Jonathan Clements's Blog, page 300
January 22, 2021
Old Arguments
THERE ARE TWO GREAT debates in retirement planning: whether the famous 4% rule is valid—and how much income folks need, relative to their final salary, to retire in comfort.
I find both subjects frustrating, in part because there’s so little consensus. I also find much of the advice way too complicated for the average American.
I participate in NewRetirement’s Facebook group and occasionally give my views on both topics. I recently expressed the opinion that the goal in retirement should be to replace 100% of the base income you earned immediately before retirement. I emphasize “immediately before” because that amount typically drives your current standard of living. Commenters said my 100% replacement rate is ridiculous—but those who disagreed suggested the right target should be everything from 30% to 120% of preretirement income. The thirty-percenters planned on moving to a farm. Most commenters supported 70% replacement.
Paying off a mortgage lowers living expenses, I was told. Those folks missed the point. Paying off that mortgage a few months before retiring is one thing. But if a couple pays off their mortgage several years before retirement, their spending has likely climbed, as they took advantage of the extra money available to them each month.
In making their case, some folks claimed living expenses will decrease significantly once retired. This was from people who were several years from retirement. Yes, expenses may change once you retire, but they probably won’t decrease and, even if they do initially, there’s still inflation to consider. Some spending may be eliminated, like commuting, work clothes and payroll taxes. Other costs, like health insurance premiums, will likely increase. My total premiums for health insurance, including Medicare, are five times higher than when I was working.
Moreover, once retired, chances are your discretionary spending will increase significantly, thanks to travel, hobbies, dining out, grandchildren and so on. Yup, these expenses are discretionary. But isn’t that what an enjoyable retirement is all about?
Other people commented that moving to a lower cost area would cut spending. If that’s the plan because you want to move, fine. But if moving is a necessity to get by in retirement, that’s another thing. It may mean your retirement savings can’t sustain the standard of living you really desire. In retirement, “frugal” isn’t a dirty word—unless you have no other choice.
Some folks seem obsessed with creating a retirement budget, going into great detail about every penny they expect to spend in retirement. Good luck with that. Certainly, having a good understanding of major living expenses is important, but there’s no need to stress over where every penny will go, which is impossible in any case.
One person asked me to outline my budget. When I said I didn’t have one, there was more criticism. “How do you know what you spend?” I was asked. You’re kidding, right? I can tell you exactly how much I spend each month.
I spend an amount equal to my net monthly pension and Social Security, except for any amount left in the bank at month’s end. Discretionary spending is automatically limited to what remains after all fixed expenses and credit card balances are paid in full. Someone may say, “That’s nice—you can afford to do that.”
But it’s not a matter of what we can afford to spend. Rather, what’s important is the amount we can’t afford to spend—otherwise known as living within our means. Once you know how much you can reasonably spend, the next question is, “Where does the money come from?”
I recently saw a Zoom discussion about retirement planning. The “expert” said to avoid the 4% rule at all costs. His reasoning: If you take just 4%, there would be a lot of money left over and you’d be needlessly deprived. How does he know that 4% means depriving yourself, when he doesn’t know your desired lifestyle or how big a portfolio that 4% draw is coming from?
A talk show advisor expressed a similar view. “Spend it down,” he said, noting that you earned that money, not your kids. But spend it down by what age? His crystal ball must be a heck of a lot better than mine. Allow me one of my favorite words: balderdash.
Here’s the deal:
Use your retirement money to maintain your lifestyle, including on things that don’t count as necessities. Don’t deprive yourself out of guilt.
If it makes you happy, plan on leaving money to your children or to your favorite charities.
Make sure your plans provide financially for a surviving spouse or other dependents.
Try not to end up as a financial burden to your children.
If the 4% rule doesn’t give you enough to live on, you either need to save more during your working years or withdraw more than the rule specifies—and the latter means there’s a risk you’ll run out of money. If 4% leaves you with extra money, invest the excess or take less than 4%. It isn’t that complicated.
Use the 4% rule to estimate how big a portfolio you need for retirement. How? Take your base pay. Subtract your expected Social Security benefit and any pension you’ll receive. The remaining income will have to come from your portfolio. To find out how big your portfolio needs to be, simply multiply the required income by 25 (or divide by 4%, or 0.04, which is the same thing). Result: You’ll know how big a nest egg you need to replicate 100% of your base salary. Happy to live on 70% instead? You can adjust the calculation accordingly.
Tell the experts to go live their own life.
I find both subjects frustrating, in part because there’s so little consensus. I also find much of the advice way too complicated for the average American.
I participate in NewRetirement’s Facebook group and occasionally give my views on both topics. I recently expressed the opinion that the goal in retirement should be to replace 100% of the base income you earned immediately before retirement. I emphasize “immediately before” because that amount typically drives your current standard of living. Commenters said my 100% replacement rate is ridiculous—but those who disagreed suggested the right target should be everything from 30% to 120% of preretirement income. The thirty-percenters planned on moving to a farm. Most commenters supported 70% replacement.
Paying off a mortgage lowers living expenses, I was told. Those folks missed the point. Paying off that mortgage a few months before retiring is one thing. But if a couple pays off their mortgage several years before retirement, their spending has likely climbed, as they took advantage of the extra money available to them each month.
In making their case, some folks claimed living expenses will decrease significantly once retired. This was from people who were several years from retirement. Yes, expenses may change once you retire, but they probably won’t decrease and, even if they do initially, there’s still inflation to consider. Some spending may be eliminated, like commuting, work clothes and payroll taxes. Other costs, like health insurance premiums, will likely increase. My total premiums for health insurance, including Medicare, are five times higher than when I was working.
Moreover, once retired, chances are your discretionary spending will increase significantly, thanks to travel, hobbies, dining out, grandchildren and so on. Yup, these expenses are discretionary. But isn’t that what an enjoyable retirement is all about?
Other people commented that moving to a lower cost area would cut spending. If that’s the plan because you want to move, fine. But if moving is a necessity to get by in retirement, that’s another thing. It may mean your retirement savings can’t sustain the standard of living you really desire. In retirement, “frugal” isn’t a dirty word—unless you have no other choice.
Some folks seem obsessed with creating a retirement budget, going into great detail about every penny they expect to spend in retirement. Good luck with that. Certainly, having a good understanding of major living expenses is important, but there’s no need to stress over where every penny will go, which is impossible in any case.
One person asked me to outline my budget. When I said I didn’t have one, there was more criticism. “How do you know what you spend?” I was asked. You’re kidding, right? I can tell you exactly how much I spend each month.
I spend an amount equal to my net monthly pension and Social Security, except for any amount left in the bank at month’s end. Discretionary spending is automatically limited to what remains after all fixed expenses and credit card balances are paid in full. Someone may say, “That’s nice—you can afford to do that.”
But it’s not a matter of what we can afford to spend. Rather, what’s important is the amount we can’t afford to spend—otherwise known as living within our means. Once you know how much you can reasonably spend, the next question is, “Where does the money come from?”
I recently saw a Zoom discussion about retirement planning. The “expert” said to avoid the 4% rule at all costs. His reasoning: If you take just 4%, there would be a lot of money left over and you’d be needlessly deprived. How does he know that 4% means depriving yourself, when he doesn’t know your desired lifestyle or how big a portfolio that 4% draw is coming from?
A talk show advisor expressed a similar view. “Spend it down,” he said, noting that you earned that money, not your kids. But spend it down by what age? His crystal ball must be a heck of a lot better than mine. Allow me one of my favorite words: balderdash.
Here’s the deal:
Use your retirement money to maintain your lifestyle, including on things that don’t count as necessities. Don’t deprive yourself out of guilt.
If it makes you happy, plan on leaving money to your children or to your favorite charities.
Make sure your plans provide financially for a surviving spouse or other dependents.
Try not to end up as a financial burden to your children.
If the 4% rule doesn’t give you enough to live on, you either need to save more during your working years or withdraw more than the rule specifies—and the latter means there’s a risk you’ll run out of money. If 4% leaves you with extra money, invest the excess or take less than 4%. It isn’t that complicated.
Use the 4% rule to estimate how big a portfolio you need for retirement. How? Take your base pay. Subtract your expected Social Security benefit and any pension you’ll receive. The remaining income will have to come from your portfolio. To find out how big your portfolio needs to be, simply multiply the required income by 25 (or divide by 4%, or 0.04, which is the same thing). Result: You’ll know how big a nest egg you need to replicate 100% of your base salary. Happy to live on 70% instead? You can adjust the calculation accordingly.
Tell the experts to go live their own life.
Richard Quinn blogs at QuinnsCommentary.com. Before retiring in 2010, he was a compensation and benefits executive. Follow Dick on Twitter @QuinnsComments and check out his earlier articles.
The post Old Arguments appeared first on HumbleDollar.
January 21, 2021
Carlson’s Way
IT ISN’T EVERY personal finance book that includes a chapter entitled, “You Will Lose Money.” But that’s Ben Carlson laying down the harsh truth for inexperienced investors in his self-published fourth book, Everything You Need to Know About Saving for Retirement.
I interviewed Carlson recently because I find his A Wealth of Common Sense blog among the most useful for a small investor like me—someone with an intermediate level of market knowledge. He’s director of institutional asset management at Ritholtz Wealth Management, where co-founder Barry Ritholtz and many on his team—including Carlson, Josh Brown and Michael Batnick—regularly blog and record podcasts.
Carlson started writing for small investors in 2013, partly to deal with constant queries from family and friends. “I was always getting kind of the same questions,” he says, talking from his home in Grand Rapids, Michigan. “Obviously, people aren’t getting the answers they need. I thought I’d just share some of my thoughts on what’s going on and try to put it in context.”
Putting things in context is among Carlson’s strengths. I appreciate his penchant for slicing data by time period, showing such things as cycles of performance for small cap, value and foreign stocks, but without making predictions. Here are my top five takeaways from his new book and from my recent interview with Carlson:
1. Watch your wallet more than you watch the ticker. “Early on in your financial lifecycle, the vast majority of your gains will come not from your investment prowess but from your savings rate,” Carlson writes. “Real wealth for normal retirement savers comes from a combination of saving, compounding and sitting on your hands.”
During our conversation, Carlson told me, “A lot of people confuse picking stocks with having a financial plan. If young people think that trading is going to be a way they make their millions, they’re going to be sorely mistaken.”
2. Avoid “the paradox of choice” by automating your finances. Psychologist Barry Schwartz theorized that having more choice, while seen by many folks as desirable, actually results in more anxiety and can lead to decision-making paralysis—the so-called paradox of choice. Elaborating on that notion, Carlson quotes legendary management consultant Peter Drucker: “Don’t make a hundred decisions when you can make one.”
That goes for both saving and investing. To reduce the number of decisions you need to make each month, set aside a portion of your paycheck automatically, such as through your employer’s 401(k). Soon enough, you won’t even notice the money is gone. That’s simpler and will likely have better results than thinking every month that you’ll save whatever you can spare. Carlson adds that target-date and index funds are also great options, especially for less experienced investors, because they simplify investing and reduce the need for constant decisions.
3. Change your behavior. “Information is useless unless it’s paired with an intelligent, concrete plan to change your behavior,” Carlson writes. Indeed, if facts were all we needed to make good decisions, the diet and exercise craze that took off in the 1960s would have made us svelte and fit. Instead, obesity has grown substantially.
This gets back to the benefit of making our saving and investing automatic. Carlson quotes food researcher Brian Wansink: “The best diet is the one you don’t know you’re on.”
4. Read up on the fundamentals. I asked Carlson what he considered the best sources of information for average investors. “I’d prefer most people just read some basic books, because a lot of this stuff about personal finance doesn’t really change that much over time,” he says. “There’s a quote from [Berkshire Hathaway Vice Chairman] Charlie Munger about how people don’t go to church to hear an 11th commandment, they just need the ones they know reinforced.”
Carlson continues: “One of the things that people misconstrue when they watch financial television or read something is that it all requires context, because it’s a one-way conversation. If you’re getting someone who’s pushing predictions and saying, ‘You have to do this immediately, you have to put your money here,’ without understanding your financial goals and your situation, it’s not going to work for you.”
5. Down markets are the difference maker. Market pullbacks are “when you understand your true risk profile as an investor and what asset allocation you can stick with,” Carlson says. “Because that one mistake—selling your stocks when they’re down—can be really hard to come back from.”
William Ehart is a journalist in the Washington, D.C., area. In his spare time, he enjoys writing for beginning and intermediate investors on why they should invest and how simple it can be, despite all the financial noise. Follow Bill on Twitter @BillEhart and check out his earlier articles.
The post Carlson’s Way appeared first on HumbleDollar.
January 20, 2021
Going Neutral
ONE OF THE KEY skills I quickly learned as a new parent: how to curb some of my emotions. Take last night. We were enjoying our normal bedtime routine, including bath time, bottles and a few favorite books.
Then I was vomited all over.
Being vomited on was just another evening with our 16-month-old twins. If you dial up or down your emotions too much in response, they have you. Dial them a bit too high, and soon you’re down an internet search vortex that has you fretting over all sorts of obscure diseases. Keep your dial too low and you aren’t paying enough attention. So how do you become a Goldilocks in this scenario—not too hot, not too cold, but just right?
Trevor Moawad, a renowned mental conditioning expert and advisor to sports stars, preaches the power of neutral thinking. In other words, focus on the facts. Here are ours:
She threw up.
She needs another bath.
Repeat bedtime routine, but this time give her water.
The place stinks. Clean up after twins are asleep.
What dials are you turning up too high? Which are you ignoring? For those who immediately thought about their investment portfolio, how can you take some of the emotion—the dials—out of it? How can you turn a wild financial year like 2020 into facts? Consider the following, all of which are reasons for optimism:
The S&P 500 was up 18.4% in 2020, including reinvested dividends, despite a brutal bear market earlier in the year.
For the first time in more than 20 years—and probably ever, but the data only go back two decades—all S&P 500 companies have at least one female board member. We know from numerous studies that companies with more diversity at senior levels are more profitable and make better decisions.
Large companies like Google, Twitter and Microsoft have adopted some form of permanent work-from-home policies, widening their pool of potential talent by removing the limitations of geography.
More than half of small and midsized businesses report they’re likely to maintain remote work options for employees in the long term, indicating that remote work isn't just a temporary shift.
The companies of the future are now being launched. Amid crises, new successes emerge. General Electric launched in 1892, right as the country headed into the Panic of 1893. Disney launched at the onset of the Great Depression and FedEx started at the end of the 1969-70 recession.
I can cite these facts, and yet you may still feel like you’ve been vomited on—that last year still stank. Partly, it’s because some terrible things did indeed happen. But partly, it’s because of negativity bias—the tendency to respond more powerfully to negative events and experiences than positives ones. We forget some of the good, allowing the bad to leave more of a mark. This is typical of human behavior. We are beautifully irrational. It’s much easier to dial up or down our emotions than to neutralize our thinking.
Moawad's approach to neutral thinking is simple: Focus on what you say out loud, what you consume and what habits you form. Last year was overwhelming and exhausting for most people. For many families, it brought tragedy. But there are still reasons for optimism.
If you are reading this, you’re still here. To be vomited on, you have to be present. I was present for that, plus a whole lot of the twins’ firsts. For our family, 2020 brought many ups and downs, but staying neutral helped us get through it. It may help yours in the months ahead, as we struggle to escape the pandemic, and its ongoing impact on our communities and our economy. My advice: Keep a tight grip on the facts—and on those pesky dials.
Anika Hedstrom, MBA, CFP, is a personal finance expert and advisor. She writes on motivational and behavioral aspects of financial planning, and has been featured in USA Today, MarketWatch, Huffington Post, Business Insider and NPR. Always up for adventure, Anika can be found exploring new countries, whitewater rafting and chasing after her twins. Follow her on Twitter
@AnikaHedstrom
and check out her earlier articles.
Then I was vomited all over.
Being vomited on was just another evening with our 16-month-old twins. If you dial up or down your emotions too much in response, they have you. Dial them a bit too high, and soon you’re down an internet search vortex that has you fretting over all sorts of obscure diseases. Keep your dial too low and you aren’t paying enough attention. So how do you become a Goldilocks in this scenario—not too hot, not too cold, but just right?
Trevor Moawad, a renowned mental conditioning expert and advisor to sports stars, preaches the power of neutral thinking. In other words, focus on the facts. Here are ours:
She threw up.
She needs another bath.
Repeat bedtime routine, but this time give her water.
The place stinks. Clean up after twins are asleep.
What dials are you turning up too high? Which are you ignoring? For those who immediately thought about their investment portfolio, how can you take some of the emotion—the dials—out of it? How can you turn a wild financial year like 2020 into facts? Consider the following, all of which are reasons for optimism:
The S&P 500 was up 18.4% in 2020, including reinvested dividends, despite a brutal bear market earlier in the year.
For the first time in more than 20 years—and probably ever, but the data only go back two decades—all S&P 500 companies have at least one female board member. We know from numerous studies that companies with more diversity at senior levels are more profitable and make better decisions.
Large companies like Google, Twitter and Microsoft have adopted some form of permanent work-from-home policies, widening their pool of potential talent by removing the limitations of geography.
More than half of small and midsized businesses report they’re likely to maintain remote work options for employees in the long term, indicating that remote work isn't just a temporary shift.
The companies of the future are now being launched. Amid crises, new successes emerge. General Electric launched in 1892, right as the country headed into the Panic of 1893. Disney launched at the onset of the Great Depression and FedEx started at the end of the 1969-70 recession.
I can cite these facts, and yet you may still feel like you’ve been vomited on—that last year still stank. Partly, it’s because some terrible things did indeed happen. But partly, it’s because of negativity bias—the tendency to respond more powerfully to negative events and experiences than positives ones. We forget some of the good, allowing the bad to leave more of a mark. This is typical of human behavior. We are beautifully irrational. It’s much easier to dial up or down our emotions than to neutralize our thinking.
Moawad's approach to neutral thinking is simple: Focus on what you say out loud, what you consume and what habits you form. Last year was overwhelming and exhausting for most people. For many families, it brought tragedy. But there are still reasons for optimism.
If you are reading this, you’re still here. To be vomited on, you have to be present. I was present for that, plus a whole lot of the twins’ firsts. For our family, 2020 brought many ups and downs, but staying neutral helped us get through it. It may help yours in the months ahead, as we struggle to escape the pandemic, and its ongoing impact on our communities and our economy. My advice: Keep a tight grip on the facts—and on those pesky dials.
Anika Hedstrom, MBA, CFP, is a personal finance expert and advisor. She writes on motivational and behavioral aspects of financial planning, and has been featured in USA Today, MarketWatch, Huffington Post, Business Insider and NPR. Always up for adventure, Anika can be found exploring new countries, whitewater rafting and chasing after her twins. Follow her on Twitter
@AnikaHedstrom
and check out her earlier articles.The post Going Neutral appeared first on HumbleDollar.
January 19, 2021
Whole New Game
BASEBALL USED TO BE a game where managers would go with their “gut.” But Brad Pitt changed everything. In the movie Moneyball, Pitt played Billy Beane, the first baseball general manager to use data analytics to great success—and suddenly it was all the rage.
Today, from a typical game, seven terabytes of data are gathered, everything from the arm angle of every single pitch to the exit velocity of hit balls. Teams then interpret these numbers using sophisticated algorithms, so managers have the insights necessary to make decisions based on statistical probabilities rather than intuition. Big data analytics now drive baseball decisions on and off the field—because the process has proven to work.
The traditionalist in me revolts at this dehumanization of baseball. But the investor in me sees an opportunity to learn from baseball’s experience. I see two key lessons.
Lesson No. 1: Be aware of cognitive biases—especially the Dunning-Kruger effect. What’s that? People who are the most ignorant about a topic tend to be the least aware of their ignorance and, as a result, often have the highest confidence. Bad things usually happen when we suffer from overconfidence.
We can see evidence of this bias in the rising number of day traders. New apps have made it easy and fun to trade stocks and options. With the market hitting all-time highs, new traders have—I suspect—been lulled into thinking investing is easy.
The media feeds into this belief. We’re bombarded with headlines like “8 Stocks to Buy and 5 to Sell,” making successful investing seem as simple as reading a monthly investment magazine.
I learned about investing by watching the popular PBS show Wall Street Week with Louis Rukeyser. The highlight of the show came at the end of the year, when the stock pickers would wear tuxedos and be either exalted or humiliated based on how their stock picks had performed that year. They would then confidently offer stocks for the next year, persuasively explaining why the new picks would be winners.
It was great theater but misleading for a novice like me. At the time, it never occurred ro me that, in any given year, random luck was possibly the biggest factor in determining which stock pickers did best.
Instead, for me, the moment of clarity came in an investment course I took during an MBA program. As I dug into the complex math of securities analysis, it dawned on me that there would always be investment analysts much smarter than me. I might get lucky now and again, but it was unlikely I would ever gain a true long-term competitive edge in investing, no matter how hard I worked. It was during that class that I found humility. I was not going to be the next Warren Buffett.
Lesson No. 2 comes from poker. Good poker players develop a process that puts the probabilities in their favor. They don’t panic about short-term losses but instead stay committed to their winning strategy. In fact, poker players expect to lose often, but it doesn’t shake the confidence of the good ones. If they’ve done the math correctly, they know the odds of eventual success are in their favor.
Modern baseball and poker players both recognize that patterns exist in games that they can exploit—provided they eliminate cognitive biases and stick to high probability strategies. As small investors, we may not have access to supercomputers to crunch big data, and we may not have the ability to count cards and mentally calculate the odds of success while sitting at the poker table. Still, we can garner sufficient understanding of such things to improve our chances of investment success. To that end, here are four suggestions:
Recognize that our brains are wired to find order in chaos. This is normally a good thing—unless we’re investing. The markets are constantly in chaos, and yet Wall Street firms try to appeal to our innate desire for order by issuing an endless stream of seemingly logical predictions. How many of these firms predicted the events of 2020? Expect the same accuracy in 2021—and ignore these useless forecasts.
Don’t base investment decisions on your gut feel for which way markets are headed. Instead, adopt practices that have worked through many different market cycles. Like a good poker player, don’t sweat the losses if you have a process in place that puts the probabilities in your favor. Focus on tax efficiency, holding down investment costs, diversifying broadly and investing in line with your risk tolerance.
Make sure you can absorb short-term losses, so you can stay in the game long enough to let your investment strategy show results. If you’re funding a retirement that’s decades away, you should be able to ride out stock market declines, because you won’t spend the money involved for many years. But if you’ll need cash for a honeymoon in Europe next year, look to take much lower risk with that money by, say, buying a short-term bond fund.
Last year turned out to be a good one for the stock market. If you have a plan in place that allocates 60% to stocks, you probably need to rebalance because your portfolio is over that threshold. In poker terms, it might be time to take some money off the table.
Joe Kesler is the author of
Smart Money with Purpose
and the founder of a
website
with the same name, which is where a version of this article first appeared. He spent 40 years in community banking, assisting small businesses and consumers. Joe served as chief executive of banks in Illinois and Montana. He currently lives with his wife in Missoula, Montana, spending his time writing on personal finance, serving on two bank boards and hiking in the Rocky Mountains. Check out Joe's previous articles.
Today, from a typical game, seven terabytes of data are gathered, everything from the arm angle of every single pitch to the exit velocity of hit balls. Teams then interpret these numbers using sophisticated algorithms, so managers have the insights necessary to make decisions based on statistical probabilities rather than intuition. Big data analytics now drive baseball decisions on and off the field—because the process has proven to work.
The traditionalist in me revolts at this dehumanization of baseball. But the investor in me sees an opportunity to learn from baseball’s experience. I see two key lessons.
Lesson No. 1: Be aware of cognitive biases—especially the Dunning-Kruger effect. What’s that? People who are the most ignorant about a topic tend to be the least aware of their ignorance and, as a result, often have the highest confidence. Bad things usually happen when we suffer from overconfidence.
We can see evidence of this bias in the rising number of day traders. New apps have made it easy and fun to trade stocks and options. With the market hitting all-time highs, new traders have—I suspect—been lulled into thinking investing is easy.
The media feeds into this belief. We’re bombarded with headlines like “8 Stocks to Buy and 5 to Sell,” making successful investing seem as simple as reading a monthly investment magazine.
I learned about investing by watching the popular PBS show Wall Street Week with Louis Rukeyser. The highlight of the show came at the end of the year, when the stock pickers would wear tuxedos and be either exalted or humiliated based on how their stock picks had performed that year. They would then confidently offer stocks for the next year, persuasively explaining why the new picks would be winners.
It was great theater but misleading for a novice like me. At the time, it never occurred ro me that, in any given year, random luck was possibly the biggest factor in determining which stock pickers did best.
Instead, for me, the moment of clarity came in an investment course I took during an MBA program. As I dug into the complex math of securities analysis, it dawned on me that there would always be investment analysts much smarter than me. I might get lucky now and again, but it was unlikely I would ever gain a true long-term competitive edge in investing, no matter how hard I worked. It was during that class that I found humility. I was not going to be the next Warren Buffett.
Lesson No. 2 comes from poker. Good poker players develop a process that puts the probabilities in their favor. They don’t panic about short-term losses but instead stay committed to their winning strategy. In fact, poker players expect to lose often, but it doesn’t shake the confidence of the good ones. If they’ve done the math correctly, they know the odds of eventual success are in their favor.
Modern baseball and poker players both recognize that patterns exist in games that they can exploit—provided they eliminate cognitive biases and stick to high probability strategies. As small investors, we may not have access to supercomputers to crunch big data, and we may not have the ability to count cards and mentally calculate the odds of success while sitting at the poker table. Still, we can garner sufficient understanding of such things to improve our chances of investment success. To that end, here are four suggestions:
Recognize that our brains are wired to find order in chaos. This is normally a good thing—unless we’re investing. The markets are constantly in chaos, and yet Wall Street firms try to appeal to our innate desire for order by issuing an endless stream of seemingly logical predictions. How many of these firms predicted the events of 2020? Expect the same accuracy in 2021—and ignore these useless forecasts.
Don’t base investment decisions on your gut feel for which way markets are headed. Instead, adopt practices that have worked through many different market cycles. Like a good poker player, don’t sweat the losses if you have a process in place that puts the probabilities in your favor. Focus on tax efficiency, holding down investment costs, diversifying broadly and investing in line with your risk tolerance.
Make sure you can absorb short-term losses, so you can stay in the game long enough to let your investment strategy show results. If you’re funding a retirement that’s decades away, you should be able to ride out stock market declines, because you won’t spend the money involved for many years. But if you’ll need cash for a honeymoon in Europe next year, look to take much lower risk with that money by, say, buying a short-term bond fund.
Last year turned out to be a good one for the stock market. If you have a plan in place that allocates 60% to stocks, you probably need to rebalance because your portfolio is over that threshold. In poker terms, it might be time to take some money off the table.
Joe Kesler is the author of
Smart Money with Purpose
and the founder of a
website
with the same name, which is where a version of this article first appeared. He spent 40 years in community banking, assisting small businesses and consumers. Joe served as chief executive of banks in Illinois and Montana. He currently lives with his wife in Missoula, Montana, spending his time writing on personal finance, serving on two bank boards and hiking in the Rocky Mountains. Check out Joe's previous articles.The post Whole New Game appeared first on HumbleDollar.
January 18, 2021
Not Preferred
PREFERRED SHARES are mighty tempting right now because their yields are so much higher than most bond yields. For instance, iShares Preferred and Income Securities ETF currently boasts a yield of 4.4%, while Invesco Preferred ETF is kicking off almost 5% and SPDR Wells Fargo Preferred Stock ETF yields 4.5%.
But the reason is simple: They’re risky. Whether you invest in individual preferred shares or preferred stock ETFs, here are five risks to consider before investing:
1. Credit risk. On this score, there are four concerns. First, many issuers of preferred stock aren’t that financially strong. If they were, they would have issued cheaper forms of financing. Second, unlike the interest payments on bonds, dividend payments aren’t guaranteed. Third, in a bankruptcy, investors in preferred stocks get repaid after bondholders. Fourth, many preferred stocks have long maturities of 30 years or more—and sometimes no maturity date at all. While issuers may pose little credit risk in the near term, given enough time, many of them could get themselves in financial trouble.
2. Interest rate risk. Two factors conspire to make preferred stocks especially sensitive to interest rate changes: Most are issued with fixed dividends and most have very long maturities or no maturity. If market interest rates rise sharply, fixed-rate preferred stocks with long durations will plummet.
3. Call risk. Most preferred stocks have call provisions. Call provisions give issuers the right, but not the obligation, to call preferred stock on specified dates and at specified prices, which is usually the preferred’s par value. This creates three problems.
First, there’s asymmetric price risk. Other, noncallable debt has symmetric price risk. In other words, a 1% rise or fall in interest rates will result in roughly the same change in the price of a bond. But that’s not the case with callable preferred stock.
Why not? If interest rates rise, the price of preferred stocks will fall. But if interest rates fall and issuers have call rights, they’ll likely call their preferred stock and replace it with cheaper financing, so holders don’t get the full benefit of falling rates. On top of that, if an issuer’s credit rating improves, it will likely call its preferred stock and refinance it more cheaply. But if its credit rating deteriorates, it may not be in a position to call the stock. In that case, the price will fall due to the issuer’s deteriorating financial condition.
The second issue: There’s limited potential for price appreciation above par. Preferred stocks usually don’t trade much above their par values, and call provisions are the primary culprit. Suppose there’s a preferred stock that pays a dividend that’s significantly above current market yields. If the stock has call provisions, it could trade at a big premium to par—but only if its call date is in the distant future. If the call date is coming up soon, it would trade at or near par. Other investors simply aren’t going to pay much, if any, premium for a stock that’s about to be called at par.
(Keep in mind that, while preferreds are called “stocks,” they don’t participate in their issuer’s earnings growth unless they have participation or convertibility rights. Since most preferreds don’t have these rights, they don’t participate in the good fortunes of their issuer companies and hence, unlike a regular stock, there isn’t the same potential for long-term price gains.)
What’s the third issue? Callable preferred stocks pose reinvestment risk. If they’re called, holders lose their higher income streams—and they may have to reinvest their money at far lower yields.
4. Stock-like volatility. In the long run, preferred stock prices move primarily in response to changes in market interest rates and issuer creditworthiness. But in the short run, they tend to behave more like common stocks. Why? Stock market swings often reflect concerns about the economy and its impact on the financial stability of corporations—and those same concerns can drive preferred shares up and down.
For example, in the 2008 financial crisis, the prices of the two largest preferred stock ETFs, iShares Preferred and Invesco Preferred, declined 45% and 48% between May and October 2008. In 2020, the price of the iShares and Invesco funds declined by some 34% between February and March, before bouncing back. Preferred stocks have also had other, less stomach-churning pullbacks over the years. The bottom line: They’ve performed enough like common stocks over time that they shouldn’t be viewed as a bond substitute.
5. Concentration risk. Preferred stocks are highly concentrated in the financial and utilities sectors. That creates a diversification problem because you’re so overweighted in these sectors. How overweighted? As of late 2020, the larger preferred stock ETFs had about 65% of their portfolios invested in financial companies and about 13% in utilities. By contrast, financials and utilities represented some 10% and 3%, respectively, of the S&P 500-stock index.
Rick Moberg is the retired chief financial officer of a publicly traded software company. He has an MBA in finance, is a CPA and has a passion for personal finance. Rick lives outside of Boston with his wife. His previous articles include Happier at Home, Venturing Abroad and Six Tips.
But the reason is simple: They’re risky. Whether you invest in individual preferred shares or preferred stock ETFs, here are five risks to consider before investing:
1. Credit risk. On this score, there are four concerns. First, many issuers of preferred stock aren’t that financially strong. If they were, they would have issued cheaper forms of financing. Second, unlike the interest payments on bonds, dividend payments aren’t guaranteed. Third, in a bankruptcy, investors in preferred stocks get repaid after bondholders. Fourth, many preferred stocks have long maturities of 30 years or more—and sometimes no maturity date at all. While issuers may pose little credit risk in the near term, given enough time, many of them could get themselves in financial trouble.
2. Interest rate risk. Two factors conspire to make preferred stocks especially sensitive to interest rate changes: Most are issued with fixed dividends and most have very long maturities or no maturity. If market interest rates rise sharply, fixed-rate preferred stocks with long durations will plummet.
3. Call risk. Most preferred stocks have call provisions. Call provisions give issuers the right, but not the obligation, to call preferred stock on specified dates and at specified prices, which is usually the preferred’s par value. This creates three problems.
First, there’s asymmetric price risk. Other, noncallable debt has symmetric price risk. In other words, a 1% rise or fall in interest rates will result in roughly the same change in the price of a bond. But that’s not the case with callable preferred stock.
Why not? If interest rates rise, the price of preferred stocks will fall. But if interest rates fall and issuers have call rights, they’ll likely call their preferred stock and replace it with cheaper financing, so holders don’t get the full benefit of falling rates. On top of that, if an issuer’s credit rating improves, it will likely call its preferred stock and refinance it more cheaply. But if its credit rating deteriorates, it may not be in a position to call the stock. In that case, the price will fall due to the issuer’s deteriorating financial condition.
The second issue: There’s limited potential for price appreciation above par. Preferred stocks usually don’t trade much above their par values, and call provisions are the primary culprit. Suppose there’s a preferred stock that pays a dividend that’s significantly above current market yields. If the stock has call provisions, it could trade at a big premium to par—but only if its call date is in the distant future. If the call date is coming up soon, it would trade at or near par. Other investors simply aren’t going to pay much, if any, premium for a stock that’s about to be called at par.
(Keep in mind that, while preferreds are called “stocks,” they don’t participate in their issuer’s earnings growth unless they have participation or convertibility rights. Since most preferreds don’t have these rights, they don’t participate in the good fortunes of their issuer companies and hence, unlike a regular stock, there isn’t the same potential for long-term price gains.)
What’s the third issue? Callable preferred stocks pose reinvestment risk. If they’re called, holders lose their higher income streams—and they may have to reinvest their money at far lower yields.
4. Stock-like volatility. In the long run, preferred stock prices move primarily in response to changes in market interest rates and issuer creditworthiness. But in the short run, they tend to behave more like common stocks. Why? Stock market swings often reflect concerns about the economy and its impact on the financial stability of corporations—and those same concerns can drive preferred shares up and down.
For example, in the 2008 financial crisis, the prices of the two largest preferred stock ETFs, iShares Preferred and Invesco Preferred, declined 45% and 48% between May and October 2008. In 2020, the price of the iShares and Invesco funds declined by some 34% between February and March, before bouncing back. Preferred stocks have also had other, less stomach-churning pullbacks over the years. The bottom line: They’ve performed enough like common stocks over time that they shouldn’t be viewed as a bond substitute.
5. Concentration risk. Preferred stocks are highly concentrated in the financial and utilities sectors. That creates a diversification problem because you’re so overweighted in these sectors. How overweighted? As of late 2020, the larger preferred stock ETFs had about 65% of their portfolios invested in financial companies and about 13% in utilities. By contrast, financials and utilities represented some 10% and 3%, respectively, of the S&P 500-stock index.
Rick Moberg is the retired chief financial officer of a publicly traded software company. He has an MBA in finance, is a CPA and has a passion for personal finance. Rick lives outside of Boston with his wife. His previous articles include Happier at Home, Venturing Abroad and Six Tips.The post Not Preferred appeared first on HumbleDollar.
January 17, 2021
Riot? What Riot?
THE CAPITOL WAS invaded by an angry mob 11 days ago. A week later, the House of Representatives voted to impeach the president. But if you’d been looking only at the stock market, you would have no idea.
Not only is the market higher today than it was the day before this all started, but also the VIX—the market’s “fear gauge”—is lower. From the perspective of the stock market, it’s been an ordinary few weeks.
You might wonder what’s going on. Shouldn’t the market have registered these unsettling events? I could trot out the standard explanations for the market's resilience:
With the COVID-19 vaccine rolling out, the economy should continue to improve.
Many businesses are struggling, but big technology companies that dominate the market indexes are thriving.
Low interest rates are pushing bond investors into the stock market.
With many people remaining close to home, money that ordinarily would have been spent on vacations and entertainment has instead ended up being saved, and a portion of those savings have been invested in the stock market.
Those are the standard explanations, and they’re part of the story. They definitely help explain why the market has been flying high in recent months. But they don’t explain why the market seemed to completely ignore the events in Washington, DC. What’s really going on?
If I had to identify one explanatory factor, it would be momentum. The stock market these days is being propelled higher by investors who don’t want to miss out on what they expect will be further gains. In short, it’s FOMO—fear of missing out—that’s driving the market.
Of course, the market has been going up almost continuously for more than a decade, so why am I now singling out FOMO? While it’s true that share prices have been rising for quite a while, things seem to have taken a turn. The market today reminds me of the late 1990s, when internet stocks captured investors’ imagination. There are a number of similarities:
Certain stocks seem unstoppable—Tesla being the most obvious example. Anyone who urges caution on a stock like that is dismissed as lacking in imagination or understanding.
Ecommerce companies are seeing their stocks rise to unreasonable levels. Etsy’s stock is trading at a price-earnings (P/E) ratio of 68. Shopify’s stock is at a difficult-to-comprehend 297. By way of comparison, the S&P 500 is trading at around 38 times trailing 12-month reported earnings and 24 times forecasted operating earnings.
Valuations on other fashionable companies are also off the charts. The P/E on Peloton’s stock is around 300.
Companies with negative earnings, such as Spotify, Roku and DraftKings, are seeing their stocks double or triple.
Investors are snapping up speculative assets like bitcoin that lack any intrinsic value.
How should you navigate an environment like this? You might fall back on Warren Buffett’s dictum to be “fearful when others are greedy.” But I’d recommend a variation on this. I don’t think you need to be fearful or run for the exits. That's because today's market, while high, is not as universally inflated as it was in early 2000, just before the 2000-02 bear market. Right now, you just need to be reasonable when others are being greedy and apply an extra dose of caution. Below are some recommendations:
If any single stock represents a big part of your portfolio, start there. Even if it looks like a great company, I’d cut it back to manage risk.
Maintain your rebalancing discipline. Even if it feels like you’re leaving the party while it’s still going, that’s okay. I wouldn’t risk losses in an effort to eke out the last few dollars of profit. J.P. Morgan once said, “I made a fortune getting out too soon.” I think that’s a good motto.
Don’t forget the fundamentals. Yes, it’s possible to make a fortune buying an overpriced stock. Its earnings could increase or it could simply become even more overpriced. But over time and on average, traditional valuation metrics can be helpful. If the valuation on a stock looks like it's in fantasyland, don't ignore the numbers. Take Tesla. Wall Street analysts estimate that the company’s earnings per share will more than double over the next few years, from $2.45 to $6.72. But the stock is trading around $850. Even if Wall Street analysts are completely wrong, and 2022 earnings end up being $10 per share, instead of $6.72, that would still make the P/E ratio 85. To be sure, the stock could keep going up from here—anything can happen—but it’s important to keep your feet on the ground, no matter how great a company it is.
If you want to make speculative bets, limit the risk. Think of it like going to a casino: Plan in advance how much you’re willing to bet and potentially lose—and then stick to that number.
Adam M. Grossman’s previous articles include Moving the Target, Those Messy Humans and What We've Learned. Adam is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, Adam advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman.
Not only is the market higher today than it was the day before this all started, but also the VIX—the market’s “fear gauge”—is lower. From the perspective of the stock market, it’s been an ordinary few weeks.
You might wonder what’s going on. Shouldn’t the market have registered these unsettling events? I could trot out the standard explanations for the market's resilience:
With the COVID-19 vaccine rolling out, the economy should continue to improve.
Many businesses are struggling, but big technology companies that dominate the market indexes are thriving.
Low interest rates are pushing bond investors into the stock market.
With many people remaining close to home, money that ordinarily would have been spent on vacations and entertainment has instead ended up being saved, and a portion of those savings have been invested in the stock market.
Those are the standard explanations, and they’re part of the story. They definitely help explain why the market has been flying high in recent months. But they don’t explain why the market seemed to completely ignore the events in Washington, DC. What’s really going on?
If I had to identify one explanatory factor, it would be momentum. The stock market these days is being propelled higher by investors who don’t want to miss out on what they expect will be further gains. In short, it’s FOMO—fear of missing out—that’s driving the market.
Of course, the market has been going up almost continuously for more than a decade, so why am I now singling out FOMO? While it’s true that share prices have been rising for quite a while, things seem to have taken a turn. The market today reminds me of the late 1990s, when internet stocks captured investors’ imagination. There are a number of similarities:
Certain stocks seem unstoppable—Tesla being the most obvious example. Anyone who urges caution on a stock like that is dismissed as lacking in imagination or understanding.
Ecommerce companies are seeing their stocks rise to unreasonable levels. Etsy’s stock is trading at a price-earnings (P/E) ratio of 68. Shopify’s stock is at a difficult-to-comprehend 297. By way of comparison, the S&P 500 is trading at around 38 times trailing 12-month reported earnings and 24 times forecasted operating earnings.
Valuations on other fashionable companies are also off the charts. The P/E on Peloton’s stock is around 300.
Companies with negative earnings, such as Spotify, Roku and DraftKings, are seeing their stocks double or triple.
Investors are snapping up speculative assets like bitcoin that lack any intrinsic value.
How should you navigate an environment like this? You might fall back on Warren Buffett’s dictum to be “fearful when others are greedy.” But I’d recommend a variation on this. I don’t think you need to be fearful or run for the exits. That's because today's market, while high, is not as universally inflated as it was in early 2000, just before the 2000-02 bear market. Right now, you just need to be reasonable when others are being greedy and apply an extra dose of caution. Below are some recommendations:
If any single stock represents a big part of your portfolio, start there. Even if it looks like a great company, I’d cut it back to manage risk.
Maintain your rebalancing discipline. Even if it feels like you’re leaving the party while it’s still going, that’s okay. I wouldn’t risk losses in an effort to eke out the last few dollars of profit. J.P. Morgan once said, “I made a fortune getting out too soon.” I think that’s a good motto.
Don’t forget the fundamentals. Yes, it’s possible to make a fortune buying an overpriced stock. Its earnings could increase or it could simply become even more overpriced. But over time and on average, traditional valuation metrics can be helpful. If the valuation on a stock looks like it's in fantasyland, don't ignore the numbers. Take Tesla. Wall Street analysts estimate that the company’s earnings per share will more than double over the next few years, from $2.45 to $6.72. But the stock is trading around $850. Even if Wall Street analysts are completely wrong, and 2022 earnings end up being $10 per share, instead of $6.72, that would still make the P/E ratio 85. To be sure, the stock could keep going up from here—anything can happen—but it’s important to keep your feet on the ground, no matter how great a company it is.
If you want to make speculative bets, limit the risk. Think of it like going to a casino: Plan in advance how much you’re willing to bet and potentially lose—and then stick to that number.
Adam M. Grossman’s previous articles include Moving the Target, Those Messy Humans and What We've Learned. Adam is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, Adam advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman.The post Riot? What Riot? appeared first on HumbleDollar.
January 16, 2021
Why We Go Wrong
I’VE LONG BEEN flummoxed by the difficulty people have managing money. It all seems so intuitive: Save, invest, repeat. Buy more when the market falls and a lot more when it crashes. Rebalance by adding more to losing asset classes—which today means buying value and international stocks.
Now, don’t get me wrong: I’m no financial genius. I’ve made my share of blunders. But I also know that being a do-it-yourself investor has saved me boatloads of money. When I’ve encouraged colleagues to do the same—imploring them that “it’s really not that hard”—I’ve received only steely stares and blank looks.
It’s slowly dawned on me that the financial demons people wrestle with are real and of Herculean proportions. Finance is a minefield that few navigate without getting maimed. It’s replete with mirages—what you see is often not what you get. Our instincts hurt us more often than they protect us. Actions that are sensible in every other realm of life lead us astray in finance.
What follows is an exploration of eight key concepts that many—and perhaps most—investors struggle with. The biggest paradox of all: While managing money may appear simple, it’s anything but.
1. Compound interest is the key to wealth. We’re woefully ill-equipped to wrap our heads around the wonder that is compound interest. Warren Buffett described his eureka moment at age 10. “That’s where the money is,” he told himself, referring to the power of compound interest.
The miracle of compound interest is a collision of two intangible concepts—exponential growth and a long time horizon. It’s well known that people struggle when making decisions that have consequences well into the future. Economists refer to such myopia as “present bias,” a universal human tendency to favor the present over the future.
The abysmally low U.S. savings rate exemplifies this mindset. But it also reflects a failure to grasp the immense power of exponential growth over long stretches of time. In brief, we each need our own eureka moment.
Consider the story of the Lenape Indians. In 1626, they sold the island of Manhattan to Peter Minuit for a mere $24. That was the greatest swindle in U.S. history, right? If you compound $24 at 7% a year—which is the average after-inflation return of the stock market—what would it be worth today? Almost $10 trillion. Let that sink in.
2. Laziness is a virtue. Life teaches, and common sense affirms, that hard work pays off. Sloth was so disdained in medieval times that it was labeled one of the seven deadly sins. Yet lazy investing leads to superior, not inferior, results.
Nearly every action an investor takes turns out to be counterproductive. For example, investors tend to sell their winners and hold on to their losers, exactly the opposite of what the tax code rewards. More important, such behavior leads to inferior results, because it flies in the face of momentum, the tendency for rising stocks to continue rising.
Overconfident in their predictive prowess or perhaps simply out of fear, investors also attempt to time the markets, jumping in and out of stocks like grasshoppers. Not only is this an exercise in futility, but also it leads to lower returns. Time in the market—the secret sauce of compound growth—is the key to long-term investing success, not timing the market.
3. Sales on Wall Street shouldn't be shunned. When cashmere sweaters are marked down 70%, customers buy in droves. But when the stock market goes on sale, investors shun its merchandise. It’s easy to ridicule such behavior as irrational. But when you dig deeper, you discover there are sensible reasons behind our reluctance to buy.
For one thing, sales on Wall Street are usually accompanied by bad news and grave uncertainties. The deeper the sale, the bleaker the news. When stocks sold off in February and March 2020, we were in the midst of a global pandemic and total lockdown of the economy. Plunging share prices felt less like a sale and more like a markdown of damaged goods.
Another key difference between Main Street and Wall Street: When a sale occurs on Wall Street, investors may be potential buyers of shares, but often they’re already significant holders. As owners of stocks, the marked down merchandise is rightly viewed as a loss and those losses hurt. The financial pain we experience makes us wary and more cautious. In financial parlance, we grow risk averse and that risk aversion makes buying more stocks—even at fire-sale prices—exceedingly difficult.
That brings us to another great paradox: Just when stocks are deeply discounted, and thus the risk of owning them is lowest and prospective returns are highest, our risk aversion peaks, making it nearly impossible to muster the courage to step up and buy.
4. Following the herd can be dangerous. As a species, we find comfort in crowds. Walking alone down a dark city street puts us on edge. But walk down the same street in the middle of a bustling crowd and we’ll feel at ease. This herding instinct has served us well as a species and helps us cope in nearly every domain of our life—but not investing.
Herdlike behavior leads to financial excesses—financial bubbles at one extreme and market collapses at the other. Following the crowd during such times feels safe, but ultimately it can lead to great wealth destruction. Think back to the dot-com bubble of the late 1990s or, for a previous generation, the Nifty Fifty stocks of the late 1960s and early 1970s. Both ended badly.
Resisting the herd during a mania sounds easy in theory, but it’s rarely so in practice. Even the great physicist Isaac Newton succumbed to the South Sea Company stock bubble of 1720, losing £20,000 in the process, the equivalent of some $3 million today. As he put it, “I can calculate the motions of the heavenly bodies, but not the madness of people.”
5. Main Street and Wall Street are worlds apart. The stark contrast between the economy and the financial markets—Main Street and Wall Street, if you will—is one of the great paradoxes in finance. We are witnessing this today. The gulf between the economy and the stock market has perhaps never been wider.
The most counterintuitive and yet historically reliable pattern is that financial markets begin to rebound when the economy is still hitting rock bottom. Conversely, it’s just when employment is peaking that recessions—and accompanying bear markets—are just around the corner. This bizarre relationship stems from two related quirks of financial markets.
First, markets look ahead. How the stock market behaves today is a reflection of what investors see six to 12 months down the line. Second, inflection points in the economy—when things go from terrible to just bad or from great to merely good—matter far more to markets than the absolute state of the economy. In other words, a terrible economy that’s getting less terrible leads to rising stock markets, while a great economy that starts growing more slowly may trigger falling share prices.
6. A great company can be a bad stock. Financial history is replete with examples of this paradox. The Nifty Fifty stocks were the blue-chip companies of their day—stocks like IBM, General Electric, Coca-Cola and Xerox. These were wonderful growth companies but ended up being terrible investments. Ditto for the internet companies of the late 1990s. They were destined to change the world—and lose their investors a truckload of money. Where did investors go wrong? They forgot the maxim that price matters. If you pay too much for a stock, you’ll likely make little or no money, no matter how great the company.
The converse is also true. Distressed companies can be great investments. Yes, some go bankrupt, but many times the best investments are found in the trash heap of companies that are widely shunned by investors. Tobacco stocks turned out to be great performers, despite the huge cloud of litigation hanging over them in the 1990s. Because these were “untouchable” stocks, their valuations fell to such bargain levels that they became wonderful investments.
7. Reversion to the mean is real. If the human brain has an Achilles’ heel, it’s a lack of statistical intuition. Nowhere is this more evident in investing than in the phenomenon of reversion to the mean.
For example, we attribute mutual fund performance entirely to the skill of the fund manager when, in fact, chance plays a much larger role that we’d like to admit. Result: Investors rush to buy a mutual fund that’s outperformed for five or 10 years and yet the fund will likely underperform in the future, as the manager’s lucky streak ends.
Even more important, mean reversion plays a major role in the relative performance of asset classes. Here, the phenomenon has more to do with the financial laws of gravity than it does with chance. When one asset class outperforms another for many years, the former becomes more expensive than the latter. Think about how U.S. stocks have outpaced international shares over the past decade. The problem: With higher valuations come lower expected returns.
When investors throw in the towel on an asset class after a period of rotten results, they aren’t always blind to mean reversion. In many cases, they understand it, but they suffer a loss of will. Patience has its limits. Mean reversion is real and ultimately exerts itself, but its time horizon—often decades—is longer than many investors have patience for.
8. If you pay Cadillac prices, you’ll likely get a Honda Civic. In life, you generally get what you pay for. If you’re looking for the best lawyer in town, you know you’ll have to pay up. If you need brain surgery, you don’t bargain hunt. If you want to buy a Cadillac, you expect to pay Cadillac prices.
It’s natural to assume the same holds true in finance. If I want the best money manager to handle my investments, I’ll need to pay a premium for his or her services, right? Wrong. Another of the great investment paradoxes is that paying more generally leads to inferior results. Quite literally, you are paying Cadillac prices for a Honda Civic.
Let’s say that your objective is an 8% annual investment return. If you pay a money manager 1% of your portfolio’s value to handle your investments, she’ll need to earn 9% a year to deliver 8% to you. If instead you pay the same manager 2%, she must now earn 10%. Unlike any other profession, the more handsomely a money manager is compensated, the more difficult his or her job becomes.
If you’re going to be widely diversified across the market—which is a good thing—why handicap your results with high fees? You can get the same broad diversification by investing in low-expense index funds, which means getting similar returns but at a far lower cost. That should translate into better performance net of fees. You have bought a Cadillac for the price of a Honda Civic.
Latest Articles
HERE ARE THE SIX other articles published by HumbleDollar this week:
Retired and trying to figure out how much you can safely withdraw from your portfolio each year? Brian White discusses three popular approaches—and names his favorite.
"Middle-class single parents, along with older parents with healthy savings, may be shocked by how much they’re expected to pay toward college," writes Catherine Horiuchi, whose twins just applied to college.
How do you keep your finances on track? Forget grand New Year's resolutions and instead focus on smaller, shorter-term goals. Adam Grossman offers 11 of them.
Starting at age 55, James McGlynn has converted part of his traditional IRA to a Roth each year. That's meant juggling a host of considerations—everything from QLACs to IRMAA to QCDs.
Want to know more about your Social Security benefits? Rick Connor digs into the Social Security Administration's website, explaining what you can find and where.
"I scoured the internet to find similar tales of woe and resolve this tax conundrum," writes Mike Flack. "I couldn’t find a single mention. Was I the only one suffering from this injustice?"
John Lim is a physician and author of "How to Raise Your Child's Financial IQ," which is available as both a free PDF and a Kindle edition. His previous articles include Ten Tips for 2021, Evasive Action and My Bad. Follow John on Twitter @JohnTLim.
Now, don’t get me wrong: I’m no financial genius. I’ve made my share of blunders. But I also know that being a do-it-yourself investor has saved me boatloads of money. When I’ve encouraged colleagues to do the same—imploring them that “it’s really not that hard”—I’ve received only steely stares and blank looks.
It’s slowly dawned on me that the financial demons people wrestle with are real and of Herculean proportions. Finance is a minefield that few navigate without getting maimed. It’s replete with mirages—what you see is often not what you get. Our instincts hurt us more often than they protect us. Actions that are sensible in every other realm of life lead us astray in finance.
What follows is an exploration of eight key concepts that many—and perhaps most—investors struggle with. The biggest paradox of all: While managing money may appear simple, it’s anything but.
1. Compound interest is the key to wealth. We’re woefully ill-equipped to wrap our heads around the wonder that is compound interest. Warren Buffett described his eureka moment at age 10. “That’s where the money is,” he told himself, referring to the power of compound interest.
The miracle of compound interest is a collision of two intangible concepts—exponential growth and a long time horizon. It’s well known that people struggle when making decisions that have consequences well into the future. Economists refer to such myopia as “present bias,” a universal human tendency to favor the present over the future.
The abysmally low U.S. savings rate exemplifies this mindset. But it also reflects a failure to grasp the immense power of exponential growth over long stretches of time. In brief, we each need our own eureka moment.
Consider the story of the Lenape Indians. In 1626, they sold the island of Manhattan to Peter Minuit for a mere $24. That was the greatest swindle in U.S. history, right? If you compound $24 at 7% a year—which is the average after-inflation return of the stock market—what would it be worth today? Almost $10 trillion. Let that sink in.
2. Laziness is a virtue. Life teaches, and common sense affirms, that hard work pays off. Sloth was so disdained in medieval times that it was labeled one of the seven deadly sins. Yet lazy investing leads to superior, not inferior, results.
Nearly every action an investor takes turns out to be counterproductive. For example, investors tend to sell their winners and hold on to their losers, exactly the opposite of what the tax code rewards. More important, such behavior leads to inferior results, because it flies in the face of momentum, the tendency for rising stocks to continue rising.
Overconfident in their predictive prowess or perhaps simply out of fear, investors also attempt to time the markets, jumping in and out of stocks like grasshoppers. Not only is this an exercise in futility, but also it leads to lower returns. Time in the market—the secret sauce of compound growth—is the key to long-term investing success, not timing the market.
3. Sales on Wall Street shouldn't be shunned. When cashmere sweaters are marked down 70%, customers buy in droves. But when the stock market goes on sale, investors shun its merchandise. It’s easy to ridicule such behavior as irrational. But when you dig deeper, you discover there are sensible reasons behind our reluctance to buy.
For one thing, sales on Wall Street are usually accompanied by bad news and grave uncertainties. The deeper the sale, the bleaker the news. When stocks sold off in February and March 2020, we were in the midst of a global pandemic and total lockdown of the economy. Plunging share prices felt less like a sale and more like a markdown of damaged goods.
Another key difference between Main Street and Wall Street: When a sale occurs on Wall Street, investors may be potential buyers of shares, but often they’re already significant holders. As owners of stocks, the marked down merchandise is rightly viewed as a loss and those losses hurt. The financial pain we experience makes us wary and more cautious. In financial parlance, we grow risk averse and that risk aversion makes buying more stocks—even at fire-sale prices—exceedingly difficult.
That brings us to another great paradox: Just when stocks are deeply discounted, and thus the risk of owning them is lowest and prospective returns are highest, our risk aversion peaks, making it nearly impossible to muster the courage to step up and buy.
4. Following the herd can be dangerous. As a species, we find comfort in crowds. Walking alone down a dark city street puts us on edge. But walk down the same street in the middle of a bustling crowd and we’ll feel at ease. This herding instinct has served us well as a species and helps us cope in nearly every domain of our life—but not investing.
Herdlike behavior leads to financial excesses—financial bubbles at one extreme and market collapses at the other. Following the crowd during such times feels safe, but ultimately it can lead to great wealth destruction. Think back to the dot-com bubble of the late 1990s or, for a previous generation, the Nifty Fifty stocks of the late 1960s and early 1970s. Both ended badly.
Resisting the herd during a mania sounds easy in theory, but it’s rarely so in practice. Even the great physicist Isaac Newton succumbed to the South Sea Company stock bubble of 1720, losing £20,000 in the process, the equivalent of some $3 million today. As he put it, “I can calculate the motions of the heavenly bodies, but not the madness of people.”
5. Main Street and Wall Street are worlds apart. The stark contrast between the economy and the financial markets—Main Street and Wall Street, if you will—is one of the great paradoxes in finance. We are witnessing this today. The gulf between the economy and the stock market has perhaps never been wider.
The most counterintuitive and yet historically reliable pattern is that financial markets begin to rebound when the economy is still hitting rock bottom. Conversely, it’s just when employment is peaking that recessions—and accompanying bear markets—are just around the corner. This bizarre relationship stems from two related quirks of financial markets.
First, markets look ahead. How the stock market behaves today is a reflection of what investors see six to 12 months down the line. Second, inflection points in the economy—when things go from terrible to just bad or from great to merely good—matter far more to markets than the absolute state of the economy. In other words, a terrible economy that’s getting less terrible leads to rising stock markets, while a great economy that starts growing more slowly may trigger falling share prices.
6. A great company can be a bad stock. Financial history is replete with examples of this paradox. The Nifty Fifty stocks were the blue-chip companies of their day—stocks like IBM, General Electric, Coca-Cola and Xerox. These were wonderful growth companies but ended up being terrible investments. Ditto for the internet companies of the late 1990s. They were destined to change the world—and lose their investors a truckload of money. Where did investors go wrong? They forgot the maxim that price matters. If you pay too much for a stock, you’ll likely make little or no money, no matter how great the company.
The converse is also true. Distressed companies can be great investments. Yes, some go bankrupt, but many times the best investments are found in the trash heap of companies that are widely shunned by investors. Tobacco stocks turned out to be great performers, despite the huge cloud of litigation hanging over them in the 1990s. Because these were “untouchable” stocks, their valuations fell to such bargain levels that they became wonderful investments.
7. Reversion to the mean is real. If the human brain has an Achilles’ heel, it’s a lack of statistical intuition. Nowhere is this more evident in investing than in the phenomenon of reversion to the mean.
For example, we attribute mutual fund performance entirely to the skill of the fund manager when, in fact, chance plays a much larger role that we’d like to admit. Result: Investors rush to buy a mutual fund that’s outperformed for five or 10 years and yet the fund will likely underperform in the future, as the manager’s lucky streak ends.
Even more important, mean reversion plays a major role in the relative performance of asset classes. Here, the phenomenon has more to do with the financial laws of gravity than it does with chance. When one asset class outperforms another for many years, the former becomes more expensive than the latter. Think about how U.S. stocks have outpaced international shares over the past decade. The problem: With higher valuations come lower expected returns.
When investors throw in the towel on an asset class after a period of rotten results, they aren’t always blind to mean reversion. In many cases, they understand it, but they suffer a loss of will. Patience has its limits. Mean reversion is real and ultimately exerts itself, but its time horizon—often decades—is longer than many investors have patience for.
8. If you pay Cadillac prices, you’ll likely get a Honda Civic. In life, you generally get what you pay for. If you’re looking for the best lawyer in town, you know you’ll have to pay up. If you need brain surgery, you don’t bargain hunt. If you want to buy a Cadillac, you expect to pay Cadillac prices.
It’s natural to assume the same holds true in finance. If I want the best money manager to handle my investments, I’ll need to pay a premium for his or her services, right? Wrong. Another of the great investment paradoxes is that paying more generally leads to inferior results. Quite literally, you are paying Cadillac prices for a Honda Civic.
Let’s say that your objective is an 8% annual investment return. If you pay a money manager 1% of your portfolio’s value to handle your investments, she’ll need to earn 9% a year to deliver 8% to you. If instead you pay the same manager 2%, she must now earn 10%. Unlike any other profession, the more handsomely a money manager is compensated, the more difficult his or her job becomes.
If you’re going to be widely diversified across the market—which is a good thing—why handicap your results with high fees? You can get the same broad diversification by investing in low-expense index funds, which means getting similar returns but at a far lower cost. That should translate into better performance net of fees. You have bought a Cadillac for the price of a Honda Civic.
Latest Articles
HERE ARE THE SIX other articles published by HumbleDollar this week:
Retired and trying to figure out how much you can safely withdraw from your portfolio each year? Brian White discusses three popular approaches—and names his favorite.
"Middle-class single parents, along with older parents with healthy savings, may be shocked by how much they’re expected to pay toward college," writes Catherine Horiuchi, whose twins just applied to college.
How do you keep your finances on track? Forget grand New Year's resolutions and instead focus on smaller, shorter-term goals. Adam Grossman offers 11 of them.
Starting at age 55, James McGlynn has converted part of his traditional IRA to a Roth each year. That's meant juggling a host of considerations—everything from QLACs to IRMAA to QCDs.
Want to know more about your Social Security benefits? Rick Connor digs into the Social Security Administration's website, explaining what you can find and where.
"I scoured the internet to find similar tales of woe and resolve this tax conundrum," writes Mike Flack. "I couldn’t find a single mention. Was I the only one suffering from this injustice?"
John Lim is a physician and author of "How to Raise Your Child's Financial IQ," which is available as both a free PDF and a Kindle edition. His previous articles include Ten Tips for 2021, Evasive Action and My Bad. Follow John on Twitter @JohnTLim.The post Why We Go Wrong appeared first on HumbleDollar.
January 15, 2021
Lost Abroad
ONE OF THE GREATEST business books I’ve ever read is
Antifragile
by Nassim Nicholas Taleb. In it, he postulates the idea that, while things that become damaged by stress are considered fragile and things that resist stress are considered resilient, “there is no word for the exact opposite of fragile,” things that become stronger due to stress. So, he coined the word “antifragile” and then wrote an entire book about the subject.
Well, we’re all familiar with a tax loophole, which has been defined as an “unintentional omission or obscurity in the law that allows the reduction of tax liability to a point below that intended by the framers of the law.” The backdoor Roth IRA is a good example. It allows those who wouldn’t ordinarily be able to make regular annual contributions to a Roth, because their income is too high, to instead contribute to a traditional IRA and then—voilà!—convert it to a Roth.
What’s a word for an “unintentional omission or obscurity in the law that allows the increase of tax liability to a point above that intended by the framers of the law”? There is none, so I’ve coined the word “antiloophole,” though I won’t be writing an entire book about it.
Like many of you, I own shares in publicly traded foreign stocks and have therefore had to pay foreign income taxes on my foreign dividends. Since I was filing a joint return with my wife and we paid less than $600 in foreign income taxes, we claimed the entire credit for these foreign taxes directly on our 1040. I like the diversification that foreign stocks afforded me, so I kept buying more and more, comforted by the innumerable articles and experts that stated that—if we lost more than $600 to foreign income taxes—all we need do was to file Form 1116. And as long as I was working, they were right.
Form 1116 calculates your foreign tax credit based on some convoluted formula that can leave you with a credit that’s less than the total foreign income tax paid. (Trust me, it’s too complicated to explain here.) In 2017, when I was still working, we were able to claim a tax credit for $799 of the $861 in total foreign income tax we paid. While I certainly didn’t like this development, it wasn’t catastrophic. But in 2018, after I retired, we were only able to claim $74 of our total foreign income tax paid, out of a total of $872.
That didn’t seem fair. After all, if a hypothetical taxpaying couple surrendered $599 to foreign income taxes, they would get to skip Form 1116 and claim the entire $599 as a tax credit, but if they paid $601, they would be kicked over to Form 1116 and would possibly get to claim much less.
It all seemed very personal, so I scoured the internet to find similar tales of woe, gain solace from the misery of others and, almost as important, resolve this tax conundrum. I couldn’t find a single mention of this issue on the entire internet. Was I the only one suffering from this injustice? Were others too ashamed to speak of it?
I contacted a good friend, who is a partner at a New York City accounting firm, for a second opinion. He congratulated me on the accuracy of my tax forms and my foreign tax knowledge. But in the end, he confirmed that—in my case—Form 1116 was a screw job (not necessarily the words he used). He gave me two options, live with it or sell some of the offending foreign stocks.
I’m not a live-and-let-live kind of guy and therefore couldn’t let this injustice continue. In January 2020, I sold one of my larger foreign stock holdings, Canadian real estate investment trust RioCan (symbol: RIOCF), which reduced my foreign income tax below $600. Problem solved.
Epilogue: In the end, this actually worked out quite well, as I used the proceeds from my sale of RIOCF to buy an S&P 500-index fund. As the once offending RIOCF has since fallen precipitously, in addition to coining the word antiloophole, I have the added benefit of being able congratulate myself on my investing acumen. Which in the latter case is quite rewarding, as boosting one’s ego can be even more important than reducing one’s taxes.
Michael Flack blogs at AfterActionReport.info. He’s a former naval officer and 20-year veteran of the oil and gas industry. Now retired, Mike enjoys traveling, blogging and spreadsheets. His previous articles were Making the Call and Trading Places.
Well, we’re all familiar with a tax loophole, which has been defined as an “unintentional omission or obscurity in the law that allows the reduction of tax liability to a point below that intended by the framers of the law.” The backdoor Roth IRA is a good example. It allows those who wouldn’t ordinarily be able to make regular annual contributions to a Roth, because their income is too high, to instead contribute to a traditional IRA and then—voilà!—convert it to a Roth.
What’s a word for an “unintentional omission or obscurity in the law that allows the increase of tax liability to a point above that intended by the framers of the law”? There is none, so I’ve coined the word “antiloophole,” though I won’t be writing an entire book about it.
Like many of you, I own shares in publicly traded foreign stocks and have therefore had to pay foreign income taxes on my foreign dividends. Since I was filing a joint return with my wife and we paid less than $600 in foreign income taxes, we claimed the entire credit for these foreign taxes directly on our 1040. I like the diversification that foreign stocks afforded me, so I kept buying more and more, comforted by the innumerable articles and experts that stated that—if we lost more than $600 to foreign income taxes—all we need do was to file Form 1116. And as long as I was working, they were right.
Form 1116 calculates your foreign tax credit based on some convoluted formula that can leave you with a credit that’s less than the total foreign income tax paid. (Trust me, it’s too complicated to explain here.) In 2017, when I was still working, we were able to claim a tax credit for $799 of the $861 in total foreign income tax we paid. While I certainly didn’t like this development, it wasn’t catastrophic. But in 2018, after I retired, we were only able to claim $74 of our total foreign income tax paid, out of a total of $872.
That didn’t seem fair. After all, if a hypothetical taxpaying couple surrendered $599 to foreign income taxes, they would get to skip Form 1116 and claim the entire $599 as a tax credit, but if they paid $601, they would be kicked over to Form 1116 and would possibly get to claim much less.
It all seemed very personal, so I scoured the internet to find similar tales of woe, gain solace from the misery of others and, almost as important, resolve this tax conundrum. I couldn’t find a single mention of this issue on the entire internet. Was I the only one suffering from this injustice? Were others too ashamed to speak of it?
I contacted a good friend, who is a partner at a New York City accounting firm, for a second opinion. He congratulated me on the accuracy of my tax forms and my foreign tax knowledge. But in the end, he confirmed that—in my case—Form 1116 was a screw job (not necessarily the words he used). He gave me two options, live with it or sell some of the offending foreign stocks.
I’m not a live-and-let-live kind of guy and therefore couldn’t let this injustice continue. In January 2020, I sold one of my larger foreign stock holdings, Canadian real estate investment trust RioCan (symbol: RIOCF), which reduced my foreign income tax below $600. Problem solved.
Epilogue: In the end, this actually worked out quite well, as I used the proceeds from my sale of RIOCF to buy an S&P 500-index fund. As the once offending RIOCF has since fallen precipitously, in addition to coining the word antiloophole, I have the added benefit of being able congratulate myself on my investing acumen. Which in the latter case is quite rewarding, as boosting one’s ego can be even more important than reducing one’s taxes.
Michael Flack blogs at AfterActionReport.info. He’s a former naval officer and 20-year veteran of the oil and gas industry. Now retired, Mike enjoys traveling, blogging and spreadsheets. His previous articles were Making the Call and Trading Places.The post Lost Abroad appeared first on HumbleDollar.
January 14, 2021
My Social Security
SOCIAL SECURITY is a crucial source of income for many retirees. But unfortunately, there’s also much confusion, because the ways benefits are calculated sure isn’t simple.
Want to learn more? To get started, I’d suggest heading to the Social Security Administration’s website and creating a free “my Social Security” account. For those currently receiving benefits, the website allows you to:
Verify your benefit payment amount
Get a replacement Social Security card
Get a replacement Medicare card
Change your address and phone number
Start or change direct deposit of your benefit payment
Get a replacement SSA-1099 or SSA-1042S for tax purposes
If you aren’t currently receiving benefits, you can:
Create, save and print your Social Security statement
Get estimates of future retirement, disability and survivors benefits
Review your earnings record
Review the estimated Social Security and Medicare taxes you’ve paid
Print a letter from the Social Security Administration (SSA) stating that you’ve never received benefits
The SSA’s site also offers a chance to get educated about Social Security generally, including:
How benefits are calculated
When you’ll reach your all-important full Social Security retirement age
How much your spouse might receive
How much of your benefit you might lose if you work while receiving Social Security
How long you can expect to live
How important Social Security is to retirees
If you’ve never done it, it’s worth creating a Social Security statement and reading it thoroughly. Keep two things in mind. First, the benefits estimates are in today’s dollars. This gives you a better idea of their purchasing power in the future. Second, the estimate of your future benefits assumes you continue to work at the same earnings rate as the past two years. If you work less, your actual benefit will reflect this. The closer you are to retirement, the more accurate the estimate will be.
If you don’t plan to work right up to the day you start benefits, you can use one of the site’s calculators to produce a customized estimate. If you think your annual earnings might differ in the future from the recent past, you can also model that scenario.
The statement and site will show your detailed earnings record. Experts recommend reviewing this once a year to verify that the amounts posted are correct. Along with your detailed earnings record, the SSA also provides the total amount of Social Security and Medicare payroll taxes that you and your employers have paid to date.
Many people wonder what kind of investment return Social Security delivers. If, instead of paying payroll taxes, I’d been able to put those dollars in a low-cost S&P 500 fund, I’d likely be far better off. But, of course, that’s not how the Social Security system works. The money collected in payroll taxes isn’t invested, but instead immediately used to pay benefits to current retirees and other Social Security recipients.
I also thought it’d be interesting to see what kind of annuity payout my estimated benefits represent. Since I turned age 63 a few months back, I was able to use an estimate of my benefit at 63, along with the total amount of Social Security payroll taxes paid over my career, to get an idea of what kind of return I’d be getting.
I looked up the average life expectancy for a 63-year-old male using the site’s life expectancy calculator. It showed I have about 20 years left. Using that number and Excel’s annuity payment function, I calculated that—to generate my estimated monthly benefit as of age 63—it would require roughly a 6% return on the combined total payroll tax that my employers and I have contributed over the years.
In today’s low interest rate environment, a 6% return doesn’t sound so bad, plus Social Security benefits are adjusted upward each year with inflation, so my return will be even higher. On the other hand, I’m also assuming that, up until now, there’s been zero gain on all the payroll taxes paid over my career—an investment return few folks would be happy with.
Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. Rick enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. His previous articles include Flunking the Test, Lucky Strikes and Rate Debate. Follow Rick on Twitter @RConnor609.
Want to learn more? To get started, I’d suggest heading to the Social Security Administration’s website and creating a free “my Social Security” account. For those currently receiving benefits, the website allows you to:
Verify your benefit payment amount
Get a replacement Social Security card
Get a replacement Medicare card
Change your address and phone number
Start or change direct deposit of your benefit payment
Get a replacement SSA-1099 or SSA-1042S for tax purposes
If you aren’t currently receiving benefits, you can:
Create, save and print your Social Security statement
Get estimates of future retirement, disability and survivors benefits
Review your earnings record
Review the estimated Social Security and Medicare taxes you’ve paid
Print a letter from the Social Security Administration (SSA) stating that you’ve never received benefits
The SSA’s site also offers a chance to get educated about Social Security generally, including:
How benefits are calculated
When you’ll reach your all-important full Social Security retirement age
How much your spouse might receive
How much of your benefit you might lose if you work while receiving Social Security
How long you can expect to live
How important Social Security is to retirees
If you’ve never done it, it’s worth creating a Social Security statement and reading it thoroughly. Keep two things in mind. First, the benefits estimates are in today’s dollars. This gives you a better idea of their purchasing power in the future. Second, the estimate of your future benefits assumes you continue to work at the same earnings rate as the past two years. If you work less, your actual benefit will reflect this. The closer you are to retirement, the more accurate the estimate will be.
If you don’t plan to work right up to the day you start benefits, you can use one of the site’s calculators to produce a customized estimate. If you think your annual earnings might differ in the future from the recent past, you can also model that scenario.
The statement and site will show your detailed earnings record. Experts recommend reviewing this once a year to verify that the amounts posted are correct. Along with your detailed earnings record, the SSA also provides the total amount of Social Security and Medicare payroll taxes that you and your employers have paid to date.
Many people wonder what kind of investment return Social Security delivers. If, instead of paying payroll taxes, I’d been able to put those dollars in a low-cost S&P 500 fund, I’d likely be far better off. But, of course, that’s not how the Social Security system works. The money collected in payroll taxes isn’t invested, but instead immediately used to pay benefits to current retirees and other Social Security recipients.
I also thought it’d be interesting to see what kind of annuity payout my estimated benefits represent. Since I turned age 63 a few months back, I was able to use an estimate of my benefit at 63, along with the total amount of Social Security payroll taxes paid over my career, to get an idea of what kind of return I’d be getting.
I looked up the average life expectancy for a 63-year-old male using the site’s life expectancy calculator. It showed I have about 20 years left. Using that number and Excel’s annuity payment function, I calculated that—to generate my estimated monthly benefit as of age 63—it would require roughly a 6% return on the combined total payroll tax that my employers and I have contributed over the years.
In today’s low interest rate environment, a 6% return doesn’t sound so bad, plus Social Security benefits are adjusted upward each year with inflation, so my return will be even higher. On the other hand, I’m also assuming that, up until now, there’s been zero gain on all the payroll taxes paid over my career—an investment return few folks would be happy with.
Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. Rick enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. His previous articles include Flunking the Test, Lucky Strikes and Rate Debate. Follow Rick on Twitter @RConnor609.The post My Social Security appeared first on HumbleDollar.
January 13, 2021
Retirement Gambit
INSPIRED BY THE TV series The Queen’s Gambit, many people suddenly want to master the game of chess. But I’m more interested in mastering the practical world of retirement gambits—and that means matching wits with Congress and the IRS.
During my working career, I saved money in taxable brokerage accounts, IRAs and 401(k)s, but never focused on Roth accounts. At age 55, having left my last employer, I had two things that compelled me to begin—time and reduced income. As an experienced investor but a Roth novice, I wanted initially to take it slowly.
The first thing I learned is that you should start a Roth IRA by age 55, so you can withdraw all amounts—contributions and earnings—tax-free beginning at age 59½. For your earnings to be entirely free of taxes and penalties, there’s a five-year waiting period, plus you need to reach the magical retirement age of 59½. If I didn’t open my Roth until age 58, I’d have had to wait until age 63 to access everything tax-free.
Aware of this rule, I opened a Roth IRA at age 55 by transferring $1,000 from my traditional IRA. This was my first Roth conversion. I made the transfer in December, but that was enough to claim that year as the first year toward meeting the five-year rule. The reason: Under the tax regulations, what matters is the year you start, not the actual month.
Next, I had to analyze if there were any other uses for my traditional IRA that should limit how much I convert to a Roth. I came up with three.
The first reason for not converting too much: I wanted to use my IRA to buy deferred income annuities and, under the rules that govern so-called qualified longevity annuity contracts (QLACs), I could only do so with up to 25% of that account. If I shrank my traditional IRA too much, I wouldn’t be able make the maximum allowable QLAC investment, which is currently set at $135,000. I’ve now purchased three QLACs to create a guaranteed income stream to help pay for my later retirement years.
Another reason not to shrink my traditional IRA too much: I wanted to use the account as a financial bridge to cover my costs between ages 62 and 70, while I delay Social Security to get the maximum monthly benefit. To that end, I used my traditional IRA to purchase a period certain annuity that’ll pay me a monthly amount roughly equal to what I would be entitled to receive from Social Security during that eight-year stretch.
I could, of course, have used Roth money to purchase the period certain annuity—but I’m looking to spend down my traditional IRA, not my Roth. Indeed, by using my traditional IRA, I’ve ensured I’ll have enough taxable income during these years to “take advantage” of the lower tax brackets. At age 70, the period certain annuity will stop paying and, in its place, I’ll have my maximum monthly Social Security benefit.
A third reason to keep at least some money in a traditional IRA: tax diversification. A future Congress might permit traditional IRA withdrawals to be tax-free if they’re used for certain activities, such as purchasing long-term-care insurance. Even without a change in the law, an IRA can be a great way to give to charity once you’re in your 70s, thanks to so-called qualified charitable distributions, or QCDs. By using a traditional IRA to give directly to charity, seniors can reduce the tax hit that accompanies required minimum distributions.
With these three reasons in mind, I faced the hard decision: How much did I want to convert from my traditional IRA to a Roth—and hence how much of my traditional IRA’s tax bill did I want to prepay? Paying taxes today to create the Roth is delayed gratification. I’ve ended up converting 10% to 20% of my traditional IRA every year, aware that there’s a risk that a future Congress could try to tax the Roth.
There are two other major timing issues with Roth conversions. The first regards Obamacare. Early retirees, who aren’t yet age 65 and hence eligible for Medicare, may receive a tax credit toward the purchase of health insurance. But if they make large Roth conversions, they could lose part or all of that tax credit, since the conversion amount will be included in their taxable income. I was fortunate to have retiree medical insurance from my old employer, so this wasn’t a concern for me.
The other issue is IRMAA, short for income-related monthly adjustment amount. IRMAA is the Medicare premium surcharge that hits higher-income recipients. Roth conversions can trip you up by generating income and putting you into a higher IRMAA bracket. Keep in mind that IRMAA considers your income from two years earlier. This means that, if you do a Roth conversion at age 63, Medicare will use that added income to calculate your potential IRMAA penalty at age 65. Result? Instead of slowly increasing my Roth conversions, I accelerated them, so most of my conversions will be done before age 63.
I’ve noticed I now have a different attitude toward my traditional and Roth IRAs. I’m much happier when my Roth account grows and less happy when my traditional IRA increases, because the latter means I’ll have to pay more in taxes.
Intrigued by my Roth Gambit? If you like the idea of sacrificing your traditional IRA pawn to create a Roth Queen, consider these three steps:
Open a Roth IRA by age 55
As you decide how much of your traditional IRA to convert to a Roth, ponder not only the conversion tax bill, but also its impact on QLAC purchases, your ability to delay Social Security during your 60s while still generating a reasonable amount of taxable income each year, and your ability to take advantage of qualified charitable distributions in your 70s and later.
Think about how the extra taxable income from your Roth conversions could affect both your Obamacare tax credit and your Medicare premiums.
James McGlynn, CFA, RICP, is chief executive of
Next Quarter Century LLC
in Fort Worth, Texas, a firm focused on helping clients make smarter decisions about long-term-care insurance, Social Security and other retirement planning issues. He was a mutual fund manager for 30 years. James is the author of
Retirement Planning Tips for Baby Boomers
. His previous articles include He Gets, She Gets, The Taxman Cometh and Back When.
During my working career, I saved money in taxable brokerage accounts, IRAs and 401(k)s, but never focused on Roth accounts. At age 55, having left my last employer, I had two things that compelled me to begin—time and reduced income. As an experienced investor but a Roth novice, I wanted initially to take it slowly.
The first thing I learned is that you should start a Roth IRA by age 55, so you can withdraw all amounts—contributions and earnings—tax-free beginning at age 59½. For your earnings to be entirely free of taxes and penalties, there’s a five-year waiting period, plus you need to reach the magical retirement age of 59½. If I didn’t open my Roth until age 58, I’d have had to wait until age 63 to access everything tax-free.
Aware of this rule, I opened a Roth IRA at age 55 by transferring $1,000 from my traditional IRA. This was my first Roth conversion. I made the transfer in December, but that was enough to claim that year as the first year toward meeting the five-year rule. The reason: Under the tax regulations, what matters is the year you start, not the actual month.
Next, I had to analyze if there were any other uses for my traditional IRA that should limit how much I convert to a Roth. I came up with three.
The first reason for not converting too much: I wanted to use my IRA to buy deferred income annuities and, under the rules that govern so-called qualified longevity annuity contracts (QLACs), I could only do so with up to 25% of that account. If I shrank my traditional IRA too much, I wouldn’t be able make the maximum allowable QLAC investment, which is currently set at $135,000. I’ve now purchased three QLACs to create a guaranteed income stream to help pay for my later retirement years.
Another reason not to shrink my traditional IRA too much: I wanted to use the account as a financial bridge to cover my costs between ages 62 and 70, while I delay Social Security to get the maximum monthly benefit. To that end, I used my traditional IRA to purchase a period certain annuity that’ll pay me a monthly amount roughly equal to what I would be entitled to receive from Social Security during that eight-year stretch.
I could, of course, have used Roth money to purchase the period certain annuity—but I’m looking to spend down my traditional IRA, not my Roth. Indeed, by using my traditional IRA, I’ve ensured I’ll have enough taxable income during these years to “take advantage” of the lower tax brackets. At age 70, the period certain annuity will stop paying and, in its place, I’ll have my maximum monthly Social Security benefit.
A third reason to keep at least some money in a traditional IRA: tax diversification. A future Congress might permit traditional IRA withdrawals to be tax-free if they’re used for certain activities, such as purchasing long-term-care insurance. Even without a change in the law, an IRA can be a great way to give to charity once you’re in your 70s, thanks to so-called qualified charitable distributions, or QCDs. By using a traditional IRA to give directly to charity, seniors can reduce the tax hit that accompanies required minimum distributions.
With these three reasons in mind, I faced the hard decision: How much did I want to convert from my traditional IRA to a Roth—and hence how much of my traditional IRA’s tax bill did I want to prepay? Paying taxes today to create the Roth is delayed gratification. I’ve ended up converting 10% to 20% of my traditional IRA every year, aware that there’s a risk that a future Congress could try to tax the Roth.
There are two other major timing issues with Roth conversions. The first regards Obamacare. Early retirees, who aren’t yet age 65 and hence eligible for Medicare, may receive a tax credit toward the purchase of health insurance. But if they make large Roth conversions, they could lose part or all of that tax credit, since the conversion amount will be included in their taxable income. I was fortunate to have retiree medical insurance from my old employer, so this wasn’t a concern for me.
The other issue is IRMAA, short for income-related monthly adjustment amount. IRMAA is the Medicare premium surcharge that hits higher-income recipients. Roth conversions can trip you up by generating income and putting you into a higher IRMAA bracket. Keep in mind that IRMAA considers your income from two years earlier. This means that, if you do a Roth conversion at age 63, Medicare will use that added income to calculate your potential IRMAA penalty at age 65. Result? Instead of slowly increasing my Roth conversions, I accelerated them, so most of my conversions will be done before age 63.
I’ve noticed I now have a different attitude toward my traditional and Roth IRAs. I’m much happier when my Roth account grows and less happy when my traditional IRA increases, because the latter means I’ll have to pay more in taxes.
Intrigued by my Roth Gambit? If you like the idea of sacrificing your traditional IRA pawn to create a Roth Queen, consider these three steps:
Open a Roth IRA by age 55
As you decide how much of your traditional IRA to convert to a Roth, ponder not only the conversion tax bill, but also its impact on QLAC purchases, your ability to delay Social Security during your 60s while still generating a reasonable amount of taxable income each year, and your ability to take advantage of qualified charitable distributions in your 70s and later.
Think about how the extra taxable income from your Roth conversions could affect both your Obamacare tax credit and your Medicare premiums.
James McGlynn, CFA, RICP, is chief executive of
Next Quarter Century LLC
in Fort Worth, Texas, a firm focused on helping clients make smarter decisions about long-term-care insurance, Social Security and other retirement planning issues. He was a mutual fund manager for 30 years. James is the author of
Retirement Planning Tips for Baby Boomers
. His previous articles include He Gets, She Gets, The Taxman Cometh and Back When.The post Retirement Gambit appeared first on HumbleDollar.
