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Long-term Investment Choices
Real estate and stocks have proven to be better long-term investment choices than bonds or gold.
Your retirement plan
Some financial advisors suggest that you should target a specific amount of retirement income. However, you probably will be living in a strange new world when you retire預 world shaped by technical innovations, wars, and political turmoil. Furthermore, your income and rate of return on your investments while saving for retirement and your obligations both before and after retirement might differ greatly from your expectations.
Instead of targeting a retirement income, target a savings plan. Think defined contribution, not defined benefit.
Treat investing for retirement as a budget item like shelter, food, insurance, transportation, education, and clothing. Set aside the budgeted amount for retirement regularly and invest it prudently. You won't know what your retirement income will be or how much income you will need, but you will be confident that you have done your best to prepare for retirement.
Pundits rightfully stress the importance of diversification, but some seem to think this applies only to securities. Diversification should encompass all assets. If your assets are primarily in real estate and stocks and your first purchase was real estate, do not buy any more real estate until the value of your stocks exceeds the value of your real estate.
Real estate
Many have become wealthy by investing in real estate. Few have become wealthy by investing in anything else. This is sufficient evidence that real estate can be expected to have a higher rate of return than stocks, bonds, or gold.
If prices are rational, your first investment should be in real estate. But if inflation in real estate has exceeded core inflation for several years, it is better to postpone buying real estate until the bubble bursts and prices have bottomed.
Real estate agents used to say a home is a safe investment. Economists used to say there might be local areas of price weakness, but there would never be widespread price weakness. The agents and economists were spectacularly wrong in 2006, and should never again be trusted.
The best real estate investment for most people is a shabby house, because of the high leverage and the probable high appreciation rate. If occupied by the owner, the required down payment is very low.
If you don't want to live in a shabby house, you can rent it out. The required down payment will be higher, but it is sometimes possible to assume the existing mortgage and acquire the house with less cash than would be required for a down payment.
Investment property is usually bought with a 30% down payment, to obtain the best interest rate and to avoid the expense of mortgage insurance. A down payment of 20% or 10% might be available on less favorable terms. Some real estate pundits suggest the seller finance 100% of the mortgage and the real estate agent accept a note for the commission, but sellers and agents willing to do this are rare.
Data showing the increases in US house prices do not give a true picture of the profit potential of a house. This chart suggests that the annual return is 5%, less the amount due to increasing house sizes, but it is possible to do much better:
One way to have a high rate of return is to buy a shabby house in a nice neighborhood, improve it, and resell it. Another way is to buy a shabby house on acreage in the path of growth, wait for the acreage to appreciate, and resell to a developer. The gain can be greatly enhanced by subdividing the acreage before the resale, but getting the necessary approvals can be maddening.
Making excessive improvements on the house will reduce the rate of return. If the house is in a nice neighborhood, anything beyond improving the house to neighborhood standards is a bad investment. If the house is on acreage, any improvement beyond making the house livable is a bad investment because the house will probably be torn down after the resale.
Capital gains tax when the house is sold can be avoided, whether the house is occupied by the owner or by a tenant. If occupied by the owner, establishing residency requires living in the house for a minimum of two years. A gain of up to $500,000 for a married couple, or $250,000 for a single person, would then be exempt from capital gains tax.
If the house is occupied by a tenant, capital gains tax can be avoided by selling the house in a tax-free exchange. A tax-free exchange results if the house is traded for other income-producing real estate of equal or greater value.
Stocks
Strategy
The most difficult thing about investing in the stock market is finding the pearls of wisdom in the sea of misinformation. This is basically an unlearning process.
Some pundits make market forecasts based on the economy. The market is a leading indicator of the economy, so the economy cannot be used to forecast the market.
Pundits explain current stock market behavior and make forecasts by citing news, but this is a gross oversimplification. Stock market behavior is determined by many overlapping fundamental, technical, and psychological factors, and these usually determine stock market behavior more than news.
Technicians cite chart patterns and critical price levels, but never provide evidence that these are meaningful. I have spent a good part of my life studying charting and have concluded that only the direction, size, and shape of the current trend matter.
Individual stocks
Over the years, the Dow Jones Industrial Average had average annual gains of 6%:
In addition, the average annual dividends were 4%, for a return of 10%. Investing prudently can be expected to produce an even higher return.
The stock market has some elements of non-randomness that can be exploited for profit:
- The market has an upward bias.
- The January Barometer can predict most years that require defensive measures.
- Stocks move in exaggerated trends.
- Low-priced stocks underperform.
- There are times of the month when stocks are especially strong.
These elements should be honored. Be bullish most of the time but be defensive at times, follow trends in individual stocks, do not buy low-priced stocks, and time trades by day of the month.
There might be more elements of non-randomness with profit potential. For example, it is possible stocks with low PEG ratios outperform or long-term options for stocks with strong current trends and low volatility are underpriced.
There are also elements of non-randomness without profit potential. For example, market bottoms tend to be sharper than market tops.
Stock funds
People who have the time and aptitude to invest prudently in individual stocks should not buy funds. The performance of the fund will be compromised by the weakest components. For people with limited time or aptitude, there is an easy strategy of investing in a stock fund.
The easy strategy includes the income averaging, timing, capital preservation, and diversification aspects of the comprehensive strategy presented on this site. Because value investing, momentum investing, and hedging are omitted, the easy strategy cannot be expected to perform as well as the comprehensive strategy.
Although easy, this strategy does require a high level of maturity. It is not suitable for prodigals who cannot follow a budget, speculators who check daily to see how their investments are doing, or neurotics who panic when their investments decline.
Invest a fixed tranche of cash on the first trading day before the 28th, except the 16th in December and the 21st in November. Adjust the tranche size if there is a substantial change in income or responsibilities, or if it seems surpluses or shortfalls will persist.
Cash in the account accumulates not only from budgeted monthly deposits, but also from dividends, interest, sales of expiring options, and extra deposits from windfalls. Exhaust excess cash by temporarily doubling the tranche size. Leverage insufficient cash by temporarily buying options.
There is a negative January Barometer signal if the S&P 500 Index declines in January. When this happens, sell all securities on the first trading day before April 11 to preserve capital. Suspend investment until the first trading day before October 28, and then invest fully.
The security purchased is SPY, or its most distant LEAP call option that is just out of the money. SPY is a highly diversified exchange-traded fund (ETF) that emulates the S&P 500 Index. These were among the 20 most actively traded ETFs in early 2011:
TARGET COMPONENTS
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SPY S&P 500 large cap blend
EFA MSCI EAFE foreign large cap blend
EEM MSCI Emerging Mkts diversified emerging markets
IWM Russell 2000 small cap blend
SPY has the lowest costs. Investing in EFA or EEM is unnecessary because the SPY components have substantial operations in advanced economies and emerging markets. Investing in IWM is also unnecessary because the performances of large cap stocks and small cap stocks are similar.
In this table, the Buy&Hold columns are the level of the S&P 500 Index. Both the Buy&Hold account and the Easy account held $16.66 on 1/3/1950. For simplification, it is assumed that there were no cash transfers in either account and somehow purchases in the Easy account emulated the S&P 500 Index:
The Buy&Hold strategy had an annual rate of return of 7.22%. The Easy strategy had an annual rate of return of 9.25%. This might seem like a small difference, but note the enormous difference in the values on 12/30/2011.
Choosing the Right Account
The right kind of stock market account and the way to use the account depend on the investor's situation. In addition to a regular brokerage account, there are many types of retirement accounts. The most popular are the traditional IRA, the Roth IRA, and the 401k.
In a traditional IRA contributions reduce income, resulting in tax savings, but withdrawals are taxed as ordinary income. In a Roth IRA contributions do not reduce income, but withdrawals are not taxed. In a 401k contributions are deductions from paychecks and the employer usually makes matching payments様ike a Traditional IRA, contributions reduce income but withdrawals are taxed as ordinary income.
Those who can afford periodic contributions above retirement account limits should have a regular account too. Retirement accounts have guidelines for what constitutes a legitimate withdrawal, and there is a 10% penalty if the withdrawal does not meet the guidelines. Some retirement accounts have very few investment options.
Each person must evaluate their situation before selecting an account and reevaluate each time their situation changes. The account to select depends on the amount of wealth to be invested, the affordable periodic contributions, the person's age, and the availability of a retirement account with matching payments.
A wealthy person should be more concerned with preservation than accumulation, so should be willing to reduce risk by sacrificing rate of return. A more diversified approach is applicable, with investments not only in real estate and stocks but also in money market funds and bonds. The best way to implement this is to hire a professional manager.
People who are not wealthy should confine their investments to real estate and stocks, and should reduce expenses by managing their investments themselves. The retirement account should be a 401k with matching payments, if available. Otherwise the right account depends on the person's age. For someone close to retirement, any retirement account that has no management fees and has many investment options is suitable.
For someone who will not retire for many years, the retirement account should be a Roth IRA if a 401k with matching payments is not available. Earnings on contributions can be expected to be high. These earnings will never be taxed, not even upon withdrawal.
Bonds
The yield of 10-year US Treasuries averages 6.8%, which is lower than the return of 10% from stocks. It might seem that switching into US Treasuries when they yield more than stock returns would be wise, but this would run the risk of capital loss if interest rates rose even higher:
Gold
Pundits say that gold is a safe investment, but it fell from $615.00 in 1980 to $271.04 in 2001. Inflation in gold has exceeded core inflation for many years, suggesting that gold might be in a bubble:
The long-term return on gold is subject to interpretation. The price was flat for many years, and then rose fairly steadily for many years. Using all data in the chart, the annual return was a puny 2%. Ignoring the early years, the annual return was 5%. This is lower than the average yield of 10-year US Treasuries, and only half of stock market returns.