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Investing 101

LESSON 6: Investment Considerations

The Effects of Taxes

Taxes reduce investment returns in two ways. First, federal and state taxes take a significant percentage out of each dollar an investor earns. Second, when the government takes its cut, you are unable to earn any returns on the money you paid in taxes. IRAs, 401(k)s and tax-deferred annuities provide some relief from taxes since all of these arrangements permit your investments to grow without taxation. Taxes are not assessed until you begin drawing on your savings. The 401(k), which is an employer-sponsored savings plan, permits you to make contributions to your account before your pay is taxed. The Roth IRA is a special case that taxes your contributions, but no tax is assessed when you begin drawing on the investment.

Nothing threatens your investments more than taxes, so tax deferral should be an important part of your investment plan. Consider funding your 401(k) up to allowable maximums. After you have fully funded your 401(k), begin funding an IRA up to the allowable maximums. When you've devoted as much savings as possible to these and other tax-favored plans, begin using tax-deferred annuities.

When it comes to municipal bonds and treasuries, the issue of taxes present a small problem -- their interest payments are generally less than those of taxable bonds. A high-grade corporate bond might pay 6 percent, while a muni or Treasury with the same maturity might pay only 5 percent. You have to ask yourself one question: "Which investment yields a higher after-tax return?"

You'll only need to know two things and have access to a calculator in order to answer this question. The first piece of information is your marginal tax rate. The second is a little formula enabling conversion of taxable interest to non-taxable interest, and vice versa.

Calculating Your Marginal Tax Rate

The marginal tax rate is the rate you pay for each additional dollar of taxable income. To figure this out, you'll have to go digging through your files and find last year's federal and state tax tables. Find the row with the taxable income you expect this year. Subtract the lower "At least" value from the higher "But less than" amount. You'll need to use this number in the next step, so jot it down and hold onto it for a while.

Next, locate the associated income tax amount and then subtract from that value the tax owed for the range of incomes immediately below yours. Add the federal and state marginal tax rates, and you will arrive at your state and federal marginal tax rate.

Translating Taxable and Non-Taxable Rates

The non-taxable equivalent of a taxable interest payment is the stated payment rate multiplied by one minus the marginal rate. Let's say your marginal rate is 30 percent and a taxable bond pays 6 percent. The non-taxable equivalent is .06 times (1 - 0.3) = .042. The result of this calculation tells you that a muni issued in your state paying more than 4.2 percent will earn more after taxes than a taxable bond paying 6 percent. Looking at this from the other direction, the taxable equivalent of a non-taxable interest payment is the stated non-taxable payment rate divided by one minus the marginal rate. Continuing with the scenario we used in the example above, a muni from the state where you reside paying 4.2 percent is .42 divided by (1 - .3) = .06. The result of this calculation tells you that a taxable bond paying more than 6 percent will earn more after taxes than a non-taxable bond paying 4.2 percent.

Use only your state marginal tax rate for Treasuries, and only use the federal marginal rate for munis issued outside your home state.

Dollar Cost Averaging

Dollar cost averaging is one of the most powerful and simple wealth-enhancing techniques ever devised. Put the same amount of money into your investments at preset intervals. Consistently apply the practice indefinitely, and do so without respect to whether the market rises or falls.

Dollar cost averaging draws its power through consistent application and by forcing you to buy more shares when prices are low and fewer shares when prices are high. Here's an example of how dollar cost averaging works: Each month you write a check for $100 and deposit it into your stock fund. Let's say that in the first month you begin the plan, shares of a stock cost $10 dollars, so you buy 10 shares.

The second month, the stock market has skyrocketed. You buy 6.67 stock fund shares at $15 with your $100. So now, after the second month, you own a total of 16.67 stock fund shares. At this point, even though stock fund shares sell for $15, your average cost is only $12.

The markets will rise and fall from month to month. But over the long run, markets will rise in value. By practicing dollar cost averaging over a long period of time, you will always buy more shares when prices are low and fewer shares when prices are high. As a result, your cost per share will be less than their current market value. Besides instilling discipline in the investing process, dollar cost averaging results in more shares purchased at lower prices than prevailing prices. That translates to a sound long-term strategy for wealth enhancement.

Records: Keeping It Simple and Organized

It is a taxable event whenever you sell an investment or your investments pay a dividend or interest. Keeping good records helps you avoid paying more tax than you have to. Brokers and investment companies do most of the record keeping for you. They send you statements itemizing all of your transactions on, at the very least, a quarterly basis. Put all of these statements in chronological order, keeping a separate file for each individual investment. But even a good filing system serves only half of the record-keeping task.

Since files can get thick and unwieldy after a few years, you should also maintain a chronological journal by investment that records each transaction. If you make it a regular practice to record the transaction each time you receive a statement, you can save yourself a lot of trouble later on when you need to call on your records in an emergency situation.

It pays to keep things simple whenever possible. Avoid buying two mutual funds with the same objective unless you have a good reason to duplicate your investment. To keep from becoming overwhelmed, minimize the number of brokerage firms you employ so that the information comes from as few sources as possible. Using brokers that supply reports via the Internet can also lessen the burden if you can download the reports and file them electronically. Just be sure they are safe in case harm comes to your computer.

Evaluating Portfolio Performance

The investor's ability to apply his or her investment plan is an essential element of evaluating a portfolio. A good investment plan starts with an introspective assessment of your risk tolerance and financial goals. These can be at odds with each other, so it's important to reduce them to objective terms.

Let's say your goal is to become rich -- really rich. How will you know when you've become really rich? Define "rich" in terms of the value of your assets or income and a time horizon for achieving it. For example: My goal is to own investments worth $1,000,000, fixed assets worth $500,000 and liabilities not exceeding $250,000 by June 30, 2020.

You'll use investments as one of the means for achieving your goal. But before you begin investing, you need to nail down your risk tolerance and reconcile it with your goals. Risk tolerance places an upper limit on the rate of return you can expect to earn. So if your goal requires above-average returns, your risk tolerance must also be above average. Reconciling risk tolerance and goals requires adjusting your risk tolerance upward or adjusting your goal downward, depending on the situation you find yourself in. Your tool for this reconciliation is the investment plan, where you write down your risk tolerance and goals.

The investment plan states, with as much objectivity as possible:

Investment categories and their allocations

Rejected investment categories

Target rates of return

Intermediate goals

General policies, such as broker selection and tax strategies

Investment strategies including decision rules that govern buying and selling

Procedures for evaluating your plan and goals

A well-conceived plan establishes your blueprint. The implementation of the plan consists of periodic performance reviews, usually on a semi-annual basis, and your ability to follow through with your plan. During the review, examine your plan. Does it still reflect your risk tolerance and goals? Compare each element of the plan with the status of your portfolio. Does the portfolio allocation match the plan? Have portfolio elements matched your targets? Are returns likely to achieve intermediate goals? Have you worked within your policies? Your answers to these questions will govern the implementation of your decision rules for buying and selling.

Evaluation takes time and effort. But like anything worthwhile, effort devoted to planning and evaluating performance yields financial success. Implementation relies on both the plan and the knowledge you have acquired about investing and strategies for success.

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