Thursday, April 2, 2009

Comparison of TAXES, COSTS, AND RISKS of investing in STOCK INVESTMENTS and BONDS

To find the actual historical performance of stocks, we must reduce the stock returns by three elements: taxes, transaction costs, and bad timing.


1. Taxes. Individuals are subject to federal and often state and local taxes on income as well as on dividends and capital gains. If stock is held in a stock fund and the fund trades its stock a great deal, some or all of the reportable gains may be treated as short-term capital gains, which may be taxed at ordinary income rates. The outcome is the same if an individual holds his stock for one year or less before its sale.

2. Transaction Costs. Individuals must pay transaction costs to buy and sell stocks including commissions on individual stocks, managed account fees, and management fees and other expenses on stock funds. "It's fair to estimate that the all-in annual costs of equity fund ownership now run in the range of 2.5 percent to 3 percent of assets," says John Bogle, founder of the Vanguard Group of mutual funds.
William Bernstein examined fund management fees and reported the following in the April 2001 issue of Financial Planning:
 The average actively managed large-cap fund has annual fees and expenses of about 2 percent.
 The average small-cap and foreign fund has annual fees and expenses of about 4 percent.
 The average microcap and emerging market fund has annual fees and expenses of almost 10 percent.

3. Bad Timing. The most costly element of all is the buying and selling habits of individual investors. Investors are generally emotional in their investment choices and often have an atrocious sense of timing. They tend to buy into the stock market when it is hot after it has gone up a lot. They often lose their nerve and sell after a severe decline. Making money in stocks requires making two correct decisions: when to buy and when to sell. "From 1983 to 2003 index funds tracking the Standard & Poor's 500 index returned 12.8 percent and the average mutual fund gained 10 percent annually," says Michael J. Mauboussin, a strategist at Legg Mason Capital Management. "Meanwhile, the average investor earned only 6.3 percent annual returns." Mauboussin attributes this seemingly impossible result to poor "market timing" and "the extraordinary proclivity for investors to invest in the wrong place at the wrong time."

By taking a savvy approach to bond buying, you can minimize your taxes, limit your expenses, reduce your risk, and increase your profit. But let's first examine the taxes, costs, and risks of investing in bonds.

1. Taxes. If you are in the 25 percent tax bracket or higher, the impact of federal and state income taxes is generally large enough to indicate that you should purchase tax-free municipal bonds for your taxable nonpension account. By purchasing municipals, you avoid paying federal income tax and possibly state and local income taxes as well on the interest income. Though the interest rate on municipals is lower than the taxable rates, after taxes you will come out ahead. Tax-free municipal bonds provide the best legal tax shelter available to individual investors.
Many taxpayers are now subject to the alternative minimum tax (AMT), which is pushing more taxpayers into paying higher federal income taxes. Municipal bond interest is not subject to the AMT, except for the interest income from the municipal bonds called AMT bonds. If you are in a lower federal income tax bracket in a high-tax state, consider purchasing Treasuries, home-state taxable munis, and certain agency bonds that are exempt from state and local income taxes, but not from federal income tax.

2. Transaction costs. The cost to purchase a bond is called the "spread," which is the difference between the price that the broker paid for the bond and the higher price at which he sells it to you. In addition to a spread, discount brokers may charge you a fee for service. Discount brokers don't save you money in the world of bonds. However, if you buy a bond on its initial public offering, you will receive an institutional price—the best possible price. If you hold an individual bond until it comes due, there are no further transaction costs.

3. Risk. With highly rated bonds, you have no significant loss of principal to worry about as long as you hold the bonds until they come due at their face value. We believe that in a comparison of stocks and bonds, highly rated bonds should be given a significant premium over stocks because these bonds are safe, dependable, and pay a steady rate of interest that can be counted on.

4. Bad timing. The risk of bad timing is small if you hold your bonds until they come due because every bond comes due at its face value, no matter what the price fluctuations might be before its due date. Keep records of your bond purchases so that they are recorded at face value, rather than adjusting their value every month as valued on your brokerage statement. If you keep your bonds recorded at face value, you will be less likely to sell your bonds before
they come due and make a market timing mistake.



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