What is a Fund?

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Most people have heard of a fund. Mutual fund is the most common kind, exchange traded funds (ETF, for short) are close behind.

What you want to understand about a fund, is that it can be made of anything. A fund is really just a sort of holder for actual investments that the fund owns.

When somebody tells me their investments are in “mutual funds”, this doesn’t actually tell me anything about the types of investments they have. A mutual fund can own stocks, bonds, a particular sector, particular geography, you name it.

Similar to stocks, it helps to know why they exist to understand them. Back in the days before Robinhood, it cost a lot to buy shares of stock, and often you had to buy a “round lot”, 100 at a time. This was onerous and expensive, and with information about stocks hard to come by, assembling a portfolio was difficult and expensive.

Enter the mutual fund. A group of people pool their money to buy many different securities, usually stocks and/or bonds, and to have a manager manage it. That’s all it is.

You can have a fund that buys the 500 biggest US companies, and that’s all it does, or you can have a fund where the manager is trying to outperform a target (usually called the “index”). You can have a fund that only invests in biotechnology, or a fund that only invests in bonds from Japan.

A fund is just a convenient way to own a whole bunch of things at once.

What is a Stock?

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A lot of people get intimidated talking about stocks, but I’ve found that most people fundamentally know what a stock is: a fractional ownership in a company.

Things start to get a little fuzzy from there, so I like to first talk about why stocks exist as we know them today. This won’t be a history lesson about joint-stock companies, but rather why you can even buy shares of McDonald’s or Nike in the first place.

Imagine you own a company that sells books. Hard to believe. Pretty soon you are selling a zillion books and making great money, and reinvesting all of that money back into your book selling company. But now, instead of just selling books, you’re selling everything. And people are buying it, and you’re making even more money.

Now, if you want to sell some or all of your company to someone else, you can. But you’ve gotta find a person and make a deal. Far better if you can just sell some to anyone that wants a piece.

Why would you want to sell? Maybe you want some cash now for yourself or your family. Maybe the selling business is great now, but who knows if it will last forever? Maybe you want to get some cash to reinvest in the selling business. It doesn’t matter: if you want to trade a piece (i.e., a share) of your company for cash, you need to sell stock.

Different countries have come up with standards that a company must meet in order to be able to trade shares on public exchanges. They are mostly built around transparency and reporting requirements. If you are going to be able to sell your shares to Joe Public, you have to at least open your books to him.

But I digress. You’ve sold some shares. What now?

Now the owners of all of the shares are entitled to their share (pro-rata) of the profits of the company. When you own stock, you own equity. However, that puts you last in line for those profits. Have people you borrowed money from? If the company stops making money, they have first dibs on the stuff it owns. Risky.

So you own something that might have some nice returns, but if it does poorly, the value could potentially evaporate. So why buy it? Well, at some point the price reaches a level where the future returns the investor expects are enough to compensate him for the risk. So he buys.

When you buy stock, you are literally purchasing a fractional interest in the company. If you buy all of the stock, you own the entire company. That’s actually how it works.

So to recap: stocks are part ownership in a company. They are risky. You buy them because you expect them to have good future returns.

 

The Savings Hierarchy

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By the time people get into their 20s and 30s and have figured out how to live within their means, they usually arrive at a daunting question: Where should I save my money?

In general, there is a hierarchy of where you should save.

#1 is to get your 401(k) (or 403(b)) match if your employer offers one. It’s very unlikely that this isn’t the best use for your savings because you’re getting an immediate return from your employer.

#2 is where it starts to get tricky, but for me, the next priority is an emergency fund. Everyone’s emergency fund needs are different, but 3 months of expenses is a good place to start.

#3 some might flip this with #2, and depending on the specifics, I might agree. Pay down your high interest debt. What’s high interest? Anything over 8%. Maybe even 6 or 7.

#4 if you have an HSA, max that out, the limit isn’t even that high. If you make the contributions direct from your paycheck, you get to avoid payroll taxes.

#5 max out your Roth IRA. The limit is $5,500 per year, if you really needed to get at it, you could probably withdraw most of it without penalty. It’s money that will never be taxed again, and you’ll probably end up with much more pre-tax money than Roth money in retirement.

#6 head back to the pre-tax retirement account (401(k) or 403(b). Tax deferral is worth a lot. There’s a decent amount of room here; $18,500 per year as of writing. You may want to skip to the next before maxing it out if you have goals earlier than retirement.

#7 taxable investment account. This is apparently the best kept secret in personal finance. You’d be amazed how many people don’t realize you can take cash that would otherwise be in your checking or savings account and invest it in stocks, bonds, or funds. If you’re a high earner that needs to save a lot to get to retirement, you’ll need to get familiar with how this kind of account works.

If you can get all the way to the point where you get your 401(k) match, have an emergency fund, have no high interest debt, max your HSA, max your Roth IRA, max your pre-tax retirement account, and are saving in a taxable account, congratulations. You’re probably crushing the retirement checkpoints.

Changing Your Brain, Tax Season from the Inside, Donor Advised Funds, and more w/ Jeremy Runnels and Kevin Bruns [Episode 4]

On this pod I’ve got Jeremy Runnels, CFP, talking about the fiduciary rule, quantifying the value of tax deferred accounts, how the choices we make literally change our brain.

Then I’ve got Kevin Bruns, CPA, to talk about what tax season is like for an accountant, the effects of the new tax law, and a buck hunter segment on donor advised funds. The audio gets a little louder at 29:10 when Bruns’ segment starts.

Special thanks to the Kitces.com weekend reading for the h/t on the articles Jeremy and I discuss.

Topics and Timestamps:

0:30 Jeremy Runnels on the fiduciary rule.

7:30 Quantifying the value of tax deferred accounts.

14:15 Changing your brain with decisions.

17:40 Predictive Processing

21:20 Kitces Pod Jeremy mentions.

29:10 Bruns comes in — warning, the audio is a little louder here.

30:00 Tax Season from an accountant’s perspective.

35:50 Practical effects of the new tax law.

38:35 Buck Hunter segment on Donor Advised Funds.

 

‘Merica, billable hours, tax cuts, and Traditional vs. Roth w/ Kevin Bruns [Episode 3]

Kevin Bruns, CPA, is back for another episode. We have a special treat, a new segment, Buck Hunter.

Topics & Timestamps:

0:40 – ‘Merica and Health Outcomes

8:30 – Billable hours, hourly vs. retainer vs. AUM at professional service firms

28:15 – Tax bill effects plus tax blog discussion

42:00 – Organization structure at professional service firms

51:22 – Buck Hunter – Traditional vs. Roth IRA/401(k) contributions

Links:

In case you forgot about shithole countries: https://www.washingtonpost.com/politics/trump-attacks-protections-for-immigrants-from-shithole-countries-in-oval-office-meeting/2018/01/11/bfc0725c-f711-11e7-91af-31ac729add94_story.html

Health Outcomes: https://www.forbes.com/sites/theapothecary/2011/11/23/the-myth-of-americans-poor-life-expectancy/#699b20e02b98

Tax Foundation blog: https://taxfoundation.org/

Rita Keller blog: http://ritakeller.com/

More on Roth vs. Traditional Contributions: http://evenlyoddly.com/tax-diversification-to-roth-or-not-to-roth/

Counterfactuals and Investment Home Runs

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On my post this week over at evenlyoddly, I introduced the concept of counterfactuals.

Here I’m going to talk about some of the problems that contemplating counterfactuals can create for your portfolio.

I’m a lucky guy when it comes to observing how people interact with their portfolios. I get to talk to clients who used to manage their own portfolios in an endless variety of styles. Many of those clients even keep a small account for their trading and enjoyment. And many clients who trust us with the management of all of their money still want to talk about the hottest topics in the market.

Now, any client that isn’t talking to me for the first time probably knows deep down that I’m going to say that most of the market’s short-term moves are as close to random as to be indistinguishable, and that most of the headlines claiming causality are nothing more than two things that happened at the same time being blamed for each other.

So believe me when I say, the most common mistake I see people making is thinking about the investments they could have made – Amazon in 1997, Apple whenever, Bitcoin at $7K.

Their mistake and conceit is two-fold:

1. Not realizing that they would almost certainly have already sold if they found it to begin with. See the below graph showing the amount you would have been down at some point each calendar year from a high earlier that same year. I find it hard to believe that our investor is hodling through all of these.

source: author’s calculations, with credit to Michael Batnick, whose numbers I can confirm.

2. Not realizing that the question isn’t about picking the next winner, it’s about changing their whole decision making process so that it makes them more likely to pick the next big winner – much harder, much subtler. They are probably not considering that a strategy change aiming to hit more home runs is also prone to more strikeouts. And perhaps a worse WAR in the long-run.

Most commonly, people imagine a world in which they bought whatever the asset is at the best possible time, and are selling it right now, whenever that is, and can do all of the things that would make them happy with that new-found wealth.

The problem is that this world they are imagining doesn’t exist. If we imagine that 10 out of 10,000 possible versions of a particular investor (perhaps you) bought Amazon in 1997, 9 of them probably sold in 2001, and the other one probably continues on to invest recklessly and manages to lose the fortune shortly into the future.

There is no counterfactual world where the investor’s fantasy of having bought in 1997 and sold today and everything else stayed the same is a coherent story.

 

 

Memes, Brain Warmups, and Roth Conversions w/ Kevin Bruns [Episode 2]

Kevin Bruns is back to talk memes, tv, books, warming up your brain, when to best answer emails, taxes, and more.

Topics & Timestamps:

1:10 Foreign Accents

2:05 Netflix & TV Shows

2:50 Internet & Memes

9:15 Books (Taleb)

10:05 Frisbee Interlude

13:00 Brain Warmups

29:40 Taxes (Roth, DISC)

34:05 Scott Sumner Post

36:30 Philippines Lose Major

Links & Notes:

Internet & Memes:

Books:

Taxes:

Link to Kitces

I used the word “sell” with regards to putting the DISC in the Roth, that’s probably not the correct terminology.

Scott Sumner:

Why is Inflation so Low?

Also mentioned: EconLog

Philippines:

Valve Pulls Major

Chinese Censorship

 

Buck Talk – Episode 1 with Kevin Bruns

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Topics & Timestamps:

0:40 Social Security Trustees Report: https://www.ssa.gov/oact/tr/2017/VI_F_infinite.html#1000194

http://www.heritage.org/social-security/report/misleading-the-public-how-the-social-security-trust-fund-really-works

6:00 State Lotteries (which suck)

11:15 2018 Tax Changes

  • Charitable Gifts
  • Property Taxes
  • State Tax Deduction

https://www.forbes.com/sites/timtodd/2018/01/05/substituting-charitable-contributions-for-state-taxes/#69361c8c2279

Cliff Asness:

21:45 Roth IRA for Tax Diversification

23:30 Corporate AMT

26:00 Interest Deductions

31:40 Property Taxes

34:20 Casualty Losses

35:00 Gambling Losses

36:35 Charitable Deductions (cash, appreciated stock, QCD)

37:45 Season Tickets & Stadiums & Sports Teams

43:00 CRUTs

48:15 Educator Deduction

49:45 Schedule C Story

52:45 Itemizing Deductions