WASHINGTON, May 30, 2016 – In our previous article, we looked at several preliminaries the conscientious investor will need to deal with before actually beginning an investment portfolio. If you’ve taken care of these items or are close to having dealt with them, the next thing you’ll want to do is to begin accumulating cash that you’ll eventually deploy, little by little, into the investment portfolio you’re about to build.
Cash for investing
Once the basics are out of the way—including that six months’ worth of sacrosanct liquid savings you’ve socked away somewhere safe vs. those pretty much inevitable 21st century layoff storms—you should begin building an “investment savings account.” I’m putting this term in scare quotes because it seems that the days of establishing an old, reliable passbook savings account at a bank are long gone. Banks today want big piles of money, not small amounts of savings from the average worker bee.
So a “savings account” today is simply a place where you stash some cash to earn at least a pittance before you re-deploy that cash into something hopefully bigger and better in the stock market. Today’s virtual savings accounts include short-term parking places like short-term certificates of deposit (CDs)—the kind where you don’t get a penalty for early withdrawal—as well as brokerage firm money market accounts and/or deposits.
At brokerage houses previously, money market funds were the way to go for a variety of reasons, including virtually instant liquidity for stock trading and investing. Today, given low interest rates and onerous federal rules that seem to change daily, many brokerages seem to be shifting their former money market accounts holders quietly, into low-paying but secure virtual savings accounts.
For a variety of reasons, they’d probably rather not do this. But once again, they, like you and me, are perpetually wrestling with the consequences of the ill thought-out Dodd-Frank legislation, which, despite its fine intentions, has generally hamstrung small savers and investors as well as homebuyers in many cases. But that’s another topic for later discussion.
Whatever the case, I’d suggest that you have roughly a minimum of $5,000 discretionary savings parked somewhere secure before you begin your investment plan, although I’ll give you a sidebar on this little savings rule later.
And, for practical purposes, you’re probably best off having that money parked at a brokerage house either in its money market or equivalent account or in one or more of the many short-term bank CDs brokerage firms offer, generally without a commission.
Bottom line, you need to have at least some cash available before you start buying and selling stocks.
Terminology: Whether you’re keeping your investible cash in short-term CDs, moneymarket funds, a bank account or simply in cash stuffed into your mattress, the generic term for this kind of instantly available money is “cash and cash equivalents.”
Stocks and securities
If you look up these terms on one of the many online financial reference sites, you’ll learn that the general term security refers to a tradable financial asset.
Common stock is a security that represents actual corporate equity ownership of a listed company, that is, a company whose equity ownership shares, i.e., common stock, trade openly on public markets or exchanges either in the U.S. or abroad. Let’s explore the major characteristics of a share of common stock.
What do you get when you own a share of common stock? First and foremost, you actually own a piece—albeit a very tiny piece—of a publicly traded company. Each piece, or share, of common stock you own usually entitles you to a vote on various corporate matters during the required annual meetings that company holds each year.
Matters you can vote on generally include choosing or re-electing members of the company’s board of directors and their respective terms. Other items can include changes in corporate compensation and amendments to the company’s by-laws. Additional items, including sometimes-outlandish items proposed by corporate gadflies, can also be proposed.
In reality, however, even if you hold a few thousand shares of a company, which seems like quite a lot, your vote may not mean a whole lot, given that larger companies in particular often have millions of shares of stock that’s publicly traded. But, as in any nominally democratic institution, you should always vote in these annual elections anyway. At the vary least, reading annual corporate reports and meeting agendas can give you tremendous insight into how the company operates.
In this century, there has been an irritating increase in the number of non-voting or “minimally voting” shares of stock being sold to the public. There’s no law that prevents a company from selling these kinds of shares to you, but personally, I don’t much like them. To me, such shares indicate that the company wants your money and then wants you to shut up when it comes to determining what to do with your money.
Usually, though not always, regular old common stocks do carry voting rights of one vote per share held. Often, though not always, when you run into a non-voting or “minimally voting” situation, a given stock is listed as two or more classes of shares, usually “A” and “B” shares. Typically, though not always, the “A” shares are the voting shares while the “B” shares are non-voting. (Sometimes, it’s the opposite.)
Another flavor of this arrangement is for those “A” shares to be entitled to 10 votes per share, while “B” shares get only one vote per share.
So, then, why wouldn’t you buy the “A” shares? The answer is relatively straightforward. Often, though not always (Note: we’ll be using that phrase a lot), the “A” shares either won’t pay a dividend or will pay a smaller one than the “B” shares. Given that as little guys, you and I will never be able to hold enough “A” shares to make a difference in those annual meetings, the commonsense default is to hold those higher dividend paying “B” shares, and perhaps grouse a bit from time to time about the essential unfairness of it all.
Oh, and we mentioned “dividends.” For me, at least, given today’s chaotic markets, a good stock dividend is a very important reason for investing in high-quality and (hopefully) high-yielding (high dividend paying) stocks. That’s because while the price of any stock will vary daily and sometimes dramatically, you’ll still get a relatively predictable dividend every quarter unless your company gets itself into a world of trouble.
A common stock dividend is roughly equivalent to the interest you get on a CD. You can thus regard it as a kind of income. And if that income keeps coming in even during a bad patch in the stock market, you’ll generally still be making money in the long term, and that will help alleviate the temptation to sell your stock for a loss when times are tough.
Not all stocks pay dividends, of course. Those that do are often more mature companies that have gotten over those early growing pains, having become more boring but, for conservative investors, more reliable. In other words, in many cases, higher dividend-paying stocks tend to be larger, more stable companies, enabling you to sleep better at night.
Companies in this category have often been around longer than your grandfather. We’re talking Johnson and Johnson (ticker symbol: JNJ), Proctor & Gamble (PG), IBM (IBM), General Electric (GE) and so forth.
Tech and biotech companies, on the other hand, are newer, presumably higher growth, and are most likely to invest any profits (if indeed they even have profits) back into products or technology. Typically, such stocks are more “volatile” (jump up and down a lot more every day than those old-line companies we just mentioned), meaning that you invest in them for potential growth and capital gains, not dividends or income. I won’t mention any names in this category just now, as they can often be pretty speculative—something I don’t want newer investors to mess with just yet.
Which brings us to another common stock issue…
Capital gains and losses
If you buy a CD, you expect to get your original investment (your “principal”) back on its date of maturity. At the same time, you will also get the full and/or final amount of interest earned.
It’s similar for a common stock. Or rather, it’s the same only different. If the stock pays a dividend, you’ll generally get that dividend four times per year. But the stock price will fluctuate, sometimes considerably, for as long as you hold it. For, as a rule, unlike CDs, stocks don’t “expire” or “mature.” They just keep on trading, whether you own any shares or not.
If you choose your stocks wisely in terms of value and yield (more later), your stocks should rise over time, enabling you to sell at a higher price. While your dividends are taxed as, well, dividends (a separate category from “interest” as per the IRS and your tax return). But if your stock rises and you sell it for a higher price, you also book another kind of profit or return, known as a capital gain.
If you’ve held your profitable stock for less than a year and then sell it, current tax law regards it as a short-term capital gain. Such gains are taxed as ordinary income, with the rate of taxation depending on your personal tax bracket.
If you’ve held that profitable stock for over a year and then sell it, your gain magically become a long-term capital gain. Such gains are taxed at the prevalent capital gains tax rate, which historically has been more favorable treatment than what’s generally accorded to short-term capital gains.
Of course, you could lose money, too. In that case, taking the short-term capital loss can be a greater advantage than taking a long-term capital loss for the simple reason that the short-term loss will generally be a more valuable deduction than the long-term capital loss.
Let’s leave this here right now, and we’ll get back to taxation in a later installment. The government and the media both have willfully confused these issues over the years. Plus, Congress is constantly tinkering with these rules, with Republicans tending to make them more generous while Democrats make them more onerous. The upcoming national election may very well determine the future value of these situations for small investors, so we’ll wait on this just a bit.
Suffice it to say that for now, for the small investor in general, if you’re going to take a capital gain, you’re usually better off taking it long term; whereas if you’re going to take a capital loss, you’re usually better off taking it short-term. But your mileage may vary.
Next: Preferred stocks
Disclaimer: This series of columns is being offered for educational purposes only. The author of this column maintains several active trading and investment portfolios and owns residential and investment real estate.
Any existing or contemplated investment positions mentioned above describe this author’s own investment decisions and should not be construed as either buy or sell recommendations. The current market is highly treacherous and all investors travel at their own risk, so caution should be exercised at all times.
Illustrations, charts, commentary, and analysis are only the author’s view of current or historical market activity and don’t constitute a recommendation to buy or sell any security or contract. Views, indications, and analysis aren’t necessarily predictive of any future market or government action. Rather they indicate the author’s opinion as to a range of possibilities that may occur going forward.
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