Investing mechanics.

Expense ratios

The annual % a fund takes. The only fee you can control with certainty.

A fee looks trivial because it's quoted as a decimal. It isn't trivial, because it compounds against you for the same thirty years your money compounds for you.

What it costs you is worked out in what investment fees really cost, and you can price your own in the fee drag calculator.

Dollar-cost averaging vs lump sum

Investing gradually vs all at once. One is mathematically better; the other is survivable.

If markets rise more often than they fall, lump sum wins on average, time in the market beats waiting. The evidence generally favors it. But this is a case where the math and the human diverge:

• Lump sum maximizes expected return and maximizes regret if you buy the week before a crash.
• DCA gives up some expected return to buy an insurance policy against your own behavior.

The right answer is whichever one you'll actually stick with. A theoretically optimal plan you abandon in month four returns less than a mediocre plan you keep for thirty years. Note also that most people never face the question, if you're investing from a salary, you're dollar-cost averaging by default.

Related: the price of admission, on what to do when the market falls while you are still buying.

Rebalancing

Selling what won, buying what lost, to hold your target allocation.

It feels wrong every single time, which is the point, it's a rule that forces you to sell high and buy low when your instincts scream the opposite.

The full argument, including why it usually costs return: the portfolio you chose is not the one you own.

Asset location

Which account holds which asset. Not to be confused with asset allocation, which is what you own.

The US taxes investment income two different ways. Bond interest, non-qualified dividends and short-term gains are taxed as ordinary income. Long-term gains and qualified dividends get preferential rates. Asset location is the practice of putting the heavily taxed things where tax cannot reach them.

The general ordering: bonds, REITs and high-turnover funds into tax-deferred accounts, because they generate ordinary income every year. Broad stock index funds into taxable accounts, because they are already tax-efficient and need the shelter least. Highest expected return holdings into a Roth, where growth is never taxed at all.

On a $200,000 portfolio split evenly between a taxable and a tax-deferred account over 30 years, getting the ordering right is worth $76,395, or 8.6%. Nothing about the portfolio changes. Only where each holding sits.

Worked through in full, including why it prints no tax brackets: two identical portfolios, different amounts of money.

Tax drag

The return you lose each year to tax on income you did not choose to realize.

A fund that distributes income forces you to pay tax on it whether you wanted the cash or not. That payment leaves the portfolio permanently, so it does not just cost you the tax. It costs you every future return that money would have earned.

The arithmetic is the same shape as a fee. A bond yielding 5% held in a taxable account at a 24% marginal rate gives up 120 basis points a year before anything else happens. That is larger than most expense ratios anyone argues about.

The difference from a fee is that tax drag is avoidable by placement rather than by shopping. The same fund in a sheltered account has no drag at all until withdrawal.

The fee version of the same mechanism: what investment fees really cost, and the fee drag calculator.

Turnover

How much of a fund's portfolio is bought and sold in a year. High turnover manufactures taxable events.

A fund with 100% turnover replaces its entire portfolio annually. Every sale at a gain is a realized gain, and in a taxable account those get distributed to you and taxed, regardless of whether you sold anything yourself.

Worse, gains on positions held a year or less are short-term, which means they are taxed as ordinary income rather than at the preferential long-term rate. A high-turnover fund can convert what would have been favorably taxed appreciation into the most heavily taxed kind of income there is.

Broad index funds typically turn over a few percent a year, which is most of why they are tax-efficient. Turnover is disclosed in every fund prospectus and almost nobody looks at it.

Why the tax-efficient fund belongs in the taxable account: asset location.

Treasury bills

Short-term government debt, bought at a discount to face value. Interest is exempt from state and local tax.

Terms run from four weeks to a year. You pay less than face value and receive face value at maturity, and the difference is the interest. Backed by the federal government directly rather than by an insurance scheme, so there is no coverage limit to manage.

The structural advantage is tax. Treasury interest is exempt from state and local income tax under federal statute, which a state cannot override. In a high-tax state that is worth up to 61 basis points of equivalent yield before you compare a single advertised rate.

The formula for comparing them to a savings account is one line: divide the Treasury yield by one minus your state marginal rate, and that is what a taxable alternative has to beat.

The full comparison: where to keep the cash you need.

Duration

How sensitive a bond is to interest rates, and, by the same number, how many years until a rate move stops mattering.

Duration is the weighted average time until a bond's payments arrive, measured in years. Divided by one plus the yield it becomes modified duration, which approximates the percentage a bond's price moves for each one-point change in interest rates. A ten-year bond yielding 4% has a duration of 8.4 years and a modified duration of 8.1, and it loses 7.7% if rates rise one point, a little less than predicted because of convexity. A two-year bond has a duration of 2.0 and loses 1.9%.

The two meanings are the same number for a reason. When rates rise, a bond fund loses value at once and then reinvests at the higher rate, so it catches up. In our model a ten-year bond ladder with a duration of 4.9 years fell 8.8% on a two-point rise and was ahead of the unshocked fund after 4.8 years. If you need the money before one duration has passed, a rate rise hurts you; after, it helps.

Holding an individual bond to maturity does not escape this. The loss stops appearing on the statement and is paid instead as a below-market coupon for the remaining life of the bond.

The full treatment: your bond fund fell because it is about to pay you more.

Tax-equivalent yield

What a taxable investment must pay to match a tax-advantaged one after tax. The only fair comparison.

Comparing advertised yields directly is comparing the wrong numbers whenever the two are taxed differently. The tax-equivalent yield restates one of them on the other's terms.

For Treasuries against a savings account, divide the Treasury yield by one minus your state marginal rate. At a 9.30% state rate, a 4% Treasury is equivalent to 4.41% in a savings account. The same logic applies to municipal bonds against corporates, where the gap is usually larger.

Where there is no state income tax, this entire adjustment is worth nothing to you, which is itself useful to know.

Worked through: where to keep cash.

FDIC insurance

Federal insurance on bank deposits, up to a limit per depositor, per bank, per account category.

It covers checking, savings, money market deposit accounts and certificates of deposit at insured banks. It does not cover investments held through a bank: not mutual funds, not money market funds, not securities.

The limit is why large cash balances get spread across institutions, and why the per-category structure matters, since different ownership types are counted separately. A Treasury has no equivalent limit because it is a direct government obligation rather than an insured private one.

Current limits are published by the FDIC. As with every figure that changes, get it from the source.

How it compares with the alternatives: where to keep cash.

Money market funds

Mutual funds holding very short-term debt. Not FDIC insured, despite sounding like a bank account.

A government or Treasury-only fund holds essentially the same collateral as a Treasury bill, with same-day liquidity and a small expense ratio taken out of the yield. A prime fund holds corporate paper, yields slightly more, and behaves differently in a crisis, which is the point of the distinction.

The Treasury portion of the income usually keeps the state tax exemption, and the fund publishes what percentage qualifies. Worth checking rather than assuming.

The name is the trap. A money market fund is not a money market deposit account, and only the second is insured.

Which job each instrument suits: where to keep cash.

Liquidity

How quickly you can turn something into spendable money without moving its price against you.

It is a spectrum rather than a property. A savings account is same-day. A Treasury bill is sellable but at whatever the market pays that morning. A certificate of deposit has an early withdrawal penalty. A house takes months and costs a large fraction of its value to sell.

Liquidity is what an emergency fund is actually buying, which is why chasing a few extra basis points with it defeats the purpose. The entire job of that money is that it is there on the day you need it.

It is also the hidden cost in buying a home. A round trip costs roughly 10% of the price, which is why the arithmetic rarely works over a short stay.

What that buffer is for: six months for whom.

Capital gains, short and long

Profit on a sale. How long you held it decides which rate applies, and the gap is large.

Hold an asset more than one year and the gain is long-term, taxed at preferential rates. Hold it a year or less and it is short-term, taxed as ordinary income at your normal graduated rate.

That single distinction is why turnover matters, why high-turnover funds are tax-inefficient, and why a position held eleven months is a different asset from the same position held thirteen. Nothing about the investment changed; the tax treatment did.

Where each belongs: asset location.

Marginal rate

The rate on your next dollar, not your average rate. The only one that matters for a decision.

People routinely use their average tax rate when deciding whether an extra dollar of income or deduction is worth pursuing. That is the wrong number. The decision is always about the next dollar, which is taxed at the marginal rate, and the marginal rate is always higher than the average.

It is also what sizes the prize in asset location. The benefit of sheltering ordinary income is the spread between your marginal ordinary rate and your long-term rate, which is why the same decision is worth roughly 17.9% to a high-bracket household and 6.7% to one in the middle.

Why the spread is the whole thing: asset location.

Cost basis

What you paid, for tax purposes. Gets adjusted more often than people expect.

Basis is the number subtracted from your sale proceeds to calculate a gain. Buy at 50 and sell at 80 and the gain is 30.

Two adjustments catch people out. Reinvested dividends were already taxed, so they increase basis and are not taxed again at sale; comparisons that miss this systematically overstate how bad a taxable account looks. And vested stock compensation has a basis equal to the value at vest, on which you already paid ordinary income tax, which is why selling immediately at vest triggers almost no additional tax.

The second case, worked through: employer stock concentration.

Wash sale

A sale at a loss followed by a purchase of substantially identical securities within 30 days. The law disallows the loss for now.

The period starts 30 days before the sale and ends 30 days after the sale. If you buy substantially identical securities in that period, you cannot claim the loss. The rule is in section 1091 of the Internal Revenue Code.

The loss is not lost permanently. The disallowed amount goes into the basis of the new shares. Thus you get the benefit later, when you sell the new shares.

The rule is important for tax-loss harvesting. To keep a loss, you buy a similar fund, not the same fund. In our example, a $20,000 loss saves $3,000 of tax now. A wash sale postpones that benefit.

How the harvest works: tax-loss harvesting mostly postpones tax.

Restricted stock units

Company shares granted as pay. Taxed as ordinary income at vest, on the full value that day.

An RSU is a promise to deliver shares once a condition is met, usually time served. At vest the full market value is ordinary income, your employer typically withholds shares to cover it, and you are left holding stock with a basis equal to that day's price.

Which produces an identity worth internalizing. A $50,000 grant at a 32% marginal rate leaves $34,000 of stock. Holding it is economically identical to being handed that cash and spending every dollar on employer shares. Selling and holding are both positions; only one of them requires an action, which is why the riskier one tends to win by default.

The concentration cost: your employer already owns enough of you.

Employee stock purchase plan

A plan that lets employees buy company stock through payroll deductions, at up to a 15% discount.

Section 423 of the tax code sets the rules. The discount can be up to 15%. Each employee can buy up to $25,000 of stock a year, valued at the start of each offering.

Some plans have a lookback. The price is then 85% of the lower of the price at the start and the price on the purchase date. Thus a sale on the purchase date gains at least 17.6% before tax.

If you sell early, the discount is wage income. Keep the shares for 2 years from the start and 1 year from the purchase, and part of the gain becomes a long-term capital gain.

Sell or keep: the ESPP discount is a sure thing. The stock is not.

Dividends

Cash paid out of profits to shareholders. The only return that arrives whether or not anyone wants to buy your shares.

A dividend is a company deciding it cannot reinvest a dollar at an attractive rate and handing it back instead. That makes it a signal as much as a payment: a rising dividend is management committing to a level of cash generation it expects to sustain, because cutting one is punished severely.

The yield is the annual dividend divided by the price. McDonald's paid $8 a share against a price of $236, a yield of 3.26%. That is the part everyone quotes. The part that matters is coverage: the same dividend was 70.4% of free cash flow, leaving a cover ratio of 1.42 times. A yield is only as reliable as the cash flow behind it, and a high yield is often a market forecast that the dividend will be cut.

In a taxable account a dividend is a forced realization: you owe tax on it whether you wanted the cash or not, which is why dividend-heavy holdings generally belong in sheltered accounts. Note also that a dividend is not free money appearing from nowhere. The share price falls by roughly the dividend when it is paid. You are moving value from one pocket to another, and paying tax for the privilege.

Payout discipline in a real company: the McDonald's report, and where a dividend ranks among a company's options, five things a dollar can do.

Qualified dividends

A dividend taxed at long-term capital gains rates rather than as ordinary income. Most dividends from US companies qualify; several things you might own do not.

The distinction is purely about the tax rate, and it is a large one. A qualified dividend is taxed on the preferential schedule that applies to long-term gains. A non-qualified, or ordinary, dividend is taxed at your marginal income rate, which for most people in the accumulation phase is meaningfully higher.

What generally does not qualify: real estate investment trust distributions, most bond fund income, interest paid by money market funds despite the word dividend appearing on the statement, and dividends on shares you have not held long enough. Foreign dividends depend on the treaty.

This is the mechanical reason asset location works. The same holding generates a different after-tax return depending on which account it sits in, and the assets that produce ordinary income are the ones with most to gain from a shelter.

Which account each asset belongs in: asset location.

The ex-dividend date

The day the share stops carrying the next dividend. Buy on or after it and the payment goes to the seller.

Four dates matter and they are routinely confused. The declaration date is the announcement. The ex-dividend date is the cutoff: own the share before it and you receive the payment. The record date is when the registry is checked. The payment date is when the cash arrives, often weeks later.

The ex-dividend date is the one with a price consequence. The share typically opens lower by approximately the dividend amount, because the thing you are buying no longer includes that cash. Nothing has happened to the business.

Which disposes of a popular idea: buying shares shortly before the ex-date to collect the dividend and selling after. You receive the dividend, you take a corresponding capital loss, and you have generated a taxable event and two commissions in exchange for nothing.

Scheduling the income rather than chasing it: how to build a dividend calendar.