You might hear friends or colleagues talking about hot stock picks. Someone might be bragging that the biotech stocks that she put in her portfolio are up while the overall market has been down. Another person might claim to have found the best mutual fund, and he claims that the manager of it has the best record in the industry in the last couple years of picking winners among large caps. Why are some people better than others at figuring out how much a stock should be valued at?
At least that's the premise of something called the market efficiency hypothesis. [link] All of the information in the public record about broadly-held stocks has been evaluated and the supply and demand pressures have balanced to find the best valuation possible. If this is true (and there is a debate) then what is the point exactly of trying to pick which stocks are "undervalued" when the market has already valued them?
Other types of information could also be helpful in picking winners among stocks--namely, knowledge of future events and insider information. If you knew what would happen in the future that will deviate from current marketplace expectations, you could of course pick stocks of companies that have good news ahead. But relying on your own intuition about surprising future news is..unscientific.
Insider information is the best way to gauge how the future value of shares in a company will fluctuate. But using insider information in making trades is..legally questionable.
The efficient market hypothesis has different forms, and what we are talking about here is the weaker version. [link] And we don't have to completely subscribe to it; but let's consider whether it may have instructive value for our investing strategy.
The typical small-to-medium investor is looking for the best returns possible over the long term and that will inevitably include a lot of shifts in the market. So even if one had some special insight as to how to allocate assets over the next couple years, sustained success would require frequent re-allocation. The costs of ongoing research and the transaction costs from this continuous trading would be considerable. What if there were a different way to look at the market, from a bigger perspective than speculating on individual stocks.
When financial news is read they will often start with how specific indices performed that day. The indices are compiled by financial news organizations and are usually named after them. Standard and Poors, for example, has for many decades compiled numerous indices. Their well-known S&P 500 is based on, well, 500 of the biggest U.S. corporations. Enterprises that large are known as "large caps" for their, as you might guess, large capitalizations. Market capitalization is one way to value a company and it consists simply of the value of one share times how many shares are out there in the world. Companies on the S&P 500 generally have market capitalizations upwards of $10 billion. While these large multi-national companies (and especially those mega-corporations in the Dow 30) get the majority of media attention, the market is filled with somewhat smaller companies that also list on stock exchanges, often referred to as mid caps and small caps. These are also represented in (less known) indices like the S&P Midcap 400 and the Russell 2000 small cap index, which track a basket of 400 mid caps and 2000 small caps respectively.
These stock indices can act as a baseline for portfolio performance. Instead of comparing returns to some made-up number, investors can compare their returns against a major benchmark like a stock index.
Another kind of benchmark comes from the debt side of the market (stocks are sometimes known as equity assets while bonds are a kind of debt). Governments and companies around the world issue bonds--they are a way of borrowing money from the public (and thus represent a promise to pay capital plus a set interest rate) while stocks are a way to sell part of the company to the public. Both ways raise capital, just with different effects on the company balance sheet.
When companies and governments decide to borrow through a bond offering, they set a nominal interest rate and then auction the bonds off. The yield (or real interest) on the bond is thus set by the market based on the purchase price. Subsequently the bond buyers can either wait for their principal to be paid back at the end of the term (while collecting interest) or trade the bond in the market. As the price of the bond changes, the yield [to any new buyer] changes (inversely) with it.
The yields on U.S. Treasury bonds can be drawn on a chart usually know as the yield curve. The 'curve' comes from the fact that yields are typically higher on the 30 year bond than the 10 year bond, which will have a higher yield than the 5 year. When little variation is seen among bonds of different maturities, the yield curve is said to be (relatively) flat.
Just as the S&P 500 is a pivotal baseline for stock performance, the yield on the 10 year U.S. Treasury bond is a major benchmark for the debt market. Since the American government is widely thought to be able meet its obligations, its yield is usually much lower than the debt of most other borrowers. Though the risk of default is considered much lower for the government, that safety has a price in the form of lower yields.
Investors can choose all the way from Treasury bonds or "investment-grade" corporate bonds to debt-laden companies making one more attempt at a turn around. The higher the expected risk of default (the bond issuer failing to pay) the higher the yield demanded by investors.
Many investors participate in the bond market through funds. Like stock funds but on the equity side, most funds will focus on a certain sector or debt rating but often leave broad discretion to the fund manager. Regular investors can buy Treasuries, and they are good for low-risk long-term holdings, but the bonds are not as liquid as stocks and are most likely to fit in as one in a diversified basket of long-term holdings.
A dinosaur is certainly going to need a considerable stash of assets for the later years, given its massive appetites. So the amount is key, but so is the type of asset. You see, a massive comet or asteroid could come out of the sky at any time. And if that doesn't happen, a metaphorical comet of economic troubles could hit any part of the economy, unpredictably, as an asteroid could hit the East or West coasts just as easily. If we think that the efficient markets hypothesis is close enough to true for our purposes then how can we know which sector or stock will do better? So instead of trying to pick a stock or sector, why not pick a basket of investments that reflects (more or less) the overall market performance? That, and compounding over time, should take care of our retirement needs given enough time and of course initial amount contributed.
The process of aggregation is very key to retirement planning like a dinosaur. Aggregation combines a wide range of factors into a smoother, more predictable total outcome.
Since many mutual funds famously fail to exceed the performance of the S&P 500 in many years, wouldn't it be better to buy an asset that tracks the performance of that index? Maybe it would be better--and many people do exactly that by investing in a mutual fund or ETF [exchange traded fund] which promises to increase and decrease at the same rate as the index. This type of fund is available for a wide range of indices.
In today's America thousands of people hunker down with shelves of freeze-dried food, stashes of heirloom seeds and closets full of firearms in their desert hideouts and mountain cabins. Why do they do such things? Well the sociological explanation would inevitably be complex and nuanced and perhaps touch on the prevalence of millenarian religious movements in the culture--but the stated reason according to some of these 'preppers' is their belief in the coming hyperinflation.
^It will be just like the Weimar Republic^ goes the oft-repeated catch phrase of the right wing over the last decade. Paul Krugman has documented the fulminating obsession with inflation in America (especially on the political right) and in Europe in his column [link] over this period. In practice, these predictions have not panned out, as inflation indices like the CPI have increased at slow rates--about 2 percent annually. [link]
What about these indicators like CPI and the unemployment rate being rigged, or something? When the numbers haven't gone up as they predicted, many right-wingers have resorted to fantasies about falsified numbers or whatever. But no convincing evidence of dishonest statistical work from government agencies like the Commerce Department seems to have emerged. This isn't to say that there aren't known methodological flaws in the way numbers are compiled--for example the unemployment number runs too low because of many who have been out of work to long to qualify--but known methodology issues are different than secretive stat rigging.
So higher inflation hasn't happened recently but is it coming in the medium or near term as 2015 begins? It doesn't seem so. First, capital remains cheap (interest rates are low) and the employment market remains weak. As long as the continued growth in the economy is mostly captured by the wealthiest one percent, demand (at least for discretionary non-luxury goods) will remain weak. With plentiful capital continuing to fund companies in a search for profit, the competition for slow-growing consumer spending should exert a downward pressure on prices. Deflation is a bigger concern. Since people seem to worry about inflation, could deflation be good? Prices are, by definition, going down in a deflationary scenario. Doesn't that benefit consumers? No, not really. For one thing wages go down too. People are more incentivized to save more and delay purchases (they'll be cheaper in the future) and a vicious cycle begins (like what Japan saw in the 1990s).
But the real problem with deflation is that it makes debt more expensive. Money is worth more so the money that you owe is a higher burden in real terms than it would in an inflationary market.
As an aside, consider how median wages are struggling to keep up with inflation these days, and have been for thirty+ years. This doesn't actually imply high inflation, but it can have similar effects. But since this trend shows no sign of slowing down, it's good to earn income on the capital side of the economy (where the gains have been better lately) as well as on the employment side.
What causes inflation anyway? A lot of market forces can exert inflationary pressures--these include increased consumer or business demand for goods, decreased supplies, wage increases, and commodity price rises.
Commodities play an important part as inputs in the economy. Companies need to buy all sorts of commoditized goods like fuel, food and raw materials. All of these goods can fluctuate in price based on a wide and unpredictable range of factors. Oil prices are affected by overseas actors like OPEC; grain prices are affected by weather in the Midwest and Great Plains (and perhaps by how popular glutens are at the moment); cattle prices are affected by traders in Chicago.
Investing in commodities (particularly gold) became trendy beyond just preppers for a few years there, but gold started a drop in price in late 2011 [link] and hasn't recovered yet as of early 2015. Buying gold (or any other commodity) is probably unwise speculation for two reasons. First, commodities of any kind are subject to erratic price fluctuations because of the unpredictability of both future supply and future demand for marketable goods. Second, commodities don't pay interest or have an obligation to seek profit. It's a thing that's going to be used for something, probably soon, and trading in futures is the province of farmers or oil drillers hedging on their crops and big financiers taking speculative positions. Not dinosaurs.
The best way for a retail investor to play in the commodities market is to buy shares of companies focused on the sector that they want to target--oil companies, farm equipment manufacturers, and gold mining companies are examples of this kind of investment. Of course these investments should be considered within the scope of a diversified portfolio.
Oil prices affect practically every company since they feed into heating and cooling prices, transportation costs and much more. On the other hand specific sectors are more affected by specific commodities: car makers are sensitive to steel prices, steel mills are sensitive to ore prices and shipping costs, which are partly affected by oil prices.
When the feedback loop of higher demand and higher prices starts going, it can acquire a great deal of momentum. For example the price of oil more than tripled from 2004 to 2008 while other commodities boomed (including food prices [link]). The combination of war in Iraq and spiking demand from China matched a supply constraint (at least from Iraq) along with an increase in demand that saw the prices increase.
By 2008 the economic crash had lowered demand and prices dipped dramatically before recovering partly and for about five years crude oil prices sat between $80 and $110 before collapsing back to 2004 levels (about $50) again in late 2014 and early 2015. [link]
So you can see why retail investors may hesitate to buy crude oil, but will still follow its price because it has an effect on the investments they are buying and selling. A look at the price history chart of oil and gold will reveal their cyclical patterns, and that's the key point about commodities--they are cyclical in nature. When the oil price goes up, oil companies look to places that are hard to get to, expensive to drill at, or which contain oil in a raw form that requires more intense harvesting (like shale). The companies around the world inevitably drill too many new wells and increase the supply, and the world economy tends to be cyclical in its demand as well. So commodity price rises will tend to fuel inflation--when demand is increasing and supply hasn't grown too large yet. But those same forces work in the opposite direction too, but this also shows the limitation of these effects. Consider: inflation tends to stay positive, perhaps just at a lower rate, when commodity prices are falling.
In order to factor in commodities, their price swings and the effects of all that on investments, the investor needs to diversify across different sectors which are affected in different (and sometimes contradictory) ways. Exposure to contradictory effects from the same category of market event is an example of hedging.
We've seen that commodities fluctuate wildly and have no real benchmark return level--but how do these goods (like oil, corn, gold or cotton) get valued? The market trades promises to buy or sell them in the future ('futures') daily at places like the Chicago Mercantile Exchange. So the commodities are valued at the current market price for the good plus or minus whatever expected future swings in price are expected by the date of maturity for the futures contract. Put simply, commodities are valued at wherever the supply and demand curves meet.
The difference with investments like stocks is that while this is all strictly speaking true for them as well from a technical standpoint, just ask yourself--what makes up the supply curve for commodities? It turns out, the supply curve is formed by how much [marginal total] can be produced plotted against how much it would cost to produce [a marginal product]. So, the more that a product can sell for, the more that can feasibly be produced.
That is all to say that although commodities do not usually make up a large allocation of a small investor's portfolio, their valuations are easier to explain using microeconomics. For stocks, their supply and demand curve are harder to deduce and probably are influenced by a number of complex upstream (macroeconomic) effects.
So, yes, valuing stocks is hard. We discussed in chapter 1 how a hypothesis holds that the market has already fairly valued the stocks out there. So why try to 'pick' one or the other, whether based on valuations or some other reason?
First of all, we can still use these techniques in aggregate to look at the valuation of the market as a whole (or some particular sector). And second, even if a dinosaur might put most of his assets in broad-based positions like index funds, a small portion of it can still easily be used to follow primitive urges to pick one bet over another.
To look at the valuation of stocks we will look in the direction of finance and consider results, ratios, and multiples. First, companies have to release audited financial statements with their annual 10-k reports. These are easy to find on the web and contain a wide range of "material" information on the company and its finances, operations and market conditions.
Digging through the 10-k can reveal the income statement, balance sheet and statement of cash flows. These are all useful documents for understanding what is going on at a company. Of these three, the cash flow statement is probably the favorite of most dinosaurs, because it deals in concrete numbers. Pretty much everything on it shows the movement of cash (as the name implies), while income statements include both cash and accruel earnings, and balance sheets accumulate charges like goodwill which are somewhat abstract. A little bit of education in accounting can help an investor gain key insights from these complex reports.
If you look up a stock quote for the online, you can find a lot of information quickly (and maybe if you are interested you may dig deeper into the reports we discussed above). If you'd like, type a stock symbol (like AAPL or AMZN or SBUX) into a search engine and click on a result from a financial site you like.
After checking the current price, notice if they list the quantity we discussed earlier, market capitalization (they do at many sites but not all). Now look for the P/E (price to earnings) ratio. This amount is a key indicator: a low P/E indicates a relatively high value at the current price. Another indicator some people look at is price to sales, but since profits are the goal for companies (they add to shareholders' equity) a company with a low price to sales ratio and a high P/E is likely selling a lot but not making much per unit.
The debt/equity ratio is worth looking at--related to shareholders' equity, it shows how much the corporation is financed by debt like bonds and loans and how much by equity in the form of shares of stock.
Another ratio that some investors like to look at is the ratio of market value to book value. The market value is created by the demand of stock buyers, while the book value reflects accounting measures. Different sectors will see different kinds of ratios in this area, so it can be helpful in comparing one similar company to another.
The dividend yield will tell you what percentage of the company's share price it returned to shareholders in the form of dividends in the last year.
Other indications, like earnings per share or dividend amount, are artificially tied to the share price number (which is in a way arbitrary in a way that ratios aren't). Other numbers you might see, like EBITDA, are garbage indicators which are based on actual totals but do not present logical or useful information.
That's not a lot of numbers, but that's enough--the problem for the investor is to figure out a few things: the direction they're heading in, and the momentum of that direction.
A traditional benchmark for valuation has long been a P/E of 10. The S&P 500 average P/E ratio for decades in the 20th Century ranged from around 8 to around 23, but after the massive bull market of the late 1990s the norm may have shifted upward somewhat. [link]
Newer companies expected to be able to grow a large amount in percentage terms may see high P/Es based on future expectations, while more mature companies may find their P/Es creep down over time as their businesses mature (and eventually stagnate).
Valuation is certainly not always the only criteria when picking a stock, but it should always play a role in the analysis. An investor may experience a product or service from a company that they find excellent, but before impulse buying the company's shares they should take a look at the valuation. If the company is doing well but has a P/E of 300, it might be a little late to try to profit from their growth. Or maybe they have enough growth left to shrink that ratio massively. For an investor, it comes down to doing adequate research and then making the best judgment possible. There are going to be some losers on some investments, but an effectively diversified portfolio with a range of assets ensures that those losses will be limited in their impact.
When people discuss stocks, they sometimes speak in terms of sectors, either for context ('my AAPL shares outperformed the overall tech sector in 2014') or investment category ("I've gotten a fund that looks for growth stocks in the tech sector"). So what sectors are there in the market, and how does an investor know how much weight to place on each one?
To a dinosaur, "overweighing" on any one sector is no better than putting a large percentage of one's assets in any one particular stock. The sectors all have their own specific risks that are unique to them: the tech sector is famously volatile, the medical sector will be broadly effected by regulations, the energy sector relies on risky overseas drilling or expensive domestic drilling. While sector-specific funds and ETFs are available, these are best deployed by a small or medium investor as a part of a diversified portfolio.
So many different sectors exist (and the lines between are blurry--are GM and U.S. Steel in the same sector or a different one? What about Apple and Microsoft?) and their relative heft varies, so coming up with a market-weighted basket of sector funds may be a rather complex task. It may be easier to come up with a balanced portfolio by diversifying by company size, which will be considered ahead.
Think for a second why that would be: buying funds on ETFs based on sector leaves it to the investor to figure out proper market weighting (more investment in bigger sectors) while funds or ETFs based on indices are usually weighted themselves based on the size of the companies in the index.
Since the major market indices (including the S&P 500 and the Dow Jones Industrial Average) typically organize themselves mainly based on the size (in market capitalization) of the companies that make them up, they can generally be categorized as large/medium/small cap[italization] indices. This makes it easy to buy index trusts or funds that track large (tens of billions in market cap), medium (around $2-$10 billion), and small ("small" here meaning a billion dollars or so) caps and to thus own a small slice of the broad market in three funds, with market-based sector diversification built in. Some funds and ETFs even claim to track the 'total market,' but make sure you like the percentage they have in different capitalization sizes before you put your money into one of those. (Alternatively, you could divide a majority of your investment funds among different-cap funds and throw a total market one in.)
Keep in mind that most small businesses do not list their stock for trading--they are mostly sole proprietorships, S Corporations, LLCs and such structures. Since these companies do not typically use the public markets to raise capital (often getting loans from banks and things like that), it can be vanishingly hard to invest in that sector of the economy directly (aside from buying into a company directly by making a private deal with the owners). Some stocks can act somewhat as proxies for small business activity but for now let's say the very small companies are not part of a typical dinosaur's diversification strategy.
The comparable performance of large, medium and small caps varies over time, so balancing investments among the three somewhat equally is a good strategy.
When looking for individual stocks to buy (for an overall minority of one's total investment due to all the specific risks associated with individual stocks of course) consider the likelihood that many of the companies that people talk about tend to be the very very large caps. There is no inherent problem in buying some shares in these companies, but just keep in mind the natural tendency for people to research the stock of companies they hear about, while many small cap companies may be doing good profitable business but not in your town (yet) and below the radar of the mainstream media (so far--or maybe they are in one of those industries that never get noticed much).
Mid caps can sometimes offer already-large businesses with room for growth. While large caps are often technology and industrial giants, many mid caps are still-growing companies that are already well-known to consumers.
While tech companies have a reputation for innovation, some recently successful stocks (like Chipotle for example) have made waves in industries that have been around forever but were just ready for some new techniques.
Since any company that issues shares in the U.S. will probably have a 10-k online, and vast amounts of online resources are available to investors, researching a broad range of companies is certainly possible. Looking around for small cap values can be done--some people will create automated reports looking for a certain financial profile [at 52-week low, or P/E is sitting below 8 for example] and narrow down what to research further based on their spreadsheets.
Many different assets can be bought through brokerage and IRA accounts, and we've discussed some of them. The types of securities available include common shares, preferred shares, ETFs, mutual funds, commodities, and bonds.
These can be broadly grouped into equities (common shares) and debts (bonds), though some have characteristics of both (preferred shares) or can be made up of both (like a fund that invests in both debt instruments and equities).
Generally speaking, bonds have a set nominal rate of return and maturity date (the date that the principal is returned to the bond holder). Their effective rate of return is thus determined by their purchase price (which can be higher or lower than the face value depending on market demand). So what will set the market demand? The perception of all future payments adjusted for the time value of money is how much the bond will sell for--and this perception is based on how creditworthy (likely to pay back) the borrower is. So bonds from well-capitalized corporations with high 'credit ratings' (put aside how dubious the rating agencies are currently seen as by critics, they still tend to determine borrowing costs) will be able to offer lower interest (only slightly higher than the benchmark U.S. Treasury bonds) while companies that are highly leveraged [have a high debt to equity ratio] and have low or no profits will have to pay a higher rate to find buyers for their bonds. If their ratings slide far enough they might move into "junk bond" territory.
Bonds are sometimes seen as the "safe" or "low return" investment but this is only true for the lowest-risk borrowers. Bonds can be all over the map risk-wise as we have seen, so they don't offer much risk differentiation from equities (unless only Treasury bonds and very low risk bonds are held, of course).
Riskier bonds and bond funds are not popular with dinosaurs for any significant percentage of their portfolios. But they will often use Treasury bonds as long-term cash equivalents in IRA accounts, for the part of the retirement allocated to cash. Fundamentally, bond values are based on a perception of ability to pay while stock values are based on expectations of the corporation's future profits. The returns from stocks versus bonds will differ somewhat predictably from market conditions--but these are both hard to predict and tend to balance out over the curved space of time, especially over the long term.
Having exposure to different regions of the country is important for a diversified portfolio, and broad funds like index trusts typically take in such a wide spectrum of companies so that geographic diversification is largely built in--in terms of the U.S. and to an extent the foreign countries that those companies do business with. But for more direct exposure to foreign economies, investors can buy funds or ETFs that put assets in a basket of foreign equities (usually focusing on specific sectors, indices or countries). For American dinosaurs, foreign-focused funds are an exotic dish that make up less than 5 percent of total assets.
The world economy may be increasingly inter-linked in a way that might put into question the need for as much geographic balance, but the current worldwide economic slowdown since 2008 widely referred to as 'The Great Recession' has actually been a depression in Europe, while Japan has long battled deflationary pressures. China and other developing economies are good growth prospects but generally present more systematic risk than the industrialized countries.
So for now in 2015, America looks like at least as good an investment as most other places. A little dabbling in foreign ETFs might offer exposure to tech manufacturing in Asia or to Australia's historically fast-growing economy, but most Americans will park most of their money stateside. For overall systematic risks to the economic system like war or climate change, their effects are hard to quantify but concerns about them can play a role in markets--and geopolitical instability is generally bad for economic growth.
Conventional wisdom on investing holds that if you have a shorter time horizon, you put a higher percentage of assets in "low-risk" securities (like highly-rated bonds) and if you plan to stay invested over the long term then you buy more "high-risk" stocks.
But we are not going to conflate asset type and risk profile. As we have seen, some bonds can be high-risk too. We need to think about the specific risks that the sectors or companies we are analyzing face in order to diversify by risk.
Higher risk and lower risk is mostly subjective, but some generalizations will often hold. An established company with steady profits will typically be seen as "low risk" (in both their stocks and bonds) while newer, smaller, less (or not) profitable companies are seen as higher-risk. It is probably fair to say that the expected behavior of lower-risk stocks and lower-risk bonds will be more similar than what investors expect from higher-risk stocks versus higher-risk bonds. High risk stocks are seen as super risky, because a highly leveraged company trying to grow quickly will sometimes go bankrupt--and in bankruptcy, bond holders are much more likely to get something out of it than shareholders. Not only that, but the risks are often 'priced-in' to the bonds in high interest rates--and while you could make the case that such is also true as far as stocks, how exactly do you price in oblivion?
So is higher (perceived) risk likely to lead to higher returns? Not always. Certainly putting most of one's portfolio in a few risky (highly-leveraged, low-priced, negative-earnings) companies with big ideas might lead to huge gains if one of them makes good on an ambitious expansion plan (they had to leverage themselves for something right?) and the stock price goes up 10 times or more. Just as likely though (okay more likely) these risky new ventures fail or stagnate, and the investor's portfolio performs much worse than a benchmark like the S&P 500. So where's the return in that risk? This is where we need to modify the equation. Instead of:
We will say:high risk x diversification = high returns / long term
The idea I'm trying to illustrate above is that you can manage to distribute the risks in many different ways over the long term thorough portfolio diversification. And consider that like in other ways of diversifying, spreading assets around different into risk areas can smooth out your returns as risky investing behavior is likely to incentivized and discouraged alternatively in different phases of the market, more or less in a cyclical pattern.
Generally bonds are more limited on the upside (payment in full of interest and principle is a best-case scenario for a bond [aside from an unlikely radical appreciation of the bond's market price]). Stocks have a higher upside because the growth of corporate profits that undergird rises in their market prices is limited only by the growth of the economy [and the market for the company's goods and services and the company's ability to acquire additional market share]. On the downside, both can lose 100% of their value. (As a side note, consider why you may want to avoid short selling--unlike as in buying it can actually lose you well over 100% of your money.)
So while some diversification by asset type (as discussed earlier) may be desirable, diversifying by risk can be done mostly with equites (though having some Treasury bonds covers the super-low-risk corner where no stock could substitute).
Consumers invest in stocks in a number of direct and indirect ways. These days many employers offer fixed contribution retirement plans usually classified as 401(k)s (in contrast to the old pension-style fixed income plans).
What fixed contribution means is pretty self-explanatory: the company will often 'match' a certain percentage amount--meaning that for every dollar (up to the percentage limit) that the worker agrees to have diverted out of their paycheck into their 401(k) account the company will put a dollar into the account from its treasury.
Workers are incentivized to divert the maximum amount that will be matched. With all other things being equal the maximum matched level of percentage of employee pay should however form not just the lower but upper bound for contributions: in other words, you want to put the maximum matched amount into your 401(k) but not more than that. Why? Because that additional amount that you can afford to invest can be placed in a brokerage account instead.
So what is the difference? Well, the 401(k) is called a tax-deferred account. This means that the money that you divert into there from your paycheck (and the whole account for that matter) is 'pre-tax,' which means that you have to pay taxes on it when you withdraw money from the account (or take a distribution). And there's one more catch: with an exception or two (down payment for a first home being one) the money in pre-tax accounts cannot be withdrawn until the account holder is at retirement age (around 65 or so) without a 15% tax-penalty taken off the top before you pay normal income taxes on the distribution.
The need to hold pre-tax funds in special accounts like 401(k)s until long after people are done working at companies is what makes IRA accounts popular (along with some federal tax credits and deductions). These accounts are controlled by an individual: the IRA account holder deals directly with the bank or brokerage that handles the account and chooses which one patronize, whereas companies have control of what financial firm handles their 401(k) program. The choice of investments is limited in many 401(k)s, so even though some allow employees to keep assets in a 401(k) after an employee leaves (the alternative being sending the former employee a distribution check) many of them will choose to "roll over" their assets from a 401(k) to an IRA when they leave. Whether the accounts are rolled over directly from the 401(k) company to the IRA company or the account holder receives a distribution check that they then deposit in the IRA within 60 days, the steep 15% penalty is avoided and the account holder can then consider a wider range of investments.
IRA accounts typically allow investments in stocks (including ETFs), bonds or mutual funds. Other than the tax implications, the accounts typically work very much like brokerage accounts.
Brokerage accounts are the 'post-tax' accounts (at least to an extent). Account holders can move money back and forth between checking accounts and savings accounts, right? Well the same is true of brokerage accounts--many people have links in their online banking to facilitate the movement of money (preferably) out of their checking and into their brokerage accounts (and in the reverse direction when they need to draw on savings).
Why would people move their money into a brokerage account instead of a bank savings account? Because they're chasing higher returns, of course. But with that comes risk, as stocks and even bonds are much more erratic and unpredictable (and risky) than savings accounts or certificates of deposit (CDs). The risk is also increased by the lack of FDIC protection for brokerage accounts. But with that risk comes a higher average reward over time, more likely than not, given effective portfolio diversification.
Brokerage and IRA accounts are often offered by the same financial institutions, and they often allow customers to view the two accounts, brokerage and IRA, under a consolidated total. This can be useful in calculating one's own personal assets-under-management number, but it's important to understand the differences between the accounts both in terms of retirement planning and investment strategy. The IRA is explicitly an account set aside for retirement; it is there to grow and compound until you need some of it when you're retired. Consider the implications of paying taxes as you withdraw the money. This means that if you are still receiving income in retirement (profits from selling brokerage investments for example, or you have a retirement job) then the money taken out of the IRA is added to your marginal tax total for the year. You can use this knowledge to tax plan: withdraw money in years when your income is lower, when possible (and this has a self-reinforcing logic to it if you think about it).
On the other hand brokerage income is post-tax, right? Yeah more or less--you don't pay when you take money out of the account (like one of those hypothetical transfers to a checking account we talked about earlier). But you do pay taxes on your profits. So just like savings account interest income is taxed, so is bond interest and bond fund income; for stocks (and generally stock funds) the taxes are owed both on dividends (the closest thing to interest income on the equities side) and the profit made from selling stock (known as capital gains and taxed under special rules [generally preferential ones]). Because of capital gains, tax planning for brokerage accounts generally involves when to sell assets. The investment strategies between IRAs and brokerage accounts will be different, certainly for tax reasons but also for liquidity and time horizon issues. Since brokerage accounts allow money to be moved in and out easily, the account holders must decide on the time frame for investments in them. While frequent trading can make an investor feel like he or she is taking advantage of every swing in the market, the transaction costs (stock trades often cost around $10 each) and problems of limited time and asymmetric information will often incentivize brokerage account holders to employ long term thinking in their brokerage and as well as IRA accounts.
How do we think long term (like a dinosaur) about retirement? By building the kind of portfolio that will last. This requires diversification along the lines that we considered earlier, an ability to adjust to new evolutions in the market while adhering to sound principles, and a determination to stick to one's convictions.
The market will move in unpredictable ways, but its fluctuations in the aggregate are minor compared to those of individual companies. Most small-to-medium investors would likely benefit from seeking returns in line with the total market over time: of course, that depends on individual investment goals. But the compounded returns of the market over a few decades are likely to outperform more conservative investments like CDs and money market funds, with only somewhat higher risk. And despite the allure in "overweighing" a portfolio in a certain hot sector, the long term returns of that sector could eventually underperform the overall market.
For all the reasons we've considered, a dinosaur is likely to place at least 2/3 of its total assets-under-management in funds or ETFs that track major stock indices.
For the portion of a portfolio that an investor doesn't place in index trusts (ETFs or funds based on broad stock market indices [such as the S&P 500]), a range of both higher and lower risks options are available (but this part should be no more than one third of a portfolio). 'Actively managed' funds and ETFs can provide one possibility--these will often focus on a particular area or be led by a big-name fund manger. While these can offer an intriguing story, a cautious dinosaur would mull the chances that this hot fund could easily end up underperforming the S&P 500 long term--with a higher percentage going to fund management costs than index trusts. Buying share in individual companies is another option and can be worthwhile (given reasonable valuations) but is on the riskier side (due to the specific risk to the stock alongside the general risk of the market). U.S. Treasury bonds are typically (especially lately with incredibly low yields) limited return but carry extremely low risk (despite Republican Party threats to default on them). Bonds issued by corporations (or ETFs and funds that buy those types of assets) can be all over the scale as far as risk. Some funds and ETFs are actually very risky, based on the type of asset they buy or how they manage them (watch out for anything backed by mortgages). Overseas stocks and stock funds are becoming increasingly common choices for investors--after all many American corporations are scattered around the world anyway, and numerous foreign companies (like Sony) are listed on U.S. stock exchanges.
Some types of investment strategies are not for any small to medium sized trader. These would include short selling (betting on a stock to go down), margin trading (borrowing money to buy stocks), and call options (locking in a price on a chance to make a future purchase of an asset). While these can be fascinating, the risks inherent are best only sustained by extremely wealthy traders able to ride the ups and downs.
Using index-based funds and ETFs is sometimes thought of as a "passive" investment strategy--and that's a good thing. It allows the investor to buy and hold, knowing that the market is cyclical but has on a long enough timeline continually shown overall positive returns and will likely continue to do so. Instead of spending time and resources trying to understand the valuation of stocks, the investor is free to put more effort into
his or her daily work, side projects or preferred modes of relaxation research into asteroids and comets.