The Basic Asset Types

While you may have stumbled across numerous investment types and vehicles, let's start by focusing on the three most common categories: cash, bonds, and stocks.

I'll start with cash because it's the easiest to understand and the asset you're probably most familiar with. Cash is simply money in a checking or savings account or another cash-like investment, like a certificate of deposit (CD) or money market fund.

Bonds Are Loans to a Company

Bonds are financial instruments used by companies to borrow money. If you buy a bond, you're essentially loaning money to a company. The financial benefit of investing in a bond is that you will receive interest payments on the loan amount. For example, let's say you loan $100 to Junebug Inc., which agrees to pay you $106 in one year. The extra $6 you receive, above and beyond your original $100 loan, represents the interest payment, or the financial benefit to you as the investor.

Stocks Are Partial Ownership in a Company

Stocks represent a partial ownership in a company. If you buy a stock, you can benefit financially by selling your shares for a profit down the line – assuming the stock price increases, of course.

In the meantime, stockholders are entitled to a portion of the company's assets and profits through dividends and stock buybacks. Dividends are payments made to shareholders from company profits. And a stock buyback is exactly what the name implies – a process through which the company repurchases existing shares of stock at the current price, decreasing the number of company shares overall. Stock buybacks increase the price for remaining shares because each share now represents a greater portion of the company's assets and profits. As a result, stockholders will earn a greater profit on their shares if they decide to sell them.

Companies decide whether to retain or distribute profits on a quarterly basis, and ask themselves: Would the shareholders benefit more if the remaining money were reinvested into the company (with the aim of further growing business earnings and therefore, the share price), or if they were to receive their share of the profits in the form of dividends or stock buybacks?

Mature companies, such as AT&T, may not have as many new or fast-growing projects to invest leftover profit in, so instead, they may return some money to shareholders in the form of dividends or share buybacks. On the other hand, fast-growing companies, like Facebook and Salesforce, may retain profits to further expand their businesses through internal projects and acquisitions.

Now I bet you're thinking: “Okay, smarty-pants. I can see that stock price growth and dividends both benefit investors. But let's get down to the brass tacks: if I decided to invest in the stock market, which benefit would make up the majority of my investment return?”

While the answer isn't so clear cut and will depend on your specific investment holdings, Table 12.3 demonstrates that for companies in the S&P 500 Index, the majority of returns for investors in these companies have historically come from an increase in stock prices, rather than from dividends.²

Taking a Closer Look at Risks versus Returns

Cash, bonds, and stocks each come with their own risks and potential returns. Generally, assets that have a wider range of possible returns from year to year are considered “riskier” than assets that have a narrower set of possible returns.

Cash, bonds, and stocks generally have the following risk and return characteristics:

• Cash: Least risky (lowest variation in returns), but provides lowest returns
• Bonds: Riskier than cash, but not as risky as stocks; generally returns more than cash, but less than stocks
• Stocks: Riskiest type of asset (highest variation in returns), but generally has the highest expected returns

To put some real numbers to this, refer to Table 12.4, which summarizes an analysis performed by Vanguard, showing the best, worst, and average annual returns for various mixes of stocks and bonds using indices that attempted to represent the broader stock and bond markets.

Let's take a closer look at the 100% stock portfolio (first row of Table 12.4). Over the time period of the analysis from 1926 to 2018, you'll notice that this portfolio earned the highest return in a single year at 54%, but it also had the greatest loss in a single year at −43%! That being said, over the long run, this all-stock portfolio brought in the highest average annual return, at more than 10%.

Now refocus your attention to the 100% bond portfolio (last row of Table 12.4). This portfolio produced the lowest average annual return of all of the portfolios (5.3%) over the time period analyzed, but it also lost the least amount of money in a single year (−8%).

What does this all mean? Generally, as you increase the percentage of stocks in your investment portfolio, you may experience more variability in your returns from year to year.

Let's put this concept into real-life terms. Say you had $100,000 to invest in any types of assets you wished. If you invested all that money into stocks, you could very well end up with $154,000 in a year from now (54% return); however, you could also be left with just $57,000 (−43% return). On the other hand, if you invested all that money into bonds, you may come away with $133,000 by year-end in the rosiest scenario (33% return); or you may lose $8,000 and be left with $92,000 in the worst-case scenario (−8% return).

Interestingly, though, these results change when we begin to look at different holding periods (i.e., the amount of time you own a stock or bond). In a 2018 study, J.P. Morgan Asset Management analyzed average annual returns of stocks and bonds over 1-, 5-, 10-, and 20-year holding periods.⁴ The study's findings are depicted in Table 12.5.

Let's focus our attention on the 100% stock portfolio first (top of the table). You'll notice that while the returns for this portfolio ranged dramatically during one-year holding periods (similar to the Vanguard analysis), the amount of variability decreased dramatically for longer holding periods – and in the investor's favor. Specifically, if you look at the 5-year and 10-year portions of the table, you'll see that the all-stock portfolio returned, on average, as much as 20% to 30% annually, while in some periods, only lost 1% to 3% per year, on average. Finally, when you look at the portion of the table for the 20-year holding period, you'll find that negative average annual returns were eliminated entirely for all-stock portfolios – with the lowest average annual return at 7%, and the highest average annual return yielding 17%!

The takeaway is, stocks aren't bad or scary. While stocks could yield a wide range of positive or negative returns from year to year, the variability of your average annual return tends to decrease as you increase your holding period – and much of the downside of investing in stocks, from an average annual return perspective, could be minimized for longer holding periods. (Note: you'll still be subject to highs and lows along the way.)

Individual Holdings versus Diversified Portfolio

All right, let's recap what we've discussed so far: bonds are loans to a company, and stocks equate to ownership in a company. Stocks have much larger swings in investment returns than bonds from year to year, but over a long period of time, stocks generally produce a higher average return than bonds.

Now that you've got the basics down, should you just go out and start picking some individual stocks and bonds to fill your portfolio based on what you read online? My answer would be no, for a couple of reasons.

Less Diversification = Bigger Swings; More Diversification = Smaller Swings

Let's refer back to the Vanguard study on the variability of returns for different stock and bond portfolios that was summarized in Table 12.4. This study assumed you held a well-diversified portfolio consisting of hundreds of different companies' stocks and bonds, not just a stock and bond from a single company. If the table illustrated a portfolio consisting of a stock and bond from a single company, the swings in returns might have been much greater across the board.

For example, a couple of years ago, owning a share of stock from MoviePass's parent company, Helios and Matheson Analytics, might have provided you with more upside if the company did well, but it also exposed you to losing much more of your original investment if the company's business performed poorly. Helios and Matheson Analytics entered 2017 with a stock price of $820 a share (accounting for stock splits), and reached a stock price high of $5,100 on October 13, 2017, a 522% increase! However, by the summer of 2018, the company's stock price had plummeted to mere pennies, losing nearly 100% of its value. What a wild ride!

On the other hand, let's say you have a portfolio with a little bit invested in a number of different companies. Some companies will do well, and others will not do so well. The strong-performing companies will hopefully outweigh the weak-performing companies to give your portfolio an overall positive investment return. We can see this dynamic play out by looking at the performance of the 100% stock portfolio in Table 12.4. While this portfolio did have a wide variation of returns from year to year (−43% to 54%), that range was relatively small compared to what we saw with Helios and Matheson Analytics.

It's Nearly Impossible to Pick the Winners Consistently

Everyone has that uncle or friend who bought a stock or two at the right time (let's say Microsoft in the '90s, or Facebook in 2012), realized a great return, and can't stop telling you about their experience. After hearing their stories, you might think, “If my idiot brother was able to pick winners, I'm sure I could. I used to beat him at everything, so I surely could beat him at this, too.”

But there's a catch: most people only talk about their winners when it comes to investing. Dig deeper, and you'll probably find that they have left a lot of questions unanswered. Sure, they invested in Google in 2004, but how much money did they invest and when did they sell? How'd they do with the rest of their portfolio? They've undoubtedly chosen some losers as well, but those aren't as fun to talk about, so they've conveniently left those details out.

If you were to do a quick online search for a list of the highest-yielding investment categories or asset classes by year, what you'd notice is that no investment category consistently yields the highest returns. Even the ranking of investment categories changes from year to year, with some categories ranking high one year and low the next year. Just think – if it's really hard to predict which asset class will yield the most in any given year, how hard would it be to identify the individual winners within an asset class? The answer is: nearly impossible.

In fact, very few people have been able to pick the winners and outperform the market consistently. Peter Lynch, who managed Fidelity's Magellan mutual fund for nearly 15 years, is a rare example of someone who did just that. During his tenure at Fidelity, his fund averaged returns of more than 29% a year – regularly surpassing the S&P 500 return by more than double.⁵ And of course there is Warren Buffett, who grew the holding company Berkshire Hathaway an average of more than 20% a year from 1965 to 2018,⁶ surpassing the S&P 500 average annual growth of less than 10%. But most other investors, including those touted as “experts” in the media, have not been so lucky.

One example is American economist Nouriel Roubini, who, in 2005, correctly predicted that the US housing market would collapse and cause a recession within the next few years, earning him the nickname “Dr. Doom.” Unfortunately, Roubini has been wrong a number of times since his correct Great Recession call. Perhaps most notably, he predicted another large stock market correction for 2012 or 2013 that never happened.⁷ Rather, the S&P 500 returned 16% in 2012, and more than 32% in 2013.

Businesswoman Meredith Whitney is another investing “expert” who hasn't always read the tea leaves accurately. In 2007, she gained fame after correctly predicting that Citigroup would need to cut its dividend. In December 2010, she appeared on 60 Minutes and famously predicted that there would be 50 to 100 sizable defaults in the municipal market in 2011, amounting to hundreds of billions of dollars of defaults⁸ – a bold call. Unfortunately for Whitney, her prediction was way off base. In fact, the municipal bond market had a great year in 2011, returning investors more than 12%.

The lesson? While people may be right about the stock market some of the time – whether by skill, luck, or a combination of both – they are rarely right all of the time. Predicting the stock market requires you to know not only what to buy, but when to buy it, and the right time to sell the investment – a tall order. So the next time your uncle, a friend, or the expert on TV gives you advice on a must-buy stock, ask yourself: if this person can predict what stocks will substantially increase in value and when, why are they working at whatever they're doing, rather than using their investment gains to relax on their own island?

How to Build Diversified Portfolios Efficiently Through Mutual Funds and ETFs

At this point, you might be thinking: if investing is such a crapshoot, I probably shouldn't even bother. I'd rather just put my hard-earned money in the bank and call it a day. Plus I really don't want to spend my free time studying up on this stuff when I could be on a pizza crawl (or doing anything else, for that matter).

But before you skip ahead to the next chapter, there's another thing you should know: two investment vehicles, mutual funds and exchange-traded funds (ETFs), can allow you to create a well-diversified investment portfolio by buying just one or more funds – giving the average investor a simple way to invest efficiently and reach their goals. Yup, you heard me right.

Mutual funds and ETFs pool money together from many different investors to purchase stocks, bonds, or other assets. Both types of funds offer investors:

• The opportunity to create a diversified investment portfolio
• Low-cost options
• The ability to invest across geographies, sectors, company types and sizes, among other options
• Access to both passively and actively managed investments (we'll come back to this point later)

Yet despite their many similarities, mutual funds and ETFs differ in several important ways. Table 12.6 outlines the key distinctions between these two investment vehicles.

How to Decide Between Mutual Funds and ETFs

If you're liking the sound of mutual funds and ETFs, how do you decide between the two? The following cheat sheet might be helpful as you ponder your options.

You may want to consider mutual funds if you:

• Have sufficient cash to meet mutual fund minimums
• Don't need to buy and sell investments throughout the day
• Prefer to automate ongoing or future purchases

You may want to consider ETFs if you:

• Don't have enough money to meet the investment minimums for mutual funds

  	Mutual Funds	ETFs
  Minimum Investment	Minimum investment varies; some funds have $0 minimums, while others may require an initial investment of $1,000 or more	Require a minimum investment equal to the price of one share, which could be less than $100
  Buying and Selling	Can be bought and sold once a day at the close of each trading day	Can be bought and sold throughout the trading day, much like a stock
  Transaction Fees	May be subject to fixed transaction fees. Most low-cost index mutual funds may not trade free unless you hold your account directly with the fund issuer. For example, buying and selling a Vanguard mutual fund with a Vanguard account may cost $0, while if bought and sold with a non-Vanguard account, it may cost as much as $50.	Are subject to bid-ask spread fees and may be subject to brokerage commissions. ETFs may be subject to a brokerage commission unless you hold your account directly with the ETF issuer. For example, buying and selling a Vanguard ETF with a Vanguard account may cost $0, while if bought and sold with a non-Vanguard account, it may cost as much as $10.

• Value being able to buy and sell investments throughout the day
• Don't mind having to manually execute ongoing or future purchases

Regardless of which you choose, consider picking a brokerage provider that offers low-cost, proprietary mutual funds and ETFs, such as Vanguard, Fidelity, or Schwab, so you can avoid paying brokerage commissions when you buy and sell your holdings. For example, if you choose to have an account with Fidelity, you will typically pay zero transaction fees for buying and selling most Fidelity mutual funds and ETFs, but could pay up to $50 to buy and sell non-Fidelity mutual funds and ETFs.

Allan Roth, financial planner at Wealth Logic and author of How a Second Grader Beats Wall Street, says it's also important to consider a provider's track record and trustworthiness, particularly with a taxable brokerage account. “My first index fund was the S&P 500 index fund from one of the industry giants in the '80s and '90s that later raised its fees (now clocking in at 0.50% compared to 0.05% or less for equivalent funds) leaving me with the miserable choice of staying put and continuing to pay higher fees or selling and being taxed on my profits by the IRS.” That's why Roth recommends Vanguard mutual funds and ETFs for his clients.

Passive versus Active Investing

As I touched on before, both mutual funds and ETFs offer you the opportunity to employ either a passive or an active investment strategy. But what does that mean exactly?

Passive management involves simply trying to track and closely match the investments of a particular market index, while actively managed funds are trying to earn a higher return than the market indexes and benchmarks. For example, a mutual fund or ETF that sought to track the S&P 500 Index would be considered a passively managed fund (and is often referred to as an index fund). Portfolio managers of an S&P 500 index fund would make sure the index fund tracked the S&P Index by selling the stock of companies leaving the index, buying the stock of companies entering the index, and ensuring the proportions of stock in the index fund aligned with the proportions in the S&P 500 Index.

In contrast, actively managed funds are not simply trying to replicate a market index or capture the market return. Rather, they are aiming to beat the market return by performing extensive research and analysis, conferring with potential companies, developing theories on what investments they think will outperform the market, and ultimately executing on those hypotheses.

Deciding whether you're going to employ a passive or an active investment strategy is an important question you'll have to ask yourself, and a decision that could have a big impact on your bottom line. So where does that leave the typical investor (i.e., you're neither a stock market junkie nor are you sitting on piles of excess cash)?

More often than not, I think passive investing through mutual funds or ETFs is the smart approach for the bulk of your investment portfolio. Although an actively managed strategy is clearly more hands-on, that extra effort doesn't always translate into better long-term returns. In fact, a lot of the research suggests the exact opposite. S&P Dow Jones Indices has been diligently tracking active versus passive fund performance for 16 years and in its 2018 year-end SPIVA Scorecard found that the S&P 500 Index outperformed nearly 65% of actively managed large-cap funds over a one-year period. Looking at longer time periods only tilted the pendulum more in favor of passive investing, with the S&P 500 Index outperforming nearly 92% of actively managed large-cap funds over a 15-year period.⁹

With so few actively managed funds able to consistently outperform their respective market benchmarks, it can be extremely difficult to identify, in advance, which active funds will deliver higher returns. And with the extra staff and legwork needed, actively managed funds generally charge much higher fees than passively managed funds, and are less tax-efficient. With that said, there may be certain instances when actively managed funds may be appropriate, such as if a low-cost index fund does not exist for a particular asset class, or if an active fund charges a lower fee than the equivalent index fund.

As you begin to think about what investment strategy may be the right fit for you, know that the choice between passive and active investing doesn't need to be an either/or decision. Even if you choose to use a passive investment strategy for the majority of your portfolio, you could still add an actively managed fund or even a couple of individual stocks into the mix. In fact, I typically allow my clients to have up to 5% of their investment portfolio in “play money” to do just that – a strategy that keeps people on track to reach their financial goals with the majority of their portfolio, while giving them some flexibility to be “active” and maybe get lucky.

Pretax or Roth?

One question you're trying to answer when deciding whether to contribute to your retirement account on a pretax or Roth basis is whether you'd be better off paying taxes today (Roth contributions) or waiting until you withdraw money in retirement (pretax contributions).

A key input is your marginal tax bracket, which determines the amount of current year tax savings you'll reap for pretax contributions or how much in taxes you'll owe for Roth contributions. As you progress to higher tax brackets, you'll realize greater current year tax savings for pretax contributions and increased taxes owed for Roth contributions.

Consider a scenario where you have $10,000 to contribute to your 401(k). If you were in the 10% marginal tax bracket, making a pretax contribution would mean saving $1,000 in taxes in the current year ($10,000 × 10%), while a Roth contribution would mean having to pay that $1,000 in taxes today. If you were in the 37% marginal tax bracket, the numbers get much larger – a pretax contribution would equate to saving $3,700 in current year taxes ($10,000 × 37%), while a Roth contribution would mean having to pay that $3,700 tax bill today.

With perfect information about your career trajectory, future income, and future tax rates, you could simply model out the most efficient decision in a spreadsheet. Unfortunately, we don't have information that is even close to perfect. Most of us have no idea what the trajectory of our careers will be, how long we'll be working, and how much we'll be making – let alone the future direction of tax rates (and if you do know, call me!).

That unpredictability is why having tax diversification, or money spread across investment buckets (i.e., pretax, tax-free, and taxable), is important as well. In the past, most people just threw as much money as they could into the pretax bucket. While withdrawals from pretax accounts are taxed at your marginal tax rate, many assumed they would be in a lower tax bracket in retirement. However, that may not be the case at all.

The US government requires people to withdraw money from their pretax retirement accounts beginning in their early 70s, whether they need to or not, through required minimum distributions. For example, a 74-year-old with a 401(k) balance of $1.5 million would be required to withdraw $63,000 from their pretax account, according to a required minimum distribution calculator from Investor.gov. Add in Social Security and other fixed taxable income, and you can see how you may be on your way to a much higher tax bracket than you anticipated. The withdrawals from pretax accounts affect not only your tax bracket but also could impact your Medicare Part B and D premium amounts, and the portion of your Social Security benefits that are subject to tax. What a major bummer!

Spreading money across investment buckets can help you combat some of these dynamics by giving “future you” flexibility to pull money from pretax, tax-free, or taxable accounts, allowing you to better control your tax bracket in retirement (read: save money).

When deciding whether to contribute to your retirement accounts on a pretax or Roth basis from year to year, you can use the following guidelines as a starting point. However, if your money is overly concentrated in one investment bucket, you may consider straying from the guidelines to diversify your investment buckets.

When to consider a Roth contribution (i.e., pay taxes today):

• You are a recent graduate and expect your salary to increase as you progress in your career.
• You only worked for a portion of the year.
• You're in a relatively low tax bracket (i.e., 10% or 12% for 2019).

When to consider a pretax contribution (i.e., pay taxes later):

• You are in one of the highest tax brackets (i.e., 32%, 35%, or 37% for 2019).
• You already contribute the maximum amount to your 401(k) and have the option and available cashflow to contribute to Roth accounts using the mega-backdoor Roth IRA and/or backdoor Roth IRA strategies.