Sunday, 14 August 2016

A Random Walk Down Wall Street - Part Four 1: A Practical Guide for RANDOM WALKers and other Investors

Chapter 12. A Fitness manual for RANDOM WALKers

I. Exercise 1: cover Thyself with Protection

1. Disraeli once wrote that “patience is a necessary ingredient of genius.” It’s also a key element in investing; you can’t afford to pull your money out at the wrong time. You need staying power to increase your odds of earning attractive long-run returns. Therefore, you have to have non-investment resources, such as medical and life insurance, to draw on should any emergency strike you or your family.

2. Two categories of life insurance:
a. High-premium policies that combine an insurance scheme with a type of savings plan. They do have some advantages. Earnings on the part of the insurance premiums that go into the savings plan accumulate tax-free. But they entail high sales charges.
b. Low premium term insurance that provides death benefits only, with no buildup of cash value. Malkiel’s advice: buy term insurance for protection – invest the difference yourself. To buy renewable term insurance. You can keep renewing your policy without the need for a physical examination. So-called decreasing term insurance, renewable for progressively lower amounts, should suit many families best, because as time passes, the need for protection usually diminishes. However, term-insurance premiums escalate sharply when you reach the age of sixty or seventy.

3. Take the time to shop around for the best deal. You do not buy insurance from any company with an A.M. Best rating of less than A.

4. In addition, you should keep some reserves in safe and liquid investments. Every family should have a reserve of several months of living expenses to provide a cushion during an emergent/hard time.

II. Exercise 2: Know your investment Objectives

You must decide at the outset what degree of risk you are willing to assume and what kinds of investments are most suitable to your tax bracket.

1. J.P. Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. The friend asked, “What should I do about my stocks?” Morgan replied, “Sell down to the sleeping point.” Every investor must decide the trade-off he is willing to make between eating well and sleeping well. High investment rewards can be achieved only at the cost of substantial risk-taking.

2. Step One: find your risk-tolerant level. a sleeping scale on investment risk and expected rate of return (P282-3): bank account Æ money market deposit accounts Æ Money-market funds Æ special six-month certificates Æ Treasury inflation-protection securities (TIPS) Æ high-quality corporate bonds (prime-quality public utilities) Æ Diversified portfolios of blue-chip US or developed foreign country common stocks Æ Real estate Æ Diversified portfolios of relative risky stocks of smaller growth companies Æ Diversified portfolios of emerging market stocks.

3. It is critical that you understand yourself before choosing specific securities for investment. Perhaps the most important question to ask yourself is how you felt during a period of sharply declining stock markets. If you became physically ill and even sold out all your stocks rather than staying the course with a diversified investment program, then a heavy exposure of common is not for you.

4. Step Two: identify your tax bracket and income needs. You have to check how much tax you have to pay for your investment returns. For those in a high marginal tax bracket there is a substantial tax advantage from tax-exempt (e.g. municipal) bonds and stocks that have low dividend yields but promise favorably taxed long-term capital gains. If you are in a low tax bracket and need a high current income, you will be better off with taxable bonds and high-dividend-paying common stocks, so that you don’t have to incur the heavy transactions charges involved in selling off shares periodically to meet current income needs.

III. Exercise 3: dodge uncle Same whenever you can

One of the best ways to obtain extra investment funds is to avoid taxes legally. You pay no income taxes on the earnings from money invested in a retirement plan until you actually retire and use the money.

1. Pension plans and IRAs: check to see if your employer has a pension or profit-sharing plan, such as a 401(k) or 403(b)7 savings plan. If so, you are home free. If not so, you can contribute up to $3000 a year to an Individual Retirement Account if your are single. Contribution limits are scheduled to rise in subsequent years. Although the contribution to your IRA is not tax deductible if your income is high, the IRA account is still a good deal because the interest earnings on your contributions compound free of tax.

2. Keogh plans: For self-employed people, they can contribute as much as 20% of their income, up to $30000 annually. The money paid to Keogh is deductible from taxable income. My advice is to save as much as you can through these tax-sheltered means. You can’t touch IRA or Keogh funds before turning fifty-nine and a half or becoming disabled. If you do, the amount withdrawn is taxed, and you must pay an additional 10% penalty on it.  But even with this catch, I believe IRAs and Keoghs are a good deal.

3. What can Keogh and IRA funds be invested in? Your choice should depend on your risk preferences as well as the composition of your other investment holdings. My own preference would be stock and bond funds.

4. Roth IRAs- for those whose income is below certain levels. The traditional IRA offers “jam today” in the form of an immediate tax deduction. Once in the account, the money and its earnings are only taxed when taken out at retirement. The Roth IRA offers “jam tomorrow” – you don’t get an upfront tax deduction, but your withdrawals are tax-free. In addition, you can Roth and roll. You can roll your regular IRA into a Roth IRA if you are within the certain income limits. You will need to pay tax on all the funds converted, but
then neither future investment income nor withdrawals at retirement will be taxed. Which IRA is best for you is dependent on: whether you are likely to be in a higher or lower tax bracket at retirement, whether you have sufficient funds outside your IRA to pay conversion taxes, your age and life expectancy.

A rule of thumb: if you are close to retirement and your tax bracket is likely to be lower in retirement, you probably shouldn’t convert, especially if conversion will push you into a higher bracket now. But if you are young and are in a lower tax bracket now, you are very likely to come out well ahead with a Roth IRA.

5. Tax-deferred annuities: it is useful if you have exceeded the limitations involved in other tax-advantaged savings programs. It is a contract between you and an insurance company, purchase with one or more payments; the funds deposited accumulate tax-deferred interest, and the money is used to provide regular income payments at some later time. The insurance company guarantees return of your original deposit at any time. But do check the fee tables. In general, annuities are more expensive than IRAs and Keogh invested in mutual funds. Therefore, you should invest in an annuity only after you have placed the maximum amount in a regular retirement plan, such as a 410(k), 403(b)7, Keogh, or IRA.

IV. Exercise 4: Let the Yield on your cash reserve keep pace with inflation

Four short-term investment instruments that can at least help you stand up to inflation.

1. Money-market mutual funds: in my judgment, they provide the best instrument for many investors’ needs. They combine safety, high yields, and the right to withdraw money with no penalty attached. Most funds allow you to write large checks against your fund balance, generally in amounts of at least $250.

2. Money-market deposit accounts: provided by banks. Money funds’ yields tend to higher than the bank accounts. In addition, the money funds allow an unlimited number of checks to be written against balances.

3. Bank Certificates: you need at least $10,000 before you can buy. And you can’t write checks against the certificates. There is a substantial penalty for premature withdrawal. Finally, the yield on bank certificates is subject to state and local taxes.

4. Tax-exempt money-market funds: they are useful for investors in high tax brackets.

V. Exercise 5: Investigate a Promenade through bond county

There are four kinds of bond purchases you may want to consider.
1. Zero-coupon bonds: the purchaser is faced with no reinvestment risk. The main disadvantage is that IRS required that taxable investors declare annually as income a pro rata share of the dollar difference between the purchase price and the par value of the bond.
2. No-load bond funds: because bond markets tend to be at least as efficient as stock markets. I recommend low-expense bond index funds, which generally outperform actively managed bond funds. In no event should you even buy a load fund. For investors who are very risk averse, I favor GNMA funds. These funds invest exclusively in GNMA (Ginnie Mae) mortgage pass-through securities. Mortgage bonds have one disadvantage in that when interest rates fall, many homeowners refinance their high-rate mortgages and some high-yielding mortgage bonds get repaid early. It is that potential disadvantage that makes the yield on government-guaranteed mortgage bonds so high.
3. Tax-exempt bonds are useful for high-bracket investors. If you buy bonds directly (rather than indirectly through mutual funds), I suggest that you buy new issues rather than already outstanding securities. New-issue yields are usually a bit sweeter than the yields of seasoned outstanding bonds and you avoid paying transactions charges on new issues. And you should keep your risk within reasonable bounds by sticking with issues rated at least A.
To protect yourself, make sure your bonds have a ten-year call-protection provision that prevents the issuer from calling your bonds to issue new ones at lower rates. If you have substantial funds to invest in tax-exempts ($25000 or more), you should buy tax-exempt bonds directly. If you only have several thousand, buy through a fund.
4. Inflation-indexed bonds: TIPS (Treasury inflation protection securities).
Although stocks have bestowed generous long-run returns, they usually suffer during inflationary periods. TIPS will offer higher nominal returns, whereas stock and bond prices are likely to fall. But TIPS are taxable. They are not ideal for taxable investors and are best used only in tax-advantaged retirement plans.

VI. Exercise 6: Renting leads to flabby investment muscles

1. A good house on good land keeps its value no matter what happens to money.  The long-run returns on residential real estate have been quite generous.
2. Interest payments on your mortgage and property taxes – are fully deductible;
3. Realized gains in the value of your house up to substantial amounts are tax exempt. Own your own home if you can possibly afford it.

VII. Exercise 7: Beef up with real estate investment trusts (REITs)

1. Ownership of real estate has produced comparable rates of return to common stocks over the past 30 years.
2. Real estate is an excellent vehicle to provide the benefits of diversification.  Because real estate returns have relatively little correlation with other assets, putting some share of your portfolio into real estate can reduce the overall risk of your investment program.
3. Real estate is probably a more dependable hedge against inflation than come stocks in general.
4. Most REITs have generous dividends and in some cases the dividends are partially tax exempt.
5. I believe all investors should have a portion of their portfolios invested in REITs.

VIII. Exercise 8: Tiptoe through the fields of gold, collectibles, and other investments.

1. The problem is these things often don’t yield a stream of benefits, such as dividend returns. I am slightly more positive about gold as an investment, but far from enthusiastic. Small gold holdings can easily be obtained now by purchasing shares in one of the specialized mutual funds concentrating on gold.
2. My advice for buying collectibles: buy those things only because you love them, not because you expect them to appreciate in value.

IX. Exercise 9: Commission Costs Are not random; some are cheaper than others

1. Many brokers today will execute your stock orders at discounts of as much as 90% off the standard commission rates charged by the leading brokerage houses. The discount broker usually provides a plain-pipe-rack service. If you want opinions on individual stocks and general portfolio advice and investment suggestions, the discount broker may not be for you.
2. If you know exactly what you want to buy, the discount broker can get it for you at much lower commission rates than the stand full-service house. Some discounters do the transactions off the exchange and the net price you end up paying is actually higher than that charged by a full-service broker. Purely for the execution of stock-market orders, you can use an honest discounter.

In sum, I believe common stocks should form the cornerstone of most portfolios. High returns can be achieved only through higher risk-taking.  The amount of risk you can tolerate is partly determined by your sleeping point. Risk is also significantly influenced by your age and by the sources and dependability of your noninvestment income.

A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel

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