on the other hand, you invest directly in bonds, your downside risk is limited to inflation. If you hold the bonds to maturity, you'll get your money back, it may just not be worth as much, and the value of the bond will fall in the secondary market for that reason. But for all of those people who are rushing into bond funds today because they've been the place to be the last fifteen years, you're way too late.
REITs and other investment trusts with master limited partnerships can be a great way to invest like a rich man, though you may run into unexpected tax consequences if you do it through an IRA account. Trusts and limited partnerships are basically a way to get you direct exposure in businesses and commodities that you can't purchase or manage directly. In the case of REITs, the returns are usually based on rents, which are fairly predictable, but I'd be careful of any fund that's basically speculating on real estate prices inevitable rise. Nothing is inevitable, and anybody who's shopped for real estate in a city like Boston or NY may suspect that prices have plenty of room to fall for apartments to be purchased by anybody other than investors.
Choice of funds limited? Many retirement funds limit participants to a couple basic choices, like, "High Risk", "Medium Risk: and "Low Risk", or focus on target date funds for years in the future. Other retirement funds let you buy any fund from a name company, like Fidelity or Vanguard. But relatively few companies have their 401K accounts set up so you can buy any index fund or stock that you want, not to mention more esoteric investments.
Can you transfer without a penalty? If you can't transfer to another fund manager without a penalty, don't even think about it. Penalties hit your principal, you'll never make it up by investing in different products, that's just gambling. Study the the choices you are offered, make your choice and live with it.
Serious interest in markets? If you don't really enjoy following financial news and rebalancing your portfolio on a regular basis, why even get started? Just pick some diversified funds according to your risk tolerance, and you'll do no better or worse than anybody else you're working with. If you are seriously interested and want to start trading your retirement account, keep it diversified. While you'll never get rich spreading your money around, putting all your eggs in one basket is just dumb.
Long term investor? If you're really a long term investor, stay the heck away from bonds these days. Bonds are at wacky all time peaks, and unless the country plunges into a deflationary spiral, even the most aggressive junk bond holders will be lucky to keep up with inflation. Buy dividend paying stocks instead, utilities or big blue chips that pay a couple percent. The share prices will go up and down, but if you're in the market for the next twenty or thirty years, they'll probably end up appreciably higher. And if you let the dividends reinvest in a tax advantaged account, you should do decently. Just don't focus on one or two high dividend paying stocks, they are usually paying high dividends for a bad reason, like that's the only way they can attract new money or keep old money. Use a mutual fund or an ETF that focuses on dividend paying stocks.
High risk tolerance? Look, if you aren't in it for the long term and you have a low risk tolerance, you have no business buying stocks or even bond funds, which will likely drop by double digits in the next few years. Stick with cash, CDs, short term inflation protected securities. Just keep an eye on the discount demanded up from on the more attractive short term securities. Some people are so desperate for the things that they basically lock in a loss, even before taxes on the inflation adjustment.
Active investor? I don't get into active investing on this chart, but what I mean is taking an active part in the business where you invest your money. The most common investment of this type in America is probably buying rental property, since it's a part time job unless you become a tycoon. But many people invest in and become part owners in small businesses like shops and restaurants. Just be careful that you do it all with lawyers, no hand-shakes, and that applies to family as well unless you are really just doing it to help them out and don't care if all the money goes up in smoke.
Retirement age? If you've already reached retirement age and you're gambling on stocks with money you need to pay the bills next year, you're an idiot. If you've got millions and you want millions more, knock yourself out, but if you're the average American with a lousy $50K socked away, or even a couple hundred thousand, you have no business playing games with it. Just try to budget yourself so you can get by on the minimum required withdrawals. You can fool around with laddering some short term bonds, even though they don't pay beans these days, but stay away from bond funds at all costs. Again, dividend paying stock funds make more sense than bond funds these days, and I hate stocks.
Zero risk tolerance? If you live in America, you can put your money into inflation adjusted securities (buy them through Treasury Direct) and you won't lose your shirt. You'll see a slow erosion of buying power and you'll get taxed on it as well, but you won't lose your shirt. Don't bet heavy on gold or other save havens. The world's banks could announce they plan to sell their gold and the price would crash instantly.
You can also look at annuities and other insurance company type products, but they tend to be costly and they just aren't paying much of a return these days. Make damn sure how much principal you are losing up front to get in and how long it will take to earn that principal back. They've got lots of fees, just like a mortgage.
WSJ and CNBC fiend? Are you addicted to financial news? If not, stick with making long term bets by picking sectors or countries and using index funds to trade them when you readjust your portfolio. Stay away from rapid trading. Just because the fees for trading have gotten so low doesn't mean you should churn your own account. You'll almost always buy and sell at the wrong times. Trust me, I've been losing money for years:-)
Futures, commodities, margins? There are things you can't do in a retirement account without risking that the IRS will claim that you've violated the rules, forcing you to cash in the whole account and to pay taxes and penalties on the whole amount that very year. There are problems with certain commodities and currency funds, for example, because they are organized as limited partnerships or produce unrelated business income, which is forbidden in retirement accounts. My advice is to talk to an accountant before you get too fancy trading with retirement funds.
Stock picker? My own stock picking days are largely behind me. I gave it one shot this year, bought a thousand shares of Barnes and Noble at near $20 in the theory that they would benefit from Borders going under than their strong position with Nook. I'm in the publishing and book selling business, so I figure I have an inside track. The next day, Barnes and Noble cancelled their dividend, declaring that they were a growth company. I lost a third of my money in a week and punched out, literally the worst stock trade I've ever made.
If you are an active investor/gambler, but you don't like picking individual stocks, stick with ETFs. They have ETFs for everything now, you can bet for or against just about anything, usually with an option for a 2X or a 3X multiplier. Just watch the fees on those things and understand they don't always do a great job tracking the index or commodity they are supposed to track. They aren't designed to be held long term, the tracking basis changes every single day, but most people probably do hold them as long term bets. I did great betting against stocks in 2008, but I lost it all back betting against stocks in 2010 and them lost even more betting against Ben Bernanke in 2011.