When considering or discussing investment options and strategies for criminal justice professionals, one thing stands out immediately; whether you’re an attorney stuck in the courtroom until 8:00pm each night or a police officer assigned to the night watch, few of us have the free time necessary to navigate today’s complex financial markets. Simultaneously, new police officers and new prosecutors who start their careers in the low to mid $40’s do not typically have the assets to justify paying a growing number of full service advisors (many firms simply will not open new accounts below certain minimums). Those who attempt to venture into the shallow end of the modern investing world are usually overwhelmed with esoteric information. The typical family saving for retirement does not need to know what the VIX is, or the price of June WTI crude oil futures, and they certainly do not get up at 5:00am to get a feel for the Asian trading day and direction of U.S. pre-market trading prior to the open.
So, what’s a cop to do?
First, some disclaimers. This article contains no client-specific advice nor any offer to dispose of or solicitation to buy any security. This publication is exempt from registration under the Investment Advisor’s Act 1940, Section 202(a)(11)(D).
Opening a Brokerage (or other investment) Account
To buy and sell most securities you need a brokerage account. There are a couple of options available to the new investor. One is to simply go to one of the “wirehouse” brokers who have satellite offices or private practices in New Orleans and open an account (wirehouse is a term used for major national firms who maintain offices across the country).
Typically all employees of major firms will be licensed as both brokers and IAR’s (investment advisor representatives), meaning they can offer advice and purchase securities on behalf of clients. Dual licensed brokers/IAR’s mean the client doesn’t have to know anything about how financial markets work, and these employees are bound by law to make appropriate decisions on behalf of clients. These relationships will be charged in one of two ways and can be up to the client; fee-based or transactional. Fee based accounts charge an annual percentage of all client assets under management (in the range of .75 – 1.5% of assets under management, i.e.; an account value of $100,000 would pay somewhere in the neighborhood of $1,000 annually). Transactional accounts forgo annual fees or reduce annual fees and charge clients fees (or commissions) on each transaction made (buy or sell orders for stocks, bonds, etc.).
Your second option, growing in popularity, is to open a more or less self-service online brokerage account where you complete transactions but have access to strategies, research, and/or advisors by phone who can answer questions. As one might expect, the absence of a live broker/IAR with no local office reduces fees. Most online brokerage accounts charge transaction fees (substantially lower than live brokers charge) for purchases and sales, and will maintain separate fees for periodic telephone consulting of IAR’s.
Which account type you choose relies substantially on how familiar you are with investment strategy, types of investments, and how much time you have for research. As with any self-service business model, online brokers are also cheaper because the homework becomes your job.
People who do their own investing are called individual investors, and there are significant risks involved with individual investing, mostly due to emotion. The reader should be aware of these pitfalls and consider them when deciding whether to hire an advisor.
The biggest risk to the non-professional is emotion, defined by the phrase Odd Lot Theory. Odd lot theory was coined by institutional investors who capitalize on the reliable panic of individual investors. Odd lot theory states that individual investors are essentially always wrong. Individual investors, whose life savings are at stake, see markets rise over time and decide that the economy is doing well so they purchase securities near their absolute peak. When prices begin to fall individual investors see their savings values decline over time, and in a panic they sell at or near market bottoms. The propensity for individual investors to buy and sell at the absolute worst times is so reliable that some professional investors monitor odd lot transactions and make decisions based on these statistics. If you take ONE THING from this article, it should be to keep emotion out of investing.
Some other risks to the non-professional include failure to completely read and understand disclosures. Many fund types include complicated fees including early redemption fees that the investor did not take into account when making buying or selling decisions. Similar failures to completely understand the investment vehicle in general, its potential volatility, or market conditions/economics can lead to buyer or sellers’ regret. In today’s world, many exotic investment types exist on the open market that are simply not suitable for the individual investor. Without an advisor, the individual investor may see an incredible chart for a particular security, not realizing that market conditions, business risk, or a variety of unforeseen circumstances are about to doom the product.
While less of a long-term concern, everyone certainly wants to get the best price possible for their security when buying or selling and DIY’ers who may not understand different order types (or know how to effectively use the various order types) can lose out to market timing or a predatory broker or market maker on the other end of the order taking advantage of your inexperience. This is certainly a risk encountered by DIY’ers for every transaction they make when they do not understand how to use limit orders.
Investors must also know how to construct a portfolio that is appropriate for their income, savings, age, and horizon (among other factors). Some self-service online firms offer allocation models that will take these factors into account and invest accordingly on behalf of the discount investor.
Common Investment Instruments
Equities (stocks); Equities are shares of a single corporation that reflect actual partial ownership. Equities have the advantage of capturing a successful company’s rise, but also the risk of capturing that particular company’s fall. An attractive feature of many stocks are dividend payments (partial ownership comes with being paid a percentage of company profits). Dividend paying corporations may pay either cash or stock dividends. Cash dividends are taxable in the year distributed, where stock dividends are not. Risks associated with owning stocks include business risk, the risk involved in the line of business of that particular corporation and market risk or general economic risk – if the entire economy or a sector of the economy is contracting it can affect the value of the company.
Mutual Funds; mutual funds are investment programs that are funded by shareholders that trade in diversified holdings (often shares of many hundreds of corporations, but mutual funds may also contain bonds, money market instruments, etc.). Mutual funds are professionally managed and there are many types of mutual funds with various fee structures. An advantage of mutual funds is diversification; simultaneous investment in hundreds of businesses that reduces the business risk associated with owning individual equities. Many mutual funds are created to capture the progress of certain industries/sectors or economic regions/countries (i.e.; energy sector funds, China funds, etc.). Mutual funds typically have minimum purchase amounts by dollar (such as “minimum initial investment $2,000”). Any corporate dividends paid to the fund can be reinvested by the shareholder, as with a stock dividend, which also avoids a taxable event for that year.
ETF (Exchange Traded Funds); ETF’s are marketable securities that track an index, sector, bonds, or other assets and trade on stock exchanges like stocks. ETF values fluctuate throughout market hours just like equities. One of the main advantages of ETF’s are their liquidity (liquidity is the ease with which an asset can be bought or sold) since they are exchange traded, unlike mutual funds (mutual funds are also priced only once per day at the market close). ETF’s have no minimum investment amount because they are exchange traded so investors can purchase singe shares.
Bonds; Bonds are debt issued by corporations, municipalities, states, or the federal government. Bonds are issued with a face value, and are bought and sold at either discounts or premiums to face value depending on interest rates. In addition to discounts and premiums of face value, bonds usually pay interest in some form in exchange for the loan to the issuer. Bonds carry interest rate risk and credit/default risk, meaning that should the issuer go bankrupt they will default on either the interest payments or debt itself (or both). Bonds are rated against the credit worthiness of the issuer. Some bonds have the advantage of being tax exempt at either the state or federal level (U.S. government bonds are taxed by the federal government only and municipal bonds are completely tax free if the purchaser resides in the state where the bond was issued). Corporate bonds are fully taxable.
Cash Equivalents; T-bills, certificates of deposit, banker’s acceptances, commercial paper, and other types of money market instruments are low risk but low return investments which are essentially regarded as a place to park cash for periods of 90 days or less.
While there are a number of other investment types including complex specialist instruments such as leveraged and inverse funds, options, futures, and the like; the instruments outlined above are commonly found in the typical balanced portfolio and are all that are required for the individual investor to save for retirement.
All of the above instruments may be housed in various account types such as;
- Brokerage account
- Retirement account
- Custodial/guardian account
- Trust account
- Business account
Most investors maintain both a standard brokerage account and a retirement account and contribute an amount up to the annual maximum to their retirement account. Standard brokerage accounts give the owner access to the cash in them and can often be used as a dual purpose bank and investment account. Buy or sell transactions and capital gains distributions in a standard brokerage account are current year tax events (selling a stock at a gain for example, would be taxable in the year of the transaction). In retirement accounts however, transactions are tax-deferred until fully withdrawn from the retirement account. Because retirement accounts are tax-deferred, early withdrawals comes with tax penalties in addition to the regular rates (10% early withdrawal penalty) with a few exceptions;
- In the event of the death of the account owner (both IRA’s and Qualified Plans such as 401k’s)
- Total and permanent disability (both IRA’s and Qualified Plans such as 401k’s)
- Certain qualified higher education expenses (IRA, Simple IRA only)
- Qualified first time home purchase (IRA, Simple IRA only up to max $10,000)
- Certain distributions to military reservists called to active duty (both IRA’s and qualified Plans such as 401k’s)
- Rollovers (both for IRA’s and Qualified Plans such as 401k’s)
- Separation from service during or after the year the employee reaches age 55 (50 years old for public safety employees of a state, county, or city in a defined benefit plan) for Qualified Plans such as 401k’s only (not IRA’s)
Other account types (trusts, guardianships, etc.) are used for specific purposes too lengthy to cover in this primer – college savings, gifts to grandchildren, etc.
(Note; taxes [in general, and especially with investments] are notoriously complicated. Tax professionals should always be consulted before making important decisions with tax implications.)
Basic Investment Strategies
Police officers and many legal professionals may sacrifice higher incomes for a career in public service, however we do have one thing going for us – stable life long income that lends itself to long term saving.
Dollar Cost Averaging; “DCA” is a technique of buying a fixed dollar amount of a particular investment on a regular schedule regardless of share price (for example, most brokerage or retirement accounts allow an investor to commit precise amounts of their income to automatically purchase additional shares of a particular mutual fund or other investment on a certain date). This results naturally over time in more shares bought when prices are low and less when prices are high. In addition to regularly contributing dollars to your savings, it reduces the risk involved in committing large sums to a security when prices may not be ideal for buying.
Balanced Portfolio; Most investors understand the basics of having a balanced portfolio, however in practice there is more to the concept than 60% equities and 40% bonds (or whatever ratio may be appropriate for you at a given time). Many factors come into play when deciding on asset allocation, and this strategy needs to be adjusted over time. If your plan works as designed, growth in equities will over time throw your allocation off and will need to be adjusted. You portfolio will also need to be adjusted as you time your way out of markets nearer to your investment objectives (such as a home purchase or retirement) to prevent capturing downturns just before these events.
Diversity and Simplicity; Diversity in a portfolio (which is very important) can be achieved with just a handful of stocks, bonds, and ETF’s or mutual funds that capture everything from world markets, various sectors and industries, commodities, and even currencies without having to actually acquire and monitor each individually. Individual investors do not have the time nor the skill to manage personal portfolios that read like a hedge fund’s transaction report. Besides the obvious risks associated with spreading yourself too thin or investing in products you don’t understand – come tax time you will need an army of tax professionals to figure out whether the IRS treats LEAP call options that you held longer than 12 months, exercised, then immediately sold the called shares as short or long-term capital gains…who wants to deal with that?
Consistency; Invest young, and consistently. Having a plan means maintaining a manageable portfolio that includes cash reserves so that you don’t have to sell out of a plan you’ve spent years building due to an emergency. While this is part of asset allocation, consistency and discipline also means retiring when you want, how you want. Most brokerage firms also have solutions to occasional cash emergencies so you are not forced out of a portfolio – but such options should be used extremely responsibly.
Invest with an Objective; Part of asset allocation and strategy involves discussing your objectives with an advisor or reviewing your own with the goal of creating a plan. Leave emotion out of the decision making process. Markets fluctuate, selling everything in a downturn is the only guaranteed way to lose money. When you set out on an objective, your allocation or specific holdings may need to be updated or adjusted from time to time, but this does NOT mean rash decisions based on panic or emotion.
Patience; Investing is a marathon, not a sprint. If there was an easy, risk free way to make enormous returns – no one would have a full time job. Diversity and allocation reduce volatility and portfolio risk, even so, markets will rise and fall – there are strategies for timing your way out of markets as your needs change over time, such as nearing retirement, etc.
Understanding the Facts of Risk; With investments, there is an absolute correlation between risk and return. The higher the potential return, the higher the risks. Likewise, lower risk comes with lower potential return. Portfolios should reflect an investors risk profile.
Research; Research is the investors best friend. Even in market downturns, if you’ve done your homework and feel confident in a company’s annual reports and its latest 10-Q, or the strategy and management of your mutual funds you should be able to sleep at night.