This paper is intended to address average household investment need. It aims to give ways for the average household to invest in the long term. In a declining economic environment with job insecurity and volatile stocks and bonds prices, ensuring a decent financial future for the average households is difficult. Thus, this paper explores low risk solutions to build up savings for the future. I. Basics of Investment
The Basics of Investment are addressed with four basic constructs: Return (The amount of return you are looking for) Risk (The amount of risk you are willing to accept) Amount you have to invest Time available to invest
When investing, there are several dimensions which households should take into account. The first and the most important dimension is return. Reward must be given primacy as a factor in the process of wealth accumulation. Depending on economic cycles, reward is higher or lower. During times of growth, reward is almost taken for granted by investors while times of economic decline drive reward down. The second one is risk. Although risk is a very important factor to consider when investing, it should not be counted equally with reward. For any investment, the assumption is that reward is higher than risk. If the potential return does not exceed the potential risk, why invest at all? However, risk gives a good idea of the probability of loss for investments and should be an important factor in investment decisions. The third dimension is cost. Costs are oftentimes neglected when investing, but they tend to reduce the reward of an investment if not managed correctly. For instance, the exceptionally high costs that characterize much of the mutual fund industry have a great impact on net fund returns that are astonishingly sensitive to cost. Indeed, when adding up income taxes, transactions costs, operating expenses as well as commissions, investing can be costly. The last dimension that should be taken into account is time. In the investment world, the importance of time in shaping returns should not be neglected. The magic of compounding is such that the longer the time horizon, the greater the power of compounding investment returns in transforming an initial outright investment, or a series of modest annual investments, into a truly breathtaking terminal value. To conclude, an average household should aim to maximize return by investing on the long term as well as reduce risk and costs. II. Mutual funds
An average household has the possibility to invest in mutual funds in order to ensure a decent financial future when retiring.
A mutual fund is a company that brings together money from many people and invests it in stocks, bonds or other assets. The combined holdings of stocks, bonds or other assets the fund owns are known as its portfolio. Each investor in the fund owns shares, which represent a part of these holdings and receives profits from those holdings. There are differently managed mutual funds, and one should carefully evaluate the principles and values of each mutual fund before investing. Following are the factors to be taken into account in order to maximize profits and reduce costs. First of all, the income made when investing in mutual funds is taxable like any other income. Yet, most mutual funds do not give enough disclosure about the tax implication of their investment strategies, portfolio turnover expectations as well as their gain realization policies. As portfolio manager’s performance is measured on the basis of pretax return, few portfolio managers take into account the tax consequences of their decisions. Second, mutual fund managers tend to invest on the short term in order to maximize return quickly. This involves high portfolio turnover and thus high transaction costs as well as high income taxes. As mutual funds are rushing to buy and sell their stocks based on transitory changes in prices and without concern for tax consequences, the after-tax returns generated for mutual funds’ taxable owners are sharply reduced. Finally, actively managed funds involve high operating expenses because managers earn commissions on every transaction they make. In order to avoid these costs, the average household should invest in specific mutual funds which promote long-term investment as well as low costs. This can be achieved by investing in structured managed funds with extremely low portfolio turnover which are passively managed index funds focused on the entire stock market or on huge market segments such as the Standard & Poor’s 500 Index. Households should also give primacy to mutual funds investing in large growth stocks. Investing in these kinds of mutual funds would lead to low transaction costs due to the low portfolio turnover. Furthermore, a long-term focus from mutual fund investors enables higher after-tax returns because income taxes are laid out over a larger period of time. To illustrate this, the rule of 72- which estimates an investment’s doubling time- shows that investments can be doubled only on the long run. Rate of Return 2% 3% 5% 7% 9% Rule of 72 36.0 24.0 14.4 10.3 8.0 Actual # of Years 35 23.45 14.21 10.24 8.04
Chart 1 This chart shows how many years it takes to double an investment based on the rate of return
Indeed, it takes at least 8 years for an investment having 9% of return, and 36 years for an investment with a rate of return of 2%. In addition, The S&P 500 is one of the best indexes in the world for large capital stocks. It offers great diversification and covers 70% of the U.S. market by including 500 different companies. As a result, the performance of the S&P 500 is considered one of the best overall indicators of market performance. Mutual funds focused on huge market
segments such as the S&P 500 give a relatively safe income to the average household. Finally, mutual funds privileging large growth stocks - shares in a company whose earnings are expected to grow at an above-average rate relative to the market but which do not pay dividends right away- is a wise way to invest with low risk and high return on the long run. Ratings for mutual funds The Street, Inc, a financial newspaper offers ratings for mutual funds and provides definitions of excellent mutual funds to poor ones. It gives a reliable assessment of its risk-adjusted performance. This offers guidance for the average household when it comes to selecting the right mutual fund for them. In this rating, it is believed that past performance is a good indicator of future performances. A (Excellent) - The mutual fund maximizes performance while minimizing risk. It has made the most of the recent economic decline to maximize returns compared to other mutual funds. B (Good) - The mutual fund has a good balance between performance and risk. Compared to other mutual funds, it achieved above average returns given the level of risk during the past economic decline. C (Fair) - In the trade-off between performance and risk, the mutual fund is about average. It is neither significantly better nor significantly worse than most other mutual funds. Based on recent history, there is no particular advantage to investing in this fund. D (Weak) - The mutual fund has underperformed in the past compared to other funds given the level of risk in its underlying investments. This resulted in a weak performance compared to risk. This is a bad investment for any household. E (Very Weak) - The mutual fund has significantly underperformed most other funds given the level of risk in its underlying investments. This resulted in a very weak risk-adjusted performance. The management has done the opposite of what was required to maximize returns in the recent economic setting. This fund is a very bad investment. An average household should aim to invest in fair to excellent mutual funds in order to maximize their return while minimizing the risk of loss. III. Nontraditional Alternatives
Instead of investing in mutual funds, many households decide to invest in tangible objects, which increase in value as time goes on.
Real Estate One major example of nontraditional alternative is real estate. Investing in real estate has become extremely popular in recent years because of rising property values and low interest rates. Typically, investors choose to invest in real estate because of five major
reasons: cash flow, capital appreciation, depreciation, tax benefits, and leverage. First of all, investors can appreciate the value of the property on their own. By enhancing the grounds, building or improving a house, etc. the value of the property increases. Property is valued using the method of substitution, comparing the current property to another similar in size and location, and one that was sold within a recent timeframe. This way, consumers will receive the most accurate diagnosis of the value of the land. Leverage, or the use of various financial tools to potentially increase the value of an asset, is one of the other advantages to investing in real estate. Let’s assume that a buyer puts a 20% down payment on a $500,000 investment, so $100,000. If the value of the property appreciates at 5% per year, the net worth has increased to $525,000 in just 12 months. If the buyer was only buying a $100,000 house however, the 5% appreciation would only allow the net worth to increase by $5,000 per year. In other words, the more expensive the house is, the more valuable leverage will be over time. It is also important to remember that the value is compounded, and therefore the 5% leverage rate increases with the new value every year. For example, if the original value of the property was quoted at $100,000, after the first twelve months, considering a 5% leverage value, the property would be worth $105,000. At the end of the next year, it would increase in value by $5,250, and therefore would be worth $110,250. At the end of the third year, it would be worth $115,762.50 and so on. One of the most important aspects of leverage in real estate is the fact that when there is inflation the cost of living goes up along with it. In other words, real estate is a hedge against inflation. This is possible for many different reasons. First, when you purchase a house you have eliminated the need to pay rent, and therefore are protected against rental rate increases. You also receive all the tax benefits from investing in real estate. Second, if you have a fixed rate mortgage, your mortgage rates will be the same in five years as they are
today. They will never increase or decrease based on inflation. The graph above depicts a century long span of time, in which the inflation rates were almost identical with the Home Price Index. One of the biggest advantages to investing in real estate is that almost every part of the process is tax deductable. First of all, if you plan to take out a loan in order to pay for the house, the amount of interest you pay on the loan is tax deductible. Plus the closing costs, the amount of money you pay to actually close the loan, is tax deductible as well. Usually, mortgage companies let an investor own 100% of the house for only a 20% down payment. For instance, if a home is worth $1,000,000, usually mortgage brokers will only require a $200,000 down payment to buy the house. Therefore, the loans that are needed to buy the house are almost never the full price of the property. Another advantage to having a loan for the purpose of purchasing real estate is that the property taxes that you are paying as a homeowner are also tax deductable. In many cases, people are even advised to not completely pay off their house because once they do so they lose their property tax deduction. Finally, if a homeowner is using a property as a business and a source of income, any improvements made to the house charge as expenses to offset income for as long as your expenses exceed revenue. For example, say I was at a loss of $85,000 this year for the house that I live in. Let’s also pretend that I made $5,000 on a house that I am renting out, categorizing this as ordinary income. If the roof leaks in the rental house and it costs $2,500 to get it fixed, that $2,500 will carry forward your loses and use the loses to receive income. In other words, these charges are offset against current or future income. One of the most important things to remember when deciding to invest in real estate is that location is key! In the case of using the property as a rental, you want to purchase a house where there is a huge demand, but a small supply. A place like San Francisco is the perfect example of this. Not only does this give you the opportunity to pick the tenants that will live there, but it will almost guarantee that there will always have someone living in your house, and thus helping you to pay off the mortgage. The power to pick your tenants is also very valuable because the homeowner has the opportunity to pick who they know will take good care of the property, and stay there for long periods of time. Finally, when deciding how to price the rent on the house, it is good to keep it a fraction lower than the market value. Therefore, you have a wider variety of clientele, and the rate of retention for the clients if much higher. Wine Another tangible good that you can invest in is wine. This is a slower and usually less rewarding process, and takes years of experience in order to have enough knowledge to be successful. Usually, a new investor is highly advised to hire a broker in order to minimize risk of lose due to lack of knowledge. Investing in wine is a longer process because in order for the wine to be valuable, the owner must wait until it reaches its’ vintage date. The wine is also not making any money until you actually sell it. In fact, you are technically losing money by paying for the insurance and storage costs while you wait for the bottle to mature. However, wine is highly valuable, and some bottles have been known to sell for tens of thousands of
dollars. If an investor is knowledgeable and extremely patient, wine has been known to be a strong investment.
Bogle, John C. Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor. New York: John Wiley, 1999. Print. "Top Rated Mutual FUnds." The Street n.d.: n. pag. Print.
"Investment Wine." Wikipedia. Wikimedia Foundation, 23 Nov. 2012. Web. 03 Dec. 2012. <http://en.wikipedia.org/wiki/Investment_wine>. "Leverage: Increasing Your Real Estate Net Worth." Leverage: Increasing Your Real Estate Net Worth. N.p., n.d. Web. 03 Dec. 2012. <http://www.investopedia.com/articles/mortgages-real-estate/10/increase-your-realestate-net-worth.asp>. "Real Estate: Diversification And Hedge Against Inflation? - Seeking Alpha." Real Estate: Diversification And Hedge Against Inflation? - Seeking Alpha. N.p., n.d. Web. 03 Dec. 2012. <http://seekingalpha.com/article/1002751-real-estate-diversification-and-hedgeagainst-inflation>. Writer, KATHY M. KRISTOF Times Staff. "Lesson 3: Protect Against Inflation." Los Angeles Times. Los Angeles Times, n.d. Web. 03 Dec. 2012. <http://www.latimes.com/la-diverse-story3,0,7475319.story>.