Understanding risk

When you make investments, even low-return ones, you accept a certain amount of risk. The risk, of course, is that seemingly attractive higher-return-producing investments can and sometimes do decline in value.

After an extended period of good economic times, like the 1990s or 2010s, some people make the mistake of feeling as if their money is wasting away or not “invested” if it’s in low-return, safer-money investments. As a result, they may rush to invest the money elsewhere with the hope of earning a higher return. After periods of extended good economic times, we see more and more conservative folks putting funds they intended to stash away for a rainy day into the stock market to get quick returns. Safe investments were derided with the expression, “Cash is trash.”

Some investments are riskier, which is to say that they fluctuate more in value and can produce greater losses over the short term. That’s why, when you select investments, you need to completely understand what potentially could happen to your money. You should consider two important points when weighing risk:

• Risk is fine as long as you understand what you’re getting yourself into. There’s nothing wrong with taking risk. In fact, an investor needs to accept risk in order to have the potential for earning a higher return. Just make sure you’re educated on the options and understand the risks you’re choosing to accept with your choices.

  You need to protect certain types of funds and take little or no risk with them. For example, your emergency reserve fund (which you can tap for unexpected expenses) money shouldn’t be in an investment subject to great fluctuations in value, such as the stock market. Instead, you should invest this money in someplace stable and accessible, such as a savings account or money market fund or a short-term high-quality bond fund.

• Not taking any risk is risky. You want to select those investments that suit your particular goals and your desire and necessity to take risk, in terms of producing sufficient returns to help pay for your retirement. The trick is to carefully balance the return you require against the risk that you may be exposed to in seeking a higher return investment. You need a certain amount of money saved to maintain a desired standard of living during retirement. If the money you’re accumulating is invested too conservatively and grows too slowly, you may need to work many more years or save at a much higher rate before you can afford to retire. That’s why you should do the number crunching for retirement planning that we discuss in Chapter 3.

Eyeing your returns

In order to fully understand investments, you must keep in mind that investments differ from one another in terms of their likely returns. Investment returns generally come in two forms: current income and appreciation. We detail both in the following sections.

Considering how investments are susceptible to inflation

Some investments are more resistant to inflation, or increases in the cost of living. The purchasing power of money invested in bonds that pay a fixed rate of interest, for example, is eroded by a rise in inflation. The value of investments such as real estate and precious metals like gold and silver, by contrast, often benefits from higher inflation (although we must note that precious metals have generated poor long-term returns). Stocks, over the long run, have proven to be a good inflation hedge and have produced long-term returns consistently well above the rate of inflation.

Being aware of tax consequences

When researching investments, you need to be clear about the possible tax consequences you face with the different investments you may make. Apart from investments in tax-sheltered retirement accounts, the interest or dividends produced by investments are generally taxable in the year they’re earned. The profits (known as capital gains) from selling an investment at a higher price than it was purchased for also are taxable.

If you invest without paying attention to taxes, you’ll likely overlook ways to maximize your returns. Two simple yet powerful moves can help you to invest in a tax-wise way:

• Contribute to your retirement accounts so that less of your money is taxed in the first place. Doing so reduces your taxes both in the years you make your contributions as well as each year your money is invested. For those approaching retirement with significant balances already saved in their retirement accounts, saving outside retirement accounts is worth evaluating. Consult Chapter 5 for more information on retirement accounts.

• With money that you invest outside retirement accounts, choose investments that match your tax situation. If you’re in a high tax bracket, you should avoid investments that produce significant highly taxed distributions. For example, you should avoid taxable bonds, certificates of deposit and other investments that pay taxable interest income, and those that tend to distribute short-term capital gains (which are taxed at the same high tax rates as ordinary income). Instead, consider growth-oriented investments, such as stocks, real estate, or investments in small business — yours or someone else’s. Long-term capital gains, which are gains from investments sold after a holding period of more than one year, are taxed at lower rates. Keep in mind that growth-oriented investments generally carry more risk.

  If you’re in a high tax bracket and would like to invest in bonds outside a retirement account, consider municipal bonds that pay federally tax-free interest. The interest on municipal bonds is also free of state taxes if the bond was issued in the state in which you live.

Monitoring sensitivity to currency and economic issues

Not all investments move in concert with the health and performance of the U.S. economy. Investments in overseas securities, for instance, allow you to participate directly in economic growth internationally as well as diversify against the risk of economic problems in the United States. International securities, however, are susceptible to currency-value fluctuations relative to the U.S. dollar.

Because foreign economies and currency values don’t always move in tandem with those in the United States, investing overseas may help to dampen the overall volatility of your portfolio. Investing in U.S. companies that operate worldwide serves a similar purpose.

Knowing your time horizon

A critical issue to weigh when investing a chunk of money toward a specific goal like retirement is knowing your time horizon, or the length of time you have in mind until you need the money.

The potential problem with timing is this: If you invest your money in a risky investment and it drops in value just before you need to sell, you could be forced to take a loss or a much lower gain than you anticipated. So you should be concerned about matching the risk or volatility of your investments with the time frame that you have in mind.

Suppose you’re investing some money that you plan to use for one-time expenses in a few years. With a short time frame in mind, investments such as stocks or real estate aren’t be appropriate, because they can fluctuate a great deal in value from year to year. These more growth-oriented (and volatile) investments, on the other hand, can be useful in working toward longer-term goals, such as retirement, that may be a decade or more away. (Chapter 3 provides information on how to figure out when you can afford to retire.)

Factoring some risk into your investment plan

In addition to the time horizon we discuss in the preceding section, your need to take risk also should be factored into your investment decisions. If the money that you’re investing for retirement grows too slowly, which may happen if you stashed it all in bank accounts and treasury bills, you may not be able to retire when you want or live the lifestyle you desire. To reach your retirement goals, you may need to take more risk.

Although your retirement goals may require you to take more risk, you don’t necessarily have to. Retaining a balanced portfolio of stocks and bonds where you have appreciation potential from the stocks and more income and less volatility from bonds sounds good in theory. But if you’re going to be a nervous wreck and follow the stock market’s every move, it may not be worth it for you to take as much risk. In that case, you need to consider rethinking your goals. Also, if you’re in the fortunate position of not needing to take much risk because you’re well ahead of your retirement savings goals, taking more risk than necessary may cause you to lose what you have accrued. (Chapter 3 provides more on retirement planning.)

Keeping the bigger picture in mind

When purchasing a new investment, make sure you consider your overall financial plan. Investors often read articles or get tips from colleagues and wind up buying some of those investments. Investing without doing sufficient homework leads to a hodgepodge portfolio that’s often not properly diversified, among other problems. Failure to make an overall plan usually results in a recipe for failure, not success.

For example, when Eric worked as a financial planner/counselor, he was surprised at how often he’d meet with clients who had excess cash in low-interest money market funds or savings accounts while they carried high-cost debts, such as auto loans and credit-card balances. He was able to convince many of them to pay down the high-cost debt after he showed them how much they could save or make by doing so. (This same logic holds for older, more conservative investors who can pay down mortgages.)

Likewise, Eric found that investors who preferred individual stocks would fret when one of their holdings fell. Because such investors wouldn’t examine their overall portfolio’s performance, too frequently they would unnecessarily dump a currently depressed stock. They’d dwell on that stock’s recent decline and overlook how little impact this one holding had on their overall portfolio.

This strategy is particularly dangerous if you fail to consider the big picture and overinvest in employer stock. You may think you’re being a loyal team player, but watch out. This strategy is hazardous because a company that falls on hard times may not only lead to the loss of a job but also to the loss of retirement assets when the stock takes a permanent nose dive. As you approach your senior years, investing more than 10 percent of your financial assets in your employer’s stock is usually too risky unless you can truly afford the risk.

Allocating your assets

When you’re investing for longer-term financial goals such as retirement, be sure to invest in an array of different investments. Diversified investments may include such things as stock mutual funds (both U.S. and international), exchange-traded funds (ETFs), bonds, and, perhaps, real estate.

How you divide your money among these different types of investments is known as asset allocation. Asset allocation need not be complicated or intimidating. As a general rule, you should conduct asset allocation for money invested for the longer term — that is, at least more than five years, though preferably ten or more years. See our advice and recommendations for determining an appropriate asset allocation in Chapter 3.

Before you begin the process of allocating your assets, make sure you have an emergency cash reserve of three to six months’ worth of living expenses. Set aside even more if your income and job are unstable and you don’t have family or friends you could tap for help. Three months’ worth of living expenses, on the other hand, is probably sufficient if your income is safe and stable or you have other resources you can easily tap.

Other investments that you hold outside of retirement accounts, such as stocks, bonds, and mutual funds and ETFs that invest in stocks and bonds, can quickly be converted into cash. However, the problem with considering these investments for emergencies is that because they fluctuate in value, the selling price may be much less than what you paid originally.

Comparing lending investments to ownership investments

Investors are often bewildered at all the investment options from which they can choose. But we can simplify things for you. All the investments you may choose from fall under one of the following two categories:

• Lending investments: A lending investment, as the name suggests, is an investment where you lend your money, typically to an organization. For example, when you place your money in a bank account, such as a savings account, you’re essentially lending your money to a bank for an agreed-upon interest rate.

  Bonds, which are IOUs issued by companies, are another common lending investment. When you buy a newly issued ten-year bond from Verizon at 5 percent, for example, you’re lending your money to Verizon for ten years in exchange for 5 percent interest per year. If things go according to plan, you’ll get your 5 percent interest annually, and you’ll get your principal (the original investment) back when the bond matures in a decade.

• Ownership investments: With ownership investments, by contrast, you own a piece of an asset that has the ability to produce profits or earnings. Stocks, which are shares of ownership in a company, and real estate are ownership investments.

  In a capitalistic economy, individual investors can build wealth faster by being owners. For example, say Verizon doubles in size and profits over the next seven years. As one of their bondholders, you won’t share in the growth, although it will help ensure they can make their bond interest payments and final repayment when the bond matures. As a stockholder, however, you should benefit from a stock price driven higher by greater profits. Ownership investments can also produce income, such as the dividends paid on some stocks or the rental income produced when you rent out real estate.

Over the past two centuries, U.S. stock market investors (owners) have earned an average of 9 percent per year, whereas bond investors (lenders) have earned about 5 percent per year.

As we mention in the earlier section “Understanding risk,” risk and return generally go hand in hand. If you seek safe investments — investments with low volatility and low likelihood of the value of the investment declining — you’ll usually have to settle for lending investments with relatively low returns. If you seek higher returns well ahead of the rate of inflation, on the other hand, you must use investments that provide an ownership stake and could either rise or fall more significantly in value, especially in the short term.

Looking into stocks

Investing in stocks is one of the most accessible ways you can invest for long-term growth. Stocks, which are shares of ownership in companies, historically have produced returns averaging about 9 percent per year. At that rate of return, even without adding to your investment, your money should double about every eight years. Thank the rule of 72 for this doubling. The rule of 72 says that if you divide 72 by your annual return, you’ll determine about how many years it takes to double your money.

When companies go public, they issue shares of stock that can be bought on one of the major stock exchanges, such as the New York Stock Exchange. As the economy grows and companies grow with it and earn greater profits, stock prices generally follow suit. Stock prices don’t move in lockstep with earnings, but over the years, the relationship is pretty close. In fact, the price-earnings ratio — which measures the level of stock prices relative to (or divided by) company earnings — of U.S. stocks has averaged approximately 15 during the past century. Although the ratio has varied and crept above 30 and gone as low as 6, it tends to fluctuate around 15 (it has been slightly higher during periods of low inflation and low interest rates).

Be forewarned that the U.S. stock market, as measured by the Dow Jones Industrial Average, has fallen more than 20 percent about every six years (the declines in the early and late 2000s were much worse). That’s the bad news. The good news is that these declines lasted, on average, less than two years. So if you can withstand declines over a few years, the stock market is a terrific place to invest for long-term growth.

If you’re investing in stocks, keep the following two suggestions in mind to help you build wealth faster in the stock market:

• Reduce fees and commissions while investing. Not only does excessive trading lead to your possibly being out of the market on the best days and reduce your returns, but it also can increase your transaction costs and taxes. A simple way to stack the stock market odds in your favor is to minimize fees and commissions when investing. That means after you make an investment, you must resist the urge to buy and sell, which raises your fees and commissions. All things being equal, lower commissions and fees paid to purchase and hold investments increase your investment returns.
• Regularly save and invest. Thanks to the miracle of compounding, if you save and invest $5,000 per year in a tax-deferred account returning an average of 10 percent per year, you’ll have about $440,000 in 20 years.

Investing in mutual funds and ETFs

Mutual funds and exchange-traded funds (ETFs) are ideal investment vehicles to help you carry out your investment plans. The three main advantages of the best mutual funds and ETFs are

• Diversification: Mutual funds and ETFs typically invest in dozens of securities. A truly diversified stock fund invests in stocks in different industries and different stocks within an industry. The same logic works for bond funds, too.
• Efficiency: Good money managers don’t come cheaply. However, because funds buy and sell large blocks of securities and typically manage hundreds of millions or billions of dollars, the cost of their services is spread out and quite economical for you.
• Professional oversight: Unless you have lots of money and free time on your hands, researching investments will, at best, be a part-time hobby for you. A fund manager and his or her team of analysts are devoted full time to selecting investments and monitoring them on an ongoing basis.

The best mutual funds offer a low cost, professionally managed way to diversify your investment dollars. Index funds, which are a type of mutual fund, invest to follow a specific stock or bond market index and usually have the advantage of low costs, which helps boost your returns. ETFs are generally index-like funds that trade on a stock exchange. (See the section “Index and exchange-traded funds” later in this chapter for more details on those types of funds.)

Several different types of funds exist. Which ones work for you depends on the level of risk you desire and are able to accept. Here’s a list of the types you may choose:

• Money market funds: These funds are the safest types of mutual funds. Money market funds seek to maintain a fixed share price of $1 per share. They invest in short-term debt of companies and governments. You make your money from the dividends, just like you would with a bank savings account’s interest. The main difference and advantage that the best money market funds have over bank savings accounts are that the better ones generate a higher yield or rate of return. Because there’s little, if any, risk of bankruptcy, money funds aren’t insured the way bank accounts are.

• Bond funds: The attraction of bond funds, diversified portfolios of bonds, is that they pay higher dividends than money market funds. So, for retirees who want more current income on which to live, bond funds can make sense.

  The drawback or risk of bonds is that they fluctuate in value with changes in interest rates. If the overall level of interest rates rises, the market value of existing bonds decreases. This occurs because with new bonds being issued at higher interest rates, the price of existing bonds must decrease enough that the resulting yield or interest rate is comparable to that offered on new bonds. Longer-term bonds are more volatile with changes in interest rates because your principal is being repaid more years down the road.

  The value of bonds issued by corporations also may fluctuate with the financial fortunes of the company. When a company hits a rough patch, investors question whether their bonds will be repaid and drive the price down. When investors fear bankruptcy is a real possibility, the bonds may sell for only a fraction of the original debt or principal.

• Stock funds: Stock funds invest in shares of stock issued by companies. Most funds invest in stocks of dozens of different companies. Funds typically focus on either U.S. or international companies.

  Stock funds are the most volatile of mutual funds and ETFs, but they also hold the promise of higher potential returns. On average, stocks have returned investors about 9 percent per year over the decades. Over short periods, however, stocks can drop significantly in value. Drops of more than 10 or 20 percent aren’t uncommon and should be expected. So don’t commit money to stock funds that you expect to need or use within the next five years. Although they’re completely liquid on a day’s notice, you don’t want to be forced to sell a stock fund during a down period and possibly lose money.

  You can choose to invest in stocks by making your own selection of individual stocks or by letting a mutual fund manager do the picking and managing. Researching individual stocks can be more than a full-time job. And if you choose to take this path, remember that you’ll be competing against the pros who do it full time.

Over the years, increasing numbers of investors have turned to mutual funds and ETFs for their stock market investing rather than picking and choosing individual stocks on their own. While there’s good debate about the merits of these two investment strategies, plenty of sources are pushing investors to individual stocks. For instance, many websites, online pundits, financial columnists, and media/television gurus advocate for individual stocks. For more information on mutual funds including ETFs, check out the latest edition of Investing For Dummies, by Eric Tyson (Wiley).

Comparing investments and risks

When considering how you want to invest or when studying your current investments, take a close look at the breakdown of the different types you have and their associated risks. Different combinations can give you different results. Consider these points:

• Bonds and savings-type vehicles, such as money market mutual funds, deserve a spot in your portfolio. For money that you expect to use within the next couple of years or for money that you need to earn a relatively high current income from, bonds and money market funds can make great sense. Historically, such investments have produced returns from about the same as to a bit more than the rate of inflation (3 percent).
• Although stocks and real estate offer investors attractive long-term returns, they can and do suffer significant short-term declines in value. Just consider what happened in the late 2000s severe stock market and real estate decline. So these investments aren’t suitable for money that you may want or need to use within the next five years.
• Money market and bond investments are good places to keep emergency money that you expect to use sooner. Everyone should have a reserve of money that they can access in an emergency. Keeping about three to six months’ worth of living expenses in a money market fund is a good start. Shorter-term bonds or bond mutual funds can serve as an additional, greater (than money funds) income-producing emergency cushion.
• Bonds can provide useful diversification for longer-term investing. For example, when investing for retirement, placing a portion of one’s money in bonds helps to buffer stock market declines. When investing for longer-term goals, however, some younger investors may not be interested in a significant stake (or any stake at all) in boring, old bonds. The reason: They have decades until they will tap their money and are comfortable with the risks of higher-returning investments like stocks and real estate.

Take a look at Figure 4-1, which shows the historic average returns and best and worst returns (over the past 93 years) and risks of various portfolios ranging from 100% bonds to 100% stocks. While the all-stock and stock heavy portfolios produced higher average annual returns, their worst years were much worse. A balanced portfolio produces solid long-term returns with quite a bit less risk than an all-stock portfolio.

Funds of funds and target-date funds

Most fund investors feel overwhelmed by having so many choices. They understand the need to hold a diversified portfolio, but they’re not sure how to assemble one. Enter funds of funds and target-date funds. Both of these types of funds give you exposure to numerous funds within a single fund. And target-date funds gradually adjust the risk of the portfolio as you approach a particular retirement date.

Index and exchange-traded funds

A simple, low-cost way to invest in stocks or bonds is to invest in what’s known as an index fund. These are passively managed funds that mechanically follow an index, such as one of the following:

• Bloomberg Barclays U.S. Aggregate Bond Index: A broad index that tracks the U.S. bond market.
• Standard & Poor’s (S&P) 500 Index: Tracks 500 large U.S.-headquartered-companies’ stocks.
• MSCI U.S. Broad Market Index: This index follows small, medium, and large U.S.-company stocks.
• MSCI Europe Index, MSCI Pacific Index, MSCI Emerging Market Index: These three indexes respectively track the major stock markets in Europe, the Pacific Rim, and in emerging economies, such as Brazil, China, India, and so on.
• FTSE All-World Index: A global stock market index.

All index funds aren’t created equal. How so? They do have these differences, so make sure you closely investigate any funds before you make an investment:

• Some have higher expenses than others. Lower costs, of course, are generally better when comparing index funds that track the same index (as long as the lower-cost index fund tracks its index well).

• Some indexes are likely to produce better long-term returns than others. For example, we have some concerns about the S&P 500 index because it’s a capitalization-weighted index. With this type of index, stocks hold a weighting in the index based on their total market value.

  For instance, during the 1990s, the technology sector’s stock weighting in the S&P 500 index ballooned from about 6 percent in 1990 to 29 percent by 1999. So investors buying into an S&P 500 at the end of 1999 had nearly 30 percent of their investment dollars going into pricey technology stocks. The financial sector experienced a similar ballooning in weighting before its steep price drop in the late 2000s.

In addition to traditional index funds, some index funds invest in value-oriented stocks, which are those selling at relatively low valuations compared to the companies’ financial positions. Value-oriented stocks are far less likely to hold hot sector stocks destined to crash back to Earth. You also can use index funds that invest in equal weights in the stocks of a given index.

Exchange-traded funds (ETFs) are index-like funds that trade on a major stock exchange. The best ETFs have even lower costs than index funds. But plenty of ETFs have flaws, such as higher costs or a narrow industry or small-country investment focus.

Here’s a list (in order from bond funds, U.S. stock funds, and then foreign funds) of index funds and ETFs that are our favorites:

• iShares Core U.S. Bond Aggregate (AGG): This ETF invests in investment-grade bonds and follows the Bloomberg Barclays Aggregate Bond Index.
• Vanguard Total Bond Market Index Admiral Shares (VBTLX): An index mutual fund that follows the Bloomberg Barclays Aggregate Bond Index. The ETF version (BND) has a slightly lower expense ratio.
• Vanguard Inflation-Protected Securities (VIPSX): This mutual fund, while technically not an index, largely follows the Bloomberg Barclays U.S. TIPS Index of inflation-protected bonds. Admiral Shares (VIAPX) has a lower expense ratio and a higher minimum ($50,000).
• Vanguard Small Cap Value ETF (VBR): This ETF tracks the value companies of the MSCI U.S. Small Cap 1750 Index.
• iShares Russell 2000 Index (IWM): This ETF tracks the Russell 2000 index of small-company stocks.
• iShares Russell 2000 Value Index (IWN): This ETF follows the Russell 2000 Value index, an index of small-company stocks.
• iShares Russell 1000 Index (IWB): An ETF that invests in the larger-company stocks that comprise the Russell 1000 Index.
• iShares Russell 1000 Value Index (IWD): This ETF follows the Russell 1000 Value Index, a larger-cap value index.
• Vanguard Total Stock Market ETF (VTI): An ETF that invests in small, medium, and large U.S. stocks.
• Vanguard Real Estate ETF (VNQ): This ETF follows the MSCI U.S. REIT Index, which invests in real estate investment trusts. You can also buy this as a fund — Vanguard Real Estate Index Fund Admiral Shares (VGSLX).
• Vanguard FTSE All-World ex-US ETF (VEU): An ETF that invests globally per the FTSE All-World ex-US Index, which includes about 2,200 stocks of companies in 46 countries, from both developed and emerging markets around the world.
• Vanguard Total International Stock Index Admiral Shares (VTIAX): This index mutual fund tracks the FTSE Global All-Cap ex-US Index. The ETF version (VXUS) has a slightly lower expense ratio.
• iShares MSCI EAFE Index (EFA): An ETF that invests to replicate the performance of the MSCI EAFE Index.

Assessing and changing your portfolio

Although we advocate doing your homework so you can buy and hold solid investments for the long haul, we do at times support selling when it’s appropriate. If you have investments that seem to be doing poorly over an extended period of time, try determining why they haven’t done well and look at making changes to your portfolio.

However, when assessing your current holdings be careful that you don’t dump a particular investment just because it’s in a temporary slump. Even the best investment managers have periods as long as a year or two during which they underperform. Sometimes this happens when the manager’s style of investing is temporarily out of favor. But remember, our definition of “temporary” isn’t measured in days or months; instead, we mean one to two years.

A useful way to evaluate your portfolio once a year or once every few years is to imagine that everything that you currently own is sold. Ask yourself whether you’d choose to go out and buy the same investments today that you were holding. This is an especially good question to ask yourself if you own lots of stock in the company you work for. Determine whether your reasons still are valid for holding your investments.

When you find something inherently wrong with an investment, such as high fees or sub-par management, take the loss and make doing so more palatable by remembering the following:

• Losses can help reduce your income taxes. You can see immediate tax relief/reduction for nonretirement losses.
• Consider opportunity cost. Consider what kind of future return that money could be providing you with if you switched into a better investment.

As you manage your portfolio:

• Don’t become attached to your investments. Over the years, Eric has worked with many clients who have difficulty being objective with and letting go of investments. Just as we get attached to people, places, and things, some investors’ judgments may be clouded due to attachment to an investment. Even if an investor makes the decision to sell an investment based on a sound and practical assessment, his attachment to it can derail the process, causing him to refuse to part with it at the current fair market value. Attachment can be especially problematic and paralyzing with inherited assets.
• Don’t let inertia become a problem for you. It wasn’t unusual for Eric to work with clients who have accumulated tens or hundreds of thousands of dollars in checking accounts. Folks who amassed their savings from work income were often fearful of selecting an investment that may fall in value. These people knew how long and hard they had to work for their money, and they didn’t want to lose any of it.