Mutual Fun(d) Decisions: Part 3, IRA What?

Happy [belated] 4^th of July, Readers!

In honor of Independence Day, today, we’ll take a reader question, one that I’m sure more than one person out there has:

Dear Stock Market Chic,

Thank you so much for the great insights! My investing life will never be the same! Anyway, I know you’ve talked in previous posts about 401Ks, but I’ve also heard of IRAs and Roth IRAs. What’s the difference?

Signed,

IRA, what?

 

Dear IRA,

Thanks for your question! With so many different investment account acronyms out there, it can be confusing to get them all sorted, so it’s a great question.

A 401K is a retirement savings account sponsored by your employer. Money may be taken from your paycheck pre-tax to help fund it, and the percentage you want to contribute is typically up to you. Some employers require a certain amount; others don’t. Either way, you should save as much as you can. Generally, your employer will match your savings with a certain percentage contribution, too, but those funds may be off limits until the “vesting period” is over; that is, you might have to stay with your employer for a certain amount of time in order to actually get their end of the contribution.

 

There are limits to how much you can contribute in a year, though. The cut-off varies year to year, but is normally somewhere between $15,000 and$17,000, which is a lot to set aside anyway. You decide how to invest your 401K assets, and none of it is taxed until you take it out of the account. BUT there is a 10% penalty tax if you take the money out of the account before you’re 59 ½ years old, on top of the income tax you’d get socked with (there are some legitimate reasons to not get penalized, though, but they are few and far between). So, to that end, leave your 401K there until you’re ready to retire, or roll it over into an IRA.

For more info on 401Ks, click here.

An IRA, or individual retirement account, is another type of retirement savings account, but is not associated with an employer. You can open an IRA at your local bank or credit union. This account is commonly known as a “traditional” IRA, as opposed to a Roth, which we’ll discuss in the next section. The biggest thing to know about traditional IRAs is that they are tax deferred, so you don’t pay any tax on contributions now, but you will when you withdrawal the funds during retirement.

Let’s say you have a 401K at your current job, but you plan to change jobs soon. You can either keep the 401K where it is or you can roll it over into an IRA. The latter option allows you to keep contributing to it, tax-deferred. The more you can shove into a traditional IRA or 401K now, the lower your taxable income will be, but contribution limits are considerably lower for IRAs, so don’t think you’re getting over on the IRS. In 2013, it’s $5,500 ($6,500 if you’re over 50).

For more info on traditional IRAs, click here.

A Roth IRA is almost the exact same thing as a traditional IRA, except that you contribute to it with after-tax income. Since you’re paying The Man now, you don’t have to pay him in the future! You might still be subject to a penalty when you withdrawal the funds, though, depending on your reason for taking the money out.

That said, there are strict income limits on Roth contributions, but most people qualify easily. Maximum contribution also has a bit of a low ceiling, at $5,000, but you can contribute to a Roth even after you’re retired.

For more info on Roths, click here.

I hope that clears things up a bit! I’m happy to take more questions!

Wishing you rich returns,

Vonetta

Thoughts on Current Market Events

So, you might have seen the headline last week: “Markets Soar to New Highs.” Or, “Job Gains Calm Slump Worries.”

The Dow Jones Industrial Average, the index that tracks the 30 largest companies in the US, hit an all-time high, above 15,000, on Friday, as did the S&P 500, which flew to over 1,600 points. (Think of “points” as the price per share of this exact index, which is very different from that of a fund or ETF that reflects the index.)

Ordinarily, this would be time for great rejoicing. If you have an index fund, it is likely performing extraordinarily well and you have no complaints at all. Companies’ earnings reports have been generally positive, although many companies are missing analysts’ estimates. 

So what’s the big deal? 

A) The big deal is the big picture: although unemployment has been falling, it is still 7.6%, which is higher than the targeted 6.5% and much higher than the historical average of 5.8% (the historical average is only this high because it is taking the past five years into account, when the rate reached over 10%). 

U.S. Treasury yields are still at near-historical lows, with the 30-year bond – traditionally the highest yielding – at 2.98%. Some blame quantitative easing for keeping these yields so low. Quantitative easing involves the Federal Reserve buying U.S. Treasuries, with the purpose of keeping yields low so it is cheaper for companies (and individuals) to borrow money to buy houses, cars, etc. The central bank began QE in 2009 and has said that it would stop when the unemployment rate reached 6.5%. 

As a result, investors who would typically rely on Treasuries for yield have not been able to make the money they sought to with yields as low as they are. So, they began buying stocks. And more stocks. And more stocks. And even more stocks, pushing the price up to 15,000 and 1,600 for the DJIA and S&P, respectively. 

Some investors are now nervous because they think the market is overbought and overvalued. Well, the S&P 500’s historical price-earnings ratio is about 15. Right now, it’s nearly 19. So, yes, the market may be a little overvalued. 

B)      Another explanation for the recent surge is that investors are anticipating stronger growth in the U.S. economy quite soon. One way that stock prices are determined is by calculating the present value of a company’s future earnings. One could say that the U.S. economy’s future earnings look so great right now that the high market price is deserved. Optimism!

I’m inclined to go with option A, based on my education. Although I am very optimistic about the outlook of the U.S. economy, I think sending the market to new highs on an uncertain foundation is not sound. I would advise my friends to hold off on stock purchases until the market cools down. However, I’m no Miss Cleo and I could be wrong (actually, that would make me a Miss Cleo, haha!).

401K/403B Mutual Fun(d) Decisions: Part 2, Fund Allocations

*My apologies for the brevity of this post. I’m feeling terribly under the weather (thanks, DC, for being 80 degrees one day and 40 the next). More on this topic to come.

Now that we’ve gotten what fees and expenses to look for out of the way, it’s time to talk actual funds. Please note again that I am not an investment professional (yet!) and can only educate on the types of funds out there. I’m not selling funds until I get some commission. ;)

For starters, you already know about equity (or, stock) funds and bond funds. (More on bonds in a future post.) Depending on the financial advisor, advice will range from “go 100% equity” for young people to “keep it 50/50 stocks/bonds.” As stated in previous posts, your choice depends on your risk tolerance, but know that risk aversion, or a very high allocations to bonds, can lower your returns potential over time.

That said, look for stock funds that have the broadest range of stocks possible, like an index fund that reflects the S&P 500 or Wilshire 5000. If you find an index fund that has every stock available (more than 5,000), go for it, for maximum equity diversification.

Next, throw in a good mix of U.S. Treasury, and maybe corporate, bonds. The longer the maturity, or length of time until you get the principal amount back, the higher the yield, to compensate you for the risk you’ve taken of giving your money to the government for such a long time (the longest maturity available for U.S. Treasury bonds is 30 years). 

Don’t forget international stocks and bonds! They provide great diversification to a U.S. investor’s portfolio. 

I recommend finding index funds for all of these asset classes. If you have to go with an actively managed fund (as you would have to do for bond funds), go with one with low fees and high ratings on Morningstar.com, a well-respected finance research website.

401K/403B Mutual Fun(d) Decisions: Part 1, Expenses

Anyone my age or younger will probably never know what a corporate pension looks like. And, sadly, Social Security will have likely run out by the time we retire. So, saving for retirement is a burden we bare all to ourselves. Employers try to help by offering 401Ks or 403Bs, but this gets overwhelming when there are typically approximately 80,000,000,000 mutual funds and ETFs to choose from.

How do you know a good fund from a bad one?
What the hell is the difference between a "core value" fund and a "large cap blend" fund, anyway?
Should you go for gold, just because a metals and mining fund is available?

Don't pull your hair out over your 401K. Remember that it's there to help you. Over the next couple of posts, we'll talk through some high-level details to consider when selecting funds for your portfolio.

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One of the biggest things to keep in mind are fees and expenses. These dollars can set the best of funds apart from the worst because of simple math: the more you pay in fees, the more your investment has to return to make up for those fees. God only knows that you don't want to just go around giving your money away for free. So, here are some brief explanations of the fees you'd typically see from mutual funds.

Mutual funds will typically have 4 types of expenses: operating expenses, a front-end load, a back-end load, and a 12b-1 fee.

Operating Expenses
Operating expenses are costs necessary to run the fund. Fund managers have to pay electricity bills like the rest of us, plus employee salaries. Operating expenses are generally hard to get around because they're just a part of doing business.

These fees can be as low as .06% (also known as 6 basis points) of invested assets and as high as 1.5% or greater. Index funds generally have the lower fees, as it doesn't take as much work on the part of the fund manager to run the fund, since it is supposed to just be a reflection of an existing stock or bond index. You might also see this style of investing called passive management. It's sister, active management, is much more expensive. Actively managed funds are typically trying to outperform the overall market or a certain index by investing in specific stocks. In order to do that, fund managers are much more involved in the fund, handpicking stocks or bonds. As a result, these funds wind up being much more expensive; unfortunately, they don't always meet their goal of beating the market, either, meaning that investors are charged more for worse performance, potentially. 

My advice to you is to go for a passive index fund that will reflect an index like the S&P 500, or even better, every stock in the market (more on that next week) for lower expenses.

Loads
Now, the front- and/or back-end loads, on the other hand, are not so necessary. A "load" is basically a sales fee charged to you when you first buy the mutual fund ("front-end" load) or when you sell, or redeem it ("back-end" load). Then there are no-load funds, mostly from a company called Vanguard, which is extremely well respected in the finance community.

These expenses can run from 0% to 8.5%. The load is especially important to note because it can be total robbery of your investment. When you pay a load, especially a front-end load, you really are just giving your money to a fund manager and not asking for it back. You do expect for the return on your investment to be greater than the load, but you've put yourself farther in the hole from the start.

Example from my own life (glad I learned these things the hard way, so you don't have to!). When I switched jobs to my last job before business school, I rolled over my previous 401K into an IRA (we'll talk about those later, too). I was curious about active management, so my retirement advisor at my bank recommended that I go with a Goldman Sachs fund that had a 5.25% load. I started with about $4,000. After the load, I was only investing $3,800. I needed the fund to return me my $200 (AT LEAST), plus the 1.25% annual expense.

Let's just say, after the market spun itself around in 2010 and 2011, I was lucky to finish right back where I "started," with $3,800. I could have lost much more. But had I invested in an index fund that reflected the S&P 500 with a no-load fund, I would have gained about 15% over that same time period. You live and learn.

12b-1 Fees
12b-1 fees are optional fees the fund can charge so investors pay for part of the fund's advertising costs. Funds do charge them, but again, if there's no need to just give your money away and dig yourself further into a hole, don't do it.

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So, now you know some the key expenses to look for when selecting a mutual fund. (Remember to go cheap!) Next week, we'll look at some of the types of funds that will help you diversify and grow your retirement savings.

Investing in Emerging Markets: Growth for your portfolio and the world over

Today we're going to talk about investing in emerging markets, what exactly that means, how to do it, and some of the risks involved.

First, let's get out of the way what emerging markets are: developing economies that may still have relatively high rates of poverty, but are growing rapidly. Examples include China, India, Brazil, Mexico, and South Africa. (For the sake of comparison, countries such as the U.S., Canada, U.K., France, Germany, and the like are all considered "developed.")

There are also "frontier markets," which are even riskier than emerging markets because they are generally less economically and politically stable, but still have potential to grow into emerging, or even developed, nations. These include countries such as Argentina, Ghana, Colombia, and Vietnam.

The key thing to note about emerging and frontier markets is their incredible growth potential. In the early part of the past decade, investors were lured by these countries' huge economic growth rates, anywhere from 7% to 10% per year or more. In contrast, the U.S.'s and other developed economies' gross domestic products (GDP) only grow about 3% per year, and that's during a good year. (GDP is typically what people are referring to when they talk about the "economy" more broadly. It's basically the value of all the goods and services made in the country.)

While the global financial crisis slowed almost all countries' economies, some emerging nations proved more resilient. For example, although China's growth has slowed, it is still grew more than 7% in 2012 (compare to the U.S., which grew only about 2%. Final numbers on U.S. GDP growth for 2012 will be out soon).

Because of this outstanding growth potential, investors stand to make a ton of money. Think about it: think about people who invested in U.S. railroads, for example, in the 1800s -- those families are still wealthy today! Emerging and frontier markets investors can take essentially the same stance. Incredible!

However, where there is significant reward, there is significant risk. Note again some of the countries I mentioned: Mexico, Argentina, Vietnam. While they make for great adventure vacation spots, they are not known for being the most politically stable. Democracy and capitalism are working their way around the world, but in many places, governments control (and often inhibit) countries' growth. This adds a lot of risk for investors.

For example, let's say an investor has found a way to fund infrastructure building in Argentina, but new government leadership comes in and decides that alleviating proverty through social programs will be the new priority and all infrastructure building will come to a halt. Panicked, the investor looks to sell her investment, but no one wants to buy it now that everyone knows that infrastructure has gone kaput. During all of this, the value of Argentina's currency declines, so she now owns even more of an investment that no one wants. So, the value of the investment tanks and the investor loses her money. 

This is a very elementary (and likely unrealistic for Argentina) example, but I want to highlight exactly how risky investing in emerging and frontier markets can be. Not only are there the risks we discussed previously about individual companies, but there are also political and currency risks.

Know that investments in other countries will likely be made in that country's currency, not in U.S. dollars, so there may be money gained or lost during the translation. Additionally, one has to pay taxes on these investments as well, which will eat into returns even more. These investments can also be less liquid, or harder to sell, than developed markets equities (stocks).

So why on earth would anyone invest in emerging markets after all that?

Because of faith in the growth stories.

Emerging markets investors get to be a part of helping build roads, factories, and maybe even schools around the world, giving people jobs, educations, and livelihoods. And, as I mentioned earlier, these countries generally grow much more rapidly than the U.S., so investment values go up very quickly. They also tend to go up when U.S. equities go down, and vice versa, so they can add a layer of diversification to a U.S.-based stock portfolio. (This excludes recent times of economic decline around the world. We live in a very unique time that I pray will get much better soon.)

So, if you are not overly risk averse, and if you are young, then you should be investing in emerging and/or frontier markets. As stated in previous posts, time has a way of ironing out wrinkles brought on by volatility.

If you have a 401k or 403b, see if there is a mutual fund that invests specifically in emerging and/or frontier markets and add it to your portfolio. You can also likely find index funds or ETFs from your brokerage to invest in, such as the Schwab Emerging Markets Equity ETF.

Only make these investments if they fit your risk appetite. Next week, we'll talk more about risk and how to determine how much of it you can stomach.

A diverse world is a safe(r) world

And by "world" I, of course, mean your stock portfolio.

So far, in each blogpost, I've explained the basics of what you need to know to buy the stock of an individual company. Although you do need to know this, a more important [and very familiar] principle stands:

Avoid putting all your eggs in one basket.

This principle is known as diversification. Basically, it involves owning a number of stocks of companies in different industries, geographies, etc etc. You might hear the rule that a properly diversified investment portfolio contains 30 to 40 stocks, which you can gather yourself OR you can let someone else do it for you, with a mutual fund or an exchange-traded fund.

A mutual fund is a diverse portfolio of stocks (or bonds) that is managed by an asset management firm. The "mutual" part comes from the fact that it is funded by a ton of different people. Money is pooled from many different investors and the asset manager invests on their behalf.

If your job offers you a 401k or 403b plan, you have likely bought a mutual fund. It is one of the easiest, best ways to get a diversified portfolio, since these funds can include hundreds, or even thousands, of stocks.

Another way to get diversity is through an exchange-traded fund, more widely known as an ETF. ETFs work essentially the same way as a mutual fund, but is traded on an exchange, such as the New York Stock Exchange. Mutual funds are not publicly traded, so an ETF can be more convenient for those who do not have access to a 401k plan.

Both mutual funds and ETFs give you about a million investing options. Some funds invest companies in one industry specifically; some invest based on geographies. Some reflect popular indices such as the Dow Jones Industrial Average or the S&P 500, called index funds.

Conservative Wall Street veterans will likely recommend that you go with an index fund, particularly one that includes more companies rather than fewer. While the Dow's price is frequently quoted, the index is made up of only 30 stocks, the largest companies in the US. Bigger isn't always better: these companies don't necessarily reflect what's going on in the whole market. The S&P 500, which contains 500 companies' stocks, is a better bet, and the Wilshire 5000, even better.

So next time you're tinkering with your job's 401k, don't be shy. See what index funds are available. Next time, I'll teach out how to seek out the best for you.