If you are new to the pot of gold series START HERE: FINANCIAL FREEDOM. This article is in reference to factor 3: savings and investment.
Now that you have set aside your rainy day fund, next step is to tackle short term investment.
OMG yawn….. this stuff is boring!
Let’s make this short and sweet.
Personally, I do not think you need to spend too much time on this part of your portfolio. It is just a way to park your money with minimal risk. Choose the best rate, park your money and move on.
As a reminder:
INVESTMENT RULE 101
- Keep an emergency fund consisting of 6-12 months of expenses as CASH.
- Keep money you may need for the next 1-5 years in short term investment.
- Keep money you probably would not touch for more than 5 years in long term investment. Those are tax advantaged retirement accounts and brokerage accounts (stocks, mutual funds, index funds).
- The sum of all the above is your portfolio. The goal is to beat inflation (3-4%).
CERTIFICATE DEPOSIT (CD)
- Make sure it is FDIC insured.
- CD accounts have fixed interest rates. The longer you lock in your money, the higher the interest rates.
- How it works: you lend money to the bank for X amount of time. In return you receive an annual interest rates. When CD matures you get your money back.
- Annual percentage yield (APY)- total interest in 1 year (takes into account of compound interest).
- Annual percentage rate (APR)- interest rates for that year.
- Pros: low risk and not at mercy of the market.
- Cons: low return and your money is locked up. Breaking CD will come at a penalty determined by your bank.
BONDS (BASIC CONCEPT)
- Very similar to CD. They are both debt securities.
- Personally, I favor CD because it usually has higher return. However, CD is not available in your retirement accounts. So bonds are a good option to diversify that part of your portfolio.
- Bond= A loan to someone. They pay you interest. And when the term is up they pay you back the original amount (principal).
- When bond is issued, the price you pay is called “face value”.
- You are promised your money back on a particular date called “maturity date”.
- In exchange, you will get a predetermined interest called “coupon”.
- A word of caution: high yield bonds are risky bonds (junk bonds). Yield is NOT return. Eg. a risky bond promises higher interest rates. But if it then bankrupt, you will lose all your money (no return).
- High quality bonds (also called investment-grade bonds) rarely default.
- Use credit rating agencies (Moody’s, S&P, Fitch) To determine bonds quality and do not go below BBB-.
HOW TO CHOOSE BONDS
- Types of bonds depend on who is the issuer:
- U.S. treasury securities by U.S. federal government (state income tax exempt).
- U.S. saving bonds by U.S. federal government. (state income tax exempt).
- Other U.S. government bonds by federal agencies like Fannie Mae.
- Mortgage backed bonds.
- Corporate bonds (investment grade and junk bonds).
- Municipal bonds by U.S. state or local government (federal tax exempt).
- Foreign bonds.
- How do you choose? By balancing interest rates, risk tolerance and your tax burden. Of course you want the highest interest rates and lowest risk. But if you are in a high tax bracket, most of your return will go to tax. So you would trade interest rate for tax protection. Municipal bonds, for example, are exempt from federal tax.
- I stick to treasuries, saving bonds and investment grade bonds. The others are too complicated.
US TREASURY SECURITIES
- This is how government borrows money to finance its deficit.
- Backed by full faith and credit of U.S. government so virtually risk free.
- 3 types: Treasury bill (days to 1 year), treasury note (2-10 years) and treasury bond (10 – 30 years). The difference is mainly the maturity date.
- Interest is exempt from state and local income taxes.
- Interest is paid every 6 month. Principal is paid when the bond matures.
- The most influential treasury note is 10 year treasury note because mortgage rates are based on it.
EE SAVING BONDS
- Backed by U.S. government.
- Similar to treasury, but cannot be bought or sold in secondary market. Can only be purchased on TreasuryDirect
- Fixed interest rates (therefore vulnerable to depreciation because of inflation).
- If you hold it to its original maturity of 20 years, it is guaranteed to double.
- It stops paying interest after 30 years. In other words, do not park your money for 30 years.
- Interest is paid when bond is redeemed. Interest is exempt from state tax.
- You cannot redeem until the bond is 12 month old.
- If redeemed less than 5 years, you will loose 3 months of interest.
I SAVING BONDS
- Variable interest rate.
- It is NOT guaranteed to double in 20 years.
- Otherwise same as EE saving bonds.
Phew! Still awake?!
Good investment is boring. You know you are doing it right if it is boring.