Episode Transcript
Brenton: [00:00:00] There are many different tools in which you can invest and different levels of risk that you take on when entering into said investments. In this episode, we go through some of the things that you have at your disposal and how to consider whether or not they're a fit for your portfolio. Let's get started.
Brenton: Hello, my name is Brenton Harrison of New Money, New Problems, and your host for the New Money, New Problems podcast. Over the last [00:01:00] several episodes, we've talked about some foundational tax terms, and we also covered some of the ways that the tax return of a high income earner can affect their investments.
So what I thought we'd do in this episode is go through some of those investments that you have at your disposal. Talk about some terms that you may not be familiar with, and also cover how they impact not just a tax return. But also the level of total risk that you're taking on in a portfolio. And to illustrate that, I wanted to read from an article that covers something called the Investment Pyramid.
And this is something that you see that seeks to give you an idea of the appropriate levels of risk that you take on when you enter into an investment.
So I'm gonna pull up on the screen, the pyramid itself, and you can see at the base. Government bonds slash Debt money, market slash bank accounts, CDs, notes, and bills, and cash and cash equivalents. We're gonna start with CDs because a CD or a certificate of deposit is something where you [00:02:00] are putting money with an institution and you are locking it up with that institution for 12, 18, 24 months in exchange for you receiving your principle back at the end of that period and an additional interest payment on top.
And as interest rates have increased across the economy, I've seen clients with increasing frequency come and say, oh, I put my money into a 12 month CD or an 18 month cd, and they're telling me this after they've already done it. And if they had talked to me before, I would've told them. I'm not the biggest fan of a CD for many reasons.
The first is, if you need to access that money before the period has expired, you pay a penalty to do so in addition to not receiving the full interest. And when you talk about that penalty, you're really talking about a loss of liquidity that comes from locking your money up for that period of time.
But people are enticed by what their banks offer because they say, oh, it's a 3% cd. It's higher than it's been in a number of years. And that may be true. But the CD interest rates that [00:03:00] you receive often dwarf in comparison to what inflation is at that time. As an example, if inflation was 8% last year, doesn't really help you to get 3% of a rate of return in a cd.
But they also don't share that many of these institutions have high yield savings accounts or even money market accounts that pay a comparable rate of return, even though it may be slightly less. But a high yield savings account may be something where if a CD is offering 3%, you could find a high yield savings account that offers 2.5 without you losing the liquidity that you find when you put that money in a CD.
At the base of the pyramid, you also see the first reference to bonds. And in this instance, they're referencing a government bond. We talked about this briefly in the episode on the Silicon Valley Bank collapse, but a bond is when an investor loans money to a corporation, a city, even a country, and they Loan it to them for a defined period of time, and a fixed or variable interest rate. And the interest rate [00:04:00] that you receive has a lot to do with the risk that your principle will or won't be repaid. So the reason that government Debt is at the base of this pyramid is if I buy a government bond for say, 10 years, the risk that the government can't repay my principle at the end of that period is slim to none.
Now, let's go to the middle of the pyramid where you see your first reference to real estate.
You see equity mutual funds. You see large slash small cap stocks. You see high income bonds and Debt. And high income bonds would be an example of ,instead of you giving money to the US government as a Loan, maybe you're loaning it to a corporation. And that corporation's finances are not as secure as the US government.
So because of that increased risk to your principle, they have to pay you a higher rate of return to compensate you for locking your money up in that Debt instrument. When it comes to equities, those are things like stocks. So let's cover what a stock is. A stock is when you buy ownership in a company by buying their [00:05:00] shares.
And when you buy that share, you're also buying a percentage of ownership based on the value of outstanding shares. As an example, if I have a company that's worth a thousand dollars and I have 10 shares of stock, each of those shares is worth a hundred dollars, but it also represents 10% ownership in my company.
So if a person buys two shares, it's worth $200. They're also 20% owner, they're hoping that the value of my company increases. So if the value of my company increases to $2,000, they still own two shares, but now their value of those shares has doubled.
Now some people will sell one or both of those shares and they will pocket the profits, and that's how they'll make money based on stock investments. They wait for a company that will increase in value and then they sell all or a portion of their investment. Others profit from stocks by investing in stocks that pay dividends.
A dividend is when a company has excess profits at the end of the year and they distribute those profits to their shareholders [00:06:00] in the form of dividends. So some people will take those dividends and they'll use it as passive income. They'll invest in companies that have a long history of paying them, and they will live off of those dividends, especially in retirement.
Other people, however, are gonna take those dividends and they're going to reinvest them whenever they receive them. And they do that and put the money right back into the market to increase the amount of money that's being contributed on a yearly basis.
But it's important to understand that whether you profit and take those dividends and live off of them, or whether you reinvest them, you still did receive them, and they are taxable to you as ordinary income in the year of receipt. So if you have a person who took and lived off of all of them, and a person who reinvested all of them, they have to pay taxes at ordinary income rates at the end of the year.
Now that you understand stocks, let's cover the difference between a large, mid, and small cap stock, as you see referenced in the middle of the pyramid. And to do this, we have to introduce a term called market [00:07:00] capitalization. Market capitalization is a way of valuing a company based on the number of the outstanding shares they have in the marketplace and the value of those shares.
So for example, if I have a thousand shares of stock that are available in the marketplace, and each of those shares of stock is worth $10, the market capitalization or value of my company is $10,000. A small cap stock is one that's going to be seen as a little more risky because it's not as established of a company, and it's one that has a market capitalization of anywhere between 250 million and 2 billion.
Mid-cap stocks are ones with a market cap of 2 billion to 10 billion, and a large cap stock is one that has a market cap of 10 billion or more.
[00:08:00]
So we've covered bonds, we've covered stocks, and now we can cover mutual funds [00:09:00] because unlike a bond where you're lending money to an institution, unlike a stock where you're buying ownership, a mutual fund is when you put your money in a pool of investments with other investors, and that money is invested in a basket of securities that could include stocks and or bonds. So you have bond mutual funds, you have equity mutual funds, you have things like index funds where instead of paying a team of people to choose your investments, you're just tracking a certain segment of the market.
So for example, there are indices like the s and p 500 that invest in the 500 companies on the US stock exchange with the biggest market capitalization.
You also have managed funds, which are a team of investors who are deciding in which companies they will or won't invest on a given year. And you even have exchange traded funds. And exchange traded funds mirror the activity of a mutual fund and also a stock. And the reason I say that is because like a mutual fund or an index fund, there are tons of companies [00:10:00] that exist in an exchange traded fund.
But when you have a mutual fund, you cannot buy into or sell out of that fund while the market is open. So if you try to buy into or sell out of a fund based on the price you see in the middle of the day, you can press submit on that order all you want to, but it's not going to be filled until the market closes. With an exchange traded fund, however, you will see similar investments to what you'd find in a mutual fund, but it can be traded throughout the day, like what you would find in a stock.
So it's something that you see not only for more active investors, but also one that you see utilized by investment managers who want broad diversification for their clients, but are also looking to be able to make moves while the market is open based on how the market is moving.
So that's one reason why people would use an exchange traded fund, but you also see this with investors who use exchange traded funds and index funds instead of using managed mutual funds because they believe that in the [00:11:00] long term there's not a manager that can beat the market.
So they would rather just track a portion of the market and let it do what it does than pay a higher fee for a team of professionals to get them a return that they feel in the long run will dwarf in comparison to the natural movement of the market.
You also see people who use these funds for tax purposes because with managed mutual funds, the activity that those managers take throughout the year can lead to taxable investment income in some cases, even when the fund itself actually had a loss for the year.
Conversely, when you look at an index fund or an etf, they do not typically kick off as much taxable gain as what you would find in a managed fund. And this taxable element is an important concern, not just for mutual funds, because you see this risk and reward even with things like the government bonds that we talked about. Because you have high income earning taxpayers where it's not just the return, it's what is the result of that [00:12:00] return in terms of their taxable investment income. And those considerations can dictate in which they invest.
Let's say that I live in New York City and I buy a municipal bond from the city of New York. Well, that bond could be what's considered tax exempt, meaning that because I live in the locale of the bond I purchased, I'm exempt from paying federal tax, state tax, and municipal.
And when evaluating the taxable bond versus the tax exempt bond, there's a term called the tax equivalent yield, which means even though I'm receiving lower interest on the municipal bond, if I compare it to what I get after taxes from the corporate bond, there's a breakeven where it makes more sense to use the municipal bond, even though it's technically giving me a lower rate of return.
This is an example of how the return and the taxation can marry together to influence the investment decisions of a high income earner.
You also see a reference to real estate, and it might be easy [00:13:00] to assume that that simply means you bought an investment property. But it doesn't have to be real estate that you own directly. It could be real estate in the form of something like a REIT or a real estate investment trust. A real estate investment trust is when you pull your money with other investors and the managers of that REIT invested in properties either directly or through its Debt components. But regardless of the ones you choose, many people choose REITs because they are passive income vehicles.
You see, REITs have to distribute at least 90% of their income to their investors throughout each year. So you have those who will participate in these REITs to get that passive income, but they should only do so with the understanding that while it does produce that income, said income is also taxable as ordinary income in the year it's received. So a knowing investor would put money into that option, understanding that they're gonna have to pay income taxes on whatever they receive.
But you also have unknowing investors who will have significant exposures to REITs either [00:14:00] directly or as a part of their investments in other areas without understanding that it is helping increase their taxable burden from year to year.
And lastly, we'll spend the smallest amount of time on the riskiest investments at the top of the pyramid. At the top of the pyramid, you see things like options, futures, and collectibles. I don't wanna spend a lot of time here because I would say, For the overwhelming majority of investors, they have no reason being at the top of this pyramid because as we've covered, you may not be in a position where you can afford to risk the money that you would put at the top of this pyramid.
But for things like options, you're really talking about a speculative form of investment that gives you the ability to buy a stock or sell a stock at a predetermined price. So, for example, when you talk about a stock option, you're really talking about a contract that gives you the ability to buy or sell a stock at those predetermined prices. And when you enter into those options contracts, you're getting an option to [00:15:00] buy or sell a hundred shares of stock at a time. So it's not just the value of the stock that you're dealing with, it's also the value of the options contract itself.
So there are different types of options called put options and call options.
A call option is when you are betting that a company's value will increase over time, and you are buying the right to purchase shares of that company at a discount to its future price. And a put option is the exact opposite. It's when you're thinking that the value of that company will decrease and you'll be able to sell those shares for more than its current market price.
Now, I'll tell you, the only reason I'm even explaining why these options contracts work is not because I'm recommending that you do them, but so that I can illustrate how you can lose 100% of your investment in an options contract. Which is why you need to be careful, cuz if you have that options contract that allows you to sell it at $70 per share, it's only for a certain period of time.
Well, If the value of that company goes below $70, it's what's called in the money. [00:16:00] It means that you are holding an options contract that you can exercise at a profit. But let's say that the value of those companies shares never goes below 70. Maybe it never goes below a hundred. Well, now, instead of a contract that's in the money, you have one that's out of the money. And it's essentially worthless because you do not have a spread between the value of the share and what you can sell it for.
That's it. A broad overview of different investments at various levels of the investment pyramid. Maybe this introduced you to or increased your familiarity with a certain type of investment and you want to do more research.
If you haven't already, please remember to join our email list and let us know what episodes you want to see in the future. And whatever you submit just might be the next thing you hear on the New Money, New Problems podcast. See you soon.
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