As You Prepare to Invest

As You Prepare to Invest

This an excerpt from How to Invest Wisely. To purchase the book, click here.

As we shall see, a coherent strategy is essential to successful investing. Before developing such a strategy there are several things you need to determine and consider. These start with a determination of what portion of your holdings you will devote to your investment portfolio and what portion is to be held in reserve for emergencies or for planned outlays in the near future.

The way to begin is to list and appraise your current and probable future resources, and your current and future obligations. The reason for this exercise is not only to determine how much you have (it is amazing how inaccurate such estimates can be in the absence of a comprehensive and detailed appraisal), but also to determine how much you can prudently invest.

Determine Necessary Reserves

Funds for day-to-day expenses, reserves for emergencies, and accumulations for anticipated major outlays should be held in checking and savings accounts, or other liquid short-term, fixed-dollar claims. Reserves for emergencies should typically amount to six to 12 months’ living expenses. Individual circumstances vary greatly, and such holdings might be larger or smaller than this rule of thumb would indicate. For example, a married man with several dependents and whose major source of income is sales commissions should keep much larger reserves in relation to living expenses than, say, a widower on a military pension who lives next door to a Veterans Administration hospital.

Similarly, accumulations toward items such as college tuition or the down payment on a house that are likely to be needed within five years are best placed in short-term bonds, certificates-of-deposits (CDs), and other fixed-dollar claims that will come due before the time of the anticipated outlay. It will be mainly the periodic contributions that will make your money grow, and the risks involved in reaching for higher returns are unwarranted.

Although short-term, fixed-dollar claims are often inappropriate investments in an era of fiat currency, if you live and work in the United States, such claims are the appropriate vehicles for working balances, reserves, and accumulations for foreseeable outlays.

Your Dollar Holdings

Bank deposits insured by the Federal Deposit Insurance Corporation (FDIC) are usually the most convenient for working balances. Do not deposit more in any one bank than the maximum insured amount per “category of legal ownership.” (The FDIC raised this maximum to $250,000 in October 2008, but it is scheduled to revert to $100,000 on January 1, 2014). Deposits maintained in different categories (single vs. joint accounts) are separately insured. Separate insurance is also available for IRAs and other retirement accounts.

Funds placed in bank certificates of deposit (CDs) should have a range of maturities and interest rates. You will be less subject to interest-rate fluctuations and, more significantly, if you need cash prior to maturity, you will only have to pay the penalty for early withdrawal on the portion you withdraw.

Some banks offer money-market deposit accounts which are insured; however, money-market funds are not insured and, accordingly, those funds that invest in commercial paper, jumbo CDs, and other private instruments carry some degree of risk. All-government money market funds that hold only U.S. Treasury obligations pay somewhat lower interest rates, but have very little risk.

Tax-Exempt Securities

Another type of fixed-dollar holding is the tax-exempt security or municipal bond (obligations of state governments and their political subdivisions). Many investors are drawn to these because the interest on them is not subject to direct federal income taxes. However, receipt of this interest income can boost the taxes due from some taxpayers on their other income. In addition, states that levy income taxes do not exempt interest receipts from other states.

Before considering municipal bonds, you should determine (preferably with the assistance of your accountant) what marginal income-tax rate (federal, state, and local) you can expect to pay on taxable interest income. You also need to determine if the effective rate on your other income would increase if you received tax-exempt interest.

For most people, the interest from municipal bonds is equal to or less than what they would have in hand after paying taxes on taxable instruments of comparable maturity and risk. In this case, the major advantage of holding municipal bonds is the psychological satisfaction of paying less in taxes.

High-income taxpayers living in high-tax jurisdictions are the most likely to find municipal bonds or municipal-bond funds attractive. But if you plan to limit fi ed-dollar holdings to the amounts you need for reserves, any advantages of municipal-bond holdings will probably be offset by their lack of liquidity, as the difference between the purchase and the sale price of municipal bonds in the secondary market tends to be large. To some extent, municipal-bond funds can overcome this lack of liquidity. But the expenses of such funds reduce their yield to the investor.

Holding Your Investments

You also need to consider, or at least understand, the implications of how and where you hold your investments.

You may hold assets as an individual or jointly with others (such as a spouse or children). You may hold them directly (tax-favored retirement ac- counts being a major exception). But receiving, holding, and delivering stock certificates and bonds and depositing dividend and interest checks involves much tedious clerical work. This may be avoided by holding securities in a brokerage (or custodian) account. You also may hold assets in revocable or irrevocable trusts.

People often make these decisions in a haphazard fashion. But these choices carry important implications for taxes, the ease (or difficulty) of administering your estate, and providing for children, especially in instance of divorce and remarriage. The issues involved should be thoroughly discussed with your lawyer and accountant, if only to give you an understanding of the possible ramifications of how your assets are titled and held.

You should take physical possession of tangible items, such as gold coins, that you acquire as investments. Tangible items represent stores of value that are not dependent on anyone’s promise, and they cannot be seized with the stroke of a pen. Turning tangible stores of value over to a fiduciary or custodian defeats much of the purpose of acquiring them. But such valuables should be held in a secure place; theft will always remain a potential problem.

On the other hand, securities of any kind are simply pieces of paper. As such they depend on someone’s explicit or implicit promise to pay you something in the future. Many investors prefer to take delivery of the securities they purchase and hold the certificates themselves. During the 1970s, this was often recommended because of severe problems in the back offices of brokerage firms. Such problems appear to have been largely overcome and, since the establishment of insurance protection, there have been no losses to customers from lost securities or broker insolvencies.

Moreover, and in contrast to 30 or 40 years or so ago, nearly all brokers now sweep dividends, interest, and sales proceeds into an interest-earning account, such as a money-market fund of the customer’s selection, as soon as received. Keeping your negotiable securities in a brokerage account can relieve you of the clerical work of depositing checks and maintaining income-tax records— the broker will send to you a year-end statement for all interest and dividends received. If needed, the broker can send you accumulated funds or deposit them directly in your checking account. The assets in tax-deferred accounts (such as IRAs) must be held by a broker or other custodian, so that you can prove to the tax collector that you have not spent the money.

Selecting a Custodian

Experience suggests that the quality of service you get for your account depends more on the local office than on the specific firm. For smaller retail accounts, there seems to be no discernible difference between discount and full-service brokerage firms in the accuracy and timeliness of statements or the responsive- ness to instructions. Bank custodians usually are less efficient and much more expensive than any broker. You not only have to pay the bank’s fees, but also full commissions on any trades.

Commissions and fees are higher at full-service brokers than at discount brokers. But a more significant difference is that a discount broker will only execute your orders. He or she will neither recommend trades nor attempt to sell to you issues they underwrite. This is often an advantage—brokers who depend on commission income for their livelihood may not always be willing to put your interests first. Unless you have established, and wish to maintain, a close relationship with an experienced and conscientious account executive, a discount brokerage firm is usually the better choice.

Read more excerpts from How to Invest Wisely:
As You Prepare to Invest
Active Versus Passive Investing
Why Most Investors Fail
The High-Yield Dow Stock Selection Strategy