Matching the Investment to the Investor

How do you know what to invest in? Why that's easy: Pick the investment that makes the most money. Skip the one that loses. If only it was that simple. Unfortunately. our crystal balls are on the fritz, and the ouija boards are buried in the closet. What are mere mortals to do?

Portfolio selection is both an art and a science. This is an introduction to picking investments that are right for you.

We've all heard that great tip at a party, and many of us have followed through to our loss. Merely buying a good investment does not guarantee wealth. It must be sold at a profit too. Many investment advisers have put people into the same investment with different results. Knowing everything about an investment means nothing if you know nothing about yourself.

Let's look at a few principles of investment. Did you know that an excellent investment for an 80-year old retiree can be a terrible one for a newly-employed 23 year old worker? The 80-year old has retired, cannot expect a large salary and has a short time horizon. The younger worker must contend with many more years of inflation due to his longer life span, has the opportunity to grow his salary and importance in the job market, and can probably take a little risk since he has the salary to fall back on.

So, the first question is: "How old are you?" Generally, income will be more important for an older, retired worker while growth is key for young workers. For younger workers funding long-term needs like retirement, growth is essential, especially since the government keeps running the printing presses while demanding ever-increasing taxes. Growth stocks and real estate are antidotes to high taxation and inflation, but they may be too risky for an investor who needs to live on the money right now.

Which brings us to our next question: "How much risk?" Compare a lottery-winner with a working stiff. At first glance, it seems that the lottery winner should shoot the moon. But that would be a mistake. One-time windfalls may never be replaced. When dealing with freak events such as a sweepstakes, inheritance or successful lawsuit, overweight your portfolio with investments that offer conservation of capital as a primary objective.

You know the expression, "a fool and his money are soon parted." Don't be that fool. Resist the urge to believe you have achieved some special level of brilliance because you have come into money. Likewise tune out all the hard-luck stories and flattery. Money goes too fast and with it may go some former friends.

A retiree has much in common with a lottery winner. Although a lifetime of hard work rather than a lightening stroke of luck is responsible, the large cash hoard of a retiree has much in common with the lottery-winner's largess. Seniors, like new winners, attract con artists like flies to sugar. When managing a retirement stash, dial down the risk. Income is key, but make sure you know where the money comes from. Being afraid to look a gift-horse in the mouth is a mistake. Make sure "conservation of capital" shows up prominently in the investment objective of your prospectus.

Investment managers use the term: "yield-seeking behavior" to describe the desperation of an investor in an income-starved environment. Sometimes the promise of large returns lulls the voice of caution. By all means replace the income lost in retirement. Dividend-paying stocks, high-quality bonds and investment funds holding same can all be useful, but remember, sometimes it is less about "return ON your investment and more about return OF your investment.

Personality determines investment success. As Shakespeare had it, "To thine own self-be true." What good is an ironclad investment if you sell it in a panic? Carefully select investments that fit your personality and timeframe and hold them. Don't sell unless you have a good reason such as changing goals or additional information. Remember, investment markets are manic-depressive.

How secure is your job? The better the future, the greater the amount of risk you can take. Your real money comes from a job in the early years of an investment program. But if you invest as if there is no tomorrow, there might not be. Always remember, things change, and funding an emergency account with 6 months worth of safe, liquid assets like bank accounts and short-term treasuries belongs on a to-do list, regardless of how boring it sounds at cocktail parties.

When will you need the money? Always a good question. " Liquidity" refers to the ability to access cash with ease and without loss. The ability to sell easily and at a good price is key for many investors, especially those of less-stable circumstances like the newly-employed or poor in health and those with less savings.

Somewhere between the long-term needs best funded through aggressive investment and the ultra safe money of an emergency fund lie a whole host of needs. Marriage, purchase of a first home, starting a business, may all be contemplated within a period of less than ten years. Stocks work fine for investors with a time horizon of at least 5 and preferably 10 years, but for a down-payment on a house, money must be available regardless of the vicissitudes of fortune.

Laddered bonds and CDs to the rescue here. A bond bond ladder is constructed by buying bonds over time so that they don't all mature at the same time. This reduces risk while increasing yield. Match the maturities of the CDs and the bond ladder to when the money will be needed.

Should you take advantage of tax law provisions for special circumstances? The government's tax provisions for first home purchases allow money to be accessed before retirement without paying the 10% penalty. Perhaps you would like to use a Roth IRA to save the house down-payment instead of a regular bank account to defer taxes and compound growth and income until the funds are used.

Additionally, the government offers ways to fund retirement and children's college expenses through specialized investment plans. For example: deductible IRAs, Roth IRAs, Keoghs, Sep-IRAs, 401K plans, 403b plans, 457 plans, and pensions are all tax-favored ways to save for old age, and any number of investment options can be used in each ranging from stocks, bonds, mutual funds, money markets real estate investment trusts and annuities. Never confuse the tax treatment, i.e. "401K" or IRA with the actual investment.

Speak to your human resources department, your accountant, insurance agent, banker or mutual fund company to see what tax-savings options are available. Don't be impulsive or easily sold, but take the time to listen and learn. Several excellent books like "Taxes for Dummies" are available at the library to learn about these specialized accounts and savings plans. One of your best resources may be an unlikely one: the IRS. The government offers many free resources to taxpayers to help them save money and comply with the law.

Speaking of taxes, what is your bracket? High-earners must take taxes into consideration. For example, compare a treasury with a lower-earning municipal bond. The muni bond looks worse, but the after-tax return will often be higher. Those in very high brackets may prefer to skip safer, but more highly-taxed bonds in favor of the slightly riskier bonds issued by their city or state that offer a better after-tax return.

Likewise, such an investor may shy away from dividend-paying stocks while these may be just the ticket for low earners. Stocks that pay few dividends are riskier but offer potentially greater growth to provide a superior opportunity for those willing and able to take the risk. Highly-taxed investors favor such growth because it is taxed at lower capital gains rates and allows for compounding over time.

Stocks that pay regular dividends are less likely to tank than many growth stocks because the promise of a dividend calms the nervous. So long as that dividend keeps coming patient shareholders may simply buy more if the price falls since the dividend yield will rise.

For those with fewer resources and lower taxes, the reduced risk is worth the price, so the first baby-steps into the stock market for younger or poorer investors includes "widows and orphans" stocks like electric and phone utilities that perform in many respects similar to a bond while still offering some growth. Preferred stock which pays a guaranteed dividend, but offers no voting rights may be attractive to some, although these are riskier than high-quality bonds since bond holders are paid first in the event of default.

No one investment offers it all. One may be more liquid, or easy to sell, another has tax advantages, while yet another offers greater growth. Match your investment profile with your investment and you will do well. Even if none of the tips pan out.

Sources:
https://personal.vanguard.com/us/home
https://www.tiaa-cref.org/public/index.html
https://individual.troweprice.com/public/Retail
http://www.irs.gov/