Long-Term Investing; a Fresh View of an Old Topic

This is Part 4 in a free five-part training series on personal finance. The other parts of this course are coming soon. If you’d like to be notified via email when they become available please click here and register for updates.

In the first three parts of this series, we worked hard to make some improvements in how we think about money and debt. That was followed by some practical action steps.

Using the analogy of a leaking bucket we addressed the potential holes through which our financial resources may flow. 

We considered credit cards and consumer debt, insurance, mortgages, and taxes.

Then on to the contingency fund idea, and retirement accounts.

The Long-Term View

Spike was an aged English Cocker Spaniel.

Every day he would attempt to dig under our backyard fence to meet up with his buddy the Airedale.

No vacations.

No let up.

Dig, dig, dig, every day.

We tried to block the base of the fence with bricks and sticks.

Then with stakes driven in the ground.

Eventually, he always found a work-around.

As a kid, I marveled at his energy and single-mindedness.

He had a clear vision of what he wanted and then pursued it relentlessly.

When you consider how to invest your Financial Freedom money, be like Spike.

Keep the intended outcome clearly in your mind.

This investing is, “Long Term.”

And because it is long-term it must be handled with the appropriate philosophy and techniques.

If you were in the market to purchase a home what factors would be significant to you?

Square footage, quality of construction, schools, shopping, crime rate, nearby homes, neighbors, or churches might all be on your research list.

Because living in a home is usually a relatively long-term proposition you would be most concerned with questions having to do with long-term factors.

Certainly, you would not go house shopping with a short-term list.

You would not look at a prospective home choice and make your decision based on the weather that day?

The color of flowers in the front yard planter would not make a large difference to your decision, would it?

Yet, when looking at long-term investments most people employ short-term criteria.

In the case of buying stocks, funds, or other investments, too many are swayed by price-performance last week or last quarter or what is on the news or social media.

Such short-term information should have little bearing on what you invest in.

What you read in a newspaper article, see on the news, or hear from a well-meaning relative or friend should have no sway over your decision process.

Be like Spike.

He held to his dream and never let up.

Now That I Have a Few Bucks in My Retirement Account, What Do I Do?

Well, let’s get this much straight. 

The money we are now talking about is what will to varying individual degrees, fund your eventual Financial Freedom. That makes it sacred money in a certain sense.

This money will not be used for anything other than its intended purpose.

It is earmarked.

Spoken for.

Already committed.

Sure, one can legally withdraw cash from a retirement account early, as long as she or he is willing to pay the penalties imposed by the IRS.

Many folks do.

But, doing that is like using the furniture in your house for firewood on a cool evening. 

By the way.

The IRS charges a cool 10% on the money taken out of an IRA before age 59 ½. On top of that the money withdrawn is added to gross taxable income. In the same situation, with a Roth just the 10% penalty applies.

Do Not Take Money Out of Your Retirement Account Until You Are Retired

And then only if you need it or are required to for required minimum distributions (RMD’s).

You may find by the time your reach retirement age that because you have no house payment or consumer debt, are receiving social security, pensions, income from rentals, annuities, dividend payments from stocks in non-IRA accounts, and so on; that taking regular distributions from your IRA accounts is not necessary.

Oh, happy day!

Whether you need to draw down your adequately funded IRA’s or not at retirement is a fine choice to have.

About 25% of adult Americans have no retirement plan or account in place at all.

Now that that’s straight, we’ll get back to the question at hand.

How Do You Invest the Money that is Accumulating in Your Account or Accounts?

Once money has been added to a self-directed retirement account you have the ability to choose which investment vehicle or vehicles you’ll employ.

Some of your long-term investment choices are as follows:

    • Stocks
    • Bonds
    • Mutual Funds
    • Master Limited Partnerships (MLP)
    • Exchange-Traded Funds
    • Money Market Funds
    • Certificates of Deposit (CDs)
    • Precious metals
    • Cryptocurrencies
    • Options
    • Real Estate
    • REITS
    • Others like CEF’s, BDC’S, and so on.

Because a number of these investment products may be offered by various institutions such as banks, credit unions, fund companies, and brokerage houses, deciding where to keep your account becomes the first decision in the process.

I recommend strongly that you consider placing your IRA or other retirement account with an online broker such as E*TRADE, Schwab, Fidelity, TD Ameritrade, or the like.

These institutions provide you with the ability to choose how to invest your money from the preceding list and beyond.

An IRA held at a bank will generally have far fewer investment options and likely higher fees.

Because the scope of this course cannot include detailed explanations of the many investment vehicles, I will give you a synopsis of the major contenders.

If these capsulations are too basic for you, please consider it a review.

9 Long Term Investment Strategies to Consider

#1 – Common Stock

Boiled down to the essence of the matter, a share of stock is a security that represents a small piece of ownership in a company.

For the company issuing stock, it is a way to raise capital to invest in their business.

For the shareholder the expectation is that the company will grow and prosper, increasing the value of its shares.

After all shares of the initial offering have been sold to investors the company does not receive further money from stock investors unless they issue another stock offering.

That is, if you buy a share of Apple stock today none of the price you paid goes to Apple. You are actually taking part in a secondary market made up of people and institutions that trade the shares back and forth.

This provides an interesting question for those who may choose to avoid buying shares in a certain company due to their own sensibilities. An example of a company that is frequently targeted in this context is Altria (MO) the maker of cigarettes and other products.

If you buy a share of MO are you actually taking part in providing tobacco to others?

An interesting question to consider at another time.

#2 – Preferred Stock

This form of stock entitles the holder to receive a fixed dividend.

The payment of these dividends takes priority over common stock dividends that may be present on the common stock of the same company.  Dividends associated with preferred stock are typically higher than common stock.

Preferred shares are more “bond like” in that the dividend is an agreed-upon rate that does not change as may happen with common stock.

Some investors in the later portion of their investing careers view preferred shares as part of the fixed income portion of their portfolios, or middle ground between fixed and growth investments.

Preferred shares in general have lower volatility than common shares but higher volatility than bonds.

#3 – Bonds

A bond is a fixed income instrument of indebtedness.

Simply put, it represents a loan made by investors to a borrower.

Think of a bond as a loan contract between two parties.

The borrower agrees to pay back the principal to the lender by a specified date referred to as the maturity date.  The borrower also agrees to pay the lender a specified rate of interest until maturity.

Interest is usually paid twice a year.

Unlike stocks, a bond has no ownership rights. Bonds are issued by corporations (corporate bonds) or by governments (government or municipal bonds) when they want to raise money.

Bonds have been used in the construction of portfolios for two primary purposes.

    1. To provide a stream of income through the interest payments.
    2. To provide a hedge against the price volatility inherent with many equities (stock).

#4 – Funds

In this category, we first think of mutual funds and exchange traded funds of stocks.

There are also funds of bonds and other instruments.  

1. Mutual Funds are characterized by a mutual fund company building a pool of money collected from investors which is then invested in a group of securities such as bonds, stocks, or money market instruments.

The mutual fund is operated by a money manager or team of managers.

The traditional purpose of mutual funds is to provide small individual investors access to professional active money management and garner the benefit of diversification as the fund is able to invest in far more individual instruments than a small investor could.

Mutual funds carry a management fee (expense ratio) which is often between 0.5% and 1.0% of the principal amount annually.  These fees might seem small, however, they can really be a detriment to your long term gains especially over many decades.

These funds are traded using the net asset value (NAV) at the close of the trading day.

If you put in an order to buy or sell shares of a mutual fund in the morning the transaction will be made at the NAV after the market close of that day.

2. Exchange Traded Funds or ETF’s differ from mutual funds in several ways.

First, the management fees are usually less than mutual funds as ETF’s are frequently based on indexes and are passively managed. Second, ETF’s trade like stocks and can be bought and sold almost instantaneously.

Like mutual funds, ETF’s are made up of baskets of securities that trade on an exchange.

3. Index Funds

The investments of an index fund are made up of the constituents of a particular set index such as the Dow Jones Industrial Average, NASDAQ Composite Index, S&P 500 Index, Russel 2000, Wilshire 5000 Total Market Index, and so on.

There are over 5,000 different indexes.

This type of fund is passively managed and should have smaller fees than actively managed funds.

Either ETF’s or mutual funds may themselves be index funds. 

For example, VFIAX is a mutual fund that is a passively managed S&P 500 fund by Vanguard.  Its expense ratio is 0.04% and requires a minimum investment of $3,000.

VOO is an ETF that also tracks the S&P 500 and has an expense ratio of 0.03% with no investment minimum beyond the cost of one share.

There is virtually no performance difference between the two.

In times past brokers charged fees for ETF trades whereas they might waive fees on mutual fund share buys if the shares were not sold before a specified hold time.

Beginning with the October 1st, 2019 groundbreaking announcement by Charles Schwab Co. that it would cut trading commissions to zero the desirability of ETF’s increased further.

Personally, I had abandoned mutual funds in favor of ETF’s some years ago.

#5 – Certificates of Deposit

CD’S are offered by banks, credit unions, or brokerage houses and feature fixed investment time frames typically between one month and 5 years.

Investors are asked to deposit a lump sum for an agreed-upon time span in return for a set interest rate.

If the investor withdraws their money before the set time period is over a substantial penalty is imposed as set within the terms. The early withdrawal penalty may range from a forfeiture of 3 to 12 months’ worth of interest.

CD’s are insured by Federal Deposit Insurance Corporation (FDIC) up to $250,000.

#6 – Money Market Accounts

These accounts are interest-bearing and often held at banks or credit unions and offer comparatively low fixed rates of return.

These accounts are typically used as cash alternatives either for added stability to a portfolio or as a place to “park” cash which may be used as an overall personal financial buffer or that is earmarked for investment when conditions are right.

Money market funds are mutual funds that are invested in debt securities with short maturities and that are purchased in shares available from brokerage companies. 

They are among the lowest volatility instruments available.

There are three types of MM Funds.

  1. Government (primarily Treasuries)
  2. General Purpose
  3. Municipal

Money Market Funds may be attractive to investors who have a very short-term time horizon, a low tolerance to volatility, or need extreme liquidity.

Like CD’s, money market accounts are also FDIC insured up to $250,000.

#7 – Business Development Companies

Typically referred to as BDC’S, these are companies that invest in small to medium-sized enterprises including distressed companies.

Many BDC’s are publicly traded and are popular among some investors seeking higher dividend yields.

BDC’s often use substantial leverage to help boost the yields they offer.

This leverage can at the same time amplify potential losses in share value.

There are tax implications that must be considered before investing in this area.

I do not suggest BDC’s for the novice investor.

Even if well experienced, BDC holdings should only be considered as a limited part of a diversified portfolio.

#8 – Real Estate Investment Trusts

A REIT is a company that owns, operates, or finances income producing properties.

REIT’s are known for their ability to provide a steady income but not for the capital appreciation that might be characterized by common stock.

Large companies are often the tenants of REIT’s such as Realty Income (O) and include names like Walgreens, FedEx, Walmart, Circle K, Dollar Tree.

Side note: REIT’s are best held in tax-deferred accounts because dividends paid are treated as ordinary income by the IRS rather than qualified dividends which are taxed at a lower rate.

#9 – Closed-End Funds

A CEF is a type of mutual fund that is structured to raise capital one time on the initial public offering (IPO).

This means that public trading then is a matter of individuals or institutions trading existing share between themselves.

With the typical open-end mutual fund repeatedly issues and buys back shares from investors.

Closed-end funds are actively managed and usually more focused on a narrow segment of the market.

These funds trade just as stocks or ETF’s do.

Like BDC’s, Closed-End Funds are often leveraged.

You can expect management fees to be higher than most open-end funds.

However, CEF’s are sought out by some income investors because of the relatively high yields they offer.

So, Where Do I Start?

The list of possibilities for investing through a bank, credit union or broker is a long one.  Long-term investing can be as simple or as complex as you choose to make it.

Many people are happy to turn their money over to a manager and forget about it.

I suspect that you are not in that group if you are reading this.

Many other investors choose to buy one or several mutual or exchange traded funds of the index type and be done with it.

Others prefer to be more active in their investing by choosing individual stocks with perhaps a mix of ETF’s, preferred shares, REIT’s or other vehicles.

There are far more ways to invest than there are ways to skin a cat.

Though I have not attempted the latter, I have certainly been involved in the former.

If investing on your own is new to you then a great place to start is with a low-cost Index ETF (exchange traded fund).

This will provide you with diversification and simplicity.

For example, you might consider the Vanguard S&P 500 ETF, ticker symbol VOO.

It has a 5 Star rating from Morningstar.

Because it is essentially a mirror of the S&P 500 index it is invested in companies such as:

  • Apple
  • Microsoft
  • Amazon
  • Facebook
  • Tesla
  • Google
  • Berkshire Hathaway
  • Johnson and Johnson
  • JP Morgan

(top 10 holdings by percentage)

With a fee of just 0.03% VOO has averaged a 13.82% yearly gain over the past decade.

There are few fund or money managers, or individuals for that matter, who have done as well or better.

A Word About Dollar Cost Averaging

This concept has been hailed and maligned as the stock market goes through cycles and as pundits pile on to trends in thinking.

Dollar cost averaging is a method of counteracting volatility over time.

It is the practice of buying a stock, fund, or other asset in measured increments over time.

Continuing with the example of VOO, a dollar cost average approach would be accomplished by buying $100 worth of VOO shares on the 15th of each month, month after month, for years.

Why do it that way?

The S&P 500 will, as time goes by, rotate from overvalued to undervalued as compared to the historical average.

If we buy our VOO today it may be that the cost per share is relatively high or overvalued, historically speaking.

A year from now we may be buying shares in an undervalued market.

In subsequent months and years, our $100 will buy more or fewer shares as the S&P valuation changes.

By buying consistently over time (5+ years) the average cost per share moves toward the median thus counteracting the short-term share price volatility.

Do We Have a Plan Yet?

Yes, we already have a possible rudimentary plan that if followed for the long-term provides a return equal to the S&P 500 (13.6% average over the last 10 years at this writing) less the fee of 0.03%.

The bulk of professional money managers as I mentioned, have not accomplished this level of return over the past decade.

Fund Manager Performance

Quoting the study from which the above percentages were cited, “Over long-term horizons, 80 percent or more of active managers across all categories underperformed their respective benchmarks,”

Take it Easy

Long-term investing is a marathon.

You should not be in a rush.

I have been asked many times questions something like this.

“I have $ X to invest right now, what should I buy?”

Learn before you buy anything.

Start slow and ease into investing.

If you have cash lying about try a money market account or fund.

If that’s old hat, you could begin investing in equities through an index ETF like VOO as mentioned above.

If a friend had $5,000 to put in VOO today I would suggest a start with $1,000 and see how that sits.

Another $1,000 in a month could then be considered.

Depending on the investment goal one might then move to several ETF’s.

ETF’s and a REIT or two might then follow.

Individual stock picking takes effort.

It is a way to customize your portfolio based on your goals.

For example, a person who is now seeing retirement emerge on the horizon may begin to think that they would like their portfolio to be more focused on income rather than growth whereas when younger the same person was most interested in hot stocks.

The Power of Compounding

Interest can be thought of as the cost of money.

If you borrow money, that service will carry a charge.

The expense of that charge is expressed as a rate of interest.

As a borrower, you are always on the paying end of interest charges.

The power of this principle is readily apparent. How many people spend a large part of their lives attempting to pay the interest charges on money they have borrowed?

What if you could reverse roles?

Instead of being the one who pays interest, it would be great to let others pay interest to you.

When you become an investor, you are doing just that. You are in essence lending money to others who then pay you interest.

The first step in this role reversal is something we have already talked about.

Get out of a debt!

Let me just slip in one more bang of the drum on that. Thank you.

Instead of living as a net borrower why not live as a net lender?

The second step in this “change of life” is to begin investing as we have been addressing.

Until the interest (or capital appreciation) you are taking in is greater than the interest you are paying out, financial freedom will be an elusive target.

Now I am being a little loose here to make the point.

Technically, the gain you receive from stock or fund ownership is not just interest but capital gain via share price appreciation and/or by dividend gain.

For the purpose of this discussion, it works out the same.

We want to move from the borrower position to the lender or investor position.

From payer to the receiver.

Take a look at the following table of numbers.

It considers a one-time investment of $10,000 and demonstrates how profoundly changes in interest (or capital gains) affect principal growth over time.

How Different Rates of Interest Over Time Alter Your Returns

Power of Investment Interest Over Time

What if we start with $10,000 and then contribute just $100 a month into the S&P 500 index via something like VOO?

Here is what it would look like over time.

Once debt is paid off how much more could you add to the $100 per month contribution?

What about after your mortgage is retired?

You can play with the numbers yourself here.

Just change the compound frequency from annually to monthly as you do so.

Shaping our Investment Plan

One of my hobbies is cultivating Desert Rose (Adenium) plants.

Adenium Obesum

These interesting blossoming succulent plants originated in Africa and the Arabian Peninsula.

They feature a severely bloated stem called a caudex which adds to their attraction.

Because these Adenium can grow into large bushes but cannot tolerate cold I keep them in pots as bonsai.

The trick is to picture them as grown plants as they are trimmed and shaped.

A major pruning is done once a year where course corrections and big decisions are made.

I have a goal in mind and set up the conditions for the plants to fulfill those goals. 

Cultivating our investment plan for eventual financial independence requires us to first picture what our portfolio will look like as it matures and what we expect it to eventually do for us. 

In the final part of this series, I will present some investing possibilities that may be new to you.

We will look further at equities, bonds, and other vehicles.

We will discuss the virtues and drawbacks of investing for alpha or income.

I’m very excited about introducing you to an alternative line of thinking and techniques that I employ in my own personal investing.

In part 5 of this Money Dreams Money Reality Your 30-Day Quick-Start to Financial Freedom free course we cover Dividend Investing one of our absolute favorite topics, which you’ll see why in a few moments.

Continue to Part 5: An Introduction to Dividend Investing