Investment Vehicles   3 comments

Yesterday I talked about whether you should start investing. And you should so long as you have an emergency fund, and no high interest debt.

I’ll soon get into some basic investing principles, and what I actually invest in, but first, we need to go over the investment vehicles available to you.

Checking account

  • Some checking accounts earn interest. However, this interest is typically not worth considering and generally shouldn’t be used as an investment vehicle (but I will discuss some exceptions in a later post).
  • FDIC insured up to $250k (ie, even if the bank goes bankrupt, the government will make sure you get your money). Risk free (so long as the US government stays solvent. If the US government can’t stay solvent, we’ve got other more pressing problems).

Savings account

  • Similar to a checking account, but generally with higher interest rates.
  • By law, you can only make six withdrawals per statement cycle. Otherwise, you are charged a fee (and if you keep doing this, your bank may close your account).
  • At least at the moment, the interest rates are low and can’t really be considered an investment vehicle (though it is a great place for your emergency fund).
  • FDIC insured up to $250k

CD – Certificate of Deposit

  • You deposit money at a bank for a fixed length of time, determined at the time of the deposit.
  • CD interest rates are generally higher than that of savings accounts.
  • The longer the term of the CD, the higher the interest rate (but also, the greater risk that interest rates will rise during the lifetime of the CD, incurring an opportunity cost).
  • CDs can be broken (as in, you get a refund before the term is up) for a penalty (typically several months worth of interest).
  • Again, right now, interest rates are low enough that they’re generally not worth considering as an investment vehicle.
  • FDIC insured up to $250k

Stocks

  • When you own a stock you own a piece of a company.
  • The return of a stock comes from two sources: the value of the stock itself, and any dividends the stock may return. The dividend yield of the CRSP US stock market index was ~2-3% in the past couple of years.
  • In order to buy stocks, you must go through a broker, who finds a seller of the stock you’re trying to buy (and vice versa).
  • Stock prices fluctuate throughout the day.
  • Typically the broker will charge a fee when you buy or sell a stock.
  • Typically you cannot buy fractional shares.
  • Stocks, and mutual funds and ETFs that invest in stocks, have the highest risk of all vehicles listed here (but also the highest return, on average)
  • There is a bid ask spread. You will always end up buying a stock at a little bit higher than the true value (the Net Asset Value, or NAV), and you will always end up selling a stock at a little bit lower than the NAV.
  • When infrequently traded, the returns from stocks are taxed at a lower rate than wage income. I’ll go into the details of this in a future post on taxes.

Bond

  • You loan an institution, such as the US government, money and they pay you back later, with interest.
  • US Treasury bonds are considered risk free (so long as the US government remains solvent)
  • Bonds are also issued by states, cities, and corporations. These have higher risk (particularly those issued by corporations)
  • Despite the above, they have a much lower risk than stocks, but a lower average return
  • As far as I am aware, there are no purchase fees associated with individual bonds.

Mutual fund

  • A mutual fund collects money from its investors.¬† A management team (or it could just be an individual) invests that money in stocks, bonds, etc. as they see fit (but they are obligated by law to tell you what they are investing in). The ones that I will discuss are those that invest in stocks, bonds, and the money market (short term CDs and bonds, and I believe a couple other things).
  • Priced once a day, after the stock market closes.
  • You can hold fractional shares of a mutual fund.
  • One interesting side effect of mutual funds being priced once per day is that you don’t actually know how many shares of the mutual fund you are buying. This isn’t a big deal though.
  • Some mutual funds charge a purchase fee. Some others charge a redemption fee. And some even charge both! Avoid these. I’ll go into more detail in my post on which funds I actually use.
  • For mutual funds that invest in stocks, similar rules on the tax advantages of investing in stocks vs wage income apply

ETF – Exchange traded fund.

  • A relatively new investment vehicle.
  • Typically have some management team like a mutual fund that decides how to invest their clients’ money.
  • Traded like stocks.
  • Update on 1/11/15: Again, for mutual funds that invest in stocks, there are tax advantages of investing in ETFs vs wage income

There are also other vehicles such as futures and options that I do not know much about, and don’t care to. I only use mutual funds as my investment vehicles (I still have bank accounts, but they’re not considered investments). With the wide selection of mutual funds available today, they cover virtually all asset classes (stocks, bonds, the money market, real estate, alternatives such as gold, etc.). Some of the reasons as to why I only use mutual funds won’t make sense until I explain taxes in a future post. But the most important reason I only use mutual funds is the ability to make automatic investments.

Why use mutual funds instead of ETFs?

A mutual fund is only priced once per day, and allows for fractional shares. This is because you just hand the fund your desired investment amount, and they invest it how they see fit. Hence, a typical mutual fund company can automate your investments by withdrawing money from your bank account on a recurring schedule. Or, at least with Vanguard, you can directly deposit your paycheck to your Vanguard account, and have them invest it in the mutual fund(s) of your choice. This is a great service that they provide! It’s far less tempting to spend your paycheck if you have to go through the trouble of logging into your Vanguard account to sell the shares of the mutual fund(s) you automatically invested in. Out of sight, out of mind.

I could use ETF versions of my mutual funds. But ETFs, just like stocks, can be stressful to buy and sell. To avoid random flash stock crashes, you should place a stop or limit order. Essentially, you specify that you do not want the purchase or sale to occur until the stock reaches a certain price. But there is no guarantee that the stock will reach your specified price. So you have to check in on your order until it actually gets filled. I’d rather not deal with that.

Finally, there is a bid-ask spread that has to be paid with ETFs, but not with mutual funds (though I believe in the end, a bid-ask spread is paid implicitly with a stock mutual fund, because the fund has to pay the bid-ask spread. However, the fund’s bid-ask spread should be lower because they are transacting far more shares. Also, even if they pay the same bid-ask spread as I would, I like not having to stress about it myself).

Update on 1/11/2015: In general, ETFs are more tax efficient than mutual funds, because you can expect them to distribute less capital gains than the mutual fund version, if at all (and why this is advantageous will be explained in a later post). But, in the case of Vanguard funds and ETFs, there is an exception (as explained on the Bogleheads wiki)

Vanguard ETFs are structured as another share class of a mutual fund, like Admiral or Investor shares. This is a process unique to Vanguard, protected by a patent until 2023, with two important consequences for the mutual fund investor:

  1. Tax efficiency: the mutual fund shares benefit from the disposition of capital gains through ETF shares, making Vanguard funds with ETF share classes as efficient as an ETF.
  2. Conversion: mutual fund shares can be converted to ETF shares without a taxable event. This helps when transferring assets to another broker, including charitable donations. Conversion in the other direction is not possible.

The second point is an argument to start with mutual fund shares at Vanguard, if unsure. One can always convert to ETF later if needed.

The tax efficiency advantage is a patented advantage you will only find at Vanguard. Combine that with point #2, and the only advantage of starting out with the ETF version is that the ETF version typically has a lower expense ratio than the Investor share class of the the mutual fund version. However, once you reach the balance threshold for admiral shares (typically $10k), your mutual fund shares qualify to be converted to admiral shares, so the cost difference in absolute terms is not that high. Also, as I discussed earlier, there is the bid-ask spread that has to be paid with the ETF.



I tried to keep this post shorter than last time. Next time, I’ll talk about some investing principles!

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Posted January 8, 2015 by Fiby in Uncategorized

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