The big question: Risk vs Return, Part 6

Having discussed the risks and returns of two types of traditional investment vehicles, now let's conclude this somewhat long series :)

Now I am a young person, with a steady income, not very risk-averse, and have a financial goal that I want to meet in about 5 years' time. So my personal asset allocation would be this:

international stock	us stock	long-term bond	intermediate-term bond	consumer lending
20.00%	30.00%	20.00%	10.00%	20.00%

Now I have not discussed consumer lending yet, for now, just understand then as short-term, high credit risk bonds.

So I have a 50-50 split between stocks and bonds.
I am not sure about how this allocation will turn out to be, since I am myself a new investor even though I've done my research. As a general rule, the more risk averse you are, the more you should allocate towards bonds. Even though bonds just had a gigantic decade long bull market, I am personally rather pessimistic as to bonds' performance over the next decade.

I've some data here that you might want to consider when you decide your own asset allocation. Keep in mind, the most important factor here is your time horizon: if you have 20 years or even 30 years, you will be much better off with riskier allocation as they generally return more over time.

Stock percentage	Bond percentage	Annual return 1926-2011
0	100	5.6%
20	80	6.7%
30	70	7.3%
40	60	7.8%
50	50	8.2%
60	40	8.6%
70	30	9%
80	20	9.4%
100	0	9.9%

The assumption here is that you invest in very broadly diversified stock and bond funds with zero expense ratio, like funds that track MSCI US index for stocks or Barclays US Aggregate Float Adjusted index for bonds. Of course, no fund is without expense ratio, therefore, your return will always be slightly lower, probably by less than half a percentage point if your fund is relatively low cost. 

The conclusion should be that the more stocks you have, the higher return. So what about risk? Now here it is:

Stock percentage	Bond percentage	Number of years with loss
0	100	13
20	80	12
30	70	14
40	60	16
50	50	17
60	40	21
70	30	22
80	20	23
100	0	25

So generally the number of years that a loss occurs increases as you allocate more of your asset in stocks.

This should hopefully help you decide how to allocate your assets. :)

The big question: Risk vs Return, Part 3

Generally, there are two ways of approaching stock selection based on their fundamentals.

1. Value:
   Value companies are those that have a consistent track record of performance. E.g. Coca-Cola, Procter & Gamble ... These companies consistently generate profit, but they have little space to grow. These are sometimes also known as blue chips or dividend stocks. They typically have relatively low Price to Earning ratio, usually below 15.
2. Growth
   Growth companies, as their name stands, are companies that are regarded to have a lot of potential in the future. They are typically new companies with limited history and possibly limited earning. Examples of this kind would be LinkedIn, Facebook, Salesforce, etc... Some of those companies don't necessarily have a positive income, (Salesforce), but the Wall Street regards them as future cash cows and is willing ignore their current earning. 

The idea is that value stocks should have less risk, less return, higher dividend payment. It's not necessarily true. The Vanguard U.S. Value fund's last 10 years has actually been a wilder ride than the Vanguard U.S. Growth fund, although the value funds dividend yield was indeed almost 4 times higher than the growth fund. 

Personally, I think both strategies make intuitive sense for long term investors, because I believe that in the long run, a company's stock price will be mirroring its performance. But I also think just like anything in investment, you need discipline for any of the strategies to work, since one must not get carried away by chasing "best performer"s. 

Another way of categorizing stocks is U.S. vs International.

Generally speaking, U.S. stocks are less risky for people who reside in the U.S. and spend U.S. dollars. This is because even if all else is equal, U.S. stocks lack any currency risks that foreign stocks inherently have, since they are traded not based on U.S. dollar but local currencies. Foreign stocks can offer higher returns in many occasions, so I would not completely shy away from them. This is true even now with the European turmoil. My international stock investment has returned 10 percent since June 1st, while my U.S. stock investment has returned less than 8%. 

My personal strategy towards equity investment is 60/40 U.S. to foreign. I've gone for passive broadly diversified indices rather than growth or value funds, but in the future, when I get more capital to invest, I think I'll keep passive funds as my equity portfolio core and add some actively-managed growth funds for possibly higher returns. 

In the next post, I'll discuss bonds in terms of risk and return. 

P.S. if you have any questions, you can leave them in the comment section. I'll try my best to answer them, but again, everything is just personal opinion, though I do guarantee you that I put my money where my mouth is. 

The big question: Risk vs Return, Part 2

So stocks.

These are high risk investments that involve very high volatility. You can experience gains of 1000% magnitude in a few years, you can also experience losses of close 100% in a couple of years. So how do we approach stocks?

One way, is to pick a few stocks yourself. Generally, the fewer stocks you pick, the higher volatility. Why? Well, unless stocks are at least 100% correlated, when one of the stocks' price changes, other do not follow suit proportionally, and therefore acts as dampening the change. Of course, if you happen to find stocks that are more than 100% correlated, then you can expose yourself to extra volatility by buying more stocks. This approach is heavily dependent on your luck (some call skill).

There are actually two camps on this approach: ones relying completely on technical data, and ones relying completely on fundamentals of a stock. Most people are actually in between. So the technical camp claims that the stock's fundamentals are already "considered" when it comes to stock pricing, and therefore all those nice curves are able to give us all the information we are ever gonna get about the company whose stock we are trading. The fundamentals guys, on the other hand, says that all that matters for a stock is how well the company behind it is performing, and therefore they pay attention to things like Price/Earning ratios (Actually P/E ratio is only a small part). Personally, I think the technical stuff is pure bullshit. Given a reasonable time frame, I am totally convinced that fundamentals guys will always outperform. Think about it, humans are often nuts, therefore those pretty curves mean nothing! They are the product of trading activities performed by some crazy, irrational beings, and how is that going to help me find stocks?

The other way is to broadly diversify, often through some kind of broadly diversified fund. The good thing is that the volatility is vastly lower. It's not uncommon for the price of a single stock to fall by 30 percent in a single day, (Zynga) but it is very rare to see the S&P 500 to fall even 5% in a day, in fact, a 3% percent drop would be termed as "plunge" by the new agents already. On the other hand, broadly diversified funds rarely rise 3% or more in a day either.

Remember, those two approaches do not have to be mutually exclusive. Personally, when it comes to equities investing, I'd like to have a core portfolio consisting of broadly diversified index funds, and then a few individual stocks here and there, acting as supplementary investments. Of course, since I am a complete non-believer of technical analysis, I'd only pick stocks based on their fundamentals. (hmm, FB is looking increasingly attractive at this point)

In the next post, I'll do a high-level discussion on stock picking strategies.

The big question: Risk vs Return, Part 1

Everyone loves higher returns. At least I assume so. All else given, I'd much prefer my money grows at 1000% compared to 100% annually. OK, I'm dreaming.

But still, everyone loves higher returns. So where do they come from? Investments. Let's start from the highest return.

1. You start a company! Yes, if you start a company, your expected return will be huge. Let's see, Bill Gates, Larry Ellison, Mark Zuckerberg, Larry Page, etc... Just take these people as an example, they probably have 30 billion dollars each, so there's your 120 billion dollars. If they started with a combined total of 100k, then it's more than 1 million times in return! Even taking people who fail when starting up their own company, the average return is probably still well over 100 times. That's 10000% return in probably 20 years, a mouth-watering yearly average of 26%. Considering increasing the return by even 5 percentage points over the average of 8% is considered a major feat, this rate of return is simply astonishing. Now clearly, we don't see people flocking to start their own companies, why? Mostly because it's risky! Of all entrepreneurs, maybe 5% will succeed with millions in 20 years, 90% will fail with no return, and 5% probably will keep their investments. (I'm making numbers up here, but I'd say it's an educated guess) We must understand that for an average person, the pain of losing 1 million dollars is much greater than the joy of making 1 million dollars if they had 1 million to start with. Of course, other factors such as higher time / energy devotion required for one's own business may also play a part. 
2. Equities. If we ignore the characteristics of derivatives such as leveraged funds, futures, options and the like, for the period of 1926 to 2011, the broad stock market, each individual stock weighted by their market value, had an annual return of 9.9%. A really high number. To put this into context, in 30 years, your portfolio is expected to grow by 16 time. I.e. what was 10k will become 170k. And the down side is that stocks are very volatile, meaning that their prices vary a lot from year to year. The worst year for 100% stocks was 1931, a year where the broad stock market dropped 43%. Take a moment and just imagine if all your savings, probably 100k, is now only 57k, in just a year! Ouch. What's more, in 25 years out of those 86, almost 30% of the entire duration, you'll end up with some kind of loss. Imagine the psychological effect it might have on you, a lot of people are not willing to bear this psychological pain, or they do not have enough time to wait for the market to "come back to normal". 
3. Bonds. Bonds have risks too. You can get defaults and interest variations. But bond risks are significantly lower: for the same historical period of 1926 to 2011, the absolutely worst year for bonds were -8.1% in 1969. In other words, in almost 100 years, investors would have never lost more than a tenth of their investment had they gone for diversified bonds only. A price had to be paid to the low risk though, in this case a much lower return of 5.6% annually, not even two thirds of what equities can provide you with.
4. Cash or cash equivalent (CDs). Now these have almost zero risk. All bank deposits in the U.S. are insured by FDIC for up to 250k. So essentially they are completely "safe".  I wasn't able to gather historical data back to 1926, but we currently have an average deposit interest rate of below 1%. 

The general trend is clear, higher risk, higher return. This may not hold true for short periods of time though, and "short" can actually be fairly long. For example, since the early 1980s, where interest rate was at sky-high 20%+, bond yield has kept dropping steadily, which created the biggest bond bull market. Therefore, for the most recent 30 years, bonds actually offered higher returns than stocks. But since interest rate can not  decrease forever (there is this magic number called zero), the potential gains from bonds will be limited. And personally I think over another 10 or 20 years, bond returns will come back to the normal 5% ish range. 

Personally I think this post has been rather chaotic, as I tried to take on too many things in a single post. I guess on the next post I'll start with just stock, and hopefully discuss risk involved in some depth when it comes to stocks. 

Stock vs Bonds, tax comparison, Summary

This is the summary table.

	Stock, Bond ST capital gain	Stock, Bond LT capital gain	Stock qualificed Dividend	Stock non-qualified Dividend	Tax-exempt bond interest	Taxable bond interest
Tax rate	28%	15%	15%	28%	0%	28%

Now let's get familiar with the concept of asset location. Many of you might have heard of the term asset allocation, which we will discuss in the future posts, but asset location is a quite different beast that is still important for a successful investor.

If every other investment decision remains the same, a good asset location will maximize after tax investment return. Note, we always talk about after-tax return, not the actual amount of taxation. It does not matter how much Uncle Sam charges you, as long as we end up with more money in the pocket, that asset location is a successful one.

Personally, I employ this strategy for when it comes to asset location:


Maximize tax-free and tax-deferred (401k and IRA, maybe 529 as well) accounts with investments with the following priority

1. Taxable bonds. These bonds are guaranteed to generate realized interest gains every year that are taxed at a hefty 28%.
2. Actively managed stock funds. Actively managed funds tend to have high turn-over, which means that they may incur a lot of realized capital gains at 28%. 
3. Foreign stocks. Foreign stocks are taxed heavily on their dividends at 28%.

The location of other types of investment does not matter too much if you are a buy-and-hold investor. If you often trade, then it makes sense to treat them the same way as actively managed stock funds with high turn-over.

So the idea is pretty simple, put the tax-efficient investments in your normal accounts and put those less tax-efficient into tax-advantaged accounts. 

At the end of this rather short post, I want to stress again, always aim for maximizing AFTER-TAX RETURN instead of minimizing tax. A lot of people have fallen to the trap of omg-I-don't-want-to-pay-tax.

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Stock vs Bonds, tax comparison, Part 3

In this post, I'll discuss the tax implications of bonds.

Bonds are actually pretty inefficient when it comes to taxation, but hey, it makes sense, because stock dividends are actually double-taxed, once at the corporate level, and once at individual income level, whereas interest payments on bonds are tax-free on the corporate side.

Following the grand theme of 2s, let me introduce you to the two types of bonds: taxable and tax-exempt.

Taxable bonds are fairly easy to understand, their interest payments are taxed at the regular income tax rate, which means 28% federal and whatever state tax. Interestingly, treasury bills are taxable!

Tax-exempt bonds are slightly more complex. Most bonds marketed as tax-exempt actually only means that you are exempt on federal taxation for interest gain. If you state happens to tax your income, then you'll have to pay the state tax. Our beloved California will then get a 9.3% cut of your interest gains. I guess this is the price you have to pay for nice weather and the existence of silicon valley, huh? There is another kind of tax-exempt bond funds, those state specific. Usually, you can only buy state-specific bond funds only if you are a resident of that state. For example, the Vanguard California Long-term Tax-exempt Fund are only available to California residents, but the interest gains from this fund is then also exempt from CA taxation.

Two common misconceptions!

1. "I bought a tax-exempt fund! Now all my gains are tax free!"
   Not true! As I mentioned, tax-exemption only applies to the interest earnings. If you sell a tax-exempt bond fund, you still have to pay tax on any capital gain. 
2. "Tax-exempt bonds are always better because I pay no tax!"
   Not true! The ultimate goal of investment is to maximize after-tax return, not minimize tax. If you have two funds with exactly the same characteristics, except A is taxable with 5% yield and B is tax-exempt with 3% yield, then obviously you should take the 5% one. 5% * (1-0.28) = 3.6%.

You may have a question with regard to the 1st misconception, namely, how exactly do you get a capital gain from bonds? Are they not just instrument that generate income? Well, just like stocks' return consist of appreciation and dividend, bonds' return also consist of both. The price of a bond varies with its demand, the higher the demand, the higher the price. If you look at it from another angle, then it can be interpreted as a variation in yield. Let's take a look at an example.

You bought 10k worth of bond at 10% yield (yeah, super bond, or maybe super risky bond), it has a maturity of 10 years. The moment you bought it, suddenly the yield dropped to 0%. (Very unlikely to happen, but we do see zero or even negative bond yields, we've even seen them recently in the case of 3 month US treasury bills and German bunds) Now how much is your 10k bond? Since most of the bonds are fixed rate, your 10% yield will continue to provide 10% annual income for 10 years before the principal is paid back to you. So your 10k bonds in 10 years time will be worth 10k + 10k * 10% * 10 years = 20k. 

Now for people that bought the 0% yield bond right after you, in 10 years time, their bond will be exactly 10k. Therefore, your 10k bond with 10% yield now is exactly the same as 20k bond with 0%. So you can sell your bond for 20k and cash in an extra 10k! This is basically how capital gain occurs. Similarly, when the yield rises, the value of bond you hold will drop. 

Of course, bonds' yield don't change by 10 percentage points every day, most of the time, their price hardly changes. This is especially true for short-term bonds, as even if the yields fluctuate, the impact on the entire value of the bond is small. Take the made-up 10k 10% example again, if the maturity is only 1 year, you'll gain 10% instead of 100%. 

In the next post, I'll summarize what I touched upon, and introduce the concept of what's known as "asset-location". 

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Stock vs Bonds, tax comparison, Part 2

In this post, I'll write about tax implications of losses in investment.

As I mentioned previously, the IRS is actually pretty fair when it comes to capital gains / losses. What I mean is that it taxes you when you make money, and it refunds you when you lose money.

In case you still haven't noticed a theme with IRS and their enormous tax code, let me give you a hint, "two" lurks around everywhere. Yes, losses come in two types, too. And no, this is not going to be the end of "two"-types streak.

First type is "short-term" capital loss. These are losses due to selling shares before holding them for one year. The second type is "long-term" capital loss, originating from selling shares that have been held by you for more than a year. And when I refer to capital loss, I always mean realized losses, you need to have sold the shares for the losses to be realized. 

As you probably noticed, they are the exact mirror of ST and LT capital gains. When it comes to tax credits, the rules are closely tied to the ST and LT characteristics as well.

ST capital losses incurred in a year can be used to offset ST capital gains, if there is any excess, you can then use it to offset LT capital gains. In case you're a super loser (in the investment sense), and you lost so much in ST investment, you can then use the rest to offset your your net LT capital gains (defined by LT capital gain - LT capital loss). Now in the hyper loser case, you can then use what's left of your current year's ST loss to offset ordinary income, up to 3k. If you qualify for ULTRA loser, i.e. you exceed 3k a year, you get to carry the losses over to the next tax year. Combined with the new losses, you repeat the steps again.

LT capital losses work much the same way as ST capital losses. The only difference is that they are used to offset LT capital gains first, then net ST capital gain, then ordinary income.

Now people have noticed a potential loophole here. Imagine you bought Stock A for 10k, before the end of the tax year, it has fallen to 5k. (I know, tough luck). You could potentially sell the stock and incur a 5k realized ST capital loss. What you could then do, is to buy it back using 5k. Sure, you lost probably 7 dollars of trading fee, but assuming a combined federal and state tax rate of 30%, you saved 5k * 0.3 = 1.5k of tax money. Of course you'll end up paying more tax later when the stock's price goes up, but you essentially have 1.5k for free until you sell the stock at a gain. And if you have those 1.5k invested, you probably end up with more than 1.5k by the time you have to pay the tax on your gains by selling Stock A. Feels like free money, huh?

Well it doesn't work, sorry to burst your bubble. What I just described there is called a "wash sale", and it is a practice forbidden by IRS. Wash sale is defined as selling and buying investments that are "substantially the same" within 30 days. The window is actually more like 60 days, because if you buy something in July 1st, you couldn't sell between June 1st and July 30th. Well, I'm being sloppy here, yes you can "sell" or "buy", but you just can't take tax credits for your losses. Of course, the IRS being "fair", it also means that you don't incur capital gains in the same window.

Some people unintentionally introduce wash sales to their portfolio when the stock market is very volatile and one tries to chase performance and stop loss. This is fine, just pay attention to the tax filing, do not blindly include your ST capital losses if your financial institution does not take wash sale related regulations into account. Because the IRS may find you later with hefty fines and other undesirable punishments.

Stock vs Bonds, tax comparison, Part 1

Stocks and Bonds are the most common investment options, each has its own tax characteristics.

In this post, I'll primarily discuss the tax liabilities of stocks.

People make money from stocks through two methods, price increase (appreciation) and dividend. Both are fairly intuitive. You buy low, you sell high, then you have appreciation, in IRS's books, it's called capital gain. Companies pay their shareholders part of the earnings, and that's dividend.

Price appreciation, or capital gain, is taxed differently depending on how long you hold the stocks for. If shares of a stock is sold within 1 year of the purchase date, whatever you gain is categorized as short-term capital gain, which means the tax rate is exactly the same as your marginal ordinary income tax rate. In my case, that's 28% federal tax + 9.3% state tax. Ouch, more than a third of what I make is going to the government! Even though I don't hate the government, I don't like it too much either, not so much that I'm willing to part with 37.3% of my investment earnings. On the other hand, if shares of a stock is held for more than 1 year and then sold, it is taxed according to the rules of long-term capital gain, at a much more favorable rate of 15% federal + 9.3% state (I know, sucks to be in California, many other states differentiate between long-term and short-term capital gains though).

Conclusion here is that Uncle Sam loves buy and hold investors more! (I'm sure it loves everyone none-the-less, LOL)

Some caveats here:

1. That 15% LT capital gain tax can change, and in fact, it's scheduled to increase to 20% starting January 2013. Moar tax plz...
2. Many of us invest through mutual funds, myself included. The taxation for mutual funds are slightly more complex than individual stocks. In the eyes of IRS, what you are buying is not "THE FUND", you are buying individual stocks in some proportion. That proportion is dictated by the fund manager, and can change over the course of a year, sometimes drastically. Every time when this proportion changes differently than the prices of each individual stock, your fund manager is essentially selling / buying stocks on your behalf. And that is a taxable event, which follows the tax rules I described above. When you sell the fund, of course, that's another taxable event, because in essence you are selling every individual stocks that you own through that mutual fund. Therefore, when you select funds, it probably makes sense to pay attention to what's known as "turn-over rate", a number that measures how much the manager has traded in a year. 0% means the manager never exchanged any shares, and 100% means none of the shares that the fund had at the beginning of a year has remained at the end of that year (read: probably a lot of tax). Index funds usually have close to 0% turn-over, and actively-managed funds tend to be a lot higher. But don't just shy away from actively-managed funds, because if they offer much better returns such that earning - tax is higher than the index fund, it makes perfect sense to buy actively-managed funds. How you determine how much a fund will return in a year, is a completely different matter though.

Now dividends also have two categories since IRS loves complexity. Those "qualified" dividends are basically all the dividends that you get from U.S. companies. They are taxed identically to LT capital gain. Those "non-qualified" dividends, are mostly foreign company dividends, some banking accounts' "dividends" (interests really) , and pretty much anything that is not included in the lonely qualified category. They are treated the same way as ST capital gain (read: a lot of tax). 

If you choose to employ a dividend-oriented investment strategy, i.e. buying shares of stable companies that pay high dividends, such as Microsoft, it then makes sense to stick to U.S.-based companies, because otherwise you'll get hit pretty heavily with non-qualified dividend tax. 

Assuming you are in the 28% tax bracket, here is a summary table for you:

Type	Long-term Capital Gain	Short-term Capital Gain	Qualified Dividend	Non-qualified Dividends
Applicable to	Share price appreciation when held for more than 1 year	Share price appreciate when held for less than a year	Dividends paid by U.S. companies	Any other kind of dividend
Tax rate	15%	28%	15%	28%

We discussed the "gain" situation in this post, as we know, stocks go down too, and they can go down by a lot, which means the "loss" situation is equally important. Luckily, the IRS is pretty fair when it comes to losses during an investment. I'll write out what I know in the next post.