How to Own Stocks and Bonds

In yesterday’s post, I asserted that there are effectively just two types of retirement investments—stocks and bonds. “Wait a minute,” you say, “there’s lots more than two. I’ve got mutual funds, I’ve got IRA’s.” Yes, you do. But these are just additional layers of legal structure which mask the nature of the investments that, at bottom, you ultimately rely on to grow your retirement security. Let’s look at a few ways to own stocks and bonds.

Physical Possession. The most direct way to own stocks and bonds is to have actual possession of the physical certificates that embody your ownership of the companies issuing the stocks and bonds. That is so twentieth century. Early twentieth century. You may get some misguided sense of security by having possession of shares of stock, but when you want to sell the stock, or you die or become incompetent, you won’t believe the hoops you (or your children) will have to jump through to transfer ownership. And each issuing corporation has its own set of rules, no two the same. So read the next paragraph, and then dematerialize your certificates.

Investment Account. You can open an account with a brokerage firm, and buy, sell and hold your investments inside your account, in the name of the firm. Your ownership of stocks and bonds is reflected in the electronic records of the broker. Then the process of buying, selling, owning, and transferring securities is much easier. You might be picking your stocks and bonds yourself, or relying on recommendations of the broker. How does the broker get paid for this advice? Often, indirectly, by earning commissions for the purchase and sale of securities. Sometimes from selling you securities it already owns, at a higher price than the broker paid.

Managed Investment Account. Rather than select individual stocks and bonds yourself, or with the recommendations of your broker, you can hire a registered investment advisor to do that for you. You still own the account, but you authorize the brokerage firm to take investment direction from the investment advisor. Of course you pay a fee to the investment advisor for this service, and you continue to pay commissions to the brokerage firm for executing buy and sell instructions.

Investment Manager’s Account. You might open an account with the registered investment advisor, who then pools the securities owned by a whole bunch of his clients. This big pooled account is then held at a brokerage firm. Your share might be, say, 1% of the investment advisor’s omnibus account, and each month or quarter or year, you’ll get a statement showing your equitable ownership of the securities. So now there are two layers between you and your stocks and bonds—the investment advisor and the broker.

Wrap Account. Some brokerage firms offer “wrap accounts” which impose one bundled fee, including both investment advice and brokerage commissions. The broker and the investment advisor split this fee in some way that may be opaque to you. One fee sounds better than two, but not if it turns out to be bigger than two fees added together.

Mutual Fund. It has been become very popular for individual investors to own stocks and bonds through a mutual fund. Essentially you and all the other owners of the mutual fund have pooled your assets, which then are collectively managed by the mutual fund manager, a professional investment advisor hired by the mutual fund to pick stocks and bonds. If you “sell” some shares of the Fund, at the end of the trading day the Fund redeems the shares at the net value of its underlying assets. You still pay brokerage and investment management fees, but they are pooled inside the fund. From your perspective, what counts most is the proportion of stocks and bonds held by the fund. You can get a general sense of what that is from the fund’s prospectus, which sets out the fund’s goals; e.g., this fund will invest in European stocks, or that fund is a balanced fund investing in both stocks and bonds within stated ranges.

(An aside. I learned recently that Quicken, a popular computer program for keeping track of your investments, actually helps you know how much of each asset class you own on any given day by looking inside your mutual funds, and seeing their current proportion of each asset class. Cool. It’s all done automatically for you so you can keep tighter control of your asset allocation if you want.)

Index Mutual Fund. An index mutual fund is just like any other mutual fund, but its internal fees are cheaper because the investment advisor is called upon to make essentially no investment decisions. Instead the advisor merely tries to replicate a recognized index, e.g., the 500 largest U.S. stocks. A monkey could do it. But then you'd have to pay the monkey 10 or 15 basis points, or it'll throw feces at you.

Exchange Traded Funds. Exchange Traded Funds, or ETFs, are similar to mutual funds, in that you equitably own a small percentage of all the Fund’s stocks and bonds. The managers of the Fund use a bunch of techniques to try to keep the Fund’s market value as close as possible to the underlying net asset value of the Fund’s investments. One difference between Exchange Traded Funds and mutual funds is that Exchange Traded Funds can be bought or sold throughout the day, rather than being limited to end-of-day transactions.

Fund of Funds. Some mutual funds invest in other mutual funds, adding another layer of legal ownership between you and your stocks and bonds. For example, those increasingly popular life-cycle funds, which dial down the stock percentage as you age, are often structured as a mutual fund which itself owns shares of both stock and bond mutual funds.

Savings Buckets. Your government has kind kindly created different types of savings buckets with favorable tax characteristics, such as 401(k) plans, Individual Retirement Accounts, and Roth IRA’s. Your stocks and bonds can be housed inside these buckets, adding another layer of legal structure between you and your investments. And if you’ve got your IRA invested in a fund of funds, you’re talking about three layers of legal structure. It boggles the mind.

Bank Accounts. You might have your money sitting in a bank. If it’s in a deposit account, like a checking account, savings account or a certificate of deposit, then you’ve got a "bond" of sorts. You have lent your money to the bank, for which it is paying you interest (not too much interest, these days). And if the bank is FDIC-insured, repayment of your loan is guaranteed by the United States government, within limits.

Variable Annuity. In prior posts, for example March 10’s post, I’ve discussed the pros and cons of pure annuities, where, in exchange for some of your dough, the insurance company promises to pay you $X per month for as long as you live. A pure annuity is bond-like. But there are variations on that investment, called variable annuities, where the insurance company invests your premium in an underlying pool of securities that might be some combination of stocks and bonds, and the value of your annuity fluctuates with the ups and downs of the pool. The insurance company charges a fee for managing the underlying pool of assets, but it’s often hard to know how much you’re paying, since the fees are all bound up with its mortality charges—the amount it charges for taking the risk that you’ll live as long as those yogurt-eaters from the Caucasus.

Of course the type of ownership structure you choose is important, as that affects the fees you pay, your tax characteristics, and the investment performance you expect. But most important to your long-term retirement security are your equitable ownership percentages of stocks and bonds, which can be buried pretty far down the chain.