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Stock Allocation in a Balanced Portfolio

This is a guest post from Gabe Lumby, CPA. He runs Cash Cow Couple & Tightwad Travelers with his brother Jacob. When he isn’t busy running his online businesses, he enjoys spending time with his family and fishing for crappie on the local lakes in Southwest Missouri.

When putting together an investment portfolio, the options are endless. This is especially true when dealing with stocks.

There are a million different possible combinations and categorizations including active vs passive, value vs growth, small-cap vs large-cap, domestic U.S. vs international, and sector specific vs market wide. There are also a number of different options that attempt to blend these various categories.

Then there is the issue of (index) mutual funds and exchange-traded funds (ETFs). Both of these vehicles are used to accomplish the same investing objective of diversification. They are just different means to an end. Whether you own an S&P 500 index fund or an S&P 500 index ETF, you still essentially own the S&P 500. It just so happens that ETFs are usually slightly more tax efficient and sometimes have lower expense ratios, which give them a slight advantage.

Let’s jump into the various categories that are available when choosing stock allocation in a diversified mutual fund or ETF.

Actively Managed vs Passive

An actively managed mutual fund attempts to beat the market through buying under priced securities and selling overpriced securities. Most actively managed funds have a fund manager and a squad of analysts attempting to find the next hot deal. Some will try to find market trends, others will try to use valuations like the P/E ratio, but the goal is always to outperform the broad market index.

Most actively managed funds have much higher expense ratios than passively managed alternatives. Herein lays the problem. Because it’s so difficult to properly forecast short term movements in the stock market, managers have a tough time outperforming an index after accounting for fees. Most research shows that actively managed funds tend to underperform their passive alternatives over a long period of time.

A passive fund tracks a market index such as the S&P 500. The fund manager, which is usually a computer, only makes trades to keep the fund in balance with the associated market index. Because of the efficiency of this process, passive index funds (and ETFs) tend to have very low fees and their only goal is to replicate the gain of their respective index – such as the S&P 500 or Russell 2000.

In light of the evidence available that compares each, I choose to invest entirely in passive ETFs.

Value vs Growth

Value stocks are those that have a low price to earnings or price to book ratio. There are multiple hypotheses on why some companies have lower valuations at any given time, but let’s not get too concerned with that.

The thing to remember is that value stocks have historically outperformed growth stocks over a long period of time. They tend to slightly underperform during bull (upward) markets (like the 2000 tech boom) but significantly outperform during bears (when the tech bubble popped).

A growth fund contains stocks that are expected to grow more rapidly compared to the rest of the market. Growth stocks typically have some recent history of above-average growth in earnings. Investors like to see this growth and that makes these stocks appear sexy and attractive. This pushes prices higher during good markets, but often results in crashes that tend to destroy growth stocks later on.

Overall, I like a value tilt with my portfolio. It has outperformed in the past and I’m hoping it will continue to do so in the future. I have no idea if that will be the case.

Small-Cap vs Mid-Cap vs Large-Cap

A small-cap fund holds stocks that generally have market capitalization of between $250 million and $2 billion. A large-cap fund holds stocks that have a market capitalization of more than $10 billion. There are also mid-cap funds that hold between $2 billion and $10 billion.

Small cap companies have historically done very well when compared to larger, more established firms. This might be because investors tend to favor the more established firms which usually pay dividends, which lowers both the risk premium and expected return, or possibly because the smaller companies have much more room for growth and expansion.

On the other hand, small cap stocks usually involve more risk and volatility and there is debate on whether or not they outperform larger companies on a risk adjusted basis.

I still choose to hold some small cap ETFs in hopes that they will continue to outperform in the future. I’m not too concerned with volatility because I won’t touch the funds for many years.

U.S. Domestic vs International

A U.S. domestic fund consists entirely of U.S. stocks while an international fund consists of stocks outside the U.S. (at least from a U.S. perspective). You may be surprised to learn that the U.S. stock market capitalization makes up only around 1/3 of the total world stock market capitalization. Therefore, it’s wise to diversify and hold stocks from many different countries.

Foreign stocks are often broken down into EAFE and emerging markets on the broadest scale. EAFE stands for Europe, Australia, and the Asia Far East, all of which are supposed to be indicative of developed first world foreign nations. In recent years, these countries have been highly correlated with U.S stocks.

Emerging markets are slightly less developed countries which tend to be more risky and less correlated to the returns of U.S equities.

There is a diversification benefit provided from adding as much diversification as possible in a portfolio.

Sector vs General Funds

A sector fund consists of stocks that are part of a particular industry or sector. For example, there are energy, health, precious metal, and telecommunication sectors. REITs, or real estate investment trusts, are another sector that investors can appreciate.

Holding a sector like energy involves more risk than just choosing to hold the entire stock market. This is easily understood because the entire market would include energy stocks. Choosing to hold a specific sector involves idiosyncratic risk, which means it doesn’t reward the investor for taking the risk.

REITs can be a nice addition to a portfolio because they represent an asset class (real estate) that isn’t as available inside the broader market. Holding and REIT index like the one provided by Vanguard should provide additional diversification benefits over time. I own both domestic and international REIT funds.


If you are just getting started, I know this can all be a bit overwhelming. Don’t worry, it gets easier. More importantly, you don’t have to be an expert to get started investing.

If you can’t tell, I like Vanguard a lot. If you want to choose your own investments, Vanguard ETFs are robust and entirely free to trade. Consider what I wrote above and find an allocation that works for you.

If you are brand new to investing and don’t want to mess with implementing the above advice yourself, we would recommend Betterment as the best robo advisor option in 2017. Betterment does have a few competitors for you to compare and the robo advisor space is constantly evolving. Robo advisors offer a low cost investment option that is ideal for those not wanting to DIY and for those who don’t want to be sold some product by a financial salesman.

How do you choose your stock investments? Let me know your thoughts with a comment below!


How Much Should You Think About Taxes When Investing?

This is a guest post from Eric Rosenberg, a finance writer at Personal Profitability, InvestmentZen, and other personal finance, technology, and travel publications.

In many cases, investment gains are measured in terms of small percentage gains. But just because you earned a gain on an investment doesn’t mean you get to keep it all. Outside of some special rules for retirement, healthcare, and college savings accounts, you have to pay taxes on your investment gain. With real dollars at stake, it is important to understand how investment taxes work before you get hit with a surprise bill. Read on to learn how it works and how you can plan for capital gains taxes.

Taxes on investment gains

When you invest, some investments may go up and others go down. When you earn a profit while investing, it is called a capital gain, and is taxed under rules called the capital gains tax. Prior to the Affordable Care Act, capital gains taxes were a little simpler. Today, there are tiers of capital gains taxes depending on your overall income and the age of investments when you sell and recognize a gain.

If you are single and earn up to $37,950 per year or married and earn up to $75,900 in combined household income, you don’t have to pay any taxes on long-term capital gains. Long-term is defined as an investment you owned for one year or longer. Above those income levels, the long-term capital gains tax rate is 15% up to $418,400 in annual income when single or $470,700 when married. If your income is above that, I’m jealous! But that also means you fall into the highest capital gains tax bracket of 20%.

In most cases, short-term capital gains are taxed at your regular income tax level. For example, a married family filing jointly earning a combined $70,000 per year falls into the 15% tax bracket. Short-term gains would be taxed at 15% for this family, while long-term capital gains would require no capital gains tax.

Because most families earn less than $75,900 per year, most families would pay no long-term capital gains tax. The remaining 38% of the population falls into the 15% or 20% category.

Capital Losses and Tax loss harvesting

If you do fall into an income range where you owe capital gains taxes, you have some options to save on taxes. The two most common options for most investors include capital losses and tax loss harvesting.

The IRS understands that some investments lead to profits and others lead to losses. Rather than charging taxes on gains and ignoring losses, tax regulations allow you to offset capital gains with capital losses. For example, if you have one stock investment that earns $10,000 in one year and another loses $8,000, you would have a $2,000 net gain and only have to pay taxes on the $2,000 profit.

This is a simplified version of opportunities to lower taxes through a process known as tax loss harvesting. With tax loss harvesting, investors can sell investments with a loss and re-buy a similar investment to capture the loss for tax purposes. Capital losses can accumulate and carry over from year-to-year, so capturing a loss this year can offset a capital gain next year.

Manual tax loss harvesting is possible, but far from simple. The best results from tax loss harvesting require a computer. Robo-advisors like Betterment and Wealthfront stand out from other investment apps because they make tax loss harvesting automatic. With automated robots handling this behind the scenes, you can capture more tax losses to offset capital gains.

Retirement and other tax advantaged accounts

But wait, there’s more! The tax rules above only apply to regular old investment accounts. These accounts are considered taxable, as there is no protection from capital gains taxes when investing in a standard investment account. There are other accounts, often offered by the same brokerages, that offer a tax advantage over a regular taxable investment account.

Some accounts shield you from taxation as long as your cash and investments remain in the account. Some account contributions are considered pre-tax and others are considered post-tax contributions. Here’s how they work:

Pre-tax contributions are made in accounts like a 401(k) through your employer or a traditional IRA at your brokerage. In these accounts, you do not pay any income taxes on the contributions you make to the account in the year you earn the income. Then, you can invest and watch your investments grow for decades without paying any taxes. When you withdraw during retirement, withdrawals are taxed at your new income tax rate, with is presumably lower in retirement than when you were working full-time.

Post-tax contributions are made in accounts like a Roth IRA or Roth designated 401(k). In this case, you pay income taxes on your contributions, but do not pay any taxes on capital gains or withdrawals in retirement. This type of account is best for younger investors with a long-time horizon before retirement.

Retirement accounts are the most common tax advantaged accounts, but they are not the only option. 529 college savings accounts offer similar rules to pre-tax accounts like a traditional IRA. Healthcare focused HSA accounts offer both tax free contributions and withdrawals, which is the best of both! With these accounts, you can plan better for capital gains taxes, as some are tax-free and others offer a very long-time frame before taxes kick in during retirement.

Plan for taxes but don’t let them dictate your investments

I was once discussing taxes with a friend who insinuated that people would want to earn less as tax rates increase. That is a ridiculous idea! I would rather earn an extra dollar and give 40% to the government than not earn the dollar at all! The same is true of capital gains taxes.

While taking advantage of legal strategies to lower your tax bill is a wise financial decision, taxes should not scare you off from investing or dictate your investment decisions. The only time I have let taxes change an investment decision was when I was just a few weeks away from turning a short-term gain into a long-term gain, lowering my taxes on that specific gain on an investment I already had. I have never bought or sold investments just for tax reasons, and most people that don’t have many millions invested are typically best off doing the same.

If you hit a hot investment that brings you hundreds or thousands of dollars in gains, it is a time to celebrate. Sure, you’ll pay a portion of that gain in taxes, but you get to keep at least 80%. With so much to gain from investing, do not let taxes scare you away. You have much more to gain than to lose, and paying capital gains taxes is proof of a winning strategy.

The next time you see an article with a scary headline about capital gains taxes, don’t let it cloud your judgement on investment decisions. Investments should be focused on a long-term strategy to grow your wealth over time. Taxes are a part of the equation, but are far from an obstacle to success.

The 2017 tax plan – A look at a single parent return

First, the disclaimer. The proposed tax plan has so few details that it’s tough to discuss its impact with any degree of accuracy. I accept that caution, but so should all the people who are flag waving supporters of this plan. Last time, I wrote how a couple’s taxes might be affected, now let’s look at a single mom’s taxes. This mom has a good income, $60K/yr, and was left, from a death or divorce, with 2 children. She has a house, worth $260K with a $210K mortgage, putting the payment at $1000/month, or 20% of her monthly income. Her itemized deductions total $19,124. This includes mortgage interest, property tax, state tax, and donations. With 2 children, she has $12,150 in personal exemptions, and ends with a taxable $28,716 and a federal tax of $3,845. The new plan/proposal? She gets a standard deduction of $12,000. Since her mortgage interest and donations don’t exceed this, she doesn’t itemize. Her taxes are simple, to be sure. 10% of the taxable $48,000, or $4,800. Nearly $1,000 more.

What we don’t know is what extras will be offered to families with children, all we have is the vague line, “tax relief for families with child and dependent care expenses.” Hopefully, this will help, but keep in mind, the current Dependent Care FSA (flexible spending account) benefit is lost when the child turns 13. If you think your child’s cost drop at 13, you don’t have kids of your own. And I am still looking at the line, “Protect the home ownership and charitable gift tax deductions.” Home ownership, not interest, which again, gives us just enough ambiguity if the property tax deduction remains.

Can You Afford to Buy a Home?

Today, a Guest Post from Crystal –

Purchasing a home is a very real investment and there are a number of factors which need to be addressed. This involves much more than your financial liquidity alone. Let us take a look at some external variables which should be carefully considered well in advance. You will then be able to make the most appropriate decision when the time is right.

All About the Location

Every state is associated with its own set of housing prices. Mississippi, Indiana, and Michigan are currently the three cheapest states in terms of these costs. For instance, the median home value is Mississippi is $120,000 dollars. This is markedly lower than the nationwide average. However, this needs to be taken with a grain of salt. The average yearly salary within Mississippi is approximately $35,000 dollars; much lower when compared to areas such as New York or California. The other major concern is whether or not the state is a good state to live in. Cost of living, access to healthcare and average lifespans will naturally differ. Those states which offer the cheapest housing are often associated with lower values of these variables.

Fixed or Variable Interest Rates?

One of the benefits associated with choosing fixed interest rates is that they can make it easier to afford a home. However, this is assuming that predominant rates will rise. The other option is to opt for variable rates. The benefit here is that should these rates fall, your mortgage will not be as expensive. Still, rising rates may cause you to pay more than if you had selected a fixed plan. This is the reason why it is important to predict the long-term status of the interest rates set by the Federal Reserve.


Domestic politics will also play an important role. An example of this can be seen in the recent tax plan unveiled by the Trump administration. The president has campaigned with a pledge to reduce the overall tax burden on consumers and if he does indeed revitalize the domestic economy, this could prove beneficial in terms of house prices (as well as rises in average salaries). However, we have yet to see whether or not his proposals will become a reality. He still faces strong opposition from the democratic party and a tranche of his own supporters.

Potential Incentives?

From a general perspective, the single population tends to have more difficulty in purchasing a home due to a lack of a secondary income. Married couples and those over 50 years are generally associated with more available liquidity. Regardless of which applies to you, there are several incentive programs to consider. For example, the Federal Housing Administration (FHA) can provide you with a one-time loan. The Department of Veterans Affairs (VA) has similar packages in place if you served in the military. Some other options worth considering are:

  • The Good Neighbor Next Door program (for police personnel, firemen and teachers).
  • Fannie Mae and Freddie Mac loans.
  • Energy Efficient Mortgage (EEM) programs.
  • Local first-time buyer offers through banks and lending institutions.

It is always a good idea to research these in more detail.

The Overall Housing Market

From a general point of view, the United States housing market is considered to be quite strong when compared to a handful of years ago. This could signal that prices will rise. However, the market tends to follow the movement of salaries and other benchmark indicators. Many predict that the this sector will continue to perform well in the coming years.

The 2017 tax plan – A quick look at the impact to a couple

The daily press briefing was held last week and a new proposed tax plan was part of that briefing. What’s strange is that even less was revealed as compared to the details offered during the campaign. This is part of the one-pager that was handed out, the part that discusses individuals. I’m in favor of simplification, but also concerned about unintended consequences of how specific bits of the tax code affect the individual. The first thing I heard, and the sheet confirms, is that the standard deduction will be doubled. I won’t quibble over the use of ‘double’ when the current standard deduction is $12,600 for a couple, and they said $24,000 in the new plan. What continues to disturb me is what would be dropped. The plan says “home ownership,” which to me is both mortgage interest and property tax, yet, in the Q&A they only said mortgage interest.

The new standard deduction would certainly eliminate the need to itemize for a good number of those who do, but at what cost?

I mocked up a 2016 return for a couple. A professional couple, both with college degrees. Their combined income after their 401(k) deduction is $100K. Their itemized deductions start with the house, $16,000 in mortgage interest, and $8,000 property tax. Their state tax is $3427, and $10,000 in donations. This accounts for their Itemized deductions. They also have $16,200 in exemptions. Net taxable, $46,373, and a tax bill of $6,029.

Now, let’s consider, what we know of the new tax plan. No exemptions, no property tax or state tax deductions. They get to deduct their $16,000 in mortgage interest as well as the $10,000 in donations. This results in a net taxable $74,000, and even though we don’t know more than “3 brackets, 10%, 25%, 35%,” let’s hope for the best and assume the 10% applies up to the $75K first discussed last year. A new tax bill of $7,400.

A few points. This couple had nothing handed to them. In 2015, the average starting salary for college grads was $39,045. If this couple met at school, and their degrees were in STEM (science, technology, engineering, math) they could have started at $110K, combined. Instead our couple is out of school 10 years and has 2 kids. They saved to put 20% down on a $500K house, which is above the country’s average, but not high considering their proximity to the city.

I’ll be the first to say that I understand there may be little sympathy for a $100K couple, but this is just an example.

The $10/hr couple (or $40K/yr) with 2 kids used to have the same $16,200 exemption, plus a $12,600 standard deduction. They paid tax on $11,200 for a tax bill of $1,120. (I know, I ignored child tax credits here, so they may be at $0), but under the new plan, will be taxed on $16,000, for a $500 increase (we don’t know what the child tax credit will be in the new tax code, we only have the one-pager.)

It’s safe to say that repealing the ‘death tax’ won’t help the average American. This tax is likely to affect .2% of estates, that’s just 1 in 500. A couple would need to have assets worth $10.98M on their death before paying a dime in the estate tax. Those who want to eliminate it are the rare top of the economic ladder. Keep in mind, a couple worth, say $10B would pay a tax of nearly $4B. It would take a million families to pay an extra $4,000 to make up these lost taxes. Crazy to just eliminate this.

As we get more details, I’ll offer more analysis of how these changes might affect wage earners at different levels.


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