Investing Methods

We hear those stories, too, and believe investors are wise to be cautious. There are basically three options with differing levels of commitment:

1. Self-directed
2. Partially self-directed
3. Advisor-directed

If you choose to be self-directed, you are deciding to make all your investment decisions on your own. This is probably the right choice if you have less than $300,000 (that's Lenore's rule of thumb) and/or you feel comfortable choosing your own investments and are willing to devote the time necessary to monitor them. (We'll go over in later chapters just how to do this in a way that is as time-efficient as possible.)

You can also choose to be partially self-directed, which entails either using a broker who will give you advice and guidance on potential investments and your portfolio as a whole or using a service. There are a plethora of services and newsletters out there than can give you guidance on stocks, mutual funds, ETFs, bonds, and so on. These services run the gamut from giving you a complete portfolio, which you actively manage by responding to email alerts, to services that just suggest various stocks, bonds, or funds that an investor may want to consider for their portfolio without giving guidance on timing or how much of your portfolio ought to be invested in any particular security.

Finally, you can choose to work with an investment advisor who works either at a registered investment advisory firm (RIA) or at one of the bigger investment companies such as JP Morgan, Goldman Sachs, Merrill Lynch, and others. This also includes those who take advantage of the family office approach. A family office is a private company that manages the investments and trusts either for a single family, or in the case of a multifamily office, for more than one. These are typically used by relatively wealthy families and may include personal services such as managing household staff, legal services, day-to-day accounting and bill pay, philanthropic efforts, and so on.

When Sophia started to get that glazed look that often comes from such a riveting conversation, we told her to think of it this way. You know how the furniture you buy from Ikea comes in those little boxes that look so harmless up until you start trying to put it all together? Some people are really comfortable with a hex key and wooden dowels; they'll put together an entertainment center from Ikea without even looking at the instructions. Others prefer to follow the instructions step-by-step and may even look for tips and tricks on Google. Some prefer to just hire someone to put the whole thing together.

She told us that she thought she was more the instructions type, but was curious as to how the others work as well.

So we told her that before we even talk about opening up a brokerage account, she first needed find out if her employer offered a 401(k) plan, and if so, did the company do any sort of matching contributions? Money that goes into a 401(k) reduces taxable income, thus reducing the amount of your income that you lose to the government, and your 401(k) savings can grow without having to pay any taxes on investment gains or income until you start taking money out of it. This helps to grow your savings a lot faster. We'll show you how.

Since Sophia was self-employed, she wouldn't be able to take advantage of an employer 401(k) plan, but she was going to contribute to an IRA she planned to set up. When possible, maximize your allowable contribution to an IRA. Depending on your income and tax-filing status, you may be able to use some or all of your contribution as a tax deduction. Either way, the money within your IRA grows, like a 401(k), without having to pay any sort of taxes. Again, taxes are only paid on it when you take the money out.

Figure 2.1 shows the difference between growing your savings inside of a nontaxable IRA or 401(k) versus in a taxable account.

If we look at a three-year period, and for the sake of simplicity assume you get 8 percent returns every year, and that were the money to be in a taxable account, you would end up paying 15 percent in taxable gains. We will also assume that all the gains are long-term gains, which have a significantly lower tax rate than short-term gains, and again for simplicity, we'll assume that annual income in this example is below the threshold for “high-income” earners.

After three years, in this example, you would end up with an additional $415 or 4 percent more than you would in a taxable account. The difference is even greater if you are considered a “high-income” earner by the tax code. In that case, even if all of your gains are long-term, you would have to pay 23.8 percent, which would mean that over three years, you would lose 7 percent of your return (or $655) in taxes! Remember, too, that the extra 7 percent gets to grow inside your account, compounding the benefit! (See Figure 2.2.)

This led us to ask Sophia one of the most important questions. Just what kind of an investor are you? What kind of returns are you looking for, and what kind of risks are you comfortable taking?

These questions, or some form of them, are the most typical questions asked by investment professionals, and are probably the most widely misunderstood, both by those asking the questions and those on the receiving end!

What these questions are meant to discern is what style of investing most suits you, based on your personality, your comfort with risk, and your individual financial needs and goals. Start first with your investing personality. One of the best ways to figure out just what type of investing will make you more comfortable is to think of it in terms of your personality.

Do you prefer to have a lot of more casual friendships, spending smaller amounts of time with a large number of people, or do you prefer to have a small set of very close friends with whom you have more intense relationships?

This is intended to identify just what type of portfolio you would be most comfortable implementing and monitoring. On the one hand, you could have 10 to 20 securities that you know really well and are committed to being with for a long time with the rest of your portfolio comprised of mutual funds or ETFs. If the price of one of your stocks were to decline significantly, you would be more likely to simply buy more of it rather than sell out quickly. On the other hand, you could have a lot more securities in your portfolio at any one time, most of which you tend to not stick with for more than a year. With those you would be more actively trading around movements in the stock, without having any particularly affinity for the company's long-term business potential, for example.

Understanding what style works best for you will help you narrow down where to look for help, be it a newsletter or trading-advice service or working with an advisor. It will also help you decide what type of brokerage account is best for you.

Another question that advisors often ask a potential client is about their risk tolerance. This is a really important point, but difficult for both parties to assess. What this comes down to is just how much money you can stand to lose in your portfolio before you start to lose sleep, or in the case of having an enviable ability to sleep regardless of life's woes, just how much you can lose before your long-term goals are threatened. When thinking about this, consider how volatile your income may be. If there is a reasonable chance you could lose your source of income for a sustained period of time, you need to have a less risky investment strategy than you would if your income was more stable and predictable.

Your timeline on your retirement savings is also a deciding factor here. The more time you have before you will start to tap into your savings, the more risk you are able to take. All of this, of course, is limited by just what makes you comfortable. That comfort is driven partly by having a portfolio that suits you and partly by understanding what your investment strategy is all about.

Regardless of whether you decide to go it alone, use some degree of outside advice, or turn your portfolio over to an investment advisor, you'll need to have a good idea of just what level of risk you are comfortable with and how to define just what levels and types of risk various securities have. We'll cover this in more detail in later chapters.

Now let's talk about a brokerage account, which is necessary if you want to buy stocks and exchange-traded, and highly useful if you only want mutual funds. The best place to start is with the online brokers such as Charles Schwab, Fidelity, TD Ameritrade, E^*Trade, or Scottrade, among others. When looking at the various options, consider how often you plan to buy or sell securities and how much money in total you will have invested or in cash in your account, as that can affect the fees you pay. Some services, such as Schwab, charge no transaction fees or loads (fees charged by the mutual fund either upon purchase or sales of shares) to buy or sell some of the funds on their platform, which can help improve your returns.

If you decide to either go it alone or use some level of advice, you'll need to open up a brokerage account yourself. If you go with an investment advisor firm that manages your money for you, they will have a brokerage firm or firm(s) that they prefer to work with, so they would handle either opening up an account for you, transferring your funds into a brokerage that they work with, or simply adding themselves to an existing account if you are already using a brokerage with whom they work.

There are two different types of brokers: a traditional, full-service style and a discount style. Discount brokers are geared more toward the do-it-yourself investor. With this type, most of your trading is done online and you will not have a dedicated broker to execute trades for you. Some of these brokers do provide research information, but they generally do not offer any investment advice. Companies like E-Trade, TD Ameritrade, Charles Schwab, and Scottrade (we list these purely as an example and are not endorsing their services) all offer discount broker services and charge lower commissions on trades.

Another way you can get help outside of using a more traditional brokerage firm is by using investment advice services. These usually take the form of newsletters, weekly or daily publications, which are typically sent via email or published regularly for subscribers on a website. These services run the gamut from giving you complete portfolio with specific security buy-and-sell recommendations to services that give more general economic or market condition information or services that help assess your portfolio's strengths, weaknesses, and risks. You can use these services with a no-frills brokerage service or in addition to a full-service brokerage as an additional source of investment advice and guidance. These services can run the gamut from around $100/year to multiple thousands per year or more and are offered by well-known companies such as Morningstar, Forbes, TheStreet.com, by investment advisory firms such as Gluskin Sheff, and by independent groups such as Mauldin Economics. Full disclosure: As of the writing of this book, Chris and Lenore are co-portfolio managers for an advisory service at The Street.

Keep in mind that the investment advice industry, like every other aspect of life, has its share of good people and utter rats, so be careful when you are evaluating advice providers. Use your good sense and be cautious concerning those that offer “guaranteed returns” and/or returns that sound too good to be true. They probably are. Investing is tough; those who tell you they can get you massive returns easily because they know “secrets” are expecting you to ignore the realistic lessons of decades. We would advise you against believing there is one investing solution that takes care of all needs for all time.

History has shown there is no such silver bullet, and portfolio theory informs us that over time, not every investment in your portfolio will be generating positive returns. But that's the nature of investing. Still, the odds are better with a well-constructed stock portfolio than with the average venture capital portfolio. Generally speaking, a venture portfolio of 10 companies will make most of its returns from just one or two investments, while three to four generate solid returns and the rest tend to generate losses. When it comes to the investment newsletter and advice industry, look at the level of service offered and the track record rather than the folksy tone and one that spends more time promoting other things to you than helping you make sound investment decisions. Remember, too, that no matter how good the past performance might be, it's not an indicator of future performance.

In the Appendix, you will find a list of service providers to help get you familiar with this world. This list is only informational as we do not endorse any of the individuals or firms listed.

If you go with a traditional brokerage firm, you will have a personal stockbroker who will offer you investment ideas, research on industries, companies, and so on, will assess your portfolio, and will generate reports for you concerning your portfolio's performance. Ultimately, you will still be the decision maker concerning what to buy and sell for your portfolio, but your broker will advise you. In return for this extra level of service, you will be charged higher commissions and fees. Morgan Stanley, Merrill Lynch/Bank of America, Solomon Smith Barney, and Wells Fargo Securities all provide this type of service.

If you decide to go with a broker from one of these big brokerage firms, ask them directly about how they are compensated. Make sure you understand just what their firm rewards them for doing. Many companies unfortunately reward brokers for pushing specific securities or types of securities on their clients. Be aware of this practice and try to get as much information as possible about how your advisor may be personally motivated, either through a bonus system or through career progression. Also keep in mind that there is a historical trend for brokers within the larger companies to build up a good-sized client list, and then leave the firm and try to take clients with them. Their former employers obviously don't take kindly to this and try to prevent this from occurring, but it does happen, so be aware.

Your final choice is to use an investment advisor who will take responsibility for managing your entire portfolio. You can be as involved in the decision-making process as you like and as much as your advisor is willing to share. Some advisors like to have their clients be actively involved; others take a more proprietary approach and prefer to have little, if any, client involvement. The typical fee for investment advisor services is around 1 percent of the assets under management on an annual basis, with declining ratio as the size of the account increases. For example, an account with $1 million at 1 percent would be charged $2,500 every quarter, typically in advance of the quarter. Some advisors charge a slightly lower rate for that portion of the portfolio that is invested in fixed income. This type of compensation structure for investment advisors has an advantage over that for most brokers in that investment advisors make more money as they increase the size of their clients' portfolios, so interests are perfectly aligned. A broker may get additional compensation if he or she invests clients' funds in particular securities, which may or may not perform up to expectations.

If you do choose to go with either a broker or an advisor, here are some things they ought to be asking you about; if they don't, we suggest you look elsewhere:

• Time horizon: How long do you expect or need your money to be working toward your objectives? In other words, how long do you have until you start taking funds out?
• Cash flow requirements: What are your near-, medium-, and expected long-term income needs and sources?
• Outside income: Do you receive income from sources other than your portfolio? If so, how stable is that income, and how does it compare to your needs?
• Outside assets: Do you own other assets that should be considered when constructing your portfolio? For example, is the majority of your wealth tied up in an office building or in the stock of a privately owned company?
• Taxes: What is the tax basis for your various accounts? Do you have realized or unrealized gains or losses that we need to consider in the management of your portfolio?
• Other restrictions or preferences: Do you prefer to avoid investments in a particular geographic region or industry?

When you are looking for an advisor, keep in mind that this can be an awful lot like online dating where everyone puts their best foot forward, and all too often tries to be too many things to too many people. The best way to get good leads on advisors is often through friends and colleagues who have a similar financial situation as you do. Your accountants and legal advisors are also potential good referral sources.

Any broker or investment advisor should also provide the following:

• At a minimum, quarterly performance reports; some may provide monthly.
• A broker should also provide a report for every transaction performed for your account. An advisor who manages your money for you is unlikely to do this directly, but the brokerage service that holds your investments will do this for you so that you know what your advisor has done on your behalf.
• All of your accounts should be held at well-known, secure institutions specializing in asset custody. All of these accounts should be accessible to you at any time and you ought to be able to remove the broker's or investment advisor's access to your account at any point. For example, in Lenore's practice, the publicly traded investments for most all clients are held with Charles Schwab and a few at Fidelity. Clients are able to log on to Schwab's website or call Schwab at any time and get information concerning their account balances, securities held, transaction history, and so forth. Clients can also immediately remove her firm's access to their account any time they want. You should not trust any advisor who does not allow for this. Note that if you are investing in non–publicly traded investments such as hedge funds, they are held in a slightly different manner from securities such as shares of Apple.

In addition, investment advisors may provide the following types of services:

• Assist with retirement planning.
• Evaluate employer benefit options.
• Evaluate retirement offers or pension plan distribution options.
• Coordinate with your accountants to minimize your taxes and provide your accountants with year-end tax reports.
• Review your life insurance policies.

A final few words of caution about retirement planning and advisors: Commissions on life insurance policies can be quite surprisingly high, which can make it difficult for an advisor who is a licensed insurance agent to provide objective advice. We highly recommend that before agreeing to purchase a life insurance policy, you have the policy terms and financials reviewed by at least one additional advisor such as an accountant or an attorney and understand how the person selling you the policy will be compensated.

Never, ever, invest in something that you do not fully understand, and always make sure you understand exactly where your money is. Our rule of thumb is to never put money in something that cannot be explained with a crayon on a cocktail napkin. You should also be very clear where your money is at all times. The Bernie Madoffs of the world would not exist if their investors did not willingly accept returns out of a magical black box. Understand exactly how your money is being invested, know exactly where it is at all times, and always make sure that you can verify both of these through independent third parties. If not, you need to walk away.

You will find a list of suggested questions to go over with any potential broker or investment advisor in the Appendix of this book.