AskDong

My blog is not an investment blog. It’s a personal finance blog. However, I’ve gotten some comments from friends that some of the dribble I’m churning out nearly every day doesn’t make very much sense, and not just because I’m a terrible writer. I believe I’m probably only reaching a quarter of my audience with my posts on investing. So over the course of the next couple weeks, I’m starting a series on the basics of investments.  Consider this the table of contents, and the introductory article.

• Investment Accounts - Brokerage, Mutual Fund Account, 401K - Today’s Topic
• Fixed Income Investments (Savings Accounts, CDs, Government Bonds, Corporate Bonds)
• Stocks
• Mutual Funds
• Options
• “Exotic” Investments - Commodities, Future Contracts

I think many individuals who are new to investing often confuse investment accounts with investments.
Brokerage Account, 401k, IRAs ARE NOT Investments.

Brokerage, 401k, and IRA accounts are just that, accounts. To use a metaphor, these accounts are nothing more than folder to hold actual investments which are stocks, bonds, cash, gold, etc. Of course some of these accounts like a 401k or Roth IRA have some special tax features that basically make them invisible temporarily to taxes (401k, standard IRA) , or permanently so (Roth IRA, Roth 401k).

Brokerage Accounts
Brokerages are not very different from standard Banks. Instead of just dealing with just cash, brokerages also hold stocks, bonds, and mutual funds for their customers. While it’s possible to buy stocks and bonds directly, and even hold the those in physical form, it’s generally not recommended. A brokerage account serves as the intermediate. The brokerage helps you buy and sell those investments, handle the bookkeeping, and consolidate all the holdings. For these services customer pay in terms trading fees (i.e. 19.95 per trade), annual account fees, and interest (if you borrow money to from the brokerage to invest).

Mutual Fund Accounts
While you can buy mutual funds through your brokerage, and some mutual fund companies offer extensive brokerage arms (Fidelity comes into mind), you can also buy Mutual Funds directly through the mutual fund company. The benefit of buying mutual funds directly through the company that operates the mutual funds is that for many fund it’s generally free to do so. For instance I own Dodge & Cox’s DODFX (Dodge & Cox International) in my E*Trade brokerage account. However I could’ve just as easily opened an account with Dodge & Cox and brought shares for free instead of paying 19.95 for each buy and sell I make through E*Trade, and that’s what I’ve done in the case of Vanguard. I have Vanguard account and because they have such a wide variety of index funds from which I can choose, it’s a perfect account to my brokerage account.

401k, Traditional IRA, Non-Deductble IRA, Roth IRA
These retirement accounts are not really types of accounts because in the case of IRA (Individual Retirement Accounts) accounts each of them is usually either a brokerage account or a mutual fund account wrapped within different tax rules. The tax shelter that each of these accounts confer is intended to encourage retirement savings.

• 401k - Ok, 401ks really are different type of account since they operated on behalf of employers, and are funded via payroll deductions.  The specifics vary from plan to plan. Some offer great investment choices, and others not at all.
• Roth IRA, Roth 401k - Offers the ability to invest after tax dollars and never pay taxes again. After tax income is income that you’ve already paid taxes. For instance let’s say you make $1500, and pay $500 in taxes, you have $1000 in after tax income in which you put into a Roth IRA. No taxes are avoided initially, but after 50 years when that $1000 has grown to $70,000 no taxes are owed either. In typical investment account, you would have to pay taxes on the gain of $69,000.   A Roth 401K behaves exactly like a Roth IRA, but like a standard 401k is employer sponsored and funded by payroll deductions.
• Traditional IRA or Deductible IRA - A traditional deductible IRA if you qualify to open allows you to shelter taxes now and while the investments are in the IRA. Going back to the example in which you have $1500 in income, you could put the full $1500 into a deductible IRA and avoid paying $500 in taxes. (I’ve simplified a bit here since you can’t avoid payroll taxes such as social security and medicare). Of course upon withdrawal you owe full income taxes
• Non Deductible IRA - Like a Roth IRA in that you put after tax dollars, and at withdrawal you owe income taxes on the gains. Doesn’t sound like much of deal does it? The only taxes you avoid is incremental annual taxes. So for instance if you make $100 in interest, typically you’d have to pay taxes on that $100 in a taxable account and would then only have let’s say $70 of that interest to invest for the next year. Within a non-deductible IRA, the full amount is available for reinvestment where taxes are only paid at distribution. This is tax-deferral.

These are only a few of the different types of investment accounts. There are 529 plans, SEP-IRA, Simple IRAs, and more. However these accounts are the basics, and that’s what I’m trying to cover in this series, the basics.

I’m generally not a fan of most actively managed mutual funds.  I think on the most part you’re paying too much for too little performance.  Most actively managed funds do not beat the index without even taking into account the higher expenses.  I’m not an absolutist, however, I think there are some quality funds and fund company.  I personally own DODFX and do think very highly of the Dodge and Cox mutual fund company.

Reading this article at Smartmoney by Jack Hough really got my gall up however.  I’ve always known Mutual Fund companies typically incubate funds before they’re allowed into the wild of retail iinvesting. Incubation involves opening a new fund to only select investors.  Often times these select investors are employees or other connected individuals.  I never thought too much of it.  I just assumed it was a way of managing the growth of a mutual fund.  If you are to believe Jack Hough, incubation is nothing more than a marketing trick to lure more suckers.  I believe Jack.

By incubating a number of different funds and only promoting the successful ones, mutual funds can effectively try a bunch of competing strategies and be right either way. Heads they win, tails you lose. After a successful incubation period, mutual fund companies then come out and market these “successful” funds showing X number of years of superior performance. The losers are tossed into the dust bin and forgotten.  If you are going to invest in actively managed funds at least look for funds with superior performance with the same manager(s) over period years while the fund has been open to investors.

Mutual funds love to tout historic performance of their funds, but this is often reflection of survivorship bias. Survivorship bias is the bias of only looking at funds (or stocks for that matter) that are still in operation. The failures are ignored.  There is survivorship bias in marketing only funds that come out successfully out of the incubation period.  Beyond incubated funds, it’s not like mutual funds ever bring attention to their poorly performing funds, and especially already liquidated funds.  Mutual funds shut down all the time because they aren’t any good, but you don’t hear too much about these losers from the fund companies.  I imagine there might be more to be learned by examining not just the record of success for a particular fund manager or company, but failures as well.  I tried tracking this information down, and haven’t had any luck other than finding aggregate numbers of liquidated funds for particular years.  Any paid users of Morningstar have access to this information?

This week one of the next steps I had for Mary Ann in her MoneyMakover was to establish an Emergency fund. Most experts including personal finance bloggers think they’re a good idea. I do as well

• JD Tells us how and why we should start an emergency fund.
• All Financial Matters tells us how an emergency fund can save us thousands a year

However just because it’s a good idea, doesn’t mean an emergency fund is without controversy as well. For instance Free Money Finances asks if establishing an emergency fund has priority over paying debt?. And even if the firm decision to establish or grow the fund, there’s question of how much you need. Lifehacker.com tells us how to calculate what someone needs given their expenditures.

Now that you know what you need, how do you save for it?

• Amanda at Young and Broke gives us creative ways to start an emergency fund.
• Frugal for Life gives 10 Ways to Save for An Emergency Fund

If you already have enough saved in your emergency fund, compare yourself with others who’ve taken MyMoneyBlogs’s poll. Is it too much as The Tao Of Money Making might think? Still have questions about emergency funds? Money Smart Life let us in on everything you wanted to know, (but were afraid to ask).

My personal feeling is that a large emergency fund is critical for younger people with fewer asset categories. Someone who is 40 with a house, brokerage accounts, 401ks, IRAs, and other assets still needs an emergency fund, but can also be more creative with funding a longer term emergency horizon with both sales of assets, a home equity line, or as Advanced Personal Finances suggest the Roth IRA. Someone in their early 20s usually doesn’t have those options. Having an emergency fund is what allows the younger person avoid using a credit card for emergencies and therefore establish a better financial footing.

p.s. Some of the articles linked are older, but emergency funds are a classic concept.