As a reminder, I embrace the fiduciary responsibility at all time with clients and new individuals I come in contact with. As an investor, when you face an agent or a professional who is trying to sell you on a specific asset class, you have to remind yourself and ask you « does this individual have my best interest in mind? Or is he simply trying to generate a commission for himself for the company he works for? ». In my practice, I have access to a wider range of options which allows me to put your best interest at the heart of my recommendations.
Over the last couple of weeks, I have met many of my clients for their annual reviews as well as prospects. One of the thing that I am seeing is a lots of them are attracted to real estate investing. (remember that owning a house for your personal use is not real estate investing). While I understand the attractiveness of owning something tangible, there are different elements you need to remember before investing in any kind of asset class. So I thought that for this months newsletter I would write an article discussing real estate investing versus investing on the financial markets.
Most common example of securities you can purchase on the financial markets:
- Mutual funds
- Options & futures
Risk vs. Reward
No one wants to lose money and everybody wants to take the smallest amount of risk for the highest potential return. When you invest in something, regardless of what it is, it is all about risk versus reward. See the chart below.
As previously mentioned, if you are trying to grow your wealth or generate an income from your investment portfolio, you have to take risk. It does not mean that you have to take lots of risk to satisfy your objectives, but you still have to take some.
According to the chart above, the more risk you take, the bigger the potential returns. And conversely, the less risky you are, the lower your potential returns.
If you include real estate (investing) as an asset class and you would like to include it in the chart above, you would probably put it right next to « common stock ». In general, real estate investing provide the same potential returns for the same potential risk of investing in common stocks. Of course we are talking about general terms here. Some investments may be more risky and can provide higher returns, and some investments may be less risky and provide lower returns. Real estate investments can be subject to unique risks than more diversified investments. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments.
Too often I hear people being steering away from financial markets because of « the level of risk that is involved », but they do not understand that this level of risk is similar to their potential real estate investing strategy.
Taxation on income
When you invest on something, your goal is to generate income through interests or dividends, or through capital appreciation. Eventually and in most cases, you will be taxed on the profits you made.
To understand the basics of taxation, long-term/short-term capital gains and interest income, please refer to this link:
It may be beneficial to be tax-diversified to diversify your tax exposure when taking distribution during your retirement for example.
As a reminder, 3 types of income exist: active, portfolio and passive (or unearned).
If you need to dig deeper into this, feel free to click on this link:
In the US, there are investments types which will allow you to not pay federal taxes on your gains and interests. The first that comes to mind is municipal bonds. While income from municipal bonds is not subject to federal income taxation, it may be subject to state and local taxes and, for certain investors, to the alternative minimum tax.
You can also take advantage of tax-advantaged accounts meant for retirement which allow you to defer or eliminate gains and income taxes. Think about IRAs, 401(k)s, 403(b)s etc…
When we set up a financial plan, we usually take in consideration the taxation on income. Having different asset classes held in different types of accounts (IRAs, trusts, 401(k)s, etc.) allows you to establish different financial planning strategies. At some point, it will be extremely beneficial for your estate to take advantage of tax advantaged accounts which will be tax deferred or tax free if respecting specific requirements.
Liquidity describes how easy it is to turn an investment into cash without impacting the current market price of your asset. It is extremely important mainly if all your eggs are in the same basket. If you are heavily invested into non-liquid assets (such as real estate) and an emergency arises, it will be extremely difficult for you to address it in a short period of time without incurring tremendous losses or facing long waiting periods.
Real estate investments are relatively not liquid compared to investment securities. If your only strategy is to invest in real estate for your retirement for example, you will face heavy difficulties to manage it. Mainly if at some point you need your initial investment back rapidly. You can ask individuals who owned multiple real estate properties in 2009 if they still thought real estate concentration was a great idea.
Importance of Diversification
I can already some up this section by saying « you should never put all your eggs into one basket ».
Regardless of your risk tolerance, you need to be a minimum diversified. In general terms, I usually recommend to not be exposed to more than 5% of your investments to an individual security. When you are building your wealth or when you have wealth, your main goal should be to either accumulate it or preserve it. Not to gamble. This is why you diversify.
When you are diversified, you also allow your portfolio to be less volatile. This will prevent you from having a heart attack when the stock market is down 40% during a market correction.
When talking about investing on financial markets, most people think about stocks. As shown above, there are many other asset classes you should consider when building your portfolio. Most of my clients do not have more than 50% of their portfolio invested in the stock market.
What I have been realizing over the years is that wealthier clients are more invested into bonds than stocks. The reason is because most of them are older, and that they need their portfolios to generate income. If you are curious about bonds, I actually wrote an article about it a couple of months ago:
Most of my clients are diversified into what is called a bucket strategy. For illustration purposes, below is my ideal investment planning strategy containing at least 3-4 buckets. In some cases we can skip the second bucket and implement the other ones.
Based on your age, risk tolerance, situation, time horizon and the state of the economy are usually come up with different percentages for each bucket. This allows us to manage volatility, risk and diversify extensively.
Be aware of the risk of what you invest in. Be mindful of diversification, do not put all your eggs in the same baskets. Make sure that if an emergency arises you will have enough liquidity to address it in a timely manner. Make sure that your investment strategy takes into consideration your tax exposure today and for the future.
If you would like me to review your situation, feel free to reach out to me. We can discuss anything related to your retirement, investment, taxes and estate planning needs & objectives.