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Individual stocks versus mutual funds

March 30, 2015March 30, 2015 Stocky 2 Comments

When you start investing, one of the first decisions that you’ll need to make early on is what should you invest in, individual stocks or mutual funds. Let’s break it down, Dr Jack-style*.

ACCESSIBILITY: There was a time when “where” you could invest in either stocks or mutual funds was a big deal. For stocks you had to go to a broker like E-trade or TD Waterhouse. For mutual funds you typically worked directly with the mutual fund company like Vanguard or Fidelity. Now days pretty much all the companies have made it so you can invest in any mutual fund you want as well as have a brokerage account to buy individual stocks. Advantage: Push

COSTS: A bit of an interesting question. Over the years trading fees have really come down. Now days you can pretty easily find a firm that will charge $5 per trade or even less (Vanguard charges me $2). Compare that to mutual fund management fees which can range from 0.1% for index funds to 1.5% on the high end. As an example, if you have a nestegg of $500,000 and you’re paying 1% in mutual fund management fees, that’s $5000 each year. That would buy you 1000 trades at $5 each; unless you’re a day-trader, you’re probably not trading anywhere near that amount. Advantage: Stocks

DIVERSIFICATION: The major advantage of mutual funds is the diversification they give you in an easy package. Statistics show that an investor can be fully diversified with 20 or 30 different stocks, but you have to be pretty strategic in picking those, and that means a lot of work. Advantage: Big advantage to mutual funds

EFFORT NEEDED: Mutual funds just seem easier. You pick the one you want and invest in it. There are also features like automatic investment which allows you to set it up over time. With stocks, you have to make every purchase, and if you’re diversifying you have to make several purchases. That just seems like more work than is necessary. Advantage: Mutual funds

INTERNATIONAL INVESTING: I’m not an expert here, but I don’t know if you can invest in foreign stocks easily from your domestic brokerage. There are ADRs (American Depositary Receipts) which is another option to invest in foreign stocks, but all that starts to get a little confusing. International mutual funds are as easy to buy as domestic mutual funds, and you don’t have to go through any of the hoops. Advantage: Mutual funds

KNOW WHAT YOU HAVE: One problem with mutual funds is knowing what you actually own. Do you own Coca-Cola stock or not? Legally, mutual funds have to disclose this to some degree, but that’s a bit of a pain and depending on the type of mutual fund it might be constantly changing. With stocks you know exactly what you have at any given time because you own the actual stock. Advantage: Stocks

PICK WHAT YOU WANT: Some people are particular about the stocks they own for reasons beyond getting a good return. You had a terrible experience with AT&T so you won’t own their stock. You have moral issues with Wal-mart’s wage policies or Exxon’s environmental record. With mutual funds you’re a bit at the whim of the mutual fund manager, so it could very well mean you end up owning these stocks, and you may not even know it. This isn’t the case if you buy individual stocks because you know exactly what you’re buying and if you don’t like it or you do like it, you can act accordingly. Advantage: Stocks

BOND INVESTING: This is about stocks, but bonds present a special problem. If you buy bonds directly, they tend to come in large denominations like $1000 or $10,000. If you want to invest less than that in a given transaction, it’s not very easy unless you do it with mutual funds which allow you to invest in pretty much any denomination you want. Advantage: Mutual funds

DIVIDENDS: Many stocks (and nearly all bonds) pay dividends . The question is what to do with them? With stocks (and bonds) you typically get the cash deposited in your account, and then you need to figure out where to invest that. You have that option with mutual funds, but a nice advantage with most mutual funds is you can automatically invest it into the mutual fund. Advantage: Mutual funds

For me, mutual funds are the clear winner. I love how they make it really easy to invest and then move on. That’s the deciding factor for me. There certainly are disadvantages, but they aren’t that big a deal to me. I’m not really that particular about which stocks I own from a moral perspective. Costs are certainly important and that’s why I try to find the mutual funds with the lowest expenses by going with index mutual funds.

Actually the only stock I own is Medtronic stock that I get from my company’s stock purchase plan. Whenever I have the choice, I always go with mutual funds and never with individual stocks.

What do you think? Did I get this right, or do you think I missed something?

* Jack Ramsay was a coach in the Hall of Fame NBA, and he actually had a PhD from University of Pennsylvania (I guess that’s a decent school). He was famous for breaking down match up of teams with different criteria like defense, rebounding, speed, etc.

Figure out your investment time horizon

March 11, 2015March 11, 2015 Stocky Leave a comment

“Time is on my side, yes it is” –Rolling Stones, Time is on my Side

Okay, you’re ready to join me in the land of financial freedom. One of the first things you need to figure out your time horizon for the money you’re saving. Will you need that money in a couple months or sooner, in the next couple years, in the next ten years, or at retirement? These answers will have the greatest impact on how you invest it. Here is my take (and as always, I’m not an expert, and these are just my opinions; any predictions I make about the future are just based on historical trends, and you should establish your own opinion on the future).

Extremely short-term (tomorrow to next 6 months)

Your property tax bill, ‘Lil Fox’s preschool tuition payment, living expenses if you’re retired like Grandpa Fox. With such a short time horizon, you really don’t have a lot of options. For amounts less than $5,000, it’s probably easiest to keep it in your checking or savings account, even though the typical interest rates on those accounts are practically zero. Money market accounts would offer a little more interest, but even then you’d be looking at 2% or less, so it may not be worth the $1.50 per month in interest you earn on $1000 to set something up.

If you’re talking a larger amount of money, you want something that has a very low risk of decreasing in value, but still offers an interest rate that makes the effort worthwhile. Short-term bond funds like Vanguard Short-Term Bond Index (VBISX) may fit the bill. There’s a pretty small chance that your investment will decrease in value (but it’s not 0% so be prepared), but you can still earn a decent ~3% interest; that’s about $25 every month for a $10,000 investment.

Short-term (6 months to 3 years)

Car fund because you have a 2001 Honda Civic with a bad transmission (the Fox family in June 2013), vacation you want to take to Hawaii without the kids two years from now. Because you have extra time compared to the “extremely short-term”, it’s definitely worth it to invest for any amount more than $500. Similar to above, you probably want a bond fund of some sort, but because of the extra time you can take on a slightly more volatile investment and grab the higher return. Something like Vanguard Medium-Term Bond Index (VBIIX) gives a decent return, about 4% historically, with a pretty low risk that you’ll lose more than you gain over a year or two. Just so you hear that “cha-ching” sound in your head, if you invested $1000 in a bond fund, after three years at 4% interest, you would have about $1125, a tidy little $125 profit earned for nothing more than being smart about where you put your money. That could fund those Mia-Tias on the beach in Hawaii while you remember all the extra free time you had before the kids came along.

Medium-term (3 years to 10 years)

Mini Fox’s college fund, down payment on Mrs Fox’s dream vacation house down the shore. With a longer time horizon, your options really start to open up. A few years starts to give you the time to weather some moderate financial storms, but probably not enough to go fully into stocks (ask someone who invested money in October 1929 or November 2000). The winner is probably some balanced fund like the Vanguard Balanced Index Fund (VBINX). These balanced funds will have a mix of bonds, with the price stability they provide, and stocks, with the potential for higher returns those provide. For those closer to the 10-year mark or those willing to take a little bit more risk for a higher return, you could jump into an all-equity mutual fund like Vanguard Total Stock Fund (VTSMX).

Long-term (10 years to retirement)

Mr Fox’s 401k, Mrs Fox’s IRA. Once your time horizon gets past 10 years, things start to get interesting and fun. Because this is where most of your savings for retirement should be (unless you’re Grandpa Fox, enjoying retirement), this is where I’ll focus most of my time. Also, because this is where you have the most options, this is where there’s the biggest risk that you can screw it up and cost yourself tens or hundreds of thousands of dollars over the years.

While we can spend a ton of time discussing this (and believe me, I will) a simple starting point on where to put your money for something like this is the Vanguard Total Stock Fund (VTSMX). In time, we’ll discuss other investment options but this is a good start.

In the cases of the medium-term and the long-term strategies, at this point you are truly entering the world of investing. Welcome. Your returns on any particular year can range from -10% or worse to 20% or better, and you can count on the fact that sometimes it will be a bumpy ride.

How to invest a windfall

March 2, 2015August 25, 2015 Stocky 1 Comment

We got this letter from a reader:

Stocky,

Sadly my father passed away, but he had a $200,000 life insurance policy. My mom spent $60,000 as a down payment on a house and $40,000 for my sister’s medical school. That leaves $100,000 left; I was thinking about going into business with a couple shady guys to start a liquor store, but my wife talked some sense into me. So we decided to invest the money in an S&P500 index fund (VFINX).

My question to you is, should we invest the $100,000 all at once or spread it out in smaller investments over a couple months?

Walter Y from Chicago, IL

I admit I may have made this letter up as a framing device, but Walter’s problem is a pretty common one. Maybe it’s an insurance payout, a tax refund in April, a bonus check, or a bunch of cash you’ve accumulated in your checking account. In fact, every July the Fox family faces this exact scenario when I get my bonus check. Let me tell you my thoughts on the matter (which of course is not an expert opinion, and which looks at historical price movements but makes no prediction on future stock movements).

When I get my bonus, and what I would have suggested to Walter, is to take the big chunk of money and invest it in equal pieces over a couple months. Vanguard and most places will let you set up an automatic investment, so in the words of Ron Popeil “you can set it and forget it.” So let’s imagine for Walter he would invest $10,000 per week into his mutual fund for the next 10 weeks. Why do I do it this way? Because I’m a spaz.

If I invested all the money at once, I would be totally freaked out that I would buy at the wrong time—either I would buy the day after stocks went up 1% or I would buy the day before stocks dropped 1%. Using Walter’s scenario of $100,000 to invest, that would mean I could “lose” $1000 by investing at the wrong time. That would totally tie me up in knots and I would be looking at the stock market trying to find the exact right time to jump in, like a kid on the playground playing jump-rope. Of course we know from A Random Walk Down Wall Street, that all that stuff is random so there’s no point trying to time it, but I’m not totally rational when dealing with that much money.

For the blog, I did a little analysis and found that 12% of the time stocks* lose at least 1% in a single day; if I bought the day before that happened, I’m out at least $1000. On the other side, about 13% of the time stocks rise 1% or more in a day; if I bought the day after that I’d similarly be out $1000.

My fragile nerves just can’t take that so I want to “diversify” the timing of my purchases to even out those big ups and big downs. This is a strategy called “dollar cost averaging”. So as I said, initially I would have recommended to Walter that he take the cautious path, take his $100,000 and split it into $10,000 chunks, and invest those each week for the next 10 weeks.

But then using the magic of spreadsheets and the internet, I decided to see what the actual data said. I looked at every week for the market since 1950 and did a comparison of the two scenarios:

Invest your entire chunk of money all at once
Spread your investment evenly over 10 weeks (dollar cost averaging)

Wouldn’t you know that on average it’s better to invest your entire chunk at once? I’ve been doing it wrong this whole time, so thank you Stocky Fox. In fact it’s not even close—historically it has been better to do option #1 about 61% of the time.

The thinking is that historically, stocks have always gone up. Sure there have been some rough patches, some of which can last a really long time, but the general trend is definitely upwards. So if you wait to invest your money over a longer time period, you’re missing out on some of that upward trend. I looked at every week since 1950 (if you were curious, there are about 3400 weeks) and on average you gain about 0.7% by going with option #1 instead of option #2. 0.7%!!! Holy cow. Remember that post on The power of a single percentage? We just found a 1% coupon right there.

So Walter, my advice is to pick a day this week and invest it all in one fell swoop. You might get hit with bad luck, but the odds are better that you’ll get hit with good luck to the tune of about 0.7% (which in your case is about $700). On the day you do it, don’t even look at the stock market and have several tablets of Alka Seltzer on hand.

*For this analysis I am using the S&P 500 data going back to 1950.

How to get started saving for retirement

February 12, 2015August 25, 2015 Stocky Leave a comment

So many people I talk to love the idea of investing for retirement and know they need to be doing it, but they just don’t know how to start the journey. As a result, they don’t do anything, months and then years go by and they’re still at square one, but now they’re pissed because they missed out on the red-hot stock market that increased 50% over the past few years. So here is what I would do in order of “Stockiness” (stockiness is a word I just made up that loosely translates to investing wisely).

401k or 403b

If you work for a company that offers a 401k or a 403b, that is probably the best and easiest place to start investing. First, most companies have it set up so it’s pretty easy to sign up and get started. Also, since they deduct the money out of your paycheck, it might be easier for some people to save the money “without having to do anything”. Plus there’s the benefit that most of these plans don’t have any minimum amounts you have to start an account with, so you can sign up, have then deduct your 4% or 10% or whatever, and you’re set.

Of course we’ve saved the best for last—there are two MAJOR advantages of 401k and 403b accounts that really help you boost your nestegg. First, both are tax-deferred (much more on this in a later post) which means that you don’t get taxed on your contributions. So when you put $10,000 into your 401k this year, you don’t pay taxes on that money; had you not used your 401k then you would be taxed at normal income rates which could go all the way up to 40% or even higher, depending on what your situation is—that’s $4000 right there. Certainly, you’ll have to pay taxes when you withdraw the money in retirement but it’s pretty likely you’ll be paying a much lower tax rate then, compared to the tax rate you’re paying while you’re working.

The other MAJOR advantage of these accounts is that most companies offer some type of matching. It’s typically something like they will match $0.50 for every dollar you put into your 401k up to 6% of your salary. Every company is different on their match but there is one thing they all have in common—they’re giving you free money if you’re willing to take it. Like so many things in investing, over time this matching can add up to a lot— tens or even hundreds of thousands of dollars for this little jewel.

As with all things, if it seems too good to be true, you should probably read the fine print. There are a lot of rules associated with 401k and 403b accounts (as I said in the disclaimer, I’m not an expert here). The big one is when you can withdraw the money. The government allows those great tax advantages at the cost of limiting your ability to get at the money; the idea is to have you save that money for your retirement, not your next car or next Berkin handbag (which can cost as much as a car—totally blew me away when Foxy Lady told me that). If you’re in a pinch you can get the money sooner, but it is a major pain in the butt, and often times there are penalties. So the general rule is: put money in your 401k or 403b that you won’t need until your late 50s.

Individual Retirement Accounts (IRAs)

If your job doesn’t offer a 401k or 403b, the next best thing is probably an IRA. They are similar to 401k accounts in that they have tax advantages that can really add up over time, so that is one of the MAJOR advantages. Unfortunately, they don’t have the matching feature which is a bummer. Also, similar to 401k and 403b accounts, these are meant for retirement savings (and have similar penalties for early withdrawal) so it’s best to put money here that you don’t plan on needing until your 50s or 60s.

Unlike 401k and 403b accounts, you have to set these up on your own. It’s not difficult, but it certainly isn’t as easy as if you just check a box at work. The first thing you’ll need to do is pick between a Roth IRA or a traditional IRA. There’s a ton of debate on which is better, but as a general rule I would go with a traditional IRA. Ironically, when I made that decision for myself 15 years ago I went with a Roth IRA and I think I made the wrong decision.

Then you’ll need to set up an account with Vanguard or Fidelity or one of a hundred other firms. Another unfortunate feature of IRAs compared to 401k accounts is that they tend to have a minimum amount required to open an account. For Vanguard it tends to be about $3000, so that may take a little while to gather before you can get started, but it’s still definitely worth the effort.

But there is a nice advantage that IRAs have over 401k accounts—you have many more investment options. With a 401k you are limited to the mutual funds that the company has set up. My experience with 401k accounts is that you have a good variety—bond funds, domestic stock funds, international stock funds, target retirement funds—but you may only have 10 or so choices. With an IRA you can choose from almost any mutual fund there is (just to put that in perspective, Vanguard has 100 funds to choose from).

Brokerage account

If neither of the above options work for you (and that would seem really odd that they wouldn’t, but I guess you have your reasons), then you can open a regular brokerage account with Vanguard or Fidelity or others. Here you could invest in all the same mutual funds that are available to you with IRA accounts.

As you’d expect, the major drawback on these is that they don’t have the tax advantages of the 401k, 403b, or IRA accounts and that can be a pretty huge deal. On the other hand, they do not have any of the penalties associated with early withdraws, so that might be something attractive depending on what you have on the time horizon.

So there you go. Investing is a long journey, but as some poet who’s been deal a long time said, “Every journey begins with a first step.” So the first step is opening an account so you can start investing.

How did you get started investing? We’d love to hear your story.