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Some thoughts on where to put your money in today’s environment. Focused on traditional investments (alternative investments featured in weeks to come).
I received an interesting question from a reader this week, one which I think is on many minds. Here it is, abbreviated for clarity:
I was hoping to get your advice on an investing matter. My husband and I are 56 and 54. We have a little over $100,000 of our savings just sitting in a bank account that pays less than 1%. Where can we put this money so it can grow for us? We plan to retire in the next few years so we don’t want to take too much risk with it. We were thinking of putting some in the market (but have we already missed the window?). Also some in the Bank of America idea you talked about. – Candice
I’ve got some ideas I’ll be outlining in the coming weeks for potential investments in real estate (without being a landlord), peer lending, tax liens, etc. But for this couple – and probably many readers – we will stick to evaluating some of the more common options in fixed income and stocks.
It’s clear to me that Candice is a regular reader (fantastic!) as she cites several ideas I’ve talked about in depth on the blog. The two at the top of the list are investing in an index fund and investing in Bank of America preferred stock.
I still believe these two options are some of the most viable for today’s environment.
The concern about whether one has “missed the window” on investing in stocks is a common one. The S&P is up 16.4% so far this year. Doesn’t this mean one should wait for the next correction to buy in?
My answer is no.
As I talk about in the primer on index fund investing, the hypothesis most of us retail investors are investing behind is the following: when you look at historical performance for the stock market, you see 8-10% returns average over the long run (defined as 10+ years). Neither you nor I professes to be an oracle on the timing of dips and spikes in the market. By buying into an index fund, we put our faith in the idea that US companies will grow in the long-term, with past data averages of 8-10% as an anchor or starting point for what we might expect those returns to be for us in the future.
If you are asking yourself whether you have “missed the window,” you are trying to time the market. You are a speculator.
It is perfectly fine to be a speculator, but you should acknowledge that that is what you are doing. You are saying you have some special knowledge about the timing of peaks and valleys and that your edge in investing is your ability to call these timings. You are willing to stake thousands of dollars on your special edge. Because if you sit out too early, you’ll miss years of 10%, 15%, 20% gains. If you buy in right before a crash, you won’t have gotten the buffer of the good years to smooth out your average return like all the long-term passive investors.
So going back to the heart of the question, no, I don’t believe anyone investing in an index fund today has “missed the window” on the stock market. But what they need to make sure they are comfortable with before investing money into an index fund is the following:
Make sure you can afford to keep this money in the market for 10 years or more.
You don’t want to have to liquidate your position when it is at a huge dip in value. A ten year horizon is doable for many, even for a couple who plans to retire in a few years. It is dependent on the allocation of the overall portfolio. If you have needs during retirement to draw regular cash, perhaps you have 20% of your portfolio in stocks which can stay at work for years, while the remaining 80% is invested in things like bonds that send you a monthly check to cover your living expenses.
Again, whether you want to invest some of that money in an index fund has less to do with whether you think the market is going to fall or rise short-term next year, but rather whether you can afford to leave $X of your portfolio in the stock market for up to 10 yrs without drawing down on it.
Preferred Stock: BAC-L
For those who have less of an appetite for risk or who have an imminent need for regular cash distributions to cover their expenses, fixed income options are appealing. One which I’ve talked about on the blog is Bank of America Preferred stock, specifically the Series L. Technically BAC-L is an equity instrument, not a debt instrument. I have heard preferred stock described as “a stock that acts like a bond,” and depending on the specific opportunity, that can be quite accurate.
I talk about the opportunity in depth over here, but the gist of it is that there is a dividend attached to the stock which meets the requirements to enjoy the qualified dividends tax rate. Depending on your tax bracket, the qualified dividends tax rate is either 0%, 15%, or 20%, making it attractive on a net after-tax basis over other options that are often taxed at your ordinary income rate.
It is important to note that the yield on BAC-L has changed since I wrote about it last. At the time I wrote about it in April, the dividend was effectively 6.1%, or 4.9% after-tax for those in the highest qualified dividends tax bracket. Since then, the stock has risen in price, making the effective dividend 5.6%, or 4.4% after-tax for folks at a 20% qualified dividends tax rate bracket. Great for those who bought in at the time it was discussed and picked up the appreciation and higher yield; less compelling for new buyers coming in at the higher price.
This may still be a good option, but at this return, I can think of some other options which might be better. It’s a good case study in how quickly the optimal investment opportunity changes, and how keeping your eye out could net you thousands of extra dollars. An extra percentage point of return on a million dollars is an extra $10,000 every year!
Other Fixed Income Alternatives: Muni Funds
One option I’m beginning to like again for fixed income is leveraged municipal bond funds. These are funds which buy bonds issued by city, state, or federal agencies. They are backed by the city, state, or government and its whole book of ‘business’ like its tax revenues. You are betting essentially that the city, state, or federal agencies don’t default. Traditionally, muni funds are considered one of the safer classes of bonds to buy given the government guarantee at play. You have probably seen a few high profile cases of cities like Detroit and Stockton declaring bankruptcy. So it does happen, but I’d say it’s still quite rare. There are funds which straight up buy a bunch of bonds, collect the payments, and distribute them to shareholders, and there are also leveraged muni funds which do the same thing but juice their return by borrowing cheap debt to buy even more of these bonds by using the existing bonds as collateral.
The nice thing about muni funds is that most of them have federal (and sometimes state) tax-exempt status. That means if your tax bracket is 30%, a muni fund can yield 30% less to you than a bond fund that is taxed at ordinary income and it will net you the same after-tax return. Similarly, compared to BAC-L above at the 20% qualified dividends rate, if you could find a muni fund that yielded 20% less, it would net you the same after-tax return, and you’d probably be sitting on instruments with a higher credit rating and lower risk profile.
You can find options for muni funds through a screening tool like CEF Connect. Here are a few examples of national tax-exempt funds and what they’re paying:
MYI – 5.7%
MFL – 5.73%
NZF – 5.85%
Compare this to BAC-L’s 4.4% after-tax return. You could be earning a full 1.3%+ more per year, and you’d be invested in bonds that were on average rated higher in quality than BAC-L.
Should you just pick the one with the highest rate and go from there? Not necessarily. If you want to learn more about how to evaluate a bond fund, I talk about the eight factors that should be on your checklist over here. If you want an even higher bird’s eye view, check out The Ultimate Guide To Understanding Bonds.
Stock and Bond Allocation
The reader’s email was silent on the exact split they expected to use in investing in the stock market vs primarily income-generating holdings like BAC-L. This is an equally important point, and it’s the one that allows you to sleep well at night. A couple who is a few years from retirement has a very different risk appetite than someone who just graduated from college and is gunning for max appreciation as fast as possible. To figure out what the appropriate allocation is for you, you can check out this full walk-through which includes historical data and a framework for how to make the decision that fits your own situation best.
And if you don’t actually know what your current stock and bond allocation is, a free net worth and investment tracker will give you some much-needed clarity. I like and have been using Personal Capital myself. It not only gives you a clean visual dashboard and the ability to drill down by category and account quickly and easily, but it also offers neat benchmarking tools that will tell you things like how the expenses and fees on your funds compare to the industry average. You also get access to their pretty cool retirement calculator tool, which will pull in all your existing information to track your progress.
These are a few options I think are viable for today’s uncertain environment. Crystallizing your long-term, 5-10+ year strategy is important, and from there it’s about slotting in the appropriate assets in the right allocations to serve your needs. In coming weeks we’ll explore some of the more exotic opportunities you might find interesting for your portfolio. Until then, batten down the hatches.
What does your current allocation look like? Where did you invest your last $1,000, $10,000, or $100,000? Where do you plan to invest your next chunk of savings?