Every year at tax time, I am asked by friends, family and clients where they should go to get financial advice. It seems very few of them are really happy with their current situation. Some of them complain of brokers or planners who aren’t available for them—who don’t really seem to be able to help them. Others say their financial advisors talk down to them or just talk beyond their level of understanding. While still others complain about how the fees they pay for financial management seem to eat up most, if not all, of the growth they earn within their nest egg and investment accounts.
Some people complain how they have to pay taxes on short-term and long-term capital gains within their mutual funds even though they never sold any of their holdings. Worst yet, in previous years, while mutual fund values were in decline, shareowners were having to pay taxes on earnings inside their mutual fund investments. This type of income is called “phantom income” because certain events trigger taxable income whether or not the funds actually made any distributions.
Know the Real Math Behind Your Investments
Tax time falls in the first quarter of the year and during this time as we all begin to pull our 1099 statements together to prepare our annual tax return—we start to notice how our investments did during the preceding year. We see the income that is being reported and we see our beginning-of-year and end-of-year account balances. In many cases, this is the time each year in which some people even look at what is really going on within their investment accounts.
One frustrating thing for me has always been working with a client and hearing them tell me that a certain mutual fund or a certain company stock in which they are invested is terrific because every month, or every quarter they are getting a nice dividend—In fact the mutual fund manager or stock company keeps upping the dividend payment every few quarters.
While this is a great thing to happen if the underlying reasons for this increasing dividend is based on sound business, financial fundamentals—and the mutual fund value or the stock value is continuing to grow over time—It isn’t so good when you go back and discover that every time you get a $1.25 quarterly dividend per share, your share value is dropping by the same $1.25, or perhaps even a little more. This is a trick often played by some of the income mutual fund account managers or dividend-paying stock companies. You see this especially in the investments where the dividends might be helping to fund an investor’s monthly cash flow needs in retirement, for example.
Let me give you an analogy to the practice described above. It would be similar to funding a CD with a $10,000 investment. Let’s say this CD is paying interest at the rate of 4% a year resulting in annual earnings (not considering compounding) of $400. Now let’s assume that you pull $600 out of your account at the end of the year. Now—applying the same above logic—you could say that your CD paid you $600 for the year—which is a 6% earnings. This is a whopping 50% better than the 4% you were told you were going to earn. You can impress your friends—and perhaps yourself—with this type of approach. However, as you can plainly see, you are simply returning some of your invested capital. You aren’t really earning 6%.
In fact, taking this one step further, you can pay out any amount you want up to $10,000 and it could appear to someone who doesn’t understand what is happening that your little CD is really paying you a great return. Well, like I said, this is a game commonly played by some of the mutual fund managers to make your investments look much better than they are in reality. It can even be applied by individual stocks of very well known businesses. Sometimes companies will pay consistent and increasing dividends even while they are losing big money—strictly for the purpose of making investors believe they are better off financially than they really are. It’s a classic case of the shell game in real world action—on your nest egg!
Apply This to Your Situation—Protect Your Nest Egg
The purpose of this article is to try to get you to think. You need to really understand what is going on with each of your holdings. Don’t just park your investment dollars hoping and trusting that the investment managers have your best interest in mind when they are making their business decisions.
Keep in the know on what is happening with your finances. Question your managers—or manage yourself—and look at the whole picture when measuring and weighing your investment choices. If you don’t know how to spot these practices, get in touch with those who can help. Most importantly, never assume you can’t stay on top of things to help make sure your nest egg is not a victim of the shell game.