Racks on Racks Part V – Why I Don’t Use A Financial Advisor

If you made it to this part of the Racks on Racks series, you may be asking yourself this question.  Many people use financial advisors to help them build their wealth and are very successful at it.  However, I take an issue with using a financial advisor in my personal situation for a couple reasons:

1)   The interests of the financial advisor are very hard to align with the interests of the client.

The way many financial advisors get paid is via commissions from selling their clients different funds.  It’s hard for an advisor to recommend what’s truly the best product for me when their paycheck partially depends on me choosing specific funds.

Even for advisors who make money purely based on the size of their client’s assets, that’s still money out of your pocket as the investor.  If you have a $1,000,000 portfolio and your advisor charges 1% of your assets annually, that’s $10,000 gone every year.  That’s whether or not you decide to buy or sell funds or securities.

2)   The median wage for a financial advisor in America is about $67,000 per year.

Now, $67,000 per year is nothing to sneeze at, and definitely above what the average household in the United States makes.  That’s not the point though.  If I hired a financial advisor, I would hire them for where I want to be in my financial future.  $67,000 is not what I want my income to look like 10, 20, 30 years from now.

When I want to be successful at something, I look around and see who’s already done it and then find out how they did it.  I’m willing to bet most financial advisors in my country are not millionaires, and a millionaire is something I want to be.  Imitating successful people is what ultimately brings success.

Now, I don’t mean to bash financial advisors completely.  Heck, there’s a couple that I know personally and am friends with.  I admit, I’m being harsh.  For folks out there who literally don’t want to think about managing their money at all, a financial advisor might be a great choice.  I’m not disputing that a financial advisor can get you wealthy – they definitely can.  However, I believe that for those who are willing to invest some time and study into their financial education, there are better paths to take when building wealth.  If you are willing to think critically and learn about investments, I strongly encourage you to educate yourself.

How do you feel about financial advisors?  Are they worth it for you?

Racks on Racks Part IV – How to Invest in the Stock Market Using Discount Brokers, DSPPs, and DRIPs

Discount Brokers

Investing in the stock market these days is way easier than it used to be.  There are so many brokerages (firms that act as an intermediary between you and the stock market) out there that are accessible to the normal layperson.  Brokerages are a pretty common tool used to purchase securities.  There are both discount brokers and full service brokers, but I’d personally lean toward the discount ones since they are much cheaper to do business with.  A full service brokerage firm may be appropriate if you want recommendations of certain funds or stocks from investment professionals.

With many discount brokers, you can easily buy or sell stocks for between $4 and $10 these days.  However, you don’t want to just throw a few hundred bucks at a stock this way.  You’ll eat away at your returns very quickly because of the cost of the transaction.  For example, if you spent $200 on Coca-Cola stock and your discount broker charges you $7 for the transaction, you’ve already lost 3.5% of your invested capital, which is just silly.  If you’re using this method to buy stocks, try to save up a little bit of a bigger pile of money so that your cost basis will be low.  In this example, investing $1400 at one time to buy the Coke stock would be better since it would only eat up 0.5% of your invested capital.

For a buy and hold strategy (which I am a fan of) discount brokers are great for another reason – no annual expense fees.  If you go out and buy a mutual fund from a Fidelity, Edward Jones, or some other financial firm, they are going to charge you usually as a percentage of the assets held in a particular fund.  This doesn’t happen when holding securities through a discount broker.  Unless you make a buy or sell transaction, you won’t get charged anything.  Even Vanguard, with its amazingly low fees on funds, is going to charge you something every year (full disclosure: I do own a Vanguard fund in a tax-advantaged account).

In summary, discount brokers are great for a buy and hold strategy in which an investor slowly builders a portfolio of individual securities over time.

DRIPs

DRIP stands for Dividend Re-investment Plan.  This is a feature that many brokers offer.  It allows you to automatically buy more shares of a company you already own using dividends received from that company.  This can be great because it allows you to constantly add to your ownership stake in a company without thinking about it.  Over long periods of time, this can really boost your returns.  DRIP plans are usually a free service offered by a broker.

One thing to note is that if the stocks being DRIPed are in a taxable brokerage account, the IRS is going to take its share of taxes on those dividends, even though they are being reinvested.  The IRS views those dividends as income because you had the option of taking it in cash instead of reinvesting it.  Consult a tax professional for how this could impact your overall tax bill.

DSPPs

DSPP is another acronym that stands for Direct Stock Purchase Program.  This is just what it sounds like – buying stock directly from a company.  The cool thing about DSPPs is that they often charge very low fees for buying stock (often $1 or $2), and they will reinvest your dividends for free if you like.  One thing to watch out for with DSPPs is that they cost money initially to setup – you usually have to make an initial deposit (maybe $100 or $500).  Not all companies offer these plans, but many of the big blue chips do (Coca-Cola, Exxon-Mobil, etc.).

Although I think DSPPs can be great for investors, I don’t plan on personally using them for my investments.  Even though my personality lends itself to looking at big blue chip companies as potential investments, I don’t like the idea of having my investment options limited to those that offer DSPPs.  Also, I think that when building a portfolio, it’s nice to have everything in one place.  I’d rather not have one DSPP for Coke over here, and another DSPP for Proctor and Gamble over there.  A discount broker, I think, is better for that.

One case where I would consider using a DSPP is if I was trying to teach a younger family member about the benefits of equity ownership.  I might initiate a DSPP for my future children at some point to give them a lesson on the nature of compound interest in the context of high-quality companies.

What vehicles do you use to invest?

Racks on Racks Part III – The What of Investing

 

At the end of Part II I mentioned that I’m not quite ready to begin investing because I still have a mortgage.  You may be in a similar situation.  However, this doesn’t mean that you or I should stop learning about investments and educating ourselves.  Let’s continue this discussion.

So, what is it most worthwhile to invest in? This is a very complex question, and one that would be answered differently by nearly any investor out there. Let’s step back and look at investing from a broad perspective. What generates cash? Well, we have:

Private businesses
Equity-based Securities
Debt-based Securities
Real Estate
Commodities
Intellectual Property

Let’s take a brief look at each type of cash-generating asset.

Private businesses
Private businesses have the most potential for cash generation, in my opinion. Businesses are the workhorse of any capitalistic system. They sell goods and services – anything from coffee makers to military aircraft. The fact that they are held privately allows for the owners to exert greater control over the business’ operations. Consequently, the owner(s) can make a handsome profit. Private businesses can require a lot of time, knowledge, and capital to become successful investments, especially when built from the ground up.  John D Rockefeller built his Standard Oil empire by starting and growing a private business (which eventually went public).  The chain of Aldi grocery stores is privately held.

Equity-Based Securities
Equity is just another word for ownership. Probably the most well known investment of this type is common stock, where shares (pieces of ownership) of a particular company are traded on a public exchange. These companies issue shares to raise money to expand their operations and to perform business. Investors form an opinion on how much each share of the company is worth, and that dictates the stock price. There are also other forms of equity investments, such as preferred stock and private equity investments. Preferred stock is basically the same as common stock except it comes with some extra benefits. Private equity investments are investments in private businesses that are not publicly traded.  Equity-based securities generate cash for owners in the form of dividends paid out to shareholders, and also the appreciation of shares over time.

Debt-Based Securities
Debt-based securities most commonly come in the form of bonds. There are also things like tax-liens, notes, and certificates of deposit (CDs). These are all fixed income instruments, and basically rely on the re-payment of principal with interest. Governments, companies, and other entities issue bonds. Just like there is a stock market, there is a bond market where investors buy and sell debt, in order to collect interest income. When buying a bond, you agree to a set time frame for repayment. For example, if you bought a 5-year treasury bond from the United States government, you would receive interest payments throughout the five years, and then once the term is up, receive all your principal back. Bonds are a good hedge against deflation.

Real Estate
Ah, real estate. For a lot of investors, real estate is a great asset class because it is very tangible and more easily understood by your average person. There are a lot of ways to make money in real estate (flipping, wholesaling, etc), but from an investment perspective rental real estate is a popular option. Acquire a property, and then lease it out to a tenant for monthly cash flow. Additionally, unlike other investments, real estate can be highly leveraged to increase rates of return. Real estate is a good hedge against inflation.

Commodities
The raw materials that make the world go round are called commodities.  Think of things like oil, coffee beans, or copper.  These things come directly from the ground and are then processed and utilized by businesses to provide different goods to society.  If I struck oil in my backyard tomorrow or if I found certain minerals on my property, I could license the right to drill/mine for those natural resources.  On Wall Street, there are commodities exchanges, where investors can trade based on the supply and demand of different goods.

A quick aside about gold – gold is probably the most well known commodity out there in the investment world.  A lot of people love gold because it has been used as a medium of exchange since almost the beginning of time.  The problem I have with gold is that it is very speculative.  There is no way for me to know whether or not the supply or demand for gold will change tomorrow.  Also, gold doesn’t really do anything.  It doesn’t have intrinsic value.  Since gold itself doesn’t cashflow, you can only make money from it through capital appreciation (selling for more than you bought it for).

Intellectual Property
Intellectual property can be an incredibly powerful wealth-building tool in today’s world.  Every successful author, artist or inventor has utilized his or her intellectual property as a way of building wealth.  This comes from royalties, which is basically the right to use an idea.

Thomas Edison founded General Electric using the vast portfolio of patents he acquired through his inventions.  Because he had the exclusive rights to so many ideas, he was able to capitalize on them and build a powerful business.  Every time Alicia Keys sells a song on iTunes, she gets a cut of the profits.  The beautiful thing about intellectual property is that you can create an income stream off of one song, patent, process, or other system.

Phew, that was a lot.  As you can see, it can get pretty overwhelming when you look at all the options out there.  The cool thing is, people make money in each of those areas every day.  In today’s world, there are so many paths to take.  If you have expertise in a particular area already, it would be wise to look to that particular asset class as a place to invest in.

For me, I am leaning toward Equity-Based Securities, specifically Common Stock.  My reasoning:

  • It is a truly passive type of investment, even up-front, unlike a lot of other types of assets.
  • As far as all asset classes go, stocks have the highest ROI over the long run, when compared with gold, bonds, or just sitting on cash.  Of course, returns on intellectual property, commodities, private businesses or real estate could far surpass those in common stock.  However, they all require lots of continual (or at least start up) effort, and great expertise within a particular field to be successful.
  • With stocks, I can own a piece of an already successful business, and reap the benefits of its success.
  • Unlike many other asset classes, it is very easy to diversify across many individual investments (for example, by using a broad-based index fund).

So, there it is.  I like stocks because I can do a little bit of research up front and then read an annual report once a year to make sure my companies are still increasing profits.  I don’t have to discover a gold mine, deal with tenants, or write a hit song.  We’ll see in Part IV how to put this money to work in the stock market, and how to avoid some common pitfalls.

What do you think about each of these asset classes?  Have you had great success/failure with any one in particular?