Part 2: The Language of Investing
Just like the world of medicine, the world of finance has its own language. All the different terms and acronyms can be intimidating, thus discouraging residents from learning more. While it is true that one could spend weeks learning the language of investing in detail, fortunately, the financial situations of most residents are simple enough that only a few key concepts need to be understood in order to make sound investment decisions.
One of the early hang-ups for residents is understanding the relationship between types of investment accounts and types of investments. An analogy that can be helpful in understanding this relationship is that of a grocery store: In this analogy, investment accounts can be thought of as the grocery bags, and individual investments are the groceries. This is graphically represented in Figure 1.
Figure 1. Grocery store analogy for types of accounts and investments
Just like you can pick whichever loaf of bread you want and put it in whichever available bag you want, so too can you buy any stock and put it in any available account. There are some income and employment restrictions on which accounts (bags) are available at any given time, but most residents will have several good options.
Discussion of which accounts are recommended for residents is included below (see account descriptions directly below and “Which account should I choose?” in Part 3: Practical Application).
Types of Accounts
There are four types of investment accounts that residents are likely to consider: 401(k), 403(b), Roth IRA, and Traditional IRA. For reference, we will also briefly comment on taxable (brokerage) accounts. The most significant difference between investment accounts is how they are taxed.
Important questions to ask when considering the tax treatment of accounts include:
Are my contributions to the account going to be taxed as they go in?
Do my investments in the account grow tax-free?
Is the money I withdraw from the account taxed on the way out?
Are there penalties if I withdraw the money before a certain amount of time?
All of the investment accounts that are most suitable for residents—401(k), 403(b), and Roth IRA—are retirement accounts. Each of these accounts has the benefit of tax-free growth of investments, whereas growth in “taxable,” also known as “brokerage” accounts (which are not retirement accounts), is taxed.
A 401(k) or 403(b) is a retirement account that is provided by an employer. IRAs, or Individual Retirement Accounts, are retirement accounts that are created and managed by you as an individual. For residents opening an IRA (including a Roth IRA), know that contributions are limited for incomes that exceed a certain amount, depending on whether you file taxes as an individual or jointly with a spouse.
Retirement accounts do differ in how investments are taxed “going in” (contributions) and “coming out” (withdrawals). Table 2 outlines the different tax treatments of several retirement accounts as well as taxable accounts.
In general, if you hear the term “Roth” referring to a 401(k), 403(b), or IRA, it means contributions are taxed but earnings and qualified withdrawals are tax-free. A Roth account can be advantageous for those who expect their income to go up in the future (e.g., residents), because taxes can be paid now, while in a lower tax bracket, as opposed to in the future, when they are expected to be in a higher tax bracket.
Also outlined in Table 2 is whether different accounts are eligible for a “match.” In short, a match is an amount of money that your employer pays into your retirement account for you—with a catch: You need to contribute a certain amount yourself to get it. For example, if your employer offers a 3% match and you put 3% of your paycheck into your 403(b), they will match your contribution and you will end up with a total of 6% of your paycheck’s value added to your 403(b) account. If you only put in 1.5% of your paycheck, your employer will match your contribution and you will end up with 3% of your paycheck’s value added to your account.
Matching is a feature of many (but not all) retirement plans that are offered by employers (e.g., 401(k) and 403(b) accounts). Roth IRAs, Traditional IRAs, and taxable accounts are all individual accounts that you set up and manage yourself. There is no employer match for individual accounts.
A match is a great benefit; unfortunately, not many organizations offer a match for their medical trainees. However, if your employer does offer this benefit, you should strongly consider contributing enough of your salary to get the full match from your employer.
Table 2. Types of Accounts (Grocery bags)
Note that, in addition to requiring you contribute a certain amount to get the match, some employers also have a vesting period.
In short, a vesting period is an amount of time that you need to work for a company before the company’s contribution (i.e., the match) belongs to you. While leaving a company before the vesting period is over may result in you losing some or all of the company’s match, anything you put into your retirement account yourself will always belong to you.
For example, a resident in a three-year program who has a 3% match with an all-or-nothing vesting period of five years would need to work for the same company for an additional two years after residency before the 3% match would belong to him or her. Leaving the company at the end of residency would result in forfeiting the 3% match. However, the resident in this case would still own whatever he or she contributed his or her retirement account, no matter when they leave the company.
Alternatively, if the program above had a five-year vesting period where employees vested 20% per year, the resident could leave at the end of the three-year program with 60% of the matched contributions, plus everything that he or she contributed.
If your employer does offer a match, be sure to check if there is a vesting period to determine whether you would qualify for this benefit based on the length of your training program.
Types of Investments (Assets)
There are five common investments that residents are likely to consider purchasing:
Target Date Funds
Below, each type of investment is briefly described. The key differences in types of investments are also outlined in Table 3.
Stock in a company is a type of claim to the value of that company. In order to raise money, companies sell these claims in parts called shares. The more shares of a company’s stock you own, the larger the share of the company’s value to which you have a claim.
The price of a stock tends to fluctuate with the perceived value of the company (e.g., if the company’s perceived value goes up, the stock price also tends to increase). Individual stocks are tied to the success or failure of a single company and are therefore viewed as highly risky investments; they could produce very high returns or deeply negative losses. If you plan to invest in individual stocks (Note: This is not at all recommended), diversifying your investments across many individual stocks is a way to reduce risk.
Bonds can be thought of as a type of loan where the investor is loaning money to the bond issuer. In return for this investment, the investor is promised to receive this same amount back at the end of a period of time in addition to interest payments along the way. The technical term for the amount the investor pays the issuer is the “par value” or “face value” of the bond; the interest payment from a bond is referred to as the “coupon rate.” While there are spectrums of how risky and how rewarding different bond investments can be, bonds are generally considered lower-risk and lower-yield than stocks.
Mutual funds are “pooled investments” that generally contain stocks, bonds, or a mixed group of stocks and bonds. Investors in mutual funds buy shares of the fund (as opposed to shares of a single company), thereby gaining investment exposure to all the investments within the fund. Mutual funds are generally categorized by the goals of the fund. For example:
A “growth” fund may contain higher-risk stocks with the goal of obtaining higher returns
A “value” fund may contain stocks that fund managers believe are currently under-priced
An “investment grade” bond fund may contain bonds from sources that are considered stable and reliable
Through holding many different individual investments in one place (a concept known as diversification), the risk associated with investing in mutual funds is generally considered to be much lower than the risk of investing in any of its component parts.
The intrinsic diversification of mutual funds is appealing; however, keeping these funds up to date and in compliance with regulations has costs. These costs are passed on to investors as fees, the most common of which is an expense ratio. Expense ratios can be thought of as the cost to own a portion of the fund; they are expressed as the percentage of your investment that goes to the fund managers each year (e.g., if you had $1,000 in a mutual fund with an expense ratio of 0.15%, $1.50 would be taken out to pay the fund managers each year). Guidelines for expense ratio limits are discussed elsewhere (see: Practical Applications: Costs).
Less common fees are “loads,” which are costs associated with buying (front-end load) or selling (back-end load) funds. Care should be taken when selecting mutual funds to minimize these expenses, including avoiding any fund with any kind of load.
Index funds are also “pooled investments.” Index funds can be thought of as a special type of mutual fund where the goal of the fund is to match the performance of a certain benchmark (i.e., an “index”), such as the Standard and Poor’s 500 (S&P 500) Index. This goal of tracking with an index is less complex than attempting to outperform an index, which is what many mutual funds try to do. Accordingly, index funds typically have lower expense ratios than traditional mutual funds.
Given their relatively low cost and broad diversification, total market index funds such as Vanguard’s Total Stock Market Index Fund and Total Bond Market Index Fund have become popular investments. A popular investing strategy (the “three fund portfolio”) even advocates for using only a few index funds for one’s entire investment portfolio.
Target Date Funds
Like mutual funds and index funds, target date funds are a third type of “pooled investment.” Target date funds can be thought of as a special type of mutual fund where the goal is to control and adjust the risk profile of the fund’s investments as the target date (typically your retirement date) approaches. As you get closer to retirement, it usually makes sense to hold less risky investments (i.e., retirement is hopefully a time of preserving your wealth, not a time when you need to grow it).
The benefit of target date funds is that the risk profile of the pool of investments is automatically adjusted over time. While you are far from retirement and therefore have plenty of time to recover in case the market drops, target date funds will typically have a large proportion of riskier assets like stocks. As the years go by and you approach retirement, the target date fund managers adjust the ratio of investments from more risky to less risky.
This type of fund is highly recommended for those who do not want to be regularly involved in checking and adjusting their investments. Other names for this type of fund include “lifecycle,” “dynamic-risk,” or “age-based” funds.
Table 3. Types of Investments/Assets (Groceries)