I am always a bit curious when I read a cover story headline like the one on Kiplinger Magazine this month. It says 18 Ways To Earn 5% or More On Your Money.

A lot of readers will make an assumption that goes along with that headline that they are talking about low-risk investments or no-risk savings products. After all, it doesn’t take a degree in advanced personal finance to know that there are literally thousands of ways to earn 5% or more on your money. Of course, most of those also come with a way to lose 5% or more on your money too.

That is not what the article is about. Instead, this particular article, whose article title inside the magazine is, “Great Rates In A Low-Yield World” manages to give a better clue. The article is NOT about where to open a savings account to earn 5% or more. It is about how to get 5% YIELD on your investment. That is, 5+ percent as income, and not counting losses on invested capital.

Real Earnings Are About More Than Dividends and Interest

Unfortunately, while the article does indeed uncover available investments earning a 5% or higher yield, it ignores the potential change in value of those investments. If you are holding bonds to maturity, of course, this factor is moot, but if your personal finance needs change or you don’t plan on holding those munis for a couple of decades, then price volatility is a very real factor in whether or not you earn that five percent target interest rate.

The first way to earn more than 5% on your money on the list is taxable municipal bonds. Specifically, they talk about Build America Bonds (BAB) which in addition to having taxable interest, have a portion of their bond insurance paid for by the Federal Government. Long-term BAB are paying 6 percent or higher in many cases.

Of course, you better be planning to hold on to those long-term bonds for a long-term investment.

As any educated investor knows, bond prices fall when interest rates rise. This is true for Build America Bonds muni bonds too. So, the $1,000 you shell out to get the 6.6% 25-year Illinois bonds the article references will soon be worth much less.

While economists are predicting the Fed won’t raise interest rates until 2012, that still means that for the next 23 years, those bonds will be trading at a discount. That is not a pretty outlook for bonds.

If rates rise far enough and you end up selling those bonds for whatever reason, your capital losses will make your actual rate of return on the bonds far less than the 5% you were trying to earn more than in the first place.

Other money earning strategies on the list potentially have the same issue. The list includes some REITS, preferred stocks, and some exchange traded limited partnerships.

Nothing drives home this point more than the inclusion of British Petroleum on the list of ways to earn more than 5% on that money. Since magazines go to print months before they hit the newsstand, the article was written before the BP oil spill in the Gulf of Mexico occurred. So, on page 39, under “Juicy Dividend Payers” is British oil giant BP (with a listed stock price of $59) and its 5.7% dividend.

Unless you have been living under a rock, you know that this is one suggestion you do not want to take. Suggestions that BP eliminate or sharply reduce its dividend payment in order to retain enough cash to pay out mounting compensation and penalties are growing louder. Furthermore, the stock’s price has been crushed, closing under $34 per share on Friday. If you bought BP at $59 hoping for a nice juicy dividend, not only is that dividend likely to be much lower (if not zero), but you have also lost 40% of your original investment!

The point is not that this one suggestion turned out very bad, but rather that any one of the suggestions in that same article could have something happen to them as well. It wouldn’t take the world’s largest oil spill to turn a 6% dividend into a 3% yield, while at the same time wiping out 5% of your original investment.

Looking for ways to earn more interest on your savings is good. Knowing the distinction between savings and investments is even better. Don’t run down to your broker’s office with your savings account because a financial magazine or money management website touts higher returns. First investigate the risks and make sure you are putting the right dollars in the right financial asset strategy buckets.

Whether or not now is a good time to invest in banks that are repaying their US government bailout dollars to the Treasury is an easy analysis to make, but a tricky question to answer.  Which among banking stocks like JP Morgan ( JPM ), Goldman Sachs ( GS), Bank of New York / Mellon ( BK ), and Wells Fargo ( WFC ) are good stock market investments in this economic environment?

For those large US banks who never really wanted any government bailout money in the first place and that have stayed relatively stable and profitable since taking the TARP funds, now might be a good time to invest.  However, for those US banks trying a little bit too hard to look like the good banks that are repaying their government loans with ease, the answer is much different.  The tricky part is knowing the difference.

Recently released emails and documents from the US Federal Reserve suggest that certain big banks had to be brought in line for the good of the whole industry when it came to taking government aid.  Other banks, like Citigroup, were already teetering too much on the edge of bankruptcy to have any real shot and avoiding a bank collapse without government help.  In between were the other big banks which definitely benefited from the banking bailout.  Knowing whether they are stronger or weaker bank stocks now is difficult to tell.

Analyzing US Bank Stocks

Any bank that was on the verge of collapse without government help should be avoided as an investment.  The only difference between now and six or eight months ago is that the economy is a little bit better.  A lot of that economic improvement is because of the massive economic stimulus package passed by Congress and the Obama administration.  Stimulus like that doesn’t last forever and if it wears off at the wrong time, the economy could head straight back down taking those banks and their stocks back with it.

Banks that never really needed the TARP funds or the CAP program are better investment targets although they will continue to be tainted by the sector overall and may have trouble returning to full health.  However, considering the banking industry no longer has a giant housing boom to bail it out if things are a little off, and that consumers might not be quite as anxious to do the kinds of banking business they used to even if things get better, the banking industry may be in for many years of lean growth regardless of how strong any single company is.

Banks that over-reached to repay their TARP money are also in danger of getting back into trouble.  Some banking companies have undone YEARS of share buybacks by reissuing as much or more stock than they managed to buy back over those years.  That means that those bank stocks will have a big supply to continuously weigh down on share prices.  It also means that forgoing all of those dividend payments over the years were wasted since there is just as much stock now as their used to be.

Banking Sector Health

Lastly, never forget that usually the way a troubled sector is able to rebuild and move forward is that the weaker players and the poorly managed companies die off and are forced into bankruptcy or sold to stronger better managed competitors.  With the US Government and the US Treasury Department stepping in a saving many of those weaker and badly managed banks, the sector did not have the necessary purge.

That means that when things return to “normal” there will be just as many competitors trying for the same number (or less) customers which means smaller profit margins and little or no room for error.  Just because that bank didn’t go bankrupt this year doesn’t mean it won’t next year, or the year after.

For now, banks are an unusually risky stock investment with little or none of the traditional upside of risky investments.  If you want to take on more risk in anticipation of a stock market run or a steadily improving US economy, then by all means do so.  Just find your risk somewhere where there are better rewards to go along with that risk.

The U.S. Supreme Court in a 7-2 decision upheld the central tenant of most state’s municipal bond [tag]tax[/tag] policy, specifically that a state can exempt it’s own muni bonds from taxes while taxing the interest on other state’s [tag]muni bonds[/tag]. So, nothing changes from before. If you live in California, the only way to avoid state tax on bond interest is to buy California Municipal Bonds. If you buy bonds from Texas, they can tax that interest.

Taxes and Bonds

Because interest on bonds is taxed as ordinary income, avoiding taxes on that interest is more important to investors than avoiding taxes on dividends paid by stocks. Most corporate bonds are taxed at both the federal and state level which reduces the real rate of return to the investor. Municipal bonds issued by states are exempt from federal income tax because one branch of the government cannot tax another branch. Whether or not the state municipal bonds are exempt from state income tax is determined by the laws of the states they are issued in. Most states make their own bonds tax-free as a way to make them more attractive for purchase. This [tag]tax-free[/tag] status, plus the relative safety of most municipal bonds can make them an attractive investment for those in higher tax brackets.

However, these same benefits mean that muni bonds generally pay lower rates than other bonds. For federal taxes, if you are in a low tax bracket, the lower rate can actually mean a lessor overall return than if you invested in corporate bonds. The break even point is often somewhere around the 25% tax-bracket or above.

For state taxes, the analysis depends on the state you reside in. In Colorado, state income taxes are a flat 4.63% while in California, they go up with income like federal taxes. So, an investor in Colorado below the 25% income tax bracket may not reap any benefit from the tax-free nature of municipal bonds, while an investor in a higher bracket in California may come out way ahead by investing in California municipal bonds.

Higher Yield Muni Bonds

Some states do not have an [tag]income tax[/tag]. (They usually have much higher sales taxes or property taxes than those that do.) For those states, municipal bonds can carry a higher interest rate. Texas, for example, does not have an income tax. Therefore, there is no advantage to Texans to buy Texas issued municipal bonds over those issued by other states. As a result, similarly rated Texas Municipal Bonds often end up paying a higher interest rate in order to attract investors. If you are looking to invest in municipal bonds but don’t need the state income tax deduction for your planning purposes (if you live in a low income tax state) then when [tag]investing[/tag] always make sure to check out the non-tax state’s municipal bonds as well as your home state.

Great Stock Fund Re-Opened

One of my favorite mutual funds is the Dodge & Cox Stock Fund (DODGX).  It’s performance is virtually flawless for its purpose (large cap stock).  This isn’t some flashy hey-look-at-me mutual fund.  In fact, this is exactly the kind of fund that people started questioning during the Internet bubble, and that is a good thing.  Notice how it did not get caught up in the Internet bubble like many other stock funds.  Its returns of just 5.4% and 20.21% in 1998 and 1999 respectively earned it a lot of scorn when Janus Funds were near 100% returns, but the proof of greatest isn’t riding along with crowd hysteria.  The proof of greatness comes in 2000 and 2001.  When other funds were getting crushed, DODGX was making money!  In 2002, it managed to drop just 10.5%, almost half of what others were losing.

The real proof of greatness is that it did not achieve these results by hiding and investing in “safer” places.  In 2003, when the market turned back up, they were right there.  This is what a great fund looks like.

Limited Time Offer?

For the last several years, the Dodge & Cox Stock Fund has been closed to new investors, so I couldn’t recommend it to my clients.  If they had it available in their 401(k) plans, it was my only large-cap recommendation.  If the clients were savvy enough, we’d load up on one spouse’s plan and the achieve diversification with the other spouse’s plan (or even with IRAs assuming there was enough money in them.)  Now, the fund is back open for new investors.  My advice is to get in there, even if you just send in the minimum.  Last time they closed the fund, they still let existing shareholders add funds.  So, get your investment open now.  They’ll probably close the fund again sooner or later.

Evaluate Good Mutual Funds

To evaluate a mutual fund, ignore the 1, 3 and 5-year averages.  There are too many ways to hide flaws in averages.  For example, the 5-year average no longer includes the popping of the Internet Bubble.  So, that fund that claims the great 5-Start Morningstar rating  on the 1, 3 and 5-year could be hiding a brutal pounding in 2000, 2001, 2002 when it cratered and took investor money with it.

Instead, always look at the individual Annual Returns.  There is no way to hide then.  Look at the returns for DODGX.  This is exactly what you want to see in a value-oriented large cap stock fund.  It lags in 1998, 1999 when things were crazy, but it survives beautifully in 2000, 2001, 2002.  Just as important, it does not get caught by surprise in 2003 and posts solid returns.

There are few no-brainers in the investing world.  The Dodge & Cox Stock Fund is one of them.  Whatever you have, I’ll bet it isn’t as good.  This is your large cap growth fund.