Stocks vs. Mutual Funds. Which is Better For Me?

Why? Simple: You are not Superman. Nobody is. And you aren’t going to get any real market advantage over the professional investors by watching CNBC Squawk Box and Cramer. By the time information gets on TV, the smart traders have already acted on the information, and you’re going to get what’s left over.

You’re going to make your share of investing mistakes – and if you are very, very good, you may well be able to match the returns of the S&P 500 over the course of your investing lifetime.

If you do, bear in mind – even if all you do is break even with the S&P 500, after all your expenses, you are already outperforming the substantial majority of all professional stock mutual fund managers. These with sophisticated computer programs, discounted institutional broker pricing, and full-time staffs of very smart and highly-trained analysts at their disposal.

The problem with the middle-class investor and buying individual stocks is this: Few investors have a portfolio large enough to efficiently buy enough different stocks to adequately diversify their portfolios against the unpredictable and uncontrollable. Buying blocks of under 100 shares (what brokers call “odd lots” is costly, in terms of commissions, and you get tagged with invisible costs, such as bid-ask spreads, that you will never see, but which conspire against your returns.

It’s only when you get to portfolios of $1 million plus, or close to it, that we really have a lot to work with, when it comes to trying to build a single-stock portfolio from scratch.

Does that mean individual stocks have no place in your portfolio? Certainly not! Here’s where individual stock ownership can really play a beneficial role in your portfolio:

• Your employer provides a 401(k) match, profit sharing, ESOP or other equity incentive. If it’s free money, take it!
• You are tax sensitive and want to be able to use ‘tax harvesting’ strategies to control your capital gains exposure. Specificially, if you have several different stocks, and you need cash from your portfolio or you need to make some changes, you can sell some stocks at a loss to offset any taxable profits. This is going to be more important if the capital gains taxes increase from 15 to 20 percent, as they are scheduled to do in 2013.
• You have maxed out your IRA, 401(k) and other tax-deferred or tax-free savings and investment contributions.
• You are participating in a well-designed and constructed DRIP, or Dividend Reinvestment Program, which helps you avoid some of the costs associated with buying individual stocks.
• You want to own stock in a company or industry that tends to do well when your company or industry does poorly. For example, if you worked for a buggy whip company in 1905, it would have been wise to hedge your bets by owning some stock in Ford.
• You have some unique knowledge of a company or industry – legally obtained, of course – that gives you an advantage even over professional Wall Street analysts and sophisticated, professional investors.
• You love the process of investing and you truly enjoy the hunt.
• You can afford to lose 50 percent or more on your entire stock portfolio, and you can afford to watch any one of your investments go completely bust overnight, and not break a sweat.

Do you fall in one or more of the above categories? Then let’s talk about forming a coherent risk management and investment strategy that balances the downside risk against your objectives and your overall portfolio and situation.

Are you in the “none-of-the-above” category? Then let’s stick to funds and index funds, and balance that against your cash savings picture, your insurance plan and your various sources of income – be they from labor, small businesses, passive activities, real estate, or anything else.

Unconventional Investments in IRAs

As a result, people have been hungry for ideas on how to find better potential returns while still keeping the tax advantages of IRAs. And, naturally, lots of planners, advisers, brokers, accountants, attorneys and other folks have been moving to fill the gap.

Here’s how it works

The IRA was first defined by the Employee Retirement Income Security Act of 1974. The law set some strict limits on how much money you could earn and still take a tax deduction for IRA contributions. But the law didn’t place many limits on what you can invest in. In fact, the only limitations on what you can buy in an IRA are these:

• You can’t buy life insurance in an IRA
• You can’t buy art, jewelry or other collectibles.
• You can’t buy alcoholic beverages.
• You can only buy gold and other precious metals that meet certain standards for purity and standardization.

There are also some other rules against self-dealing or using your IRA for your own personal convenience or to enrich certain relatives or fiduciaries advising you on the plan. Other than that, you can own just about anything you can imagine in an IRA, including these popular asset classes:

• Real estate
• Raw land
• Farms and Ranches
• Small, closely-held businesses
• Private lending securities
• Private equity
• Tax deeds and tax liens
• Foreign investments, including real estate
• Commercial property
• Hard money lending and bridge loans
• Mortgages

Currently, only about 4 percent of all IRAs are used to invest in these kinds of assets, via a special arrangement called a “self-directed IRA.” Basically, you hire a third-party administrator to act as a trustee for you and hold your IRA assets on your behalf. Naturally, you pay them a fee to do so. You just identify what you want to invest in, and you provide your administrator with written, specific direction on what you want your IRA to buy or sell on your behalf.

Is it a good idea?

Well, that depends a lot on the individual situation. Allocating a portion of your IRA to these kinds of assets may make sense if you want to diversify your assets away from stocks, bonds and funds. Most of the assets in the categories above are not closely correlated with the major stock and bond indexes, such as the S&P 500. So they can possibly add quite a bit of diversification benefit, as part of a balanced portfolio.

They also may make sense if you have substantial professional expertise and access to a ready market in any of these arenas. If you have been investing in real estate all your life, and you are simply a much better real estate investor than you are at picking mutual funds, and you believe that leverage is your friend, it makes just as much sense to concentrate on real estate inside your IRA as it does outside your IRA.

Things to Be Aware Of

Once you get down to the brass tacks of execution, there are a lot of rules to be aware of. Running afoul of them could cause the IRS to disallow your IRA. This could result in immediate income tax liability and penalties if you don’t watch yourself.

Not every self-directed IRA planner has the same experience. There’s a lot of case law and private letter IRS rulings that affect how you must handle self-directed IRA transactions, and these are not common knowledge, even among many financial professionals. If you get some bad advice from them, it’s still you that will have to pay the price.

Liquidity is a huge issue with these kinds of accounts. Remember, you can only contribute $5,000 in new money to an IRA in any given year. Which means if you own a home in your IRA, but have little cash, and you need to buy a new roof for $30,000, you are in a tough spot. You can only add $5,000 in cash. You will have to borrow the rest.

You can borrow to fund your IRA investments – including purchasing assets, or maintaining them, as long as you don’t borrow from yourself or a related party (as defined by the IRS in Publication 590), and as long as the loan is a non-recourse loan. That means the loan must be secured entirely by the IRA itself.  In practice, you will only be able to borrow about 65 percent of the purchase price of any asset within an IRA. Your IRA will need to put up about 35 percent equity, so you can’t leverage up the same way you can when you buy residential property outside the IRA and cross collateralize.

Also, if you do borrow within your IRA, you will find that your tax-deferred growth isn’t completely tax deferred at all.  Your IRA will be assessed a special tax called an “unrelated debt income tax” or “unrelated business income tax.” This is just a tax assessed on any profits or income to the IRA attributable to non-IRA (i.e., borrowed) money.

The $5,000 window is a very tight one, unfortunately. You can, however, mitigate that by placing these assets in a self-directed SEP IRA account, with a maximum contribution of $49,000 per year or 25 percent of your compensation, (depending on your employment/self-employment status) or a self-directed 401(k) plan.)

If you use any tax-deferred vehicle, though, you also need to be mindful of required minimum distributions (RMD) later in life. You need to be able to start taking actual income out of the IRA by April 1 of the year after the year in which you turn 70½. So if you get caught with a big, indivisible and illiquid asset, such as a house, and not much cash, you could find yourself painted into an RMD corner.

If you are considering using a self-directed IRA, it’s certainly worth making an appointment and discussing it with us in more detail, in the context of your overall financial situation.

Investing DRIP by DRIP

DRIP Basics

Continuing with our ‘dividend investing’ theme, I’d like to talk a bit about DRIPs. The term “DRIP” stands for “dividend re-investment plan.”  In a recent column, we discussed the concept of stock dividends. In a nutshell, when a company has excess operating earnings, they can choose to reinvest those earnings in the company (by buying inventory, upgrading technology, paying down debt, making acquisitions, etc.), or they can return that cash to the shareholders in the form of dividends.

In their purest form, dividends are paid to shareholders by check, or the equivalent amount of cash is credited to their brokerage accounts.

Companies that offer DRIP plans, however, do something a little different: Instead of sending DRIP participants a check, they will simply credit them with as many shares, or fractions of shares, as their regularly scheduled dividend will buy. DRIP participants generally don’t purchase shares from a broker. Instead, they buy shares directly from the company’s department of investor relations, or from a transfer agent.

Advantages

You can usually start a DRIP plan with a company for a very small amount of money – sometimes as little as a single share. DRIPs can be good for smaller investors, because their dividends may not otherwise be big enough to do anything with: Not enough money to buy more shares with, efficiently, and not enough to make it worthwhile to keep around in a money market fund.

For this reason, DRIP programs can be good for those with smaller accounts, who still want to hold individual securities. They allow a way for very small investors to dollar cost average small amounts of money into company shares, often without having to pay onerous brokerage commissions, which can be very inefficient for very small transactions.

They can also be very good gifts – for example, a grandparent can “gift” a very young child a few shares in, say, Campbell’s Soup. Campbell’s will continue to issue dividends, of course, but the cash will be credited to the child in the form of additional shares or fractions of shares. The parent and grandparent can teach the child the basics of investing through ownership of a company that the child can understand.

If you want to scale up, it is quite possible to build a portfolio consisting of dozens, or even hundreds of companies that sponsor DRIP programs – building up a sizeable investment portfolio, but with generally lower commissions, fees and expenses you would associate with mutual funds and brokerage accounts.

This is a laborious process, though, in practice – so it’s best suited for true DRIP aficionados.

You also have the advantage of a lot more tax planning flexibility than you would get in a single mutual fund. For example, you can manage your exposure to capital gains taxes by selling money losers along with winners, to the extent practicable. Capital losses cancel out gains, thus lowering your capital gains tax bill – a practice known as “tax loss harvesting.”

Disadvantages of DRIPs

Any dividends you receive are taxable – normally as qualified dividend income, if the companies are qualified U.S. companies. This is true, even if you don’t personally receive a check. The company will issue you a Form 1099-DIV, and you must declare this as qualified dividend income on your taxes.

If, instead, you elected a company that didn’t generate dividends at all, but instead reinvested all of its earnings back into the company, you would be able to defer those taxes until such time as the company did issue a dividend (Meanwhile, Uncle Sam still gets a cut if you sell shares at a profit, in the form of a capital gains tax, except in retirement accounts).

As a practical matter, DRIPs don’t function well in IRAs, because you need a formal custodian to hold assets within IRAs. There are ways to do it by opening up a self-directed IRA account with a third-party administrator, but that probably only makes sense as part of a larger self-directed IRA strategy. More on those in a future column!

Those on limited budgets who use DRIPS are also taking on quite a bit of individual security risk. Companies can and do go out of business from time to time, and shareholders can potentially by wiped out. If you don’t want to bet the whole caboodle on one company, there are also mutual funds that accept relatively low minimums, if you commit to a monthly amount in a retirement plan. This will instantly diversify your holdings among dozens, hundreds and even thousands of companies, in some cases – and they will also reinvest your dividends for you in the form of fund shares.

This could be a better solution, depending on your budget, risk tolerance, and overall situation. If you want to know more about either DRIP plans, or options for low-minimum mutual fund investing, please give our office a call. We would love to work with you.