Getting Income from Your Retirement Portfolio


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top.  The posts will appear in reverse order, with the newest post first. 

A portion of your retirement portfolio should be dedicated to generating current income.  This means that you want assets in your portfolio to be sending you a check regularly so that you can pay for food, utilities, and other expenses you’ll have in retirement.  For example, if you own bonds they will send you an interest check twice per year.  Likewise, many stocks will send you a dividend check four times per year.  REITs (Real estate portfolios) will send you money from rents that they receive from properties in the portfolio.  All three of these types of investments will also send you capital gains distributions periodically from when they sell a security at a profit.  While you can also sell off shares to generate cash, it is better to have interest and dividend payments coming into your account so that you don’t generate brokerage commissions and other costs by selling.  Once you have things set up, it also means that you don’t need to do much of anything.

To show how the process works, let’s assume that I have a two million dollar portfolio, of which I’m using $1.5 M to generate income.  The other half-million I am leaving in growth stocks to keep up with inflation and get better returns than I can from income generating assets.  I’ll use a combination of bonds, dividend-paying stocks, and REITs to generate income.  Let’s say that I want to generate about $50,000 per year in current income from the portfolio.

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Looking through the Vanguard funds, I find the following:

Bond Funds:

Long-Term Bond Index – Yield 3.78%

Total Bond Market Index – Yield 2.96%

Long-Term Corporate Bond Index – Yield 4.42%

High-Yield Stock Funds:

High-Dividend Yield Corporate – Yield 2.89%

REIT Funds:

Real-Estate Index Fund – Yield 4.03 %

I’ll use these funds as building blocks to generate the income I want.  Bond funds tend to pay the most cash, but the higher-paying bonds funds are also riskier.  The amount they pay (in dollars) will also stay relatively fixed with time, while the value of a dollar will decrease due to inflation, so over many years my spending power will be reduced if I only buy bond funds.

The dividend-paying stocks don’t pay as much as the bond funds, but the amount that they pay will increase with time.  I may only get $5,000 from a dividend fund this year, but in ten years I may be getting $10,000.  An equal investment in a bond fund may pay $7500 this year, but in ten years it will still be paying $7500.  The dividend part of the portfolio will help me keep up with inflation.  The growth stock portion will do this as well.

The REIT fund will pay as well as some of the bond funds, but also will have some capital appreciation, helping to keep up with inflation as well.  It is also in a different sector of the economy than stocks or bonds, so the price of the fund may stay up when the stock and bond funds go down and vice-versa.  This adds stability to the value of my portfolio.

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The strategy is to utilize the higher-yielding bond funds to increase my returns, but also buy some lower-yield funds for security and to reduce volatility.  I’ll add dividend-producing stocks for growth of income.  I’ll add REITs to help provide income, stability, and some capital appreciation.

Let’s say that I invested as follows:

Long-Term Bond Index – $200,000, yearly income $7560

Total Bond Market Index – $200,000, yearly income $5920

Long-Term Corporate Bond Index – $300,000, yearly income $13,260

High-Dividend Yield Corporate – $300,000, yearly income $8670

Real-Estate Index Fund – $500,000, yearly income $20,150

My total income would be $55,560, which is $5560 above my goal.  This is fairly close to my goal, so I may say this is good enough and go with it.  The portfolio is nicely balanced, with 47% in bonds, 20% in bonds, and 33% in real-estate.  If I really didn’t need more than $50,000, I would probably shift more money into the high-yield stock fund, which would reduce my current income but increase my future income and get a little better overall return on the portfolio over time.

So there you have it – the strategy for setting up the income portion of your portfolio.  Develop a list of funds with their yields, allocate money to each fund, trying to spread the money out among bonds, dividend-paying stocks, and real estate, and then adjust the allocations until you reach your needed income needs.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

It’s Time for the Public Sector to Follow the Private in Retirement Plans


Let’s say that you went to a bed and breakfast, checked in, and went up to your room.  The room was a mess with bed-clothes strewn on the floor, breakfast dishes piled up on the table, and a big black ring around the whirlpool tub and soap suds near the drain at the bottom.  You are then told that you owe a $100 cleaning fee to get the room back in shape so that you can enjoy it.  At least, you might get to enjoy it, but then again they may need to raise the rates after you pay the cleaning fee, or maybe they’ll just shut the place down entirely.

You protest, saying that you were not the ones who used the room last and that the ones who did should pay the fee.  The host replies that the last people have gone, that someone needs to pay to have the room cleaned, and that the someone is you.  You try to back out of your reservation, but you’re told that you must pay the fee or they are calling the cops.

How would you feel?  Would you feel that you had a responsibility to pay the fee?  Would you begrudgingly do so, hoping that the next person would pick up the tab for you?  If you paid the fee, would you then feel entitled to having the fee paid for you by the next guest?  A guest who, just like you, hasn’t stayed in the room yet and had nothing to do with any bargain you make with the inn keeper.

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The same thing happens with things like public pension plans and Social Security.  People long ago made agreements with politicians long since gone to receive something far in the future in exchange for their services or tax money.  In the case of public workers, voters and residents forty years ago received services for which they paid some taxes, but salaries were low in exchange for promises of generous retirement pensions, free healthcare for life, and other benefits.  Those benefits were not paid for by the residents who hired the politicians who made those deals.  They only paid for the salaries of the workers and in exchange they received various city, state, and federal services. Now that the workers are retiring or have been retired, the next generation is expected to pay for those retirement benefits.  This next generation is paying for the retirement of workers from which they received no benefit based on agreements they did not make.  Kind of like needing to pay for a room to be cleaned that you did not use.

Social Security is the same way.  Back in the 1930’s, people voted for President Roosevelt and a Congress who created Social Security, originally charging about 2% of pay in exchange for just enough retirement income to avoid starvation and to keep the lights on.  Voters at the time agreed to pay these taxes and pay out benefits to people who were starting their retirement at that point even though those people had paid next to nothing into the system, in exchange for the promise that they would receive a payment in the future.  As it looked like more people were going to retire than the system could sustain, the tax rates were raised in anticipation of needing more money, eventually reaching more than 12% of pay even though benefits remained flat.  This would have helped, but all of the extra money was spent as soon as it was collected, leading to the current situation where benefits will need to be cut in the near future unless taxes are raised further.  Again, people who had no part in the agreement are expected to pay up.

What if they say, “No?”  What if they decide to cancel Social Security, or cancel public pensions?  If they are forced to pay for these items because they are in the minority, what if they just decide to work minimal amounts, or quit work and raise a garden, producing just enough to feed themselves?  What if they move away to other countries or simply stop working and go on the public dole themselves?  What then?  Are you going to try to force them to work?  Isn’t that called, “slavery?”

Sorry, but those in the next generation are no more morally obligated to pay these bills than you would be if you would be obligated to pay for the cleaning of a room if you showed up to a bed and breakfast with a dirty room.  They did not make this agreement.  They did not continue to vote the politicians in who made these arrangements.  They did not look the other way while all of the extra money raised for Social Security was blown on battleships and public rail lines.  It is neither their agreement nor their responsibility.

“But someone needs to pay the bill,” you say.  There is no good answer for this.  Somebody will feel some pain because of bad agreements made years ago.  Perhaps the pain should be spread around a bit, but perhaps those who made the deals should take a greater share of the pain.

Going forward there is a better way.  Public employees and public retirement plans should follow the lead of private employers.  Rather than a future promise, retirement should be paid for as-you-go.  If a politician promises a lavish retirement in the future, the city, state, or Federal government should pay for their share of it right away by putting money away into an account owned by the employee.  Future governments are free to stop putting money into the account, just as the employee is free to leave and find another job if the retirement benefits being funded are not to his/her liking.  When the employee retires, his/her retirement is paid for and there is no need to rely on future taxpayers.

Likewise, money for Social Security should be paid into private accounts.  These could be invested automatically in broad stock and bond market index funds to eliminate the risk of poor personal management.  When individuals are ready to retire, they would have their own account and not need to rely on future workers contributing in order to continue to receive a check.  Isn’t that a better way?

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to Use an IRA in Retirement to Fund Your Lifestyle


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Saving up enough for retirement is critical.  There are many articles on how you should be saving for retirement, putting money away into 401ks, and building up an IRA for retirement.  But what about when you get to retirement?  How do you put the hard-saved money to work to fund your retirement?  Do you convert your 401k and IRA to cash and put it into CDs?  Do you buy a bunch of bonds and live on the interest?  Or should you stay invested in stocks and use the capital gains to fund your retirement?  Here are some tips on how to unwind your IRA when the time comes.

1.  Hold on as long as you can

Hopefully you will have saved up enough money and cut expenses enough in preparation for retirement to not need to touch your IRA for the first several years.  So long as it is in the IRA, it continues to grow tax deferred (or tax-free, if it is a Roth IRA).  Unfortunately, the government is itching to get their money on those dollars, so they will force you to start withdrawing money.  For a traditional IRA, the age at which you must start taking withdrawals is currently 70 and ½.  This can and probably will change over time, however, so it is worth it to talk with your CPA to verify the tax rules and come up with a plan.  Get it wrong and you can end up owing a lot of extra money in taxes, so paying a good CPA a few hundred dollars is well worth the price.

There is a strategy in making withdrawals from an IRA.  Ideally you will have enough dividend and interest paying assets in the account to produce enough cash each year to cover the required withdrawal.  This means that you can just let the cash build up, withdraw it at the end of the year, and then let the process start again.  This will work for a while, but the required amount of the withdrawals will increase each year (the government wants it all out by the time you reach a certain age) so eventually you’ll need to start selling assets and pulling them out.

 

 

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2.  Sell your losers, hold your winners

Eventually you will need to start selling stocks and pulling money out of your IRA.  When doing so, start by selling things that are just not doing well and don’t have the promise they once had.  For example, if you bought a stock but the business you expected never materialized and the stock has been flat, you might as well sell it rather than sell shares in a company that is doing well instead.  Likewise, if you have a stock that has had a good run but now has reached a plateau and the growth rate has slowed considerably, you might as well sell it.  Since the tax paid will be based on the amount withdrawn regardless of how well you did on the investment, it doesn’t matter whether you are taking a loss or not.

3.  Shelter your Income generators.

It is also a good idea to try to keep dividend and interest paying assets in the IRA as long as possible.  Because you will pay taxes each year on the interest and dividends when you hold income stocks and bonds outside of the IRA account, while you will only pay taxes on the capital gains when you sell an equity that has appreciated in price, it makes sense to keep the income producing assets sheltered as long as you can.  I would therefore sell a stock on which I’d had a capital gain, withdraw the funds, pay the taxes and then reinvest in the stock again if I wanted to continue to own it before I would do the same thing with a stock I was holding for the dividend or a bond.

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Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to Find Information for Picking Stocks


Stock selection is definitely more of an art than a science.  When screening stocks – going through the thousands of potential companies and deciding which to buy – I typically use price history, earnings growth, dividend growth, return on equity and return on sales, and a general description of the company to make selections.  These are the factors that are most important to me in my buy-and-hold style.  This is because I’m looking for stocks I can hold for ten or twenty years and see them double every five or six years.

I first of all look for companies that are growing and have a lot of room to grow.  One of the easiest ways to find stocks that are growing is to just look at the multi-year price history and find those that are increasing in a linear manner for five to ten years or more.    I also want companies that are obviously well-managed, which is shown by regular earnings and dividend growth and a good return on equity.  Finally, I look at the company description because I want to select stocks in different industries.  More specifically, I try to find the best stock in each industry and buy stocks in several different industries.

All right – so now you know how to screen stocks, but where can you find information such as earnings?  The internet is obviously a wealth of information, but more and more of it is becoming a paid service.  Still, there is a lot of information out there for free.  Sites such as Yahoo give basic current stats, although I don’t know of any site that gives several quarters of earnings, P/E ratios, etc… any more.  You really need to be able to look back for several years to see how the company has grown and how it is priced currently relative to where it normally trades.

A great publication for the long-term investor is the Value Line Investment Survey (www.valueline.com).  I tend to use the print version, although there is an online version that I’m sure is also useful.  I like Value Line because it gives full-page descriptions on each stock including a price graph, stats going back several years, and  a review of the company.  It also screens stock, assigning a value for Timeliness, Safety, and Technical.  Here, buying stocks with a 1 of 2 for Timeliness and at least a 3 for safety would be recommended in general.  Value Line costs quite a bit (about $800 per year), but it is worth the price because one will make far more in investments than the subscription price for a moderate-sized portfolio.  For someone starting out, most libraries also have Value Line subscriptions.  Given that you’ll only need to research new stocks every few months at most, this would be a good way to go initially.

Value Line

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Select®: Dividend Income & Growth April 2017: Discover dividend-yielding stocks selected by Value Line analysts.

For getting investment ideas – which stocks at which to take a closer look, publications such as The Wall Street Journal, Barrons, Forbes, and Money can be useful.  You need to be careful though in that many stocks will jump in price just because they are recommended in one of these publications.  The price will normally fall back within a couple of weeks after the jump, so perhaps a good strategy would be to wait a couple of weeks after the issue comes out before buying in.  The publications also periodically have articles on ways to invest, although I’d avoid taking anything you read by itself on faith.  It is better to read a lot, and then make your own decisions.

Another possibility is simply going to the websites for the companies and looking for annual reports and data they provide.  This, however, doesn’t give you the ability to screen several stocks, looking for the ones that stand out.  If you get a tip from a magazine, however, you can go to the company website and find annual reports to get more information.

Want all the details on using Investing to grow financially Independent?  Try The SmallIvy Book of Investing.  

 

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The Three Investments Every New Investor Should Have


There are a lot of investment choices.  There are stocks, bonds, REITs, Options, Warrants, and convertibles.  Then there are funds that buy and sell these different investments for you, which would make things simpler, except that there are many different funds out there.  In fact, there are actually more mutual funds buying and selling individual stocks than there are individual stocks.  So, how do you choose?

The good news is, there are really only a few things that you should invest your money in.  Once you know these few investments, you can cut through all of the noise and make a wise choice of where to place your money.  I would say that there are three investments you really should make before you get near retirement.  Ignore the rest.  Here are the three:

1.  Total Stock Market Index Mutual Fund

This investment does what it says – it buys stocks in the total US stock market.  Buying just this one mutual fund will mean that you are diversified over the whole stock market.  You’ll want this because it eliminates the risk of picking a bad stock or a bad sector.  It is possible that one company could go out-of-business and you’d lose your whole investment if you try to pick a stock.  But what are the chances that every company in the US stock market will be wiped out?  If that happened, you wouldn’t be too worried about your portfolio.  You would be worried about finding enough ammo to keep the wandering bands of marauders at bay.

You need to have stocks when you are investing for a long time since they are the only investment that will grow over time.  This means that you will make real money, even when inflation is taken into account.  Put your money in the bank for 30 years and you’ll find that you’ll be able to buy maybe 75% of the stuff you could have bought with the money when you put it in.  Put your money in the stock market for the same period of time, and you’ll be able to buy about eight times as much stuff.

You buy an index fund because they are cheap.  The fees are really low, often below 0.25% of the amount of money in your account each year.  If you go out and buy a managed mutual fund where someone, or a team of someones, buys and sells stocks for you, you’ll pay 1% or more per year.  Given that most managers match the indexes at best over long periods of time, you’ll probably make a lower return in a managed fund than an index fund.  So, go for the index.

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2.  A Corporate Bond Index Fund

A bond is a loan to a company.  In exchange for the loan, they pay you interest payments twice a year for a period of time.  At the end of the period, they pay you your money back.  Bonds are good because they give you steady income that quiets down the gyrations caused by a stocks.  If you have an all-stock portfolio, you might be up 30% one year, but then down 30% the next.  Over time you’ll make about 7% after inflation, but it is a wild ride in the mean time.  Add 20-30% bonds, and you’ll see lower swings since the bonds will always be there, paying out interest, which helps offset the swings in stock prices.

You don’t want to have all bonds.  That is even more risky than having a mix of bonds and stocks.  You also don’t want to hold a lot of bonds for thirty years or longer since the returns you’ll get will be lower than they will be from stocks.  Over shorter periods of time, however, bonds will sometimes outperform stocks, particularly if there is a big downswing like we saw in 2008 and early 2009.  In that period, while stocks lost 40%, bonds actually went up a few percent.  They did a lot worse than stocks in late 2009 and 2010 as the markets recovered, but people who were holding bonds during 2008 and 2009 felt a lot better than those holding stocks.  Again, buy an index fund that holds a lot of different types of bonds for low cost and diversification.

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3.  An International Stock Fund

US stocks are often the place to be since the economy is stable and often growing, but it is not always the best place.  You’ll always want to have some of your money in whatever segment of the market is doing the best at any given time.  You should therefore put some of your money, maybe 20-25%, into an international stock fund.  Here you want to look for inexpensive index funds that invest all over the world, rather than picking a niche fund that invests only in Asia, for example.

So there you have it.  A total stock market fund, a bond fund, and an international fund.  Find cheap index funds, send in a check, and never look back.  Happy investing!

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Sneak Preview of Cash Flow Your Way to Wealth


 

I’m working on the last read through of Cash Flow Your Way to Wealth and expect the book to be released within a month.  I’m very excited!  I think it will help a lot of people learn to manage their money well and become financially independent.  Here’s a sneak preview of the book.   This is the Introduction, which sets the stage for the rest of the book.

Most people have the opportunity to become wealthy within their lifetimes, just using the income they have from their jobs. The reason that few do is because of the way they handle their money once they earn it, also known as how they setup their cash flow. Their whole lives they setup and maintain the cash flow of a middle class person, or even the cash flow of a poor person. People who will become rich and stay that way have setup the cash flow of a rich person. Even if you were to take all of the wealth accumulated by the wealthy people away, they would be wealthy again in a few years because of the way they have configured their cash flow. Likewise, if you gave the poor or the middle class people a bunch of money, in a few years they would be back where they were again because of the way they setup their cash flow. Knowing how to setup the cash flow of a rich person is the key to becoming wealthy, regardless of your income level.

The term “cash flow” is often used to describe the amount of money passing through your fingers each month, and many people say that the reason they cannot improve their financial place in life is because their cash flow is too small. But your cash flow is also how money flows into, through, and out of your life. This is the definition we’ll use in this book. Everyone has some sort of cash flow, regardless of their income. Even if you don’t deliberately configure and control your cash flow using a cash flow plan, you still have one.

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Most people have a cash flow that is exactly balanced – every dollar that comes in goes out. In fact, many people don’t even see their money at all since their checks are direct deposited and their bills are paid automatically. They just know that their lights don’t typically get shut off, so things must be working. The issue with this sort of cash flow, however, is that it is extremely fragile. Any disruption in your income stream will result in the light bills not being paid and your lights being shut off.

The purpose of this book is to help the reader develop a different sort of cash flow. One that causes wealth to be built over time. Very quickly (in less than a year) an individual with this sort of cash flow will be protected from minor disturbances such as a missed paycheck or an unexpected expense like a car repair. Within a few years the same individual will be protected from major disturbances like a job loss with a couple of months spent finding another one. After a couple of decades, financial independence can be built – that magical state where one no longer depends on a job to pay for basic bills and put food on the table. In other words, financial security.

To understand the different kinds of cash flow, picture a large canyon. A water source flows into this canyon from one end. For some people it is a small creek. For others it is a moderate stream. For others it is a raging river.

Many people would see the raging river and think that the individual who owned that canyon would never run out of water. Truth be told, most people we think of as rich do not necessary have a rich-person cash flow, but instead are individuals with a raging water income. These are people who are NBA stars with multi-million dollar deals, rock stars, brain surgeons, and Wall Street financiers. They probably drive Lamborghinis and Ferraris, live in huge homes with maybe a servant or two, and are always going on lavish vacations and out to the finest restaurants.

Those in the middle class would have a moderate stream income. Many of them would drive late model cars, but be limited to SUVs and maybe a lessor luxury-brand like a Lexus. They would still eat out a lot but usually at the moderately priced chains with perhaps a spurge on a nicer restaurant once in a while. They would have nice homes with large yards and granite counter-tops, but nothing like the mansions owned by the raging water set. While they would not have as much water flowing through their canyons, you would still not expect them to run out of water very easily and expect the stream to always be flowing.

Those in the working class would have a creek flowing into their canyon. It would be steady, but nothing excessive. They would drive older cars, live in modest homes or apartments, and generally need to watch their money carefully to cover everything. At times the creek may slow and even dry up for a period of days. If you were living with a creek income, not being able to afford the things you need would be a concern.

 

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The truth is, however, that all of these individuals are equally vulnerable. All of the water flowing into the canyon flows right back out. Even for the individuals with the raging river income like a movie star, if there is a disruption in the flow of water coming into the canyon – like if someone builds a dam upstream (a job loss or an injury), they could very quickly be in trouble.

Now picture the same canyon with the same water source flowing into it, but now place an earthen dam at the downstream end. Now the water does not all flow out instantly – water starts to rise in the canyon, forming a small pond, then a small lake. Obviously the water level would rise a lot faster for the individuals with a raging river flowing into their canyons, but even those with just a creek would see water building up over time.

Now, these individuals are protected somewhat from an interruption in their income stream. When the water stops flowing for a period of time, depending on how far their canyon had filled with water before the interruption, they would have some buffer before they ran out of water. The amount of time they had would depend on how many holes they had in their dam – how many expenses they had each month.

Individuals who become wealthy – truly wealthy – build dams at the end of their canyons. They also limit the number of holes in their dams and work to increase the water source coming into their canyons. In fact they build additional feeder streams into their canyons, called assets, that build upon themselves to increase the flow over time This causes their canyons to fill with water and become large lakes from which they can draw and never worry about running out of water because of the feeder streams replenishing any water that they remove.

In this book you’ll learn how to manage your cash flow to build a dam at the end of your canyon. You’ll learn how to increase your income by adding feeder streams, assets, that will increase how much water is flowing into your canyon. You’ll learn the investments that you must make to pay for important things like retirement. And then you’ll learn how to set yourself up to never need to worry about money again. It all starts and ends with a cash flow plan.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Is a Buy-Write Fund Right for Your Retirement Account?


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top.  The posts will appear in reverse order, with the newest post first. 

Today’s topic is a bit advanced, so I’ll begin by boiling the lesson down to the key points, then elaborate for those who want to know the details.  The key things you need to know about buy-write funds are:

  1.  They can generate a good amount of cash income regardless of current interest rates (with option writing, you can basically turn any stock into a dividend-paying stock).
  2. They are more volatile than bond funds but less volatile than stock funds.
  3. They won’t go up as fast as stock funds, but also won’t go down as much.
  4. You have the potential to make on the order of 25% per year from buy-write funds, but you will rarely do this.
  5. They will perform the best of anything when markets are stagnant.

So there’s the minimal you need to know.  For those who want more explanation, please read on.

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What are call and put options?

You have probably heard the term, “stock options,” when hearing about a CEO who made a fortune because he received stock options from the company.  An option is a legal contract between two people.  This contract allows one person, the option buyer, 1) to purchase (or sell) 2) a fixed number of shares 3)at a specified price, 4) before a specified date.  An option to purchase is called a call option, where the option to sell is called a put option.  It is called an option because the purchase or sale is optional, purely at the discretion of the option buyer.  The option buyer would buy (or sell) shares from (to) the option seller, also known as the option writer.

Option writers can be covered, meaning they own the shares in the case of a call or have the cash in the case of a put, or naked, meaning they don’t.  A naked option writer hopes that the person who holds the contract never executes it, otherwise he’d need to somehow go out and buy the shares at whatever price they were trading so that he could turn around and sell them to the option buyer (in the case of a put, he’d need to find the cash to buy the shares at the specified price, regardless of where they were selling for now).  As you can imagine, being a naked option writer is insanely stupid and a great way to lose lots of money.  Really, it was naked option writers (who didn’t know they were naked because they bought offsetting options from other naked option writers) who caused the housing market crash in 2008 to almost take out several US financial firms.

To make things easy, most option contracts are standardized, meaning they all are for the same number of shares (typically 100 per contract), have regularly spaced prices at which the shares are bought or sold (called the strike price), and all expire in monthly groups on the same date (the date at which the contract expires is called the expiration date).  For example, this month all of the options expire on Friday, March 16th.

 

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Why would someone buy options?

Options were originally meant as little insurance policies, whether letting someone buy or sell a stock at a certain price.  They have become much more popular as speculating tools, however, since they provide something called leverage, which is when you use a little money to control a lot of money.  Most readers are probably most familiar with leverage when it comes to home buying, where you can put $10,000 down on a $500,000 house.  If the home price goes up 1o% over the next year, you could then sell it for $550,000, making $50,000, or 500% profit.  This is really good for a one-year speculation.  If you had put down the full $500,000 for the home, you would have still made $50,000, but now it would have only been a 10% profit.  Leverage magnifies potential gains.

Options do the same thing.  You might buy a set of 10 calls on a $100 stock for $500, meaning that with $500 you now control $10,000 worth of stock.  If the stock goes up $10 per share to $110, you might be able to execute the options and sell the stock, making a quick $1000, or 100% profit.  (You might also be able to just sell the options to someone else for $1000 since the price of the options would go up when the stock price went up.)  If you had bought the shares for $10,000 instead of buying options, you would have only made a 10% profit, plus you would need to find the $10,000 somewhere to buy the stock.  This is why people use options, the potential to make a fast profit without putting too much money down.  This potential return comes with great risk, however, since your options expire worthless on the expiration date if you don’t use them.  You therefore need to be right about both the direction and the timing.

What about writing options?

The person on the other side of the trade described above, the option writer, would get money from the option buyer called a premium.  The premium in the example above was the $500 the option buyer paid for the calls, which went to the option writer.  The value of the premium varies constantly, based upon the price of the stock relative to the strike price, how volatile the stock is, and how long it is until the expiration date.  Basically it is whatever the person who is writing the option is willing to accept from the person buying it at any given time.  While the option buyer has the potential to make a lot of money, most of the time he doesn’t.  Some thing like 9 out of 10 options expire worthless, meaning the option writer pockets the premium and the buyer limps away with nothing.

For this reason, while the potential profit is less, it is still better to be the option writer because the odds are so much on your side.  You might only collect $800 when you write a set of calls on $20,000 worth of stock you own, but if you can do that six times a year, that’s $4800 per year, or a 24% return.  Compare that with the historical 10-15% return you can get from buying and holding stocks, and you can see why it is attractive.  It is like being able to make any stock into a dividend-paying stock.

Writing covered calls is not without risk.  If the price of the stock drops, you will lose money, or at least need to wait for the price of the stock to recover, which could take weeks, months, or years (or never).  You are also setting a limit on your potential return.  If you have shares of XYZ stock, selling at $95 per share, and you write calls with a strike price of $100, once the stock passes $100 per share you will no longer be making any more money.  Also, because there will be some positions where the stock declines in price and times when you just can’t get a good price when writing a new option, it is unlikely that you’ll actually get 25% returns.  In actuality, I’d say that you would be more likely to make 8-12% per year, but still it is a good return , especially when dividends are like they are today, at 2% or lower.  It is putting cash into your retirement account, so you’ll have cash-flow that you can use without needing to sell stocks to raise cash.

Is there an easier way than writing calls yourself?

Yes.  There are mutual fund companies that create buy-write portfolios for you.  For example, PowerShares has an S&P 500 buy-write ETF that is like an S&P 500 fund with a call option written against the portfolio.  You won’t do as well in this fund if markets are going up as you would be by just buying an S&P 500 fund, but you’ll be doing a lot better if markets are stagnant and a little better if they are dropping.  In both cases, you’ll be making 8-12% in premiums to offset whatever the underlying index is doing.  For example, in 2017 the fund provided about 11% in cash payments.  This is not as good as the 20% percent return you would have had if you were just invested in an S&P 500 index fund, but would provide the cash needed for living expenses.

Note that the price of the buy-write fund will change, meaning that your total return will probably not be 10-12% each year even though you were receiving payments of 10-12% per year.  For example, if you receive a 10% payment but the share price drops by 8%, your total return would only be 2%.  With income investment, however, you should be focused on the cash return you are getting and not the share price.  The fund price may go up or down, but all you need it for the fund to continue providing you the income you need each year.  In many ways this is similar to a rental property, where home prices may change constantly in an active market, but unless you are trying to sell the property, all you care about is getting good tenants in and seeing a steady rent check each month that increases over time.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Eight Simple Steps to Start Investing


 

Don’t forget about the first Small Investor Investing Twitter Show tonight from

8-9 PM Eastern Standard Time. 

I’ll be answering your questions live via Twitter.  Just follow me @Smallivy_SI .  You can also submit questions through comments to this post.

Maybe you’ve been working on your personal finances for a while.  You’ve got a budget. You’ve paid off all of your debt (or never had any in the first place).  You’ve gotten your emergency fund together and have about $10,000 in cash sitting there.  At this point you’ve got a line in your budget called “Investing” and you’re starting to siphon money out of your income to a bank account that you’ve created to store up your investing funds until you have enough to get into the markets. But now you’re worried about what you should do, where you should invest, and even how you go through the actions needed to buy stocks and bonds.

Luckily, investing is a lot easier today than it was before about the year 2005.  Where in the past you would need to have a fairly large amount of money before brokers would even work with you, the mutual fund industry has answered the need for the common man (and woman) to invest and discovered that there are a lot of people out there needing such services.  At places like Vanguard you can set up an account and start investing with as little as $3,000 ($1,000 if you’re starting a retirement account like a traditional or Roth IRA).  You might be able to invest with even less at places like Charles Schwab and/or if you set up autodraft from your checking account.  With these accounts, you have access to a wide array of mutual funds, and even individual stocks and ETFs, all with a few clicks of a mouse.

Still, there are a lot of options and it is probably fairly intimidating for the new investor.  That is why I’m providing the Simple Steps needed to get started in investing.

Hey – if you like The Small Investor, help keep it going.  Buy a copy of the SmallIvy Book of Investing: Book1: Investing to Grow Wealthy or just click on one of the product links below, then browse and buy something you need from Amazon’s huge collection.  The Small Investor will make a small commission each time you buy a product through one of our links.

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Step 1:  Pay off all credit cards.

Before you even think about investing, get rid of your credit card debt.  During a really good period in the stock market, you’ll get a return of 15% per year.  Long-term returns average around 10% (which is 7% after inflation).  You just can’t compete with a 19 or 25% interest rate on a credit card balance.  Just think of yourself getting a 25% return on the money you use to pay off credit cards.  Then, cut up your cards and get debit cards instead so that you won’t go into credit card debt again.

Step 2:  Start with a retirement account.

Someday you will want to retire, which means that you need to have retirement savings to last you for about thirty years, plus something like $500,000 to $750,000 to pay for healthcare expenses beyond what Medicare covers.  If you have a 401k or 403b at work, start there, putting in at least as much as your company will match.  Putting in less means that you are leaving free money on-the-table.  If your company matches the first 5%, you can effectively increase your salary by 5% by just putting 5% of your pay into your 401k.  If you don’t have a 401k plan at work, sign up for the pension plan if one exists.  Regardless if there is a plan at work, go to Vanguard or Schwab and start a Roth IRA.

Fund your retirement plans with 15% of your salary.  Start by putting whatever the company matches into your work plan (or whatever is required by your pension plan), then fund your IRA up to the yearly maximum.  If there is anything left over, put it into your work retirement plan.  Still have money left over?  Start a standard, taxable account at Schwab or Vanguard and fund that account.

Step 3:  Determine your retirement fund asset allocations.

Assets are things like stocks and bonds.  They are things that pay you money, adding to your income.  Standard asset types for investing include stocks, bonds, and real estate.  To determine you asset allocation:

  1.  If you’re less than age 40, start with 100% stocks.
  2. If you’re over age 40, start with your age minus 20% in bonds, 110% minus your age in stocks, and 10% in real estate.   For example, if you’re 45, you would start with 25% bonds, 65% stocks, and 10% in real estate.
  3. If you’ve worried about losing money and are very nervous, increase your bond allocation by 10% and reduce your stock allocation by 10%.  This will smooth things out somewhat.  For example, someone who was 45 would increase their bond allocation to 35%, reduce their stock allocation to 55%, and still have 10% in real estate.  Someone who was 20 would reduce their stock allocation to 90% and add 10% bonds.

 

Want all the details on using Investing to grow financially Independent?  Try The SmallIvy Book of Investing.  

Step 4:  Select your retirement account stock funds.

Go through the funds you have available and try to find index funds.  If you can, select a total stock market index fund.  If that is not available, try to find a large-cap (like an S&P500 fund) and a small-cap (like a Russell 2000 fund) fund.  If index funds are not available (for example, in a 401k plan without the best choices), find the lowest cost stock funds available (try to find funds that charge less than 1% of assets invested) and select one that invests in all sectors of the market or one that invests in growth and one that invests in value.  Also find a fund that invests in international stocks, hopefully something like a total international stock fund.  Read the fund descriptions to find what the fund invests in and manager’s style, as well as total fees.  

Step 5:  Find your retirement account Bond and Real Estate Funds

Go through the same process in selecting your bond and real estate funds.  Try to find a total bond index fund and an REIT index fund.  If you don’t have an REIT fund available, just add 10% to your bond allocation.

Step 6: Buy your retirement account funds.

You should be able to buy your funds using the website for your 401k or IRA.  Many sites will allow you to specify specific percentages of the account to put into each fund.  If that is the case, go ahead and set those percentages based upon the asset allocations you determined in Step 3.  If not, you’ll need to pull out a calculator or spreadsheet, do the math, then enter the dollar amounts.  Note that you will want to set your investment percentages in two different places, one for how to allocate the money you have in the account already, and the other for how to invest new funds.  Set both of these the same and matching the allocations you determined.

Divide the money within an asset category (stocks, bonds, real estate) equally to each of the funds in that category.  The exception is international stocks, which should be 20% of your stock allocation (so if you are investing 80% stocks, you would put 16 % of your account (80% x 20% = 16%) into international stocks and then 64% into US stocks and 10% into bonds and 10% into real estate.

Step 7:  Setup taxable brokerage accounts with Vanguard or Schwab if you have more money to invest.

Hopefully, after you are through putting money away for retirement, you’ll still have more money to invest.  Unlike your retirement funds, which you won’t be able to touch until retirement, money you invest in taxable accounts can generate additional income to enhance your life and hopefully make you financially independent before retirement.  Put 100% of your taxable investing accounts into stocks and only sell when you want to generate cash for something since you’ll be taxed each time that you do. As long as you don’t sell the shares, you won’t be taxed on the increases in value of your account due to increases in price of the funds in the account.  You will be taxed on the dividends and capital gains that the stocks in your funds are generating, but these should be small amounts if you buy index funds investing in the whole stock market.

If you want to, you can set these accounts up to spin off cash when the stocks in the funds pay dividends or there are capital gains.  You’ll then just magically see money appearing in your money market account with the fund company, with a larger amount n December (fund companies tend to move money around and realize capital gains at the end of the year.  This money will be taxable, but then can be used as you wish.  This is a great way to get extra cash without needing to sell shares.

Step 8: Wait until January 15th, then rebalance.

You should rebalance your accounts – set them back to your desired asset allocations – about once a year.  You should also adjust your allocations for changes in your age at this time (as you get older, you should be shifting more into bonds).  Luckily, most mutual fund companies also have tools to let you rebalance.  Just set the percentages you want into the tool and press the button.  Do this again every January 15th (or a date somewhere near then).

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The First Small Investor Investing Twitter Show


 

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Join me for the first Small Investor Investing Twitter show.  I’ll be answering questions on investing and personal finance by Twitter live  from 8-9 PM Eastern Standard Time Sunday night (3/4/2018).  Also look for a post on the basics of stock investing here at the site, and feel free to send in your questions as comments or via twitter @Smallivy_SI.

See you Sunday night!

 

SI

How to and Why You Should Invest in Stocks


Certainly the first step to becoming financially fit is to start to budget.  Once you plan where your money goes each month, rather than just seeing how things turn out, you’ll find that you actually feel more wealthy because you’re using your money more efficiently.  Budgeting also helps to keep you out of debt since you need to balance your income and your spending.

Once you’ve gotten your spending under control, the next step in becoming financially secure is to grow your non-work income stream.  Having sources of income beyond your job helps shield you from the bad effects of layoffs, increases your income, allowing you to enhance your lifestyle, and provides freedom in your life because you will have money for necessities when looking for the next job or if you decide to change careers.

Hey – if you like The Small Investor, help keep it going.  Buy a copy of the SmallIvy Book of Investing: Book1: Investing to Grow Wealthy or just click on one of the product links below, then browse and buy something you need from Amazon’s huge collection.  The Small Investor will make a small commission each time you buy a product through one of our links.

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Stock investing is one of the easiest and best ways to gain additional income.  With stock investing, you’re buying a stake in different companies.  You become a part owner, and with ownership, share in the profits of the company.  You make money either through dividends that the companies pay or by selling shares of the companies once they have grown and become more valuable.

Personally, I have been investing in common stocks since I was twelve, starting with a few shares in a local utility company.  When I went away to college, my parents transferred shares of stock to me (which also reduced the taxes due on the shares) rather than sending me money for tuition and rent.  I was actually able to make it all the way through undergraduate school without the portfolio value declining since I was able to make up any money I was spending with capital gains and dividends from the portfolio.  I did need to sell off a good portion of the portfolio when I went to grad school in California since things cost more, but I still had some money in the portfolio to help get me started once I graduated.

When I started investing, I invested mostly in individual stocks.  There were very few mutual funds around, and really no index funds.  Today investing is really easy since there are a wide variety of mutual funds, including low-cost index funds and Exchange Traded Funds (ETFs).  You really can’t go wrong if you regularly buy a set of broad-market index funds and hold onto them for long periods of time (like 10 years or more).

Want all the details on using Investing to grow financially Independent?  Try The SmallIvy Book of Investing.  

The simple act of investing was once more complicated.  You needed to find a broker, set up an account, and learn how to place an order.  You could pay someone to manage your money for you, but more often than not, they would end up selling you expensive products that benefited them more than you.

Today it is really simple.  You can just go to Vanguard or Schwab (or some other mutual fund companies, I’m sure), set up an account online in less than 30 minutes, and then choose from among their low-cost index funds.  To start, just buy some shares of a large-cap index fund such as an S&P 500 fund or one with “large cap index” in the name.  You’ll want to minimizes fees (less than 0.25% of funds invested).  Once you have a few thousand dollars in a large cap fund, add a small cap fund such as a Russell 2000 fund.  From there you cold add a bond fund, an international stock fund, and perhaps something like a REIT fund.

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You’ll want to invest regularly since that will both ensure you get a good price and allow you to build up wealth and income over time.  You can do this by either putting an investing line in you budget each month and sending in money, or by setting up automatic drafts from your checking account.  Many mutual fund companies offer perks like low initial investments or no fees if you use autodraft.

So, what is stopping you?  If you have $3,000 or more in cash available, you could be an investor in just a few days.  While I can’t say what you portfolio will be worth at the end of a year, I can almost guarantee you’ll make more than you could make in a bank account if you buy regularly for a period of ten years or more.  Give it a try – it really isn’t hard and really not that scary once you’ve gotten started.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.