Real estate investment trusts

Real estate investment trusts (“REIT’s”) are vehicles through which an investor can invest in real assets.  Real assets can include real estate such as commercial and residential rental properties and hospitals, as well as other income producing real property such as timber land.  REIT’s can also hold real estate related debt instruments such as mortgage backed securities.

Similar to other trusts, distributions of income, dividends and capital gains from a REIT are passed through to the investor and are not taxable to the trust entity provided that certain requirements are met.

REIT’s can be publicly traded, similar to a stock, or be closely held by a small group of investors.

REIT’s which are not publicly traded oftentimes do not have much liquidity and can be difficult for an investor to dispose of in certain cases.  Such REIT’s oftentimes have higher yields which compensate investors for taking on the additional liquidity risk.

Publicly traded REIT’s, on the other hand, tend to be liquid and be relatively easy to buy and sell on an exchange.  The result of this is a “liquidity premium” where an investor will typically receive a lower yield from a publicly traded REIT than from a non publicly traded REIT in exchange for the REIT having greater liquidity.



Allocating commodities to an investment portfolio can add many benefits to the portfolio including inflation protection and diversification.  Commodities can include metals such as gold, silver and copper; natural resources such as crude oil and natural gas; agricultural products such as corn, sugar, wheat, soybeans, and coffee; and livestock such as cattle and hogs.

Commodities are typically purchased via futures contracts, which trade on a exchange.  Market participants in the commodity futures markets include speculators and hedgers.  Speculators buy and sell futures with the intention of profiting from their transactions, while hedgers purchase futures to protect their business from price fluctuations.

Adding commodities to an asset allocation can be beneficial in several ways.  Such an allocation can provide protection against inflation by providing a hedge against a weakening currency.  It can also reduce the risk in a portfolio by providing diversification away from more traditional assets such as stocks and bonds.

Futures contracts traded on U.S. exchanges are taxed according to the “60/40” rule.  As per this rule, contracts are taxed at long term capital gains rates of 60% and short term capital gains rates of 40%.  This rule applies regardless of how long the contracts are held, making futures contracts more attractive than stocks and bonds for short term trading.



Sovereign bonds

Sovereign bonds are debt instruments issued by national governments.  They are one of the least risky debt instruments as they are typically backed by tax revenue and the ability of the sovereign nation to issue additional debt.  They usually pay a lower yield than corporate bonds due to the stability and reliability of their collateral.  Keep in mind that not all sovereign nations have favorable credit ratings, and the risk and corresponding yield will vary according to the quality of the underlying collateral.

Many sovereign governments issue what are known as inflation protected bonds, whose value is linked to an inflation related benchmark such as the consumer price index.

Similar to corporate bonds, treasury bonds trade over the counter through financial institutions known as market makers or dealers.

Like any other bond or fixed income instrument, sovereign bonds are subject to interest rate risk.  The interest rate risk of the bond increases as the duration of the bond increases.

Sovereign bonds tend to be the least risky asset class, and accordingly also typically offer the lowest rate of return.  They can provide a valuable addition to an investment portfolio when combined with other asset classes such as common stocks, preferred stocks, and corporate bonds.


Small cap stocks

Small cap stocks are publicly traded equity interests in smaller companies, typically companies with $1 – $5 billion in market capitalization and less.  Unlike most large cap stocks, which include household names such as IBM, Apple and Google, small cap stocks tend to be less well known to the public.  As an asset class, they tend to have more risk and be more volatile than large cap stocks.  This is mostly due to the fact that smaller firms have less access to capital and are less diversified in their operations than larger firms.

Historically small cap stocks have, generally speaking, outperformed their larger capitalization counterparts over the long run.  This is due to the fact that small firms oftentimes have a smaller market share, and therefore have more room for growth than larger firms, who may have already captured a large share of the market in which they operate.  As a result, smaller firms are oftentimes able to grow and expand their market share, revenues and earnings at a higher rate than larger firms.

Due to their relatively high volatility and risk, small cap stocks are best suited for investors with longer time horizons and higher risk tolerances.  For the right investor, small cap stocks can play an important and valuable role in his or her overall asset allocation.  By combining them with other asset classes such as domestic large cap stocks, international stocks and fixed income instruments, the portfolio can be tailored to the risk tolerance and time horizon of the investor.

Exchange traded funds

Exchange traded funds (“ETFs”) are securities which trade on an exchange and usually track a stock, bond, or commodity index.  Unlike an open end mutual fund, whose price is calculated daily at market close, exchange traded funds trade throughout the day and their price is determined by supply and demand.  Unlike a closed end mutual fund, whose market price frequently deviates from its net asset value due to supply and demand imbalances, ETFs are created and redeemed by certain market participants, resulting in additional liquidity and market prices which tend to more accurately reflect their net asset value.

Exchange traded funds tend to have lower expense ratios than mutual funds as they are usually passive and oftentimes track a stock index such as the S&P 500 (U.S. large cap equity), Russell 2000 (U.S. small cap equity), or EAFE (Europe, Asia, Far East equity).  They can also track a bond index such as the Barclays Aggregate Bond Index, or a commodity such as gold, silver or oil.  They thus provide a way for an investor to obtain exposure to an asset class in a low cost, passive manner.

Exchange traded funds are typically structured as corporations or investment trusts, and the investor is thus entitled to dividends and interest generated by the underlying assets of the funds.  Similarly, the investor is entitled to proceeds from the sale of the underlying assets upon liquidation of the fund.

Equity exchange traded funds are usually more tax efficient than open end mutual funds. This is due to the fact that ETF shares are created and redeemed in a manner which allows the share holder to have a cost basis in the fund which closely tracks the cost basis of the underlying assets of the fund.

Corporate bonds

Corporate bonds are debt instruments issued by private enterprises, and are sometimes backed by tangible assets of the company issuing the bond.  They generally have more credit risk than sovereign bonds due to the fact that they are backed by corporate revenue, which is less reliable than tax revenue.  They tend to have higher yields than sovereign bonds, although this is not always the case.

Unlike common stock and preferred stock shares which trade on an exchange, corporate bonds trade over the counter through certain market participants known as market makers.  Market makers tend to be large financial institutions such as banks, broker dealers and insurance companies.  Corporate bonds typically trade at a level based on internal factors such as the credit risk of the issuer as well as external factors such as interest rates.

Corporate bond holders have a higher claim on company assets and equity than preferred stock holders, and the interest payment on corporate bonds is typically lower than the dividend payment on preferred stock shares.  The interest payment is taxable to the bond holder at the federal, state and local level.

As an asset class, corporate bonds are less risky than both preferred stock shares and common stock shares, and typically offer a lower rate of return.  They are more risky than most sovereign bonds and offer a higher rate of return.

Master limited partnerships

Master limited partnerships (“MLP’s”) are limited partnership interests in businesses which trade publicly on an exchange, similar to a stock.  Unlike stocks, which are typically structured as corporations under state law and therefore subject to double taxation, master limited partnerships avoid double taxation by directly passing their profits through to limited partners.

Master limited partnerships typically involve businesses in the energy sector, such as oil and natural gas production, storage, transportation and distribution.  Because they are contractually required to make distributions to limited partners on a periodic basis, they usually consist of businesses with predictable revenue streams and long term contracts.

As an asset class, MLP’s tend to be less volatile than stocks, although this is not always the case.  Because a reasonable portion of the distributions which are paid to unit holders are return of capital rather than income, limited partners can defer taxes on their distributions until their units are sold.  When the units are finally disposed of by the limited partners, the proceeds will be taxed at the capital gains rate.

Taxation and reporting of MLP’s is complex and can cause an administrative burden for many individual investors.  Many of these issues can be avoided by holding these units in retirement accounts such as IRA and 401K accounts, where such reporting is in many cases not required.



Closed end funds

Closed end funds are, as discussed previously, mutual fund shares which trade on an exchange much like a stock.  Like open end funds, they are registered as investment companies under the Investment Company Act of 1940 and are highly regulated.  Unlike open end funds, which are priced at the end of the day and valued based upon the holdings in the fund, the market price of a closed end fund is determined by supply and demand for the fund on an exchange.

This results in a closed end fund having a market price which can at times vary significantly from its net asset value.  As discussed previously, this discrepancy can create an opportunity for an investor to buy fund shares at a discount to net asset value and sell fund shares at a premium to net asset value.

Closed end fund shares are issued once during an initial public offering, after which point shares can only be obtained by purchasing them from other shareholders.  This is on contrast to an open end fund, whose operators have the ability to create and redeem shares in reaction to capital flowing in and out of the fund.

Closed end funds tend to be capitalized in the $100 million to $1 billion range, which is much smaller than the typical open end fund, which oftentimes has a market capitalization exceeding $10 billion.  Closed end funds oftentimes employ leverage to boost returns, and frequently pay dividends and interest exceeding 6% per annum.



Preferred stock

Preferred stock is equity interest in a company which is has a higher claim to company equity and assets than common stock and a lower claim to company equity and assets than bonds.  Preferred shares typically pay higher dividends than common stock, and dividends must be paid to preferred stock shareholders prior to being paid to common stock shareholders.

Unlike common stock shares, preferred shares typically do not entitle their holder to voting rights.  Publicly traded preferred shares are issued by financial institutions such as banks and insurance companies, real estate investment trusts, and utilities.

Preferred stock can be either cumulative or non-cumulative.  If a dividend payment for cumulative preferred shares is missed, it will accumulate and be due in a future payment.  This is in contrast with non-cumulative preferred shares, for which no future dividend payment is due if one is missed.

As an asset class, preferred shares tend to be less volatile than common stock shares and more volatile than bonds.  While they tend to pay higher dividends than common stock shares, they offer less opportunity for capital appreciation.  While they typically pay more in dividends than bonds pay in interest, they have greater credit risk than bonds and therefore tend to be more volatile.

Asset allocation

As an investor, a primary goal is to manage the risk in the investment portfolio, and this is typically accomplished by allocating capital across different asset classes.  Which asset allocation is appropriate is dependent upon the time horizon, risk tolerance, and investment objectives of the investor as well as other external factors.

Strategic asset allocation versus tactical asset allocation

At the most basic level, asset allocation models are oftentimes classified as “strategic” or “tactical”.   A strategic asset allocation is based upon the time horizon, risk tolerance and investment objectives of the investor, while a tactical allocation takes into account market conditions, economic and political factors, security analysis, and other factors external to the situation and needs of the individual investor.

Strategic asset allocation

The strategic allocation will depend on factors unique to the investor.  For example, for a risk averse individual with a short time horizon the ideal strategic asset allocation will likely consist of a large amount of bonds and cash and a small amount of stocks, whereas for an aggressive investor with a long time horizon the ideal strategic asset allocation will likely consist of a large amount of stocks and a small amount of bonds.  When constructing a strategic allocation, a common rule of thumb is to base the bond allocation in the portfolio on the investor’s age.


For example, a 30 year old investor using this method would allocate 30% of the portfolio to bonds and cash and the remaining 70% to stocks, whereas a 65 year old investor would allocate 65% of the portfolio to bonds and cash and the remaining 35% to stocks.  Of course, this is only a rule of thumb should be used in conjunction with the time horizon and risk tolerance of the investor as well as other factors related to the financial situation of the investor.  We emphasize the importance of consulting with the appropriate advisers in implementing an asset allocation and a corresponding investment program.

Tactical asset allocation

Tactical asset allocation involves taking into account factors external to the needs and attributes of the investor.  Factors include economic, political, and market conditions.  For example, if the investor and/or investment manager believe that a recession is imminent, they may consider reducing exposure to equities and making a corresponding increase in the exposure to bonds and cash.  Another example involves factors related to the financial position of the individual company or companies in question, and the capital structure represented by the corresponding securities which are involved.  In this scenario, the investor may consider increasing exposure to those securities which are believed to be undervalued and decreasing exposure to those securities believed to be overvalued.


High yield bonds

High yield bonds, frequently referred to as “junk bonds”, are debt obligations of companies which are considered to be high credit risks.  They typically pay a higher yield than investment grade bonds to compensate investors for taking on additional risk.

Like all corporate bonds, junk bonds typically trade over the counter through dealers and their liquidity depends on a variety of factors.

Oftentimes investment grade bonds will be downgraded due to business difficulties of the issuer, and begin trading at a significant discount to their par value as a result.  Such issues are frequently referred to as “fallen angels”.  These junk bonds should be viewed by prospective investors with caution as they could be an indication of an imminent default of the issuer.

As an asset class, high yield bonds tend to be slightly less risky than stocks, and significantly more risky than most investment grade corporate bonds.

Like all fixed income instruments, junk bonds are susceptible to interest rate risk, which increases as the duration of the bond increases.

Junk bonds can be a valuable addition to an investment portfolio, however caution should be taken before allocating them to accounts whose owner has a short time horizon or low risk tolerance.


Cost basis reporting

How the cost basis of an investment is determined will have a significant impact on how the investment is taxed when sold.  Here we will provide an overview of some of the most common cost basis conventions which are currently being used in the tax code for the 2016 and 2017 year.

First in, first out (FIFO)

With this method, the shares or units which were purchased first are the ones which are used to determine the basis when the asset is disposed of.  Another way of looking at this is that the shares which remain are the shares which were most recently purchased.  As an example, let’s say you purchase 100 shares of XYZ stock on September 1, 2016 for $5 per share, purchase another 50 shares of XYZ stock on October 1, 2016 for $10 per share and then sell 100 shares of XYZ stock on November 1, 2016 for $15 per share.  When using the FIFO method the basis for these shares would be $5 per share, or the price paid for the first 100 shares of XYZ stock on October 1, 2016.

Specific share identification (Spec ID)

With this method, the specific shares are identified upon the disposal of those shares.  Using the example above: upon selling the 100 shares of XYZ stock on November 1, 2016, these shares could be identified as the shares purchased on October 1, 2016, resulting in a basis of $10 per share, in contrast with the basis of $5 per share which would be the result of using the FIFO method.

Average cost single category

With this method, the average cost of the shares is calculated by dividing the total dollar amount of the purchases by the total number of the corresponding shares or units.  Using the example above, the total number of shares purchased would 150 and the total dollar amount of shares purchased would be $1,000, resulting in an average cost basis of $6.67 per share.

Highest in, first out

With this method, the shares with the highest cost are the shares which are sold or disposed of.  The purpose of using this method is to minimize the taxable gain within a specified period.  Using the example above, the 100 shares sold on November 1, 2016 would be identified as the 50 shares purchased on October 1, 2016 for $10 per share plus 50 of the shares purchased on September 1, 2016 for  $5 per share.  The basis in this case  would be $7.50 per share, which is the total dollar amount of the shares purchased divided by the number of shares sold.

Minimum tax

Under the minimum tax method, shares are sold in the order which minimizes taxable gains and maximizes tax deductible losses.  Specifically, shares are sold in the following order:  maximum short term capital losses, maximum long term capital losses, minimum long term gains and finally minimum short term gains.

Maximum gain

This method is the exact opposite of the minimum tax method in that it will tend to maximize the taxable gains, and would only be used in a situation where such an outcome would be advantageous, for example to offset against losses.   Using the maximum gain method, shares are disposed of in the following order:  maximum short term gains, maximum long term gains, minimum long term losses an finally minimum short term losses.

Municipal bonds

Municipal bonds are bonds issued by municipalities, oftentimes for the purpose of funding infrastructure or other public works projects.  One of the major advantages of municipal bonds is that their interest is exempt from federal income tax, making them especially attractive to investors in high tax brackets.

Municipal bonds can be either general obligation bonds or revenue bonds.

Revenue bonds are backed by revenue generating municipal projects including stadiums, toll roads, and transit projects such as New York State’s Metropolitan Transit Authority.  Because they are not backed by the full faith and credit of the issuer, these bonds are typically riskier and subsequently pay a higher coupon than general obligation bonds.

General obligation bonds are backed by the full faith and credit of the municipality issuing the bonds and are serviced using general municipal government revenue including income taxes and property taxes.  General obligation bonds are typically less risky than revenue bonds and subsequently pay a lower coupon than revenue bonds.

Like all fixed income instruments, municipal bonds have both interest rate risk and credit risk.  From a credit risk standpoint, municipal bonds tend to be slightly riskier than sovereign bonds and slightly less risky than corporate bonds, although this is not always the case.  As with other fixed income instruments, the interest rate risk of a municipal bond increases as the duration of the bond increases.

Large cap stocks

Large cap stocks represent publicly traded equity interest in the largest corporations in the economy, typically in the $10’s of billions and higher.  They tend to be well known companies and are usually household names.  Large cap stocks tend to be less volatile and risky than small cap stocks but typically offer less opportunity for growth and appreciation.

The shares of large cap companies tend to trade frequently and be more liquid than shares of small cap companies, which oftentimes do not trade as frequently and can be less liquid.

Large cap companies tend to be very established in their line(s) of business and highly diversified in their operations. Many large companies are known as “blue chip” companies due to their high level of quality.  The advantage which such companies have is that they tend to be less risky and more stable than smaller companies due to their breadth, size, and access to capital. The main disadvantage which these companies have is that they are unable to grow their revenues and earnings as rapidly as small companies.

As an investor, having a portfolio which is diversified across many different asset classes is a good strategy to manage the risk of your portfolio.  By combining large cap stocks with other asset classes such as small cap stocks, international stocks and bonds an investor can tailor their portfolio to their needs.


Risk tolerance and time horizon

An investment portfolio, and the underlying asset allocation which makes up the portfolio, is typically designed based upon attributes unique to the investor, such as risk tolerance and time horizon, as well as factors external to the investor.  Such external factors include market conditions, macro and micro economic factors, individual security analysis, as well as a large variety of other factors, the details of which will not be discussed here.  Here we will focus on two factors which are unique to each investor: the investor’s time horizon and the investor’s risk tolerance.  By varying the amounts of stocks, bonds and other asset classes based upon these two factors a portfolio can be designed and managed to meet an investor’s goals and objectives.

Time horizon

Investments with greater returns typically have greater risks, and investments with lower returns typically have lower risks.  An investor with a long time horizon can afford to suffer through market downturns; and for this reason could have a larger amount of risky, high return investments than an investor with a short time horizon.  An investor with a short time horizon should have a higher concentration of lower return, lower risk investments than an investor with a longer time horizon.

Risk tolerance

An investor with a high risk tolerance can afford to hold a larger concentration of high risk, high return investments than an investor with a low risk tolerance.  Such an investor will be less likely to become upset during a market decline and sell their investments.  This is a critical aspect of portfolio design and construction, particularly for individual investors.  An investor with a low risk tolerance would be more likely to become upset and sell risky investments during a market downturn, incurring a loss.  Such an investor should therefore hold a larger concentration of lower risk, lower return investments, as such investments will be less likely to decline in value by significant amounts.

Mutual funds

Mutual funds are diversified investment pools which are available to the general public, and are frequently used by investors to provide diversified exposure to securities as part of an overall asset allocation.  They are registered securities and are highly regulated.  They are frequently referred to as “investment companies”, and are structured in either an “open end ” or “closed end” format.  We will review the basics of open end funds and closed end funds here, and discuss some of their advantages and disadvantages as relates to issues such as liquidity and valuation.

Open end funds

Open end funds are mutual funds which can be redeemed or purchased by an investor on a daily basis, and can be done so at the market price, or “net asset value”, of the securities which are held by the fund.  The advantage of open end funds is that the investor does not run the risk of being unable to redeem his or her shares at the market price of the underlying securities in the fund.  The main disadvantage of open end funds relates to the fact that assets flow in and out of the fund on a daily basis, the net result of which can be a negative impact on fund performance.

Closed end funds

Closed end mutual funds trade on a securities exchange, similar to a stock.  The market price of the closed end fund will be determined by supply and demand of the fund on the exchange, and frequently will differ from the net asset value of the fund.  A shrewd and disciplined investor can purchase such shares at a discount from their net asset value, and sell them at a premium to their net asset value.  An advantage of closed end funds is that there are no daily inflows or outflows of fund assets, so the fund manager is able to manage the assets inside the funds in a long term manner.

Stocks and bonds

Stocks and bonds are some of the most common assets held in accounts by individuals, such as 401K and IRA accounts.  Previously we provided an overview of the asset allocation process and how it can be used to customize your investment portfolio based upon your investment objectives, time horizon and risk tolerance.  We also discussed briefly how this process can be implemented in your 401K account.  Here we will provide a very basic overview of stocks and bonds.


Stocks are publicly traded equity interests in businesses, and are typically riskier than bonds.  As an asset class, stocks are oftentimes broken down by company size (frequently referred to as “market cap” or “market capitalization”) and geographic region, (such as U.S., developed markets, emerging markets, and frontier markets).  Emerging market stocks typically can provide a higher return than developed market stocks, but are riskier.  As stocks are overall riskier than bonds, they are usually allocated more heavily to portfolios with a longer time horizon and for individuals with higher risk tolerances.


Bonds are debt instruments issued by businesses or governments (both national and local), and are typically less risky than stocks.  They are usually allocated more heavily to portfolios with shorter time horizons for individuals with lower risk tolerances.

Holding bonds entails several risks, including credit risk and interest rate risk.  Credit risk can be defined as the risk that the issuer will default and fail to make payments of interest and/or principal.  Interest rate risk is the risk that interest rates will rise, resulting in a decrease in the present value of the bond principal.  Interest rate risk can be somewhat mitigated by holding bonds until their maturity, however this is often difficult for an individual investor who is more likely to be invested in bond funds rather than individual bonds.


Stocks and bonds have different risk and return characteristics.  By combining them with other asset classes and weighting their allocation appropriately, an investor can customize an investment portfolio based upon his or her time horizon, investment objectives, and risk tolerance.

Currency risk of assets held overseas

Assets held overseas or denominated in a foreign currency can expose your investment portfolio and assets to currency risk.  Here we will discuss the risks associated with holding stocks, bonds, real assets and cash denominated in a foreign currency, and options for mitigating this risk via hedging.  Overall we believe that hedging as an investment strategy is an expense which will have the net effect of reducing the return of the portfolio over time.

Currency risk of stocks and bonds

The effect which exchange rate risk has on overseas assets such as stocks and bonds is a very complex subject.  The performance of the foreign business issuing the securities is effected by currency risk due to its inventory, receivables, and other assets being denominated in the country’s currency.  When stocks or bonds are issued and denominated in a foreign currency, they typically pay interest or dividends in that currency.  The investor is therefore exposed to currency risk in a variety of ways.

A portion of these currency risks can be hedged using currency futures, however keep in mind that there are inherent costs associated with hedging.  Additionally, there may be an underlying need to own assets denominated in the currency of another country, as discussed more below.

Currency risk of real assets

There may be an underlying need to hold assets in a foreign country, and real assets held overseas, such as real estate and commodities, can serve as both a currency hedge and an inflation hedge.  An instance of this is where real property is held in a country to which the holder of the asset intends to return to at a future date, for example to retire.

Tax advantages of rental real estate

Rental real estate can be an excellent investment.  Real property offers a significant opportunity to obtain income and capital appreciation for an investor.  It also has many advantages to an investor from a tax perspective.  These advantages include the ability to exchange property on a tax deferred basis, as well as the ability to write off numerous expenses associated with the property, including depreciation and depletion of the underlying assets.

Tax deferral

Investment property can qualify for a “like kind exchange” which is known as a section 1031 exchange.  Under a section 1031 exchange, the investor can defer gains on the property as long as the proceeds from the real estate sale are re-invested in another property.  Certain requirements must be met, including the identification of a replacement property and subsequent closing on that property within certain time frames, as well as the use of a qualified intermediary to transfer the funds from one property to another.  It is important that such an exchange be done in consultation with the appropriate advisers as the rules are complex.

Deduction of investment expenses

In addition to expenses associated with operating the real property including contractor and employee expenses, real estate taxes, utilities, repair costs, and travel related to running and managing the property, real estate investors can also deduct depreciation of the property and of many of the fixtures inside the property.  There are certain IRS conventions which are used to depreciate property, including the accelerated cost recovery system (“ACRS”) as well as the modified cost recovery system (“MACRS”).  Under these systems the depreciation is calculated based upon the current basis in the property as well as the number of years remaining in the cost recovery period.  A unique feature of deducting depreciation expenses is that the cash flow of the property is not affected.  In certain situations an investor can operate a property which has positive cash flow but which shows a loss on the income statement, resulting in a tax advantage.



Capital gains and dividends

Investments can be be taxed in several ways.  When they are held inside retirement accounts, taxes are levied upon withdrawals from the retirement accounts based upon the rules related to those accounts.  When they are held outside of retirement accounts, they can be taxed on both the income which the investments generate as well as on the gains obtained when the investments are disposed of.


We restrict discussion to dividends and interest here, and how they are treated for the recipient.  Income paid in the form of dividends and interest is typically taxable to the recipient upon being paid by the issuer or payer.  In the case where dividends are reinvested to purchase additional securities the dividends are still taxed upon being paid.  Dividends and interest are typically taxed as ordinary income, the exception being certain “qualified” dividends which are taxed at the capital gains tax rate.

Capital gains

Capital gains taxes are incurred when an asset is disposed of, and are based upon the amount of time which the asset is held.  Assets held for one year or less are taxed at the short term capital gains tax rate, while assets held for more than one year are taxed at the long term capital gains tax rate.  The amount of the gain is a function of the sales price and the cost basis of the asset.  The table below shows the capital gain tax rates for their corresponding income tax bracket.

2016 capital gains tax rates
Income tax bracket short term rate long term rate
10% 10% 0%
15% 15% 0%
25% 25% 15%
28% 28% 15%
33% 33% 15%
35% 35% 15%
39.6% 39.6% 20%

Efficient Market Hypothesis

The efficient market hypothesis makes the overall statement that all available information related to the valuation of an asset is fully reflected in the market price.  If it were true, investing in undervalued assets would not be possible because the valuation would already be reflected in the market price.  This theory is propagated, discussed and debated mainly in academic circles and has little use related to actually allocating assets or selecting securities.  The theory can easily be disproved by simply looking at the track records of the handful of investment managers who have consistently outperformed the market over many decades.  A shrewd, disciplined, objective and focused investor can find inefficiencies in the market and identify undervalued and overvalued securities.

Nonetheless, the efficient market hypothesis is a popular theory and therefore understanding its basic tenets is important for any investor.

Stock options

A stock option gives the owner the right, but not obligation, to purchase or sell shares of a stock at a certain price, for a given amount of time.  Companies frequently use stock options as a means to compensate employees.  Employee stock options can be broken down into two general categories: incentive stock options (“ISOs”) and non-qualified stock options  (“NSOs”).

The Intelligent Investor by Benjamin Graham

There are several excellent books in print which were written by extremely successful money managers, and “The Intelligent Investor” by Benjamin Graham is one of them (“The Alchemy of Finance” by George Soros is another one).  Graham was Warren Buffett’s teacher and mentor and ran the Graham Newman investment partnership in the first part of the 20th century.  This book outlines Graham’s philosophy of value investing.  The book is relatively easy to understand for a lay person, and outlines in detail the underlying principals behind Graham’s investment philosophy and how it can be applied to analyzing and valuing individual securities.

529 Plans

529 plans are savings vehicles for the purpose of funding higher education expenses.  They have numerous tax advantages, including tax deferral and tax free withdrawals.  The withdrawals are typically tax free as long as they are used to fund qualified higher education expenses such as tuition, board, fees, books and other expenses at an eligible school.  Under certain circumstances, 529 plan contributions are eligible for a tax deduction at the state and local level.

With a 529 plan, the owner sets up an account for the benefit of a child, grandchild, or other family member (the beneficiary).  Unlike with custodial accounts, the owner retains control of the 529 plan account, even after the beneficiary reaches the age of majority.  The owner also has the ability to change the beneficiary of the account after establishing it.  For example, if a parent creates an account for the benefit of one child and that child later decides not to attend college, the beneficiary of the account can be changed to another child.

Keep in mind that 529 plan contributions are considered gifts and are thus subject to the gift tax rules.  For 2016, the gift tax exclusion is $14K per beneficiary.  Keep in mind that all gifts, not just 529 plan contributions, are subject to this limit.  There are rules unique to 529 plans which allow the gift tax exclusion for the next five years to be taken in the current year by making an election on your gift tax return.  Using this election you could make a contribution of $70K ($140K for a married couple) to a 529 plan for a single beneficiary in the current year.