Investments vs. Savings- A Resident’s Guide- Part 2
As a reminder, last week we went through the difference between savings and investments and talked about why the difference is so important with examples of using savings as an investment and investments as savings as a resident. We also discussed many different ways to put money away for savings. This is all encompassed in the first part of the this series called Investments vs. Savings- A Resident’s Guide- Part 1. Please refer back to this article if you want to review these important concepts. Today, we are going to discuss what many residents are more excited about- what are the common options available for investing money as a resident? In particular, we will emphasize the usual individual types of investments available (stocks, bonds, mutual funds, and ETFs). This post is not going to include other sorts of alternative investments such as peer-peer lending, real estate, MLPs, etc. Also, I am not going to discuss the different overarching account types (IRAs, brokerage accounts, 401k, etc.). Both of these latter topics are grounds for another discussion as a full blown article at a later point!!!
To make it easier to follow, I will divide the investment types into the following categories: stocks and bonds. I will give examples of each and examine which places are good places to park your money as a radiology resident. Let’s start with the best place to put your money for most residents: stocks.
Before we begin with the types of investments, let’s first address the definition of a stock. Simply put, a stock is a share or portion of a company. An issued stock can be publicly traded or privately traded, meaning that some stocks can be traded on the public markets, like the New York Stock Exchange or the NASDAQ. Other private stocks/shares are not available for general public trading and you need to be an “insider” or in a private market to buy and sell available shares. For this discussion, we will emphasize publicly traded stocks because it is what is much more commonly available.
Some publicly traded stocks, allow the investor to recover a percentage of a company’s profits back into something called a dividend. Dividends are often issued on a quarterly basis and can be either reinvested back into the shares of the company or can be taken back by the individual investor as cash. Since dividends have been traditionally a large percentage of the annual return on investment, I would recommend the former strategy of reinvesting one’s dividends.
When investing in stocks, there are two main ways to go about purchasing stocks, individually or in groups. As a radiology resident, most of you are not going to have much time to research and purchase stocks individually, so I would highly recommend following the strategy of buying groups of stocks. In fact, I would wait until you finish your residency and fellowship when you can dedicate more time and resources toward this endeavor of “stock picking”. For now, stick with the low maintenance plan, mutual funds and ETFs.
Stock Mutual Funds/ETFs
Stock mutual funds and ETFs (exchange traded funds) are groups of stocks that you can buy and sell, usually run by a portfolio manager. The price of the mutual fund is set at one time, at the end of the day. And, the mutual fund can only be bought or sold at the end of the day price.
The portfolio manager usually charges a fee to maintain the portfolio of a mutual fund. Sometimes it’s baked into the price of the mutual fund. Other times, there is an additional fee called a load. Sometimes the load is added to the purchase price of the mutual fund on the “front end”, meaning that the fee is added at the initial purchase time. Other times, it is added a the “back end”, meaning that the fee is added when you sell the mutual fund. That fee can range as high as 5% of the value of the purchase price. I would tend to stay away from mutual funds that charge a load because it erodes the potential earnings from the mutual fund investment. You essentially have to subtract the 1-5% load from the annual earnings that you make from the fund, so it is possible that you can actually have a loss for the year in the fund even though the fund has made money!
On the other hand, an ETF price changes continually throughout the day and can be bought and sold at any time. Whenever you buy or sell an ETF, typically you have to pay a brokerage fee, which can be substantial relative to the amount that you are buying at a resident’s salary level. If you want to buy 50 dollars of an ETF and the brokerage fee is $7.95. You are being charged (7.95/50*100) or 15.9 percent, an exorbitant amount. For this reason, if you are going to buy an ETF, it only makes sense at a resident level if you can afford to buy it in 1 thousand dollar increments or more. I typically like ETFs overall more than mutual funds because of the flexibility of buying and selling these instruments at any time during the given day, if needed. But, you have to be able to put enough money into the ETF for it to make sense at a resident level. So, your best bet is likely to purchase a no-load mutual fund.
What types of mutual funds or ETF should you buy?
My suggestion is to stick to index funds. Index funds are funds that follow an index such as the Standard and Poors 500, the Russell 2000, and so on. They are groups of stocks that are widely followed that generally have a theme. They may follow large capitalization stocks, small capitalization stocks, international stocks, value stocks, growth stocks, and more. Index funds are not actively managed portfolios, meaning that the manager just follows whatever the index does when it comes to buying or selling stocks within the index. For this reason, the fees on these funds tend to be significantly lower because the manager does not have to make these decisions on his/her own and tends to trade a lot less.
On the other hand, actively managed mutual funds allow the portfolio manager to buy and sell stocks on his/her own. Therefore, these managers are paid a higher managing fee. These funds also tend to have higher turnover costs from more frequent buying and selling within the fund and that may erode the original purchase price of the mutual fund. For these reasons, I would tend to stick with the index fund at your stage as a resident.
I would also recommend that you should diversify your mutual fund holdings, whether you decide to purchase a mutual fund or an ETF. Diversification allows you to profit from upswings in any given investing theme when money is being made and prevents you from losing a lot when one theme is not doing so well. What does that mean? When you are buying mutual fund or ETFs, make sure to buy one that invests in large cap stocks (like the S and P 500), another that invest in mid capitalization stocks, another that invests in small capitalization stocks, and another that invests in international stocks. Sometimes large capitalization stocks perform the best and others times it is small capitalization stocks. And likewise, sometimes any one of these options will perform poorly. Therefore, the upswings and downswings will be more muted (otherwise called reducing volatility). Typically, it is more tolerable to have losses that are not exorbitant!!!
Buying and selling individual stocks takes time, research, and a desire to do so. Stocks need to be monitored continually because news may come out about a company that may change the reason you bought the company. And, you may not be available to buy or sell the stock at that time, especially as a resident. So, it generally does not make sense for the radiology resident to purchase individual stocks. I think most residents would be better served by concentrating on their prospective career and becoming the best radiologist possible. It will have a much higher payoff than taking the time to invest in individual stocks. When you have finished training, you can decide for yourself whether to invest in individual stocks if you have the inclination.
What are bonds? Bonds are essentially loans that are taken out by an entity that are scheduled to be repaid with interest to the buyer. Bonds can be issued by the federal government, municipalities, corporate entities, or private persons.
In the current environment, the prevailing interest rates are extremely low and the interest provided to the buyer is very low. So, returns on investments are muted. When interest rates start to rise, your bond becomes less valuable due to erosion from interest rate risk and inflation. When interest rates decline, the value of your bond holding increases. It is very unlikely that we will see interest rates go much lower given the innately low rate at the present time. So, you are investing in an asset class without much upside. Granted, the potential to lose your initial capital investment is lower than a stock if you hold a bond to maturity (the due date). But the potential to have capital appreciation is also significantly lower and risks of inflation eroding your investment become substantially higher. Also, when you are young the potential for compounding your interest is much higher with a stock than a bond over a long period of time. For these reasons, I would stay away from investing too much of your money into bonds at the present time, perhaps no more than 5-10 percent, if that.
Short, Intermediate, and Long Dated Bonds
Time to bond maturity is a very important concept that all investors/residents should understand. When you invest in a bond or bond fund that invests in bonds that expire a long time from the present date, the value of your holding is much more volatile than a short term dated bond. If you think about it, it makes a lot of sense. When interest rates rise, your bond becomes less valuable because your interest is now lower compared to other new bonds out on the market. Also, the maturity date is far away and you have years and years of interest that will accumulate over time. So, now those years and years of interest are less valuable as well. With a short term bond or bond fund/ETF, you only have potentially a few years or months at your current interest rate, so the value will not change as much from face value. Therefore, in rising rate environments, long dated bonds are usually not as valuable investments.
Federal Government Bonds
These bonds are backed by the federal government and are the safest bonds in terms of default rates.(meaning to miss interest payments or principal payments) It is significantly less likely for the United States government to default than a municipality or corporation. Due to a lower risk profile, these bonds tend to issue bonds at a lower rate than other entities. Bond maturity length range from a few months to 30 years. There are a variety of different types of federal bonds issued including treasury bills (short term notes with maturity dates less than one year), notes (intermediate notes with maturity dates between 1-10 years), and bonds (long term notes with maturity dates greater than 10 years). Treasury notes and bonds issue interest every 6 months. There are also treasury inflation protected securities (TIPS). These bonds adjust based upon the consumer price index. And, there are federal savings bonds. These bonds do not offer coupons/interest payments and are redeemed at the maturity value.
Municipal bonds are backed by individual municipalities including local, county, and state governments. The interest on these bonds are usually not taxed by the federal government. They also tend offer lower coupons/interest payments than other types of bonds. So, they are usually more advantageous to investors in higher tax brackets (usually not a resident!!!). Although they have a significant role in a radiology attending’s portfolio, at your stage of the game, I would generally avoid this group of bonds.
Corporate bonds are backed by individual corporations and vary widely in quality and duration. Corporate bonds have a real default rate (some companies go out of business!!!), but they can potentially be a good investment. Corporate bonds range in quality from investment grade to junk bonds, based upon the likelihood of default. Interest rates are typically higher than government issued bonds.
Bond Mutual Funds/ETFs
What are bond mutual funds and ETFs? These investing instruments are very similar to stock mutual funds and ETFs. They are groups of bonds that are being invested by a large entity such as a brokerage and are run by a portfolio manager. Just like stock mutual funds and ETFs, bond mutual funds are valued at the end of the day and can only be bought and sold at the end of day. ETFs can be continually be bought and sold throughout normal investment hours. Both bond mutual funds and ETFs are run by portfolio managers that charge fees just like stock mutual funds. Again, avoid funds with loads because they can significantly reduce your return on investment.
Unlike stock mutual funds and ETFs, bond mutual funds and ETFs may not necessarily be better than individual bonds held to maturity. The reason is that bonds can be bought and sold at different prices from the face value of the bond (a loss or gain) when you are invested in mutual fund or ETF. So, the price of the bond fund can be less than the price at which you originally bought the fund. On the other hand, if you hold your own individual bond to maturity, you are guaranteed to get the face value back (as long as the bond does not default!). Bond funds and ETF also continually take money from the sold and maturing bonds and reinvest the proceeds into new bonds. These new bonds can have a higher or lower interest rate than the original purchase depending on market conditions. During times of rising rates, you may notice that your bond fund rates will rise and the prices will decline. During times of falling rates, you will experience decreasing interest rates and increasing prices of your bond fund/ETF.
Many plans only allow the purchasers to buy bond mutual funds and not individual bonds. So, my recommendation would be to find a diversified bond fund that invests in federal government, international government, and corporate bonds with a nice mix of different maturity dates. In this sort of low interest rate environment, you may want to refrain from investing too much in this sort of instrument, especially as a young resident with years and years ahead of you.
On the other hand, individual bonds typically have a fixed interest rate that is determined at the time of purchase. And at the time of maturity, you will get the face value back of the bond. For this reason, individual bonds are not a bad choice if you have enough money to diversify and buy a few treasuries and corporate bonds of varying quality and duration. The problem is that residents often do not have enough capital to make purchasing multiple individual bonds a viable option. So, for most residents consider the mutual fund/ETF option if you decide to invest in bonds. But remember… as a resident, only a minimal amount should be invested in this category due to lack of capital appreciation with respect to inflation.
What Does The Resident Investor Really Need to Know in the End?
Stocks and bonds are the mainstay of resident investing. Due to the long road ahead for residents, you should be concentrating on capital appreciation and not capital preservation. So, look into holding a lot more stock related assets than bond related assets (probably not much more than 5-10%). If you are going to buy stocks, buy diversified index mutual funds covering the different types stocks- large caps, intermediate caps, small caps, and foreign stocks. If you are going to buy bonds, most residents should buy a diversified fund of treasuries and corporates with widely varying maturities. Residency is a time to learn about your prospective field, so make sure to automate your investments as much as possible by putting money away on a regular automated basis (weekly, biweekly, or monthly). Don’t forget- your dollar is much more powerful when you are young, so it is important to invest and stay in the game!!!
Please send me your comments!!!