Five Questions to Ask Before You Invest

Success in investing is often dependent on timing, patience and how much homework the individual has done on a particular investment. Yes, sometimes a raging bull market can make an amateur look like a genius and bad timing can lay waste to even the most well-researched investment or to the strongest companies. (Just ask anyone who has invested in energy stocks over the past year – incredibly solid companies like Exxon Mobil, Royal Dutch Petroleum and Schlumberger have been decimated.) I’ve seen people make large investments in stocks on a whim without doing the slightest research or due diligence. On the other hand, I have seen individuals put endless time into buying shoes or flat screen TVs. As you navigate a wide menu of investments in the financial world, whether it is stocks, bonds, real estate, cash, and alternatives, it would be prudent to consider the following questions.

What are the potential risks?

Too many people fail to understand the risks of a particular investment. They focus so much on returns that they fail to see that certain investments contain an inordinate amount of risk. They are constantly fixated on how much can they make—10%? 30%? Can they double their money every year? The bursting of the tech bubble in 2000 was particularly devastating for investors that ignored risk. Most dot com stocks lost 99% of their value in a short amount of time. Fifteen years later, even seasoned tech companies like Cisco, Microsoft and dozens of others are still far short of their 2000 highs.

So let’s try and learn more about risk by comparing a stalwart, blue-chip company like Johnson and Johnson with much younger and riskier Diplomat Pharmacy. JNJ has a long operating history as a public company and has delivered solid long-term gains with much less risk. In the August/September 2015 correction, JNJ dropped about 10%. Diplomat Pharmacy, a specialty pharmaceutical company is a relative newcomer compared with 130 year old JNJ. Its potential growth rate is much higher than JNJ and the stock more than tripled after it went public in October of 2014. But in the 2015 correction, Diplomat fell by 50%! It’s a fast growing company with a promising future. But in any stock market correction or earnings disappointment, Diplomat’s “downside risk” will surface. Riskier stocks are just wired up for more volatility. Remember, taking more risk should lead to higher returns. But this isn’t always the case (see our article on investing in healthcare mutual funds and observe how some mutual funds take greater risk but don’t always get higher returns). We want our readers to carefully weigh the risks.

What are the potential returns?

Over the past 80 years the U.S. Stock market has returned roughly 10 percent (small cap stocks a bit higher). Treasury bonds over the same period returned 5.5%. Cash instruments like T-bills, roughly 3.5%. Warren Buffett has compounded money at about 25% over 40 years. The very best hedge fund operators get between 20% and 30% returns—but that’s usually over a time period considerably shorter than 20-40 years. It amazes me that many investors feel they can beat these returns. A family member once told me how he was going to make 60% annually on real estate investments—double the returns of the greatest investors of all time. In addition to educating our readers on risks, we want them to set reasonable expectations for returns. If you can get double digit returns, you can attain considerable wealth. Returns in the 15-20% range would be knocking the cover off the ball. But most importantly, what risks will you have to take to obtain a given return?

What are all the costs?

Over the course of my investing career I have watched the commissions associated with buying stocks drop from $90 to buy 100 shares of a stock to a mere couple of bucks. This dramatic reduction in commissions is excellent for investors. However, commission costs aren’t the only cost. The bid/offer spread is another cost. The bid/offer spread is simply the difference between the highest anyone is willing to pay for a stock and the lowest price anyone is willing to sell for. Some stocks have very tight bid/offer spreads (typically a penny), others are large enough to drive a Buick through (as high as 5 to 20 cents per share). A bid/offer spread of a penny on 100 shares will add $1.00 to your costs. But there are some illiquid and/or volatile stocks that have bid/offer spreads several times larger. If the bid/offer spread is 7 cents, you just doubled your transaction costs if you traded at a typical discount broker. Is there a way to minimize the costs associated with the bid/offer spread? Yes – many investors place “market order”—they will buy at the best offer available and sell the highest bid. In other words they give up “the edge.” You can avoid this with a little discipline and try and buy either at the bid or somewhere in between the bid and the offer. The savings could be substantial. Of course doing this means you risk not getting your trade off right away, or not at all. If you hold for the longer term, these costs are minimized. If you constantly trade, these costs will mount rapidly and substantially reduce your returns.

Stocks aren’t the only investments that have costs. Mutual funds have costs as well. Even so-called No Load (i.e., no upfront and back loaded sales charge) funds have an annual expense ratio. Every time they buy or sell a stock they incur transaction costs such as commissions and bid/offer spreads. According to Morningstar, annual expense ratios for a typical equity mutual fund (ETFs are included in this) run about 0.7 percent per annum. There are some funds with dramatically higher expense ratios, and some with expense ratios as low as 0.09 percent. Certain indexed ETFs and mutual funds such as the Vanguard 500 fund (a fund that merely buys all the stocks in the S&P 500) have some of the lowest expense ratios.

Mutual funds that have upfront sales charges are referred to as load funds. These costs are significant in some cases and can run 5 percent or more—and that is on top of the annual expense fee you pay. If you put $10,000 into a loaded mutual fund that carries a 4.75% sales charge, you will pay $475 upfront before you even get invested! Why pay these onerous fees? Funds with sales loads are usually sold by commission-based financial planners and full service brokerage firms. They get a portion of the sales charge in exchange for selling the funds to clients that need greater servicing or handholding. Fee-only financial planners (those that charge by the hour or as a percentage of assets) and do-it-yourself investors are the typical people who buy a no-load fund.

There are some investments that carry even higher fees and commissions. Many insurance products, annuities, limited partnerships and real estate usually carry higher fees. Some of these products are good and worthwhile investments, but there is usually a cheaper alternative that will get you the same exposure. Another family member once came to me with questions. It seems a financial planner was pitching him on a real estate partnership. The planner wanted him to put 40 percent of his net worth into this partnership (definitely a red flag). I read the prospectus and noted that the total fees exceeded 10%! I told the family member to avoid this type of investment; that he could pretty much duplicate the partnerships real estate portfolio in the publicly traded REIT market (Real Estate Investment trust market) at far lower cost and infinitely greater liquidity.

Is there adequate liquidity?

Liquidity is a financial term that represents how easily an investment can be sold or turned into cash. Stocks are highly liquid. You can sell hundreds of millions of dollars of stock in a matter of moments. The top stocks on the NYSE and NASDAQ have amazing liquidity as do the top tier ETFs. Many futures contracts are also among the leaders in liquidity. Mutual funds can generally be liquidated at the close of business each day.

But residential and commercial real estate usually take months to sell. Partnerships and private equity also have decidedly less liquidity. Does this mean they are bad investments? No, some are terrific investments. But selling requires longer time (things such as title clearance, closing, and legal wrangling all proceed at glacial pace). A $500,000 house might take months to sell. Selling $500k worth of Apple or Treasury futures can be done in milliseconds.

What are the tax implications?

The time will eventually come when you have to sell an investment. When you do sell an investment in the United States (and many other countries for that matter), you create what is known as a taxable event. And, as we all know, the Internal Revenue Service is one entity that ALWAYS gets its take. Given that the IRS will be taking some of your hard earned money it’s no surprise why tax avoidance is a now a national sport (noting that tax avoidance is perfectly legal, as opposed to tax evasion, which is illegal and can land you in the slammer!) A good accountant is always a valuable part of your financial team.

Some investments carry heavier tax burdens than others. Some investments also complicate the tax filing process. (Ever try to figure out the taxes on Master Limited Partnerships with their complicated K-1 forms? Good luck. Even with software, MLPs added 2 hours to my tax prep time.) Income investments such as bonds or utility stocks that pay high dividends also carry heavier tax burdens as they are taxed as ordinary income and can run as high as 39.6% depending on your tax bracket. Hence, if you invest for mostly income, try to do so through a tax advantaged account such as a regular or Roth IRA or a 401k account.

The tax rate can vary dramatically between short-term and long-term gains. The Internal Revenue Service taxes different kinds of income at different rates. Capital gains, such as profits from a stock sale, are generally taxed at a more favorable rate than your salary or wages. However, not all capital gains are treated equally.

Short-term capital gains: Short-term capital gains do not benefit from any special tax rate – they are taxed at the same rate as your ordinary income. For 2015, ordinary tax rates range from 10 percent to 39.6 percent, depending on your total taxable income. If you sell an asset you have held for one year or less, any profit you make is considered a short-term capital gain.

Long-term capital gains: If you can manage to hold your assets for longer than a year, you can benefit from a reduced tax rate on your profits. For 2015, the long-term capital gains tax rates are 0, 15, and 20 percent for most taxpayers. If your ordinary tax rate is already less than 15 percent, you could qualify for the zero percent long-term capital gains rate. For high-income taxpayers, the capital gains rate could save as much as 19.6 percent off the ordinary income rate.

Asking these questions about the potential risks/returns, liquidity, and associated costs and tax implications, is a good start to assessing potential investments. Going forward, In Sickness and Wealth will provide further education and research to assist the investor in making wise choices.

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