Monday, August 29, 2016

How to Invest $1 Million Today

You've heard about record highs in the US stock market, and how bond yields are so low it's not even worth it.  Either way you start to get anxious thinking you might be missing out on something.  Especially when your annoying lawyer neighbor starts blabbing that he's "killing it this year blah blah blah", and you want to unleash some fury on him. Financially of course.

If you only began following stock markets this year you'd have already witnessed wild swings down & up(Jan-Feb), followed by some relative calm(Mar-May), a sudden spike down & back up(June Brexit), followed by more calm(June-today). Pretty crazy stuff you might think. Actually sounds about normal for the market. Yes the market can look like a pinata getting cracked on all sides from your favorite group of 8 year olds salivating for the moment it unleashes a torrent of sugary treats. But it's one of the best time tested creators of wealth.

Now investing $1 million isn't a reality for most people. Although if you followed my original Why You're Poor Series you could save that in less than 20 years with minimal effort. I'm going to detail today how you could invest $1 million if ya know, it's just lying around. For those following at home you can adjust your numbers accordingly, or contact me.

Now I can go over hundreds of different variations, but for today's article we'll highlight just a few strategies besides the obvious going all in. I'm also using ETF's for this article since they can be accessed by anyone with a standard online brokerage account.


Strategy 1 - The Covered Call Approach

With the S&P 500 still near all time highs you are hesitant to go all out long equities with no downside protection.  So you buy the SPY index fund as of writing trading around $218.50/share.  $1 million allows you to buy 4,500 shares, or 45 lots*.   It's also decided approximately 12% downside protection is desirable for your risk preferences. Additionally you want to take advantage of long term capital gain tax rates. Of course you could adjust this to any time frame or risk profile you desire.

 Looking at the options market we check the September 2017 option contracts. We see the $200 strike contract is bid at $25.12, which is the price we could sell it for no questions asked right now.  By selling the calls we'd receive $25.12 in premium for each share we own, or $2,512 for 1 option contract. Receiving this money reduces our "basis". Let's calculate what our new "per share basis" would be.


InstrumentPrice
SPY$218.50
Sept'17 200 Call-$25.12
New SPY Basis$193.38

This basis is our new price shares would have to trade below in order to incur a loss.  By selling the Sept'17 200 strike option contract we are now obligated to sell our shares at $200 each.  This means as long as the market stays above $200 share our profit will be the difference between $200-$193.38 = $6.62/share. Your profit would equal 3.31%, but you were protected 11.5% to the downside in this example. Here is the total dollar value if the trade was called out, or in other words if SPY traded above $200 at expiration.

ActionInstrumentSharesPriceValue
BuySPY4,500$218.50-$983,250.00
SellSept'17 200 Call45$25.12$113,040.00
SellSPY4,500$200.00$900,000.00
ExercisedSept'17 200 CallExercisedExercised0
Total Profit$29,790.00

This is a fairly conservative approach that would still net you close to $30k in just over a year. You are also entitled to approximately 4 dividend payments. With a current 2% yield we can estimate about $19,660 in dividends. That'd bring your total return to $49,450, or 5.50%.

Now just for fun I want to take an after-tax look with this example since it's easy to calculate.

Pre-tax Profit$29,790.00
Capital Gains Tax 20%**-$5,958.00
Dividends$19,660
Dividends Tax 20%**-$3,932
Total After Tax Profits$39,560.00

All in after taxes you could net yourself a still respectable 4.40%. 

Strategy 2 - The Stock/Bond Approach.

Let's take a look at the widely popular 60/40 stock & bond portfolio split.  Whether or not that's appropriate is outside the realm of this article.  The idea of holding bonds is to make your overall portfolio less volatile.

ETFRatioValueYieldDividends/Interest
SPY60$600,0002%$12,000
BND 40$400,0004.20%$16,800
Total Income$28,800
Income Yield2.88%

The estimated $28k in dividends and interest is not to bad overall considering plenty of people don't make that going to work full time. Yet the overall return is lower than our covered call approach. I should note this is an allocation widely used in research which is why I'm using it. Now what if we assumed a 3% capital appreciation.

ETFRatioValueYieldDividends/Interest
SPY60$600,0002%$12,000
BND 40$400,0002.40%$9,600
Total Income$21,600
3% Capital Gain$630,000$30,000
Total Return5.16%

Here we see our total return will equal 5.16%.  While the percentage might look low it's actually a $51.6k return you netted. Or just about an average persons salary for the year.

If we tax the income portion at 20%** the total return would be 4.72%

Strategy 3 - The Diversification Approach

Diversifying means you split up your assets into different asset classes, and you split up each major asset class into different sectors where possible.  Here is one basic stock/real estate/bond allocation split. Of course this can be customized to any specific plan, goal, or risk preference.

Asset ClassRatioETFValueYieldDividends/Interest
US Equities20.00%SPY$200,0002.00%$4,000
International Equities20.00%VXUS$200,0002.70%$5,400
Real Estate - US15.00%VNQ$150,0003.21%$4,815
Real Estate - Intl15.00%VNQI$150,0002.85%$4,275
US Bonds15.00%BND$150,0002.40%$3,600
International Bonds15.00%BNDX$150,0001.48%$2,220
Total100.00%$1,000,000$24,310

We are diversified across many asset classes. Which in theory should provide us with less volatility and risk. It's noteworthy some of the international sectors are yielding less than their US counterparts. This should keep the US based investments attractive not only domestically, but to international buyers if they reside in a locale where their currency is weakening versus the dollar.

This approach also produces the most passive income of all 3 strategies. When we add in a 3% capital gain it brings the total return to $54,310 for a solid 5.43% gain. Or in other words right smack dab in the middle of the middle class. In theory you could live off this portfolio with a comfortable middle class lifestyle.

Let's look at this in total with capital gains and even a 20% tax on the income portion.

Asset ClassRatioETFValueYieldDividends/Interest
US Equities20.00%SPY$200,0002.00%$4,000
International Equities20.00%VXUS$200,0002.70%$5,400
Real Estate - US15.00%VNQ$150,0003.21%$4,815
Real Estate - Intl15.00%VNQI$150,0002.85%$4,275
US Bonds15.00%BND$150,0002.40%$3,600
International Bonds15.00%BNDX$150,0001.48%$2,220
Total100.00%$1,000,000$24,310
3% Capital Gain$1,030,000$30,000
Pre-Tax Gain5.43%
Tax on Income 20%-$4,862
Total After Tax Gain4.94%

This rather simple diversified approach produces the highest estimated return of our 3 scenarios on an after tax basis at 4.94%. 

Conclusion

Each strategy offers different amounts of risk, and income. We should note in Strategy 1 the full $1 million isn't invested bringing down it's total return just a bit.  FYI you can sell mini options on the SPY which cover 10 shares, but for simplicity it was excluded from our example. Taking a look at all three here is the total yield each strategy would give you not accounting for taxes.

Strategy 1 - 5.50%
Strategy 2 - 5.16%
Strategy 3 - 5.43%

In summary these are just 3 different approaches you could take today.  They don't even have to be right now, but anytime you decide.  There are plenty of different ways to customize each approach.  With just a little imagination the options are unlimited!


*1 lot is considered 100 shares for stocks. so 45 lots equals 45x100= 4,500 shares, and total purchase of $983.250.00 .  Since this example is using options, and 1 option contract is equal to 100 shares it makes illustration easier. 1 options contract is also considered 1 lot. 

**Assuming this person is in the 39.6% tax bracket and thus dividends are taxed at 20%. Also the tax scenarios for strategy 2 & 3 assume the positions are not sold, only the income is taxed. 

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