Before Investing, Know the Rules of the Road
In the past, we discussed with our clients their goals and objectives, risk tolerance, and what their timeline is for when they need the funds. We would then allocate the appropriate amount to the three major asset classes, cash, fixed income, and equity.
Then, we will drill down into the Morningstar style boxes to make sure we had the appropriate amount of assets spread among investment style and size.
Times have changed and so did our approach to investing. Do not get me wrong. We still need to understand our clients’ goals and objectives, risk tolerance, and time horizons. How we allocate investments among the low, moderate, and high-risk categories continues to be our mission.
The Brimson, Hood and Beebower study found that 94% of the returns you achieve are related to the asset allocation model you select. 1)
Before investing, consider maintaining an adequate cash reserve fund. When you first start out, we prefer to call this a rainy-day fund. This is because it rains…usually when you do not expect.
Commentators suggest having six months of living expenses in your cash reserve. Most folks have nowhere near this amount. That is fine. Start where you are and go from there.
Now we will address the specific strategies to consider in this investment climate.
Red Light
Investments in this category will have no risk at maturity. When we say no risk, we need to explain what that means. If we invested in a 10-year treasury note today, the yield would be approximately 4.0%.
If this note were held to maturity, we would get all our principal back and have received the annual 4.0% yield. So, the question is:
What is the risk?
The primary risk is the loss of purchasing power. From this 4.0% we need to subtract taxes and inflation. Taxes might take away about 25% of our return and, therefore, we would be left with a little over 3%. With inflation currently running at 2.9% this would eat into the entire yield, and our return would be nothing. No real return, after taxes and inflation for 10 years.
Ouch!
With our red-light investments, the key consideration is the guarantee. If you have a certificate of deposit, the guarantee is from the Federal Deposit Insurance Corporation (FDIC). Likewise, if you have an annuity, the guarantee is from the insurance company that issued the contract. Remember, the guarantee is only as good as the party making the guarantee.
The time frame on these investments would be the shortest, somewhere between one and three years. Some of the investments in the red-light category would include money markets, certificates of deposits, treasury bills, and short-term treasury notes.
However, this mission here is:
Not return on principal but return of principal.
Your Red-Light investments, along with your cash reserve is your ‘war chest.’ Having a war chest is needed to ride out the next bear market. When will the next bear market come?
Nobody Knows.
For pre-retires and retirees, their cash reserve fund needs usually should be increased significantly over the six months mentioned above. We believe their cash reserve fund should be at least three years of living expenses.
This elevated amount will allow you to ride out the next bear market. By maintaining this cash reserve fund:
You will not be forced to sell your stocks when the market is down.
Yellow Light
The investment in your yellow light would be moderately risky. The time horizon on this category would be from about 3 to 10 years. This portion of the portfolio would have fixed income investments such as bonds or real estate. Additionally, so-called absolute return investments could also be a portion of this.
The U.S. Government issues several types of debt. These are bills, notes, and bonds. Treasury Bills have maturities of less than 1 year. Treasury Notes mature between 2 and 10 years. Treasury Bonds mature in either 20 or 30 years.
The main advantage to owning U.S. Government issued securities is that there has not been any credit risk. This means that if you hold these securities until maturity, you will get back your entire principal. These bonds are backed by the full faith and credit of the U.S. Government.
Will this continue? As we say a lot around here:
“We will see.”
The full faith and credit of the U.S. Government is not on an upward trend. In May 2025, Moody’s cut its rating from Aaa to Aa1. Moody’s was the last of the big three rating agencies to downgrade with S&P and Fitch having done this previously.
The federal deficit increased from $39 billion in 2015 to $1,775 trillion in 2025. This is an increase of $1,336 trillion or 304%. 2)
This, of course, increased the U.S. National Debt. In 2015, the U.S National Debt stood at $19.18 trillion. In 2025 it stood at $37.85 trillion. An increase of $18.67 trillion or 97.34%. 3)
Warren Buffett said, “The insurance business is unique in that it sells a product, a promise, that may not be called upon for decades.” 4)
His point was that insurance companies operate on the concept of meeting their future obligations. The U.S. Government sure has a lot of future obligations.
The U.S. Government has a fair amount of assets, around $5.7 trillion. However, many of these are not liquid. When you only look at just the financial assets, there is approximately $4.5 trillion.
However, their largest financial asset is student loans of $1.55 trillion or 33.9% of the total. The issue here now is the default rate and the seriously delinquent rate. For 2025, the default rate and seriously delinquent rate is estimated at 20%.
That is a big percentage.
For the U.S. Government, keeping your promises becomes more difficult based on them borrowing more money, at higher rates, and having higher default and seriously delinquent rates with their loans receivable.
State and local governments also issue bonds, known as municipal bonds. These bonds are tax-free from federal income taxes. They may also be state tax-free if they are issued from the state where you reside. Also, many corporations issue bonds.
Real Estate Investment Trusts (REITs)
One way to own real estate is through real estate investment trusts (REITs). They pool money to invest in real estate. REITs could own apartment buildings, retail property, office property, warehouse space or even health care facilities.
One of the primary advantages of investing in REITs as opposed to direct ownership of real estate is that the properties are professionally managed. In lieu of investing in REITs, you can invest in mutual funds that invest in REITs. This allows the investor to maintain liquidly while investing in real estate.
Some exposure to this asset class, which has a low to moderate correlation with the equity markets, should be considered.5)
Naturally, you need to take into consideration what other real estate holdings you have before you decide on your allocation to real estate in your investment portfolio. Additionally, real estate has traditionally been a hedge against inflation.
The current winners in REITs are Data Centers with 21% year over year funds from operations growth. The current losers are Hotels and Lodging, down 18.8% year to date in 2025. 6)
Many people scratch their head or give me a blank look when I discuss absolute return investment with them for the first time. That is OK… At first it may be a tough concept to get. But once you get it, well… it is cool.
So here we go. If the funds’ objective is to attempt to provide an absolute return, then it will provide the investor with a baseline benchmark, plus a rate of return every year.
For example, let us say the benchmark was the treasury bill rate, currently at about 4% plus 3%.
If the management of the fund can achieve this, then they get their performance bonus. This is known as “pay for performance” as opposed to other fund managers that get their bonus at the end of the year for just hanging around. This is known as “show up and get paid.”
For this absolute return fund manager to get his bonus, he must hit his benchmark. Keep in mind that simply because the fund strategy is absolute return, it does not mean that you are guaranteed an absolute return.
Some absolute return investment strategies could include hedge funds, managed futures, and private equity. One of the more popular absolute investing strategies is the so-called market neutral strategy. A market neutral mutual fund will have a strategy that involves going long, owning the positions, and going short. When you go short, you are hoping to profit by having the position go down.
Green Light
The higher risk category is for investments that you do not need to access for a ten-year time or longer.
Please note the long-term time horizon reference here.
In the past, we would have indicated that you need to maintain your equity investments for a minimum of at least 5 years. The 5 years would normally allow an investor to invest through an economic cycle. Certainly, the longer holding period you have, the risk associated with owning equities declines.
Here is What You Need to Know to Understand the Math of the Stock Market Now.
This category would include your equity investments. Why are we considering equity investments to be in the high-risk category? It has to do with the equity premium.
This is the premium (in total return) that you would expect to get when you invest in the equity markets. We compare the expected rate of return in stocks against the risk- free of the 10-year Treasury Note. Over the past 75 years, the equity premium has been about 5 percent. 7)
However, going forward, over the next decade, Vanguard projects a very modest equity premium. 8)
This is not surprising.
Stocks have been on a tear since the end of the 2008-2009 Great Recession.
What we are expecting to see going forward is regression to the mean. When we have a larger premium for an extended period, we expect to have a smaller, or no premium going forward to keep the long-term average intact.
Income Tax Considerations
Given the choice we believe, it is much more advantageous to own your equity investments in a taxable account as opposed to tax-deferred accounts like a 401(k) plan or an Individual Retirement Account (IRA).
There are several reasons for this. First, qualified dividends are subject to federal income tax based on your long-term capital gains tax rate. This rate is 0% for low-income income, 15% for middle-income earners and 20% for high-income earners.
Second, as was just mentioned, the long-term capital gains rates are preferred, lower tax rates. The highest long-term capital gains rate is 20%. This is as opposed to ordinary income tax rates as high as 37%.
Third, any realized losses in your taxable accounts can be deducted as capital loss. After netting any gains and losses, if there is a net loss, you can deduct up to $3,000 on your income tax return. Any losses above this amount can be carried over in future years.
Contributions to a taxable account are made with after-tax dollars and do not provide an upfront tax break, unlike pre-tax contributions to a traditional 401(k) or IRA.
The Roth IRA
Consider the ultimate place for your more aggressive investments in your Roth IRA. Beginning in 2026, taxpayers can contribute up to $7,500 per year into a Roth IRA. Those aged 50 and older, the catch-up contribution is $1,100 for a total of $8,600.
To fund a Roth IRA, you need to have earned income of at least the amount of your contribution. Earned Income is your wages as an employee or from self-employment income. Income eligibility limits some higher-income earners as they may be ineligible to contribute directly to a Roth IRA.
Here are 3 Easy Reasons to Open a Roth IRA. Additionally, here are Practical Reasons for a Partial, Annual Roth IRA Conversions.
Conclusion
If you need help with Before Investing, Know the Rules of the Road, call Thomas F. Scanlon, CFP®, CPA at (860) 645-1515 or E-Mail Thomas.scanlon@raymondjames.com.
This is original content prepared by Manchester, CT Financial Advisor, Thomas F. Scanlon, CFP®, CPA.
1)Financial Analysts Journal – July -August 1986
2)CBO.org – September 2025
3)govfacts.org
4) Warren Buffet, Berkshire Hataway Letter 2004 Shareholder Letter
5)nbr.org – May 2019
6)Hendrick.edu
7)paperfree.com – September 11, 2025
8)corporatevanguard.com/content- July 23, 2025
The information contained in this report does not purport to be a complete description of the securities, markets or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Thomas F. Scanlon, CPA, CFP® and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and subject to change.
Changes in tax laws or regulations may occur at any time and could substantially impact your situation. While familiar with the tax provisions of the issues presented herein, Raymond James Financial Advisors are not qualified to render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional. Investing involves risk and investors may incur a profit or a loss.
Like traditional IRA’s, contribution limits may apply to Roth IRA. In addition, with a Roth IRA, your allowable contribution may be reduced or eliminated if your annual income exceeds certain limits. Contributions to a Roth IRA are never tax deductible, but if certain conditions are met, distributions will be completely income tax free. Roth IRA owners must be 59 1/2 or older and have held the IRA for five years before tax-free withdrawals are permitted.
401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty.
Contributions to a traditional IRA may be tax-deductible depending on the taxpayer’s income, tax-filing status, and other factors. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, maybe subject to a 10% federal tax penalty.
Be advised that investments in real estate and in REIT’s have various risks, including possible lack of liquidity and devaluation based on adverse economic and regulatory changes. Additionally, investments in REIT’s will fluctuate with the value of the underlying properties, and the price at redemption may be more or less than the original price paid.
Treasury bonds are certificates reflecting long-term (20 or 30 years) obligations of the U.S. government. Interest payments are paid semi-annually.
Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. Holding bonds to term allows redemption at par value. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices rise.