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Low Expense Value Investing Strategies for Long Term Investors

Guideline to Frugal Investing - Building and Maintaining a Proper Stock Portfolio

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Guideline to Frugal Investing

Choosing the right stocks

Tax Strategies

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Building and maintaining a proper portfolio is critical to maximizing gains, minimizing costs and minimizing risk. Investing can be intimidating for many new investors. That is why many investors decide to pay excessive fees to their stock brokers and money managers for the piece of mind that their money is in good hands. In reality, many investors may be better avoiding excessive investment fees and following these simple rules of investing so they can meet their saving goals. The following are rules that should apply to most investors:
Maximize_Tax_Sheltered_Retirement
Invest_in_Stocks_over_Mutual_Funds
Buy_The_Right_Stocks
Get_a_Frugal_Brokerage_Account
Invest_in_Stocks_for_The_Long_Term
Diversify
Dont_Panic
Hold_Some Cash
Consider_Tax_Implications

1. Maximize Tax Sheltered Retirement Accounts

Traditional IRA's, 401Ks and Roth IRAs are great because any capital gains, dividends and interest are not taxed until you withdraw your money. Roth IRAs are potentially better because the Government has promised that these accounts will not be taxed even when the money is withdrawn. The advantage of 401Ks and traditional IRAs is that the money contributed is deducted from that year's taxable income. However, all distributions will be taxed at the income tax rate when the money is withdrawn. In reality either type of account will be good places to save. There is debate on which account is better for long term investors.

Example: Mr. Johnson has a pre-tax amount of $2000 to save in 1980. In 1980 he put that savings in a traditional IRA. He put the money into S&P stocks with negligible investment expenses. The traditional IRA has accumulated to $28,000 (The S&P returned approximately 14 times from Jan 1980 to April 2007). When the $28,000 is withdrawn, it is taxed as income. So if income taxes are 30%, he will be left with $19,600.

The next example assumes Mr. Johnson puts money in a Roth IRA. Note Roth IRAs did not exist in 1980 but it is good for illustrative purposes. The after tax equivilent of saving $2,000 assuming 30% income tax is $1,400 ($2,000*[1-30%]). This after tax income is contributed into a Roth IRA because there is not a deduction to current income. However, that $1,400 will grow compounded for many years to $19,600.

It is no coincidence that the returns were exactly the same in both the traditional and Roth IRA. Assuming the tax rate is the same at the time of withdrawl and the time of contribution either option will be equally as good. Of course, if Mr. Johnson had more than $2,000 to save then he could still put as much as $2,000 after tax into the Roth IRA and keep the full $28,000 when the money is withdrawn in 2007.

Tax sheltered retirement accounts are the only place where a significant portion of bonds and money market accounts should be held because interest is taxed every year. So if you are earning 5% in taxable account you are really earning 3.5% which barely beats inflation (this assumes a combined federal and state tax rate of 30%).
The only caveat to putting money in a retirement account is that you should plan on holding your money in these accounts until you reach 59 1/2. Otherwise it is considered an early withdrawl and the penalty for early withdrawal can be steep. Not only do you pay taxes on the withdrawl at the marginal income tax rate, an additional 10% penalty is imposed. The only exception to avoiding the penalty are qualifying events. These include medical expenses greater than 7.5% of your AGI, Disability, Death, higher education expenses and first time home costs. Note that tax laws change frequently and it is important to check with a tax professional before assuming a qualified event.

2. Invest in Stocks over Mutual Funds

The advantage of mutual funds is that they are easy to manage and offer diversification. The downside is that fees and taxes can cause the portfolio to significantly under perform (see why become a frugal investor for more illustrations on this point). Individual stocks have many advantages over mutual funds for the following reasons:

- You can decide when to take capital gains. This gives you much flexibility for tax purposes and most importantly with a simple buy and hold strategy you can avoid paying annual capital gains taxes. You can always change brokerage houses without selling stocks but if you are unhappy with a mutual fund you will be forced to sell and get taxed immediately on capital any gains.

- The fees for buying a stock is small in comparison to a mutual fund. for a $5,000 investment, the average mutual fund charges 2% expenses which translates into $100 per year. With a deep discount brokerage account, you could buy, for example, 3 stocks assuming a commission of $10 per trade and purchasing our individual stock recommendations. This amount would come to less than $30 for one time only. The following year the mutual fund would charge $100 but the stock investor is charged nothing. Recently some brokerage accounts have offered free stock trades assuming a minimum balance.

- Stocks allow you to take full advantage of long term capital gains. By holding stocks you can determine when to take capital gains. It is best to wait as long as possible to take capital gains because securities held for one year or more are considered long term capital gains. Long term capital gains tax rates are federally maxed out at 15%. Short term capital gains are taxed as ordinary income. You can own stocks as long as necessary and take the gain when it is convenient for you. Mutual funds take gains at the discretion of the fund manager. Thus, mutual funds buy and sell securities generating short and long term capital gains on an almost daily basis. Some of these capital gains are distributed to the shareholders and reported in the 1099-Div statement provided by the mutual fund.

- There are some mutual funds that have low expenses and minimal capital gains distributions. ETF's generally fall in this category. Though an ETF will give diversificiation at low cost - the ETF will generally buy securities that track some sort of index. This means that while the investor may have some quality securities in the portfolio they will undoubtedly hold marginal securities as well.

3. Buy The Right Stocks

There are thousands of different stocks to choose from and here seems to be plenty of analysts and journalists recommending stocks. For an new investor it is hard to make sense of it all. The frugal investor only wants to buy a stock for a cheap price. It is not easy to determine whether a stock is cheap or expensive. This is where the importance valuation comes to play. Valuing a stock requires a lot of time and diligence but it is the best method to truly assess the value of a company. For an overview on choosing stocks see choosing the right stocks.

4. Get a Frugal Brokerage Account

The best brokerage accounts are those that are deep discount brokers and do not charge an annual fee. There are many brokerage accounts that charge excessive commissions. In reality it matters very little which brokerage you trade with. The most important factor is the fees, ease of use, and customer service. The frugal investor is not a day trader and will likely only make only a few trades a year so it does not make sense to pay annual or monthly inactivity fees.

There are many brokerage companies to choose from and fierce competitition has knocked down comissions. Some examples of brokerage companies include the following: WellsFargo offers 100 free trades per year with a minimum balance of $25K in deposits, stocks and loans. Etrade has $10 commissions but it has an easy to use website and allows trades in international stocks

5. Invest in Stocks For The Long Term

Stocks are not financial instruments to be held for a short period of time. Stocks can be very volatile and the values can drop significantly lower than the price you paid. Realistically assess your financial situation and plan on keeping the money in a stock for at least 5 years. If you know you will need money in a shorter time frame consider investing in bonds or money market accounts.

6. Diversify

It is true that the more diversified your portfolio the lower the volatility and risk your portfolio. In theory, a non diversified portfolio is not necessarily a bad thing. It is just more risky. A non-diversified portfolio is more like going to Vegas with $100 and putting it all on one blackjack hand- you could win big or lose it all. Stock investing works the same way. An investor will usually want to spread risk because it is better to win a little and lose a little rather than win big and lose big. Thus a non diversified portfolio can just as easily beat the market as underperform the market. The risk of a non diversified portfolio can be substantial especially considering that a stock in a company can go bankrupt and the stock price goes to zero. The frugal investor should avoid speculative stocks when building an initial portfolio. When building an initial portfolio consider having at least $5,000 to invest and buy 3 stocks. When the investor obtains more money to invest, more stocks and even speculative stocks can be bought over time. A diversified portfolio should span across different industries and asset classes which may include real estate and even commodities. A good book on Real Estate Investing is

7.  Don't Panic

Patience is the one edge that the small investor has over Wall Street. The pros worry about the daily fluctuations of stock prices. For the long term investor there is no need to stress, volatile market situations may present some opportunity. Stocks move up and down due to changes in industry cycles, interest rates, competition etc. As long as the company that was bought was researched thoroughly, then the ups and downs should not be a bother. Besides, according to efficient market theory it does not much matter which stocks you buy anyway because according to the theory the market has already factored in all information. So even if an investor gets it wrong then it should not matter as long as the portfolio is diversified. Remember though, that the frugal investor believes that a portfolio bought with stocks that are undervalued will outperform the market.

Stocks and the stock market at times behave irrationally. The frugal investor will see this as opportunity. Some stocks take years to turn the corner and get noticed by Wall Street. Wall Street strives for immediate results and have invested millions of dollars developing trading algorithms to make a quick profit. The frugal investor does not have the expertise to build elaborate models but has one attribute that Wall Street does not have - and that is patience. For the frugal investor, it is long term performance that only matters.

Using a value based investment approach the frugal investor hopes to do better than the market. A frugal investor wants to hold on to a stock for as long as possible. Over the long run, it is the better managed companies that outperform their peers. So choosing the stock for the long term does matter.

Although an investor would probably do OK by randomly picking stocks for his portfolio, the Frugal investor does not want to just blindly pick a stock just as a frugual consumer won't randomly pick a TV or car without doing some research. The Frugal investor does the same thing - buys a stock that gives the best value for his money. There are too many mediocre companies that should not be in any Frugal investors portfolio.

8. Hold Some Cash

Individual stocks over the long term have historically had much higher returns compared with other asset classes. Stocks on average return of 10% a year compared with 6% for real estate and bonds. Despite the higher returns, investors still do not need to allocate 100% to stocks.

Sometimes the stock market is over-valued and it makes sense to hold some cash. The more the market is over-valued, the more cash should be held. The amount that market is overvalued cannot be determined by looking at the DOW or NASDAQ. It comes back to valuing each individual company. If there are many companies that are valued too richly given the prevailing estimated future cash flows and interest rates then the market is getting overvalued. Cash can be a great asset in the case of the market or stocks prices coming down and thus presenting buying opportunities. Note if cash is held in a brokerage account, make sure that the interest rate is sufficient. Many brokerage accounts default their sweep cash accounts to low yielding funds. Usually all it takes is a phone call to switch to a higher yielding sweep account.

9. Consider Tax Implications

Many investors do not consider taxes in making investment decisions. However, this is a mistake since the goal of most investors is to maximize long term gains. Maximizing gains means keeping as much of the winnings to yourself as possible and minimizing payements to the government. The following link details few simple tax strategies that every investor should consider.