Investing 101

Finally got bored of seeing my money sit in a savings account and not do much so decided to educate myself on the finer points of investing. 401k’s through work are nice, but I wanted to have more control over what I was investing in and actually try to understand the complex and often misleading(see Wolf of Wall Street) world of stocks and bonds.

DIVERSIFY

Diversification is one of the cliches you hear about investing that people don't really understand. What it means is having an investment portfolio that protects you under various economic fluctuations and minimizes losses while emphasizing gains during these conditions. Various such fluctuations might include:

    * Inflation : Weakens faith in the U.S dollar. During this time, gold becomes more valuable.
    * Prosperity : Produces an upward tick in Stocks . Prosperity causes interest rates to fall and long term go up in price.
    * Deflation : Reduces price in most consumer goods and investments and the dollar becomes more valuable, causing interest rates to fall. Bond prices go up.
    * Government instability(Tight money): Only valuable asset during this is cash and foreign accounts.
    
Having a diversified porfolio with 4 different investments can keep you protected in all these different environments:

    * Stocks : Take advantage of prosperity, poor during inflation, deflation and tight money.
    * Bonds : Good during prosperity, also profit during deflation when interest rates collapse. Poor during inflation and tight money.
    * Gold : Very good during intense inflation, poor during others. Only asset that accounts for inflation.
    * Cash : Most profitable during a period of tight money. Rise in increase rates increase returns on dollars and during deflation. Poor during inflation.

STOCKS

• Fully Invested
• Broadly invested
• No commissions(ETF)
• Minimum investment(no greater than 8% of total portfolio, since you want to invest 25% of total portfolio in stocks)
• Reliable.

BONDS

• US Treasury bonds are the safest.
• Bonds with potential for big price movements are attractive, so buy bonds with longest time to mature and keep replacing it with longer bonds after certain periods of time.

CASH

• Money market fund investing only in short-term U.S treasury securities, so you don’t have to evaluate credit risk.

TAXATION

• Stocks which are low dividend ones do not have a lot of taxable income.
• Gold produces no dividends or interest, so no tax liability.
• Treasury bills produce interest income each year, so they are taxable, hence put the cash portion in a 401K or IRA.
• Bonds also pay interest twice a year, so good idea to fill the remaining space of a 401K or IRA with bonds.

YIELD

• Interest, dividends and rise in price of investment.
• Interest and dividends are immediately taxable, the other one can be deferred.
• Higher interest rate can cause capital to be lost through default or inflation.
• High dividends mean a stick isn’t likely to appreciate in price and may even mean the company is using some of its capital to pay dividends.
• Under what circumstances will the yield appreciate, depreciate and will it help the portoflio overcome losses in other investments.
• Mutual funds with lowest yields are desirable as any dividend paid reduces the price of the shares by considerable amount.
• Dividends are less tax efficient than capital gains, as they get taxed yearly and capital gains do not until you sell the stock.

ETF

An Exchange Traded fund is a low-expense-ratio index mutual fund. It is a form of an index fund which has consistent benchmarks but the important difference being that it can be traded commission-free where as index funds often have costly commission fees.

There are certain decisions that need to be made to allocate assets across a diversified portfolio:

• Percentage of portfolio to invest in stocks which generally contain more risk.
• Percentage of allocation to international vs domestic(U.S) stocks. This is not as critical as the first one since both US and international stocks have similar risk profiles and similar long term returns.
• Tax-efficient fund placement. In general, the international fund should go into a taxable account, the bond fund should go into a tax-advantaged account, and the domestic equity fund should fill in the remaining space.

Different kinds of Vanguard portfolios:

Three-fund portfolio:
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            * Total U.S. stock market index fund
            * Total international stock index fund
            * Total U.S. bond index fund

The four-fund portfolio that Vanguard is now employing consists of the following broad asset class index funds:
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            * Total U.S. stock market index fund
            * Total international stock index fund
            * Total U.S. bond index fund
            * Total international bond index fund