Sunday, January 15

Week 28 - Net-Net-Net investing

Situation: Our ITR blog is focused on long-term savings that can be used for retirement, and without paying any more in fees than is necessary to achieve that goal. That means explaining how a newby investor can set aside 15% of income for at least 15 yrs and maintain a risk level that is less than 1 in 20 of losing her principal investment. In prior blogs, we discussed minimizing fees & commissions by using point-and-click investing but there are also fungible costs that cannot be avoided, namely, inflation and taxes. According to Webster's Collegiate Dictionary (11th Ed), fungible means “that one part or quantity may be replaced by another equal part or quantity in the satisfaction of an obligation”. In other words, someone else defines those obligations and those definitions can change over time. Here at ITR, we’ve factored the cost of inflation into the calculations presented in our spreadsheets but we haven’t said much about how to minimize it. And the only mention of taxes we’ve made has been to encourage you to use Roth IRAs, employer’s 401(a) & 403(b) plans, and savings bonds. Again, we haven’t said much about how to reduce the taxes due on your investment winnings.

Goal: a) Construct an investment portfolio consistent with our Goldilocks Allocation (Week 3) distribution while attempting to achieve a positive return net of fees, inflation, and taxes.
b) Assume that our investor is 50 yrs old with a gross taxable income of $96,000/yr.
c) Assume that our investor will spend $1200/mo on combined retirement and Rainy Day savings over a 15 yr period, resulting in an out-of-pocket expenditure of $216,000.

For the portfolio: We recommend allocating $6000/yr to a Roth IRA composed of dividend re-investment plans (DRIPs) in 5 stocks, $6000/yr to ISBs (inflation-protected savings bonds) and EESBs (standard savings bonds that guarantee a 3.5% return if held for 20 years), $1200/yr to a NextEra Energy (NEE) DRIP, and $1200/yr to a Rainy Day Fund composed 50:50 of a Johnson & Johnson (JNJ) DRIP and ISBs. Central to our strategy is to pay no taxes on the 50% of retirement savings in stocks (by assigning those DRIPs to a Roth IRA), and to delay paying federal taxes on the 50% in savings in bonds until retirement (there are no state or local taxes due on savings bonds). A Rainy Day Fund by definition needs to be accessible, so the stock portion of the fund will be taxable.

An investment of $1200/yr in stock of the regulated utility (NEE) is a “hybrid investment”, i.e., it doesn’t need to be hedged in the usual way with an equally weighted purchase of investment-grade bonds--because both the debt and the return on investment are guaranteed by a state government. These unusual features also help to offset the tax bill; you’re rewarded with a higher dividend (~4%) that helps pay taxes on those dividends. (Capital gains will be taxed upon sale but that isn’t until after you’ve retired and are in a lower tax bracket.)

Recommended Roth IRA stocks: We support the plan of investing 2/3rds of our sample portfolio’s monies in DRIPs chosen from among Core Holding stocks (e.g. XOM, CVX, PX, NSC, UTX). Care needs to be taken to include at least one company with heavy exposure to international markets (e.g. MCD, KO, MMM, BHP). The remaining 1/3rd of investment monies should be used to purchase DRIPs from among the Lifeboat Stocks (e.g. MKC, PG, ABT, JNJ, BDX, WMT, WAG).

In our virtual retirement portfolio, we’ll assign $125/mo to each of 4 Roth IRA DRIPs (XOM, KO, WMT, UTX), $250/mo to EESBs, $250/mo to ISBs, and $100/mo to the NEE DRIP (for a total of $1100 per month). For the Rainy Day Fund, we’ll assign $50/mo to ISBs and $50/mo to a JNJ DRIP. That brings the total monthly investment to $1200.

In a future blog, we’ll see how this portfolio holds up going forward and retrospectively. Will it provide a positive return after tallying and subtracting all expenses (fees & commissions, inflation, and taxes)? We’ll also look at the small number of academic studies that have been done on Net-Net-Net investing. Be warned--these studies are perhaps a little discouraging because any positive return is considered worthy of recognition! That’s mainly because it’s hard to spend less than 2%/yr on fees & commissions unless you “go it alone”. Another reason is that savings bonds are excluded from most asset allocation models because purchases are limited ($5000/yr for both ISBs and EESBs).

Bottom Line: Have you figured out what your “take home pay” is in real terms? It’s one thing to crow about winnings but quite another to add up all the losses incurred from such things as commissions & fees, taxes, and inflation. After those 3 expenses have been backed out of total annual gains, what remains is called “Net-Net-Net investing” and this is what real investing for profit is all about.

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