What is in your portfolio?
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During the COVID-19 pandemic, physicians of all specialties have demonstrated a renewed focus on long-term financial and life goals.
For some physicians, this focus also led to a greater interest in how their investments will help them reach their goals and how exactly their portfolio is constructed. In this article, we explain the some basic, intermediate and more complex components that make up most portfolios and examine reasons why you may or may not want to include these products in your long-term investment plan.
Stocks
What is it? A stock is a type of security providing investors with ownership in a corporation.
How are they structured? Publicly traded stocks trade on an exchange, and each corporation has a limited number of shares available for purchase. Basic forces of supply and demand influence the perceived value of a company, particularly over short periods of time.
Why would an investor purchase? Stocks offer investors the greatest potential for growth over long periods of time.
Why would an investor avoid? Investing in stocks comes with a high level of risk. Investors are much more likely to lose all or a portion of their investment in a single company. The risk of investing in stocks can be reduced through diversification (owning many stocks, across different industries).
Bonds
What is it? A bond is a debt security, commonly issued by a municipality or corporation, which will pay investors a fixed rate of interest for a defined period of time. The investor will have their principal returned by the lender once the bond has matured.
How are they structured? Interest from the bond will be taxed as ordinary income if lent to a corporation. Municipalities may qualify to issue debt, providing tax-free income to investors. The rate of interest an investor receives is dictated by taxability of income, credit worthiness of the issuer, period of time until maturity, and current economic conditions. A bond can be issued with a callable feature, allowing the issuer to return your principal prior to the stated maturity date. The issuer will be required to pay a premium for this feature.
Why would an investor purchase? Bonds offer a predictable income stream, and in certain circumstances, the income is tax-free. Because bonds usually have a lower risk profile compared with stocks, they can provide stability to an investment portfolio.
Why would an investor avoid? Bonds have a limited return and there is a credit risk if the issuer defaults or simply goes out of business. Other disadvantages include limited liquidity. Unlike stocks, bonds typically have a sizeable spread between purchase and sale price. There is also a risk the current market value of bonds can decline in value if interest rates rise, which could negatively impact an investor wishing to sell prior to maturity.
Mutual funds
What is it? A mutual fund is a company that pools money from a group of investors and invests in securities such as stocks, bonds, or a combination of the two.
How are they structured? There are two general types of mutual funds on the market. Open-end funds are what investors typically know as a mutual fund. They don't have a limit as to how many shares they can issue. When an investor purchases shares in a mutual fund, more shares are created, and when somebody sells his or her shares, those shares are taken out of circulation.
Closed-end funds may seem similar, but they are very different. A closed-end fund functions more like an exchange-traded fund than a mutual fund. They are launched through an initial public offer (IPO) to raise money and then traded in the open market like a stock.
Why would an investor purchase? Reasons include professional management, potential diversification (a fund typically owns 50-200 securities), liquidity and comparative low cost of entry (an inexpensive way to own a basket of securities vs. purchasing each of the underlying securities individually).
Why would an investor avoid? There is a potential tax-inefficiency if the fund is owned in a non-retirement account, particularly for physician investors in the top two tax brackets. Mutual funds must distribute income and capital gains on to investors; therefore, it is possible to have a tax liability in a calendar year when your fund loses money. Compared with an exchange-traded fund, the ongoing management fees associated with investing in many mutual funds can be high.
Exchange traded funds
What is it? An exchange-traded fund (ETF) is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund.
How are they structured? Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold.
Why would an investor purchase? ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors. ETFs give the investor the opportunity to buy or sell an entire portfolio of stocks or other securities in a single security, just like buying or selling a share of a single stock.
Also, index portfolios generally have lower turnover than actively managed funds, which makes ETFs ideal for taxable accounts. Unlike many actively managed mutual funds, there are no front-end or deferred sales charges with ETFs, which are bought and sold like stocks. On the exchange, the investor pays brokerage costs and the spread between the buying and selling price, which may be lower cost than the front-end load and transaction fees of mutual funds.
Why would an investor avoid? Costs could be higher — most people compare ETFs with mutual funds, but if you compare ETFs with investing in a specific stock, then the costs are higher. There is no internal management fee cost in owning individual stocks. Vehicles like ETFs that live by an index can also die by an index — with no nimble manager to shield performance from a downward move.
Alternative investments
What is it? “Alternative investment” is a broad term encompassing a wide range of investment strategies that fall outside traditional asset classes. They generally include nontraded investment programs, gold and other precious metals, commodities, currency, hedge funds, long/short, and other market-neutral strategies.
How are they structured? Alternative investments can be liquid in a mutual fund or nontraded structures, such as private equity, hedge funds, real estate investment trusts, commodities, as well as real assets such as precious metals, rare coins, wine and art.
Why would an investor purchase? Alternatives usually represent investments that have a low correlation to the S&P 500. The lack of correlation between the two helps dampen portfolio volatility.
Why would an investor avoid? It may be difficult with some alternative investments to determine the current market value of the investment. They may also be relatively illiquid. In some instances, these investments may have limited historical risk and return data and the cost of purchase and sale may be high.
Conclusion
It is always important for physicians to understand the components that make up their portfolios. This article provides a quick overview of the products and tools commonly contained in many investment portfolios. How these tools are employed depends on the individual investor’s financial goals, appetite for risk and retirement time horizon. Working with a knowledgeable professional advisor to build and manage your portfolio is always recommended.
"Know what you own and know why you own it."
Peter Lynch, American investor, philanthropist and mutual fund manager
For more information:
Wealth Planning for the Modern Physician: Residency to Retirement and Wealth Management Made Simple are available free in print or by ebook download by texting HEALIO to 844-418-1212 or at www.ojmbookstore.com. Enter code HEALIO at checkout.
David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group. He can be reached at mandell@ojmgroup.com or 877-656-4362. Bob Peelman is a partner and director of Wealth Advisors. You should seek professional tax and legal advice before implementing any strategy discussed herein.
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