A Practical Guide to Choosing an Investment Account Overview

Investment Picture

Opening an investment account is a crucial first step to saving wisely. Today, you have the option to invest through a discount brokerage account, a mutual fund account, a full-service brokerage account, or even a bank account. You should pay extremely close attention to fees when choosing an account, since seemingly small yearly charges can act as sharp brakes on the amazing effects of compound interest. Discount brokerages are an appropriate choice for many, since they combine low fees with the widest selection of investment options. It is relatively easy to select a discount brokerage firm since competition has lowered fees substantially.

 Why Expenses Matter A Lot

Cooking is something that I have a love-hate relationship with. Although I love being able to control exactly what goes into my body, having an unlimited array of culinary possibilities, and saving money by not eating at restaurants, I hate figuring out what combinations of food will taste good, burning rice for the third time in two weeks, and spending time in front of a stove with a potholder and not in front of a TV with a beer. Frequently the tension of this dilemma is resolved with a takeout order. I am perfectly okay with this, because it is still relatively affordable to outsource this part of my life for $10 a meal or so. But if local takeout places were charging $10,000 a meal, you can bet I would be in a cooking class in no time. No one would eat out at those kinds of prices.

Yet an equivalent price structure exists in the world of investment management, and rather than learning to cook, most people are instead opting to pay $400,000 for a hamburger that has been sitting out in the sun too long.

To see why, let’s bring back Jill and Average Joe.

Imagine each makes an identical $100k investment that earns 8% a year before fees. Jill invests directly in a low cost index fund that charges a fee of 0.2% of assets. Average Joe invests in an average mutual fund through an average financial advisor. The mutual fund charges a management fee of 1.3% of assets (not all funds are as expensive, but 1.3% is about average for an actively managed fund), and his financial advisor charges a fee of 1% of assets for managing the investment on his behalf.

To Joe, it seems like it is well worth it to pay roughly 2% of his assets a year for the convenience of professional management, especially when his investments are easily earning more than this every year. But in actuality he is reducing his returns by a stunning amount over time. After 30 years, Jill’s account would have grown to $952,000 whereas Joe’s account would have grown to only $528,000. Solely by paying 2% a year less in fees, Jill will be nearly twice as wealthy as Joe. The fees that Joe paid did not seem high relative to the returns he was making at the time, but over the course of 30 years they ended up “costing” him $424,000, or four times his initial investment.

Where the “Value” of an Investment Comes From


Often, commentators will talk about a stock or bond as being particularly “overvalued” or “undervalued.” Such a description poses the question of how to define “fair value.”

The theory of intrinsic value says that an investment’s price should equal the value it would have to a buyer who planned to hold it forever (even though, with the advent of secondary markets, most investors do not actually do so). Investors who plan to hold a stock or bond forever are not concerned about what the asset is trading for on secondary markets, they are simply concerned with the value that they will receive from the annual or semi-annual interest, or dividend payments. Thus the value of a stock that is correctly priced today should be the present value of its future dividends.

The idea that a string of dividends going forever into the future has a “present value” seems a bit strange at first. But it makes complete sense in the context of what economists call the time value of money. The basic idea is that receiving $1 today is worth more than receiving $1 five years from now. You can think about this in three different ways:

  1. If you had a dollar today you could invest it in a guaranteed bank account or certificate of deposit (CD).
  2. You can buy more things with a dollar today than you will be able to with a dollar five years from now, the same applies for your annuity payments, Washington Accord experts claim. This is because of inflation, the slow rise in the cost of living over time. For instance, a dollar in 1970 bought four loaves of bread; today it will not even get you half a loaf.
  3. If you are human, you probably would prefer to spend a dollar today, even if it could be used to buy the same things five years from now. Most of us prefer immediate gratification to delayed gratification. Given the choice of eating cake now or eating cake one week from now, we choose now. Which is not to mention that many of us have to spend money today for things like eating, which cannot be delayed indefinitely.

Because dividend payments received in the future are worth less than those received today, we need to apply a discount rate to them in order to express what they are worth to a rational investor today.

If we know or can observe what the time value of money is, than we can place a dollar value today on the promise of $1 five years from now. In doing so, we are “discounting it back to the present.” And if we can place a current dollar value on the promise of $1 five years from now, then there is no reason we cannot place a current dollar value on any stream of future dividends or interest payments.

This is precisely what is needed to value a stock, bond, or any other kind of investment – estimate the income the investment will provide at each year in the future, and discount it back to the present at an appropriate time value of money.

A good estimate for the time value of money today is the interest rate on a very safe investment, such as U.S. Treasury bonds (IOUs from the U.S. government). There is a kind of Treasury bond known as a zero-coupon bond. If you purchase a zero-coupon bond, such as a U.S. savings bond, you receive a guaranteed amount of money at a specified time in the future, but you do not receive any interest payments until then. Because of this, the price of a zero-coupon bond that will pay us $1 ten years from now will be much less than $1 today, and this price is just the time value of money. For instance, if a ten year zero-coupon bond that pays $100 at maturity is selling for $60 today, then that means that $100 ten years from now is equivalent to 60 of today’s dollars.

Table 3 – Present value calculation for a hypothetical investment paying a $10 dividend for 5 years

In the Bill and Ted example, the intrinsic value of Ted’s investment will always be his best guess on how many bushels of corn Bill will give him in the future. This would vary with the probability of success of the project and/or Bill’s credit worthiness. In today’s markets, intrinsic value equates to the estimated future dividend or income stream of a company, discounted back to the present to reflect the time value of money and the riskiness of the investment.