Volume 41: Frank Armstrong, author of Investment Strategies For The 21st Century, answers questions from members of the MFI community. To submit a question to Frank, please write to us.

Questions and Responses

Should I choose a Roth IRA or just invest in a mutual fund?

How can a child's fund investment be "protected" from a parent?

Does REIT appreciation correlate best to small cap appreciation?

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Should I choose a Roth IRA or just invest in a mutual fund?

from Lance

Q: I started my 401k plan with my company about 6 months ago. I currently contribute 10% and plan to increase that to the maximum amount of 15% within 6 months. I am now considering investing in a Roth IRA or mutual funds. Which would be the better option given that I have just begun my investment portfolio?

A: It's not possible to give advice without knowing more about your situation. First, the 401(k) is a great thing, and all other things being equal, you should try to max out your contributions. If you put 15% of your income in each year, then over your working career you should accumulate a very substantial sum. It's hard to imagine a better combination than current tax deduction for your contributions, and tax deferral for a long term investor wishing to accumulate for retirement.

The Roth IRA provides no current deduction, but allows tax free withdrawals, and does not have the mandatory distribution at age 70 1/2 that other pension plans require. However, to benefit fully from the Roth, you must hold it until age 59 1/2 or at least five years whichever occurs later. Otherwise gains may be subject to taxes and penalties.

A straight mutual fund purchase provides no deduction, and is subject to some taxes as you go along. However, you can sell at any time without penalty, and if shares are held long enough, they qualify as long term capital gains, the lowest possible tax rate. So, if you are saving up to buy a speed boat in 12 years, this may be the more tax effective way to go, especially if you select tax efficient funds.

As you can see, you can't make a good decision without knowing why you are investing, how long the funds will remain invested, how the funds will be invested, and what your tax situation is.

How can a child's fund investment be "protected" from a parent?

from Jeffrey

Q: I just read your answer about mutual funds for a new child. I usually really like your columns, and I learned a lot from you book, but I have two complaints here.

First, the question said that the daughter had accumulated the money through gifts. That means that it is her money and you must use a UGMA account. I agree that if the parent is deciding whether to give money to a child, then your points are important. But if someone such as a grandparent gives a gift to a child, the parent can't just take it away. (This is why I use a UGMA for my children -- if I am wrong here let me know!)

Second, if the parent keeps the money, you say that the parents can later give the daughter the account. This is now subject to the $10,000/yr. limit on tax free gifts and things can get more complicated than you indicated.

A: Minors may not own securities. Parents can either own them for the children, set up a formal trust, or use a Uniform Gifts for Minors Account (UGMA). The UGMA account is very awkward, and as previously indicated may lead to undesired results. During my 25 years in the financial services business, I have heard more than one horror story where an UGMA account was consumed for recreational drugs or fast cars rather than college. So, I recommend that parents enforce the golden rule: He who has the gold, rules!

Holding the funds on behalf of your children is not exactly "taking it away" or "stealing" the assets. If you wish, you can set up an account earmarked for the child, and not commingle the assets with your other holdings. If we can presume a two parent household, and both parents consent to the gift, the annual gift exclusion becomes $20,000 per child. Gifts can be spread over a number of years. In any event, funds spent on education for the child are not considered gifts. So, the limitation shouldn't impose any particular hardship.

Does REIT appreciation correlate best to small cap stock appreciation?

from Joe

Q: I read with great interest your series of articles about asset allocation. I have been steadily moving to reduce the amount of large cap US equities in my portfolio since Jan 98 by buying mid term Treasury bonds and global mutual funds. Did I understand correctly that you think that REIT appreciation correlates best to small cap stock appreciation? If that is so, could I buy the unit trust REIT my brokerage is offering as a means of adding an asset class not highly correlated to the large cap US stocks that now dominate my portfolio WITHOUT having to go long in small cap US stocks which I don't currently own or want to own.

In short, I have a personal preference for REIT versus small caps but would like the benefit of asset allocation. Am I kidding myself?

A: REITS have very strong correlation to small cap value funds. Adding them to your portfolio will give you a measure of diversification from your existing large company portfolio. I don't think that it would be accurate to say that they are perfectly interchangeable with small company stocks, but given your distaste for small companies your choice should improve your present portfolio. You might also consider any of the foreign markets or emerging markets as potential diversifiers.

Copyright (c) 1998 Frank Armstrong.

Frank Armstrong is author of Investment Strategies for the 21st Century, published here, and president of Managed Account Services, Inc., a fee-only advisor specializing in global asset allocation strategies utilizing no-load mutual funds. Frank is a Certified Financial Planner (CFP) with 24 years' experience helping investors build wealth. The firm, an SEC Registered Investment Advisor currently manages in excess of $60 million for over 140 clients worldwide. Visit Frank's Managed Account Services, Inc. or call 1-800-508-8500 for more information about the Alternative to Business as Usual on Wall Street.

Copyright © 1998, Frank Armstrong.

Frank Armstrong is author of Investment Strategies for the 21st Century, published here, and president of Managed Account Services, Inc., a fee-only advisor specializing in global asset allocation strategies utilizing no-load mutual funds. Frank is a Certified Financial Planner (CFP) with 24 years' experience helping investors build wealth. The firm, an SEC Registered Investment Advisor currently manages in excess of $60 million for over 140 clients worldwide. Visit Frank's Managed Account Services, Inc. for more information about the Alternative to Business as Usual on Wall Street or call 1-800-508-8500.

Disclaimer

Investing in equities involves a serious principal risk, and no assurance can be given that the techniques described here will be successful. Returns vary and you may have a gain or loss when you sell your shares. Past performance is no guarantee of future results. Index returns shown are historical and include the change in share price, reinvestment of dividends, and capital gains. Indexes are unmanaged and do not reflect the impact of transaction costs. Transaction costs would have reduced the total returns.

International investments, especially those in emerging markets, entail greater risks (as well as greater potential rewards) than U.S. investing. These risks include political and economic uncertainties of foreign countries, as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less-established markets and economies.

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