Jonathan Clements's Blog, page 315

Taking Credit

BACK IN APRIL, I wrote the last in a series of articles about my ill-fated cruise around South America, the last few weeks of which were spent in quarantine. In that article, I mentioned efforts to obtain a refund for airline tickets we bought to fly home but couldn’t use, because the ship was refused permission to dock in Punta Arenas, Chile.

For several weeks after our return home, I attempted to get the refund. I spent hours on the airline’s website, only to be stifled by instructions in Spanish and pop-ups saying the codes I entered weren’t recognized. The airline did offer a credit on future flights, which was useless since I will never fly out of Punta Arenas. Ever.

So I disputed the credit card charge with my bank.

Finally, the airline changed policy and offered a refund as an alternative. The refund, however, wouldn’t be applied to the credit card, but instead deposited into our bank account. To obtain the refund, it was back to the airline’s website to enter the ticket info, an identification number—in my case, my passport number—and bank info. All that made me a little nervous, but I did it.

To make matters worse, I had charged tickets for five different individuals on my card, so I had to gather all their info as well. Nothing worked. The system didn’t recognize our passport numbers. After many attempts, I was about to give up, but I called and luckily got hold of a representative who spoke English and offered to enter all the information in the airline’s system for me. Success. Two weeks later, the money appeared in my bank account.

What about my bank credit card? Amid all the airline gyrations, my bank denied my disputed claim. To avoid interest, I paid the $3,100 charge, while I waited to receive the airline refund.

A few weeks later, I got a form from the bank, which said that—to investigate my claim—I needed to compete the form and return it, which I did. Mind you, this is after the claim was denied.

Then it happened. I looked at my credit card statement and there was the $3,100 credit, less my current charges, so suddenly I had a negative balance of about $1,300. But I knew my true balance was accruing and would be due once the erroneous credit was removed, so I stopped using the card and placed the amount I actually owed on the card in a savings account, knowing eventually it would be needed.

I called the bank again and explained the situation, telling the representative I had already received the refund from the airline. We will investigate and take care of it, I was told. They took care of it all right. The bank applied a second credit of $3,100. Now, I have a credit balance of about $4,400.

I received a second bank letter telling me about the new credit and stating that, if the airline didn’t respond within 45 days, the credit would be made permanent.

This was getting more profitable than the shipboard slots. I called the bank again, my frustration level rising. “Where did the second credit come from?” I asked.

The dispute was reopened in June, I was told.

“By who?” I asked.

You competed a form to open it, came the response.

You mean the form you sent me months ago regarding my original dispute request? Oh my.

In our conversation, the representative acknowledged that the record showed I’d received two credits, that I did call and tell them I was refunded by the airline, and the original credit should be voided. We will investigate, I was told… again.

The 45 days are up. Do I get to keep the credit balance on my credit card? Am I going to make $3,100 or perhaps $6,200?

One last—and I do mean last—call to the bank. “Are you going to fix this or not?” I said in a restrained tone.

“I have to escalate it to a higher level in the dispute department,” the rep said. “You will be hearing shortly.”

That was a week ago and there’s still red numbers on my account balance. I suppose we can blame this on the coronavirus. Or perhaps there’s some other excuse.

Now I may face a bit of a moral dilemma. Do I keep fighting to give money back or rationalize that the seventh largest bank in the world can afford it? Time will tell, but I suspect sooner or later the folks there will figure it out.

Richard Quinn blogs at QuinnsCommentary.com. Before retiring in 2010, Dick was a compensation and benefits executive. His previous articles include Do as I Don’t, About That 4% and Banking from A to F. Follow Dick on Twitter @QuinnsComments.

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11 Remodeling Tips

WE JUST STARTED remodeling our house. I knew it would be an expensive project. Indeed, my next-door neighbor warned me about the difficulty of controlling costs.

He said they netted $250,000 from the sale of their old house. Their plan was to remodel their current home and use the remaining proceeds to pay off the mortgage on their vacation property. But unfortunately, they blew through their remodeling budget and didn’t have enough left over to pay off the other mortgage.

Have you heard the term “scope creep?” This is when a project’s requirements increase over the life of the project. In other words, you keep adding more work to the original plan. I’m guilty of scope creep.

After the start of our project, we decided to upgrade the overhead lighting in our kitchen and add LED lights under the cabinets. This wasn’t in our original plan, but the contractor suggested it would be an energy efficient way to add more lighting, while improving the look of the kitchen.

One way to prevent scope creep is to have a signed written statement of work that you and the project manager agree on. This will help prevent unauthorized work. Another way is to just say “no” to unnecessary work, which I didn’t.

Here are 11 other pointers:

Hire licensed contractors. They might be more expensive, but it can be worth the extra money. Licensed contractors are trained to meet all the requirements proposed by the city and federal government. This includes obtaining all permits, passing safety inspections and meeting all quality tests. For instance, after the demolition of our kitchen, our contractor made sure the required air quality test was performed.
Consider legal issues. Most licensed contractors have liability insurance that provides financial protection in case of bodily injury claims or property damage during the renovation. For instance, if someone gets injured on your property, the contractor’s insurance will cover the medical expenses. If an unlicensed contractor damaged your home and you had hired someone who wasn’t qualified to do the work, your homeowner’s insurance might not cover the damage. Licensed contractors will also provide you with a signed legal contract that can give you additional protection, should there be a dispute over the work performed.
Get at least three quotes. If you have multiple rooms being renovated, ask the contractors to quote each room separately. That makes it easier to compare bids and you may decide it’s worth using more than one contractor.
Pay in increments. Tie those payments to work that’s been completed. Ask for a payment schedule prior to the start of the project, so you can get a better understanding of how the contractor is going to charge you. Never pay the full amount upfront.
Budget for contingencies. You should always have a reserve fund for the unknown, such as mold discovered after the demolition of a kitchen or bathroom.
Avoid self-inflicted wounds. If you’re replacing kitchen cabinets, it’s a good idea to have one person handle the job from start to finish. For instance, you don’t want your contractor to take the required measurements and then you use those figures to purchase the cabinets. If the cabinets don’t fit, you could be responsible for the discrepancy—and stuck with cabinets that don’t fit. Faced with that risk, we ordered our cabinets and countertop through our contractor.
Make sure your contractor is responsible for all worked performed by the subcontractors. It’ll make your life easier when resolving issues with poor workmanship.
Save shipping costs by asking your contractor to pick up your big and heavy items from local stores. For instance, we purchased tile, vanities and toilets online, and had them shipped to local stores for pickup.
Some contractors are notorious for not returning calls and meeting schedules. If they delay getting you a quote, that’s a good indication of how they’ll perform on the job.
Ask contractors how they’re dealing with COVID-19. Our contractor requires its employees to wear masks and to get tested periodically.
Ask for references. See if you can get videos or photos from contractors of their completed projects to help you determine the quality of their work.

Dennis Friedman retired from Boeing Satellite Systems after a 30-year career in manufacturing. Born in Ohio, Dennis is a California transplant with a bachelor’s degree in history and an MBA. A self-described “humble investor,” he likes reading historical novels and about personal finance. His previous articles include Trust but Verify, No Vacation and Changing My Mind. Follow Dennis on Twitter @DMFrie.

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Portfolio Checkup

THE STOCK MARKET hit a milestone last week, surpassing its pre-coronavirus all-time high. There’s a lot of debate about whether this is justified or sustainable. But the bottom line is, your portfolio today probably looks very different from the way it looked six months or a year ago. This may be a good time to take stock of what you own and to consider whether changes are warranted.

Back in February, I talked about the importance of asset allocation—and that’s a critical first step. Research suggests asset allocation explains 90% or more of a portfolio’s return. But asset allocation isn’t the only consideration. It’s also important to evaluate your portfolio’s individual holdings. But how? If your portfolio is what I call a “broker’s special”—a jumble of individual stocks, bonds funds, exchange-traded funds (ETFs) and more—what’s the best way to make sense of what you own? Try this seven-step process:

Step 1: X-Ray

A great online resource is Instant X-Ray, provided at no charge by the investment research firm Morningstar. Just enter the names of each of your investments, along with the dollar amount of your holdings, and Instant X-Ray will return a dozen pages of analysis. With your report in hand, these are the sections I’d review first:

Style. Morningstar uses a nine-square “style box” grid to illustrate the breakdown of a portfolio along two critical dimensions: You’ll see how the stocks in your portfolio fall along a spectrum from large-cap to small-cap, and you’ll see how they fall along a spectrum from growth to value. Morningstar knows what stocks are held by every mutual fund and ETF. Result: No matter how many different funds and stocks you own, your X-Ray report will show you exactly what you hold on a consolidated basis.
Sector. This section will show you the composition of your stock portfolio—including the underlying holdings in your mutual funds—by industry sector, such as technology, health care, utilities and so on. It will also show you how the breakdown in your portfolio compares to the S&P 500’s breakdown.
Geography. Whether you should hold international stocks—and to what degree—is a crucial question. As a starting point, it’s important to know where your portfolio stands today.

Step 2: Oddballs

As I’ve noted before, there are lots of ways you can invest your money. But in my view, there are really only four worthwhile investments: stocks, bonds, real estate and cash. That’s why you’ll want to comb through your portfolio looking for oddballs—holdings that don’t fit into one of these straightforward categories. Some oddballs I’d keep an eye out for:

Gold and commodities
Funds labeled “alternatives”
Structured products
Nontraded real estate investment trusts
Leveraged ETFs
Any other investment that carries an inscrutable name

As we’ve seen this year, the stock market and even the bond market are unpredictable. Why make your life harder with one of these Wall Street creations?

Step 3: Concentration

There’s been much talk lately about the disproportionate success of a small number of stocks—Apple, Amazon and so forth. Do you own shares in these companies? If so, that’s great. But you also want to be careful. If a modest holding in one or more of these companies has ballooned over time and now represents a large portion of your net worth, that’s important to know. Fortunately, this is another area where your Instant X-Ray can help. Look for the “Top 10 Holdings” section of the report.

Step 4: Costs

The investment industry takes advantage of what I like to call the law of small numbers. By pricing their funds in percentage terms, rather than in dollar terms like any other business, fund companies make their fees look small and innocuous. In reality, though, many funds’ fees are unnecessarily high.

Fortunately, the trend toward index fund investing has put downward pressure on fees industrywide. That’s a good thing—but you still want to audit your portfolio carefully. X-Ray reports include expense information. You can also check fund fees on many finance websites.

For most funds and ETFs, this should be easy. But if you own more complex vehicles, such as an annuity or a whole life insurance policy, you’ll have to dig a little more. I suspect it’ll be worth the effort. In my experience, the harder it is to figure out what a financial product charges, the higher the cost turns out to be.

Step 5: Tax-efficiency

In an earlier article, I detailed a process for evaluating the tax efficiency of a mutual fund or ETF. I’ve found tax efficiency to be one of the most overlooked aspects of an investment portfolio. But with tax season recently completed, this is a perfect time to tackle this issue.

Step 6: Benchmark

A while back, a fellow investment analyst made a simple but insightful comment: “What the hell does the S&P 500 have to do with my goals?” It was a good point. The S&P 500 is, more often than not, viewed as the gold standard against which all investments are measured. But this isn’t the only way to achieve your financial goals. In fact, academics have found that it takes only 30 or 40 stocks to build a portfolio that’s sufficiently diversified.

If your portfolio is well-diversified but simply looks different from popular benchmarks like the S&P 500 or the Dow Jones Industrial Average, it’s important to ask whether that really matters. This is a somewhat subjective question—but one that’s crucial to consider before reflexively selling an investment.

Step 7: Bonds

The above steps have focused mainly on stocks. That’s because stocks, in general, carry much more risk than bonds. But don’t overlook the bonds and bond funds in your portfolio. X-Ray reports include a section on bonds, and you’ll definitely want to pay close attention. After all, bonds these days offer little in the way of income. Their only appeal is that they promise to return your principal in full. Audit your bond portfolio to be sure you’re comfortable that all your holdings will be able to fulfill that promise.

After conducting the above exercise, you may identify one or more investments that don’t make the cut. If selling those investments would leave you with a tax bill, should you sell or leave well enough alone? Stay tuned. I’ll address that question next week.

Adam M. Grossman’s previous articles include Don’t Feel Bad, Minimizing Regret and  Don’t Be That Person . 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 .

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Think Like Eeyore

FOR THOSE WHO know their A.A. Milne, they’ll recall Eeyore as Winnie the Pooh’s perennially gloomy donkey friend. Which brings me to my inner Eeyore—and a thought provoked by the stock market’s astonishing recovery.

Now that the S&P 500 is once again hitting new highs, it’s time to prepare for the next bear market. No, I haven’t reduced my stock holdings as share prices have bounced back and, no, I’m not predicting that another crash is imminent. Like everybody else, I haven’t the slightest clue where stocks are headed next.

Instead, this article is prompted by a different concern. It’s pretty clear many investors were badly shaken by the coronavirus crash and some made panicky investment decisions that they now regret. How can we do better in future? Here are five steps to take now, so you’re prepared for when the economy and the stock market next falter:

1. Ponder your history. The coronavirus crash may have been painful, but it was also instructive: If you didn’t know your risk tolerance before, you do now. During the dark days of mid-March, did you buy stocks, sit tight or sell?

All this happened just a few months ago, but don’t trust your recollection. In an act of self-preservation, we often rewrite our memories with the goal of making our behavior look better. That’s why you should go back and look at your account statements. What did you really do—buy, hold or sell?

If you were among those who sold during the coronavirus crash or came close to it, perhaps you should lower your target allocation for stocks. Even those who are happy with their asset allocation may want to rebalance from stocks to bonds, so they bring their investment mix back into line with their target portfolio percentages. The good news: If you sell part of your stock holdings today, you’ll be lightening up at decent prices, thanks to the market’s remarkable rebound.

2. Get spending money out of stocks. Even if you have nerves of steel, money you’ll need to spend in the next five years should not be invested in stocks. Instead, it should be in low-drama investments like savings accounts, certificates of deposit, money market mutual funds and high-quality short-term bonds.

Imagine the S&P 500 took a 34% nosedive, as it did earlier this year. Think about what that would mean for your teenager’s college fund or the money you have earmarked for a house down payment. Not pretty? That’s why you should get those dollars out of stocks.

3. Invest with conviction. Individual stocks and market sectors often fall by the wayside—and sometimes they never come back. What does the financial future look like for department stores, airlines and cruise ships? It’s anybody’s guess. But even as a huge question mark looms over such companies, we’ve seen the broad global stock market recover. It’s a compelling argument for owning total stock market index funds that give you exposure to the global market.

But total market index funds don’t just deliver broad diversification. They also offer relative predictability. Whatever the market delivers, that’s what fund shareholders get. It’s a quality I find comforting and it gives me greater conviction in my stock market strategy.

By contrast, active fund managers can find themselves badly out of step with the market. Result: Shareholders not only suffer market-lagging returns, but also they may lose faith—potentially bailing out at just the wrong time in the market cycle.

4. Hold your nose and buy Treasurys. It isn’t easy to suggest buying government bonds when 10-year Treasury notes are yielding just 0.6%. But the past two bear markets—this year’s decline and 2007-09—offer an unequivocal lesson: If you want something that’ll prop up your portfolio when share prices are in the dumps, Treasurys are a top choice.

They may offer skimpy yields and you’ll lose money over the long haul, once inflation and taxes are figured in. But you should think of that as the price you pay for portfolio insurance. When the world looks darkest, your Treasurys should shine brightly, offering not only solace, but also something to sell if you need cash from your portfolio.

5. Prepare for rough economic times. Why might you need cash? A stock market relapse would likely be triggered by signs that the economy is slowing again, perhaps heralding the double-dip recession that some pundits have been discussing. I have no idea whether that’ll come to pass.

But I think it’s always important to ponder risk—and, if the economy slows again, the big danger facing many folks will be losing their job. With that in mind, make sure your finances are ready. Pay off credit card debt and pay back 401(k) loans. Set up a home equity line of credit, so you have a backup source of emergency money.

Also add up your fixed monthly costs, so you know how much cash you’ll need to come up with each month, should you find yourself out of work. See if any of these costs can be reduced or eliminated. In addition, build up your regular taxable account and consider funding a Roth IRA. The latter is a low-commitment investment: You can withdraw your Roth contributions at any time with no taxes or penalties owed—provided you don’t touch the account’s investment earnings.

Latest Articles

HERE ARE THE SIX other articles published by HumbleDollar this week:

James McGlynn spent much of his career as a mutual fund manager. What’s he doing to prepare for retirement? Buying lots of insurance products.
If you want excitement, buy leveraged exchange-traded funds. But if you want to make money, look elsewhere. Sanjib Saha explains why.
Kicking yourself over past financial decisions? Adam Grossman offers six strategies for putting your blunders in perspective.
Joe Kesler was a well-meaning community bank executive hoping to serve the town’s poorer members. So he bought the operation of a local loan shark—and got himself an education.
“Things were going pretty smoothly—and then the dot-com bubble burst,” recalls Brian White. “By then, I was convinced that rebalancing was the way to go, but this was the first big test of my convictions.”
Turning 60 this year? It won’t be such a happy birthday—thanks to a quirk in Social Security’s methodology that could leave you with a benefit that’s 14% smaller. Rick Connor explains.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Getting Emotional, Risking My Life and Take the Low Road.

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Lesson Well Learned

WHEN I BEGAN investing in 1987 at age 33, I knew very little about the financial markets. As a new University of North Carolina employee, I just started having money taken from my paycheck each month and put in North Carolina’s 457 plan for state employees. A 457 plan is a deferred compensation plan, similar to a 401(k) plan, but the plans are offered by state and local governments, and they’re subject to somewhat different rules.

I have no idea how I chose the mutual fund in which I initially invested. Fortunately, since I didn’t have much invested then, it didn’t make a whole lot of difference.

Sometime in the mid-1990s, I started reading the “work and money” section every Sunday in Raleigh’s The News & Observer. The section included a couple of pages on personal finance from The Wall Street Journal. Besides the usual articles on recent market performance and where the market was sure to go in the near future, there was solid personal finance advice: establish goals, allocate assets based on risk tolerance, diversify, rebalance, save regularly, use low-cost index funds, “ignore the noise” from all the market prognosticators and invest for the long term.

These sounded like good ideas to me, as they were based on research and mathematics, both of which are dear to my heart. But I wasn’t yet at a point where I could implement all these ideas in a simple way, because the funds available to me through my 457 plan were limited to actively managed mutual funds, along with a “stable value” fund that paid a relatively low interest rate.

Nevertheless, I was able to invest in a bond fund, a couple of stock funds, a balanced fund and an international fund. I set up a spreadsheet to determine what my combined allocations were to large, medium and small-cap U.S. companies, as well as bonds and international stocks. I decided on a target allocation that was fairly conservative given my age, about two-thirds stocks and one-third bonds, because I didn’t want to do anything too risky.

I also started rebalancing quarterly, by adjusting my monthly contributions so they went into whichever areas were low. Rebalancing was a complicated process, since most of the funds I owned had money invested in more than one asset class. I couldn’t just add more to my mid-cap fund, for instance, since I had no fund that was just mid-cap stocks. Unfortunately, my 457 plan also didn’t provide a total stock market index fund with the various asset classes represented according to their market capitalization, which would have made things far simpler. Still, my asset allocation spreadsheet helped immensely in figuring out how to rebalance things. It didn’t hurt that I’m a computer geek with a mathematical bent.

Things were going pretty smoothly with my regular saving, rebalancing and ignoring the noise—and then the dot-com bubble burst in March 2000. By then, I was convinced that rebalancing was the way to go, but this was the first big test of my convictions. Rather than panicking and selling my stocks, I moved money from bond funds into stock funds and set my monthly purchases to be all stocks, thus keeping my allocation to stocks at around 67%. I also tried not to watch too closely and continued to tune out the noise, recognizing that selling stocks when their price was low would only lock in my losses.

Shortly into the market crash, I was approached by a helpful “advisor” working for the company through which I made my 457 investments. This advisor, who was really a salesman, urged me to move my investments into a stable value fund to stop the bleeding. He claimed this was what he was recommending to his mother, which I found questionable. The stable value fund locked you into a low interest rate, there were fees if you withdrew more than 10% in a year and it likely paid a commission to the salesman.

Fortunately, I had learned enough by this point—and I ignored his advice. It was one of the smarter things I never did: As readers likely know, the market bounced back and rebalancing through the 2000-02 market decline ultimately paid off nicely. It was a lesson well learned—and it stood me in good stead during 2008-09’s market collapse and this year as well.

Brian White retired from the University of North Carolina, where he worked as a systems programmer and then director of information technology in the computer science department. His previous article was Rookie Mistakes. Brian likes hiking with his wife in a nearby forest, dancing to rocking blues music, camping with friends and stamp collecting. He also enjoys doing volunteer income tax assistance (VITA) work in the Chapel Hill senior center.

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Fatal Attraction

HOW WOULD YOU feel about a stock market strategy that routinely invests more after prices go up and sells when prices drop? As someone who invests for the long haul, I’m skeptical—which is why the increasing popularity of leveraged exchange-traded funds (ETFs) puzzles me.

A leveraged ETF aims to amplify the daily return of its stated benchmark. The fund’s benchmark might be a widely followed stock or bond index, a particular market sector, a single industry or one country. These ETFs are easily identified by their names, which often include terms like 2x, 3x, bull and ultra. For instance, ProShares Ultra S&P 500 (symbol: SSO) seeks to return twice the daily performance of the S&P 500-stock index, while Direxion Daily MSCI India Bull 3X Shares (INDL) tries to triple the daily return of Indian stocks.

Leverage is a double-edged sword that exaggerates both gains and losses—often costing investors dearly. Yet a wrongheaded narrative keeps attracting inexperienced investor to leveraged ETFs. Consider ProShares Ultra S&P 500, mentioned above.

It lost almost 20% in the five years following its June 2006 launch, including dropping more than 80% from peak to trough during the 2007-09 bear market. In the same five-year period, a low-cost S&P 500 ETF would have gained a cumulative 15% with half the volatility. Wasn’t the ProShares ETF supposed to double the benchmark’s gain, by rising 30% over the five years, instead of losing 20%? This is the dangerous misconception about leveraged ETFs—and the reason they shouldn’t be used as long-term investments.

Instead, leveraged ETFs are tools for sophisticated day traders and swing traders. They’re meant to be held for a day or so and kept under close watch. When market timers are firmly convinced about the market’s immediate direction, they try to use leveraged ETFs to make a quick buck.

Fund companies emphasize that the stated performance goal of a leveraged ETF is strictly a daily target. A 2x ETF is structured to generate—before costs—twice the gain or loss that the benchmark experiences during the course of a single day. Its return over longer holding periods is anyone’s guess.

To illustrate the effect of mandating a daily target, suppose we mimic a 2x S&P 500 ETF starting with $100. To double our market exposure, we borrow another $100, allowing us to buy $200 worth of S&P 500 stocks. By keeping the debt at the same level as our “net balance”—meaning our account value after deducting the debt—we can earn twice the market’s return for that day.

As the market moves in either direction during the day, the portfolio’s gross value changes proportionally, but the debt remains constant, thus amplifying changes in our portfolio’s net balance. For instance, if the market goes up by 25% on the first day, the stocks rise from $200 to $250. Our net balance, after subtracting the $100 loan, is—voilà!—$150, a 50% gain on our initial $100 investment.

At the close of that first day, the $100 debt is below our $150 net balance. As a result, we’re no longer positioned to generate twice the market’s return the next day, so we need to take on more debt. We do that by borrowing another $50 to buy more S&P 500 stocks, thus ensuring our debt is equal to our net balance of $150. In other words, if prices rise on day No. 1, the daily performance goal compels us to buy more stocks before day No. 2.

Leveraged ETFs do the same thing. In practice, they don’t buy stocks with borrowed money. Instead, they use indirect leverage through derivatives. But conceptually, their rebalancing is the equivalent of buying more after prices rise.

What if the market had gone sour on the first day and dropped 20%, instead of rising 25%? In our portfolio that mimics a 2x ETF, the value of our stocks would drop from $200 to $160. After subtracting the $100 outstanding debt, our net balance falls to $60, a 40% drop.

Our portfolio is now overleveraged, so we need to make adjustments to set us up to earn twice the market on day No. 2. This time, we have to reduce borrowing to bring it to the same level as our net portfolio balance. That means selling stocks worth $40 and using the proceeds to bring down the debt from $100 to $60, so it’s the same as our net balance. In other words, we’d be obliged to sell stocks because their prices have fallen. Again, similar adjustments happen with a leveraged ETF.

This daily rebalancing causes the leveraged ETF to buy stocks after prices rise and sell after prices drop, day in and day out. The continuous adjustment of the leverage causes the long-term performance to deviate significantly from the daily target. Indeed, thanks to the costs involved and the difficulty in recouping losses suffered on down days, a leveraged ETF can lose money over longer periods even when the underlying benchmark posts gains in the same timeframe.

What would happen to a triple leveraged ETF if its benchmark dropped by a third in a single day? You guessed it: The ETF would be wiped out. But even if a leveraged ETF survives a big market drop, the underlying benchmark has to soar for the ETF to recoup its loss. A 20% drop of an unleveraged asset requires a subsequent 25% gain to break even. In the case of a leveraged ETF, a 20% benchmark drop leads to a 40% drop in the fund’s value. Result: The fund needs to go up by almost 67% to break even, which can only happen if the benchmark rises by more than 33%.

Market volatility can be devastating for leveraged ETFs, even when the underlying benchmark recoups its losses. Suppose that Mr. Market goes up 10% on day No. 1 and down by 9% on day No. 2, and follows this whimsical pattern for a year. Despite the extreme volatility, the market would be up by 0.1% over any two-day stretch and, over the course of a year, its rise would exceed 13%.

How does a 2x ETF fare in the same year? It experiences a 20% gain on day No. 1 and an 18% drop on day No. 2. Compounding the daily returns, the ETF loses 1.6% over two days. If this seesaw continues for a year, the ETF would lose almost 87% of its original value.

Even on a profitable day, the pretax profit of a leveraged ETF is likely to be less than its stated goal. Why? The leverage isn’t free. If the ETF uses a total return swap—a contract that gives the return exposure of an asset without having to own it outright—it has to pay interest for the swap contract. The already high expense ratios of these ETFs, typically close to 1% and sometimes more, don’t include either the cost of leverage or the fund’s trading costs.

The bottom line: If I could get my hands on a crystal ball that accurately predicts short-term market movements, I’d use leveraged ETFs in a heartbeat. Until then, count me out.

A software engineer by profession, Sanjib Saha is transitioning to early retirement. His previous articles include Identity Crisis, Triple Blunder and Freedom Formula . Self-taught in investments, Sanjib passed the Series 65 licensing exam as a non-industry candidate. He’s passionate about raising financial literacy and enjoys helping others with their finances.

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Victims of the Virus

SOCIAL SECURITY retirement benefits are one of the most complicated topics in financial planning. As you try to figure out how much you might receive, there are thousands of rules, different types of benefit and numerous scenarios to evaluate.

And then there’s the impact of COVID-19.

It turns out that this year’s economic slump, which caused the economy to shrink by a tenth in the second quarter, may interact with Social Security’s methodology to hurt those who turn age 60 in 2020.

It’s a tad confusing, so bear with me while I explain. Social Security benefits are based on your lifetime earnings. To make sure earnings can be compared across time, your actual earnings from each year are adjusted, or “indexed,” to account for differences in average wages from one year to the next. This puts each year’s earnings on a comparable footing.

Social Security then calculates your “average indexed monthly earnings,” or AIME, based on your 35 years with the highest index-adjusted earnings. Think of this as your average career earnings. Your AIME is then used to calculate your base benefit amount as of your full Social Security retirement age, which will be either age 66 or 67. This base benefit is also called your primary insurance amount, or PIA. It’s the amount all other benefits are based on, such as spousal and family benefits.

With me so far?

This is where things get funky—and it has to do with the methodology that Social Security uses to calculate your all-important AIME, that measure of your average career earnings. Each year, Social Security calculates an Average Wage Index, or AWI, based on economywide earnings for that year. Your lifetime earnings are then indexed to the economy’s earnings as of the year you turn age 60. Any earnings received after age 60 are not indexed, but instead they enter the benefit formula in nominal terms.

This creates a huge problem for those who were born in 1960 and hence reach age 60 this year—an issue highlighted in a recent paper by Andrew Biggs and published by the University of Pennsylvania’s Wharton School. What’s the problem? To calculate each year’s AWI, the Social Security Administration divides aggregate payroll earnings for that year by the number of workers who receive W-2 tax forms.

If you turn age 60 this year, all of your earnings from earlier years will be indexed based on the Average Wage Index for 2020. But so far, 2020 has seen record unemployment and a serious economic downturn. The number of W-2s issued shouldn’t change much—remember, lots of people were working at the beginning of the year—but aggregate payroll earnings will likely be significantly lower, because so many of these workers got laid off. This will cause 2020’s AWI to be far lower than expected. That, in turn, means that when your lifetime earnings are indexed to this year’s AWI, you’ll end up with a lower AIME—and hence a lower Social Security benefit.

According to Biggs’s paper, “For 2018, the most recent year for which data are available, the AWI was $52,146. The 2019 Social Security Trustees Report estimated that the nominal AWI for 2020 would be $56,396, or 8 percent higher. This is highly likely to be overstated due to the Coronavirus-related economic downturn.”

Biggs estimates the reduction in AWI could cause annual retirement benefits for workers born in 1960 to be lower by between 13.6% and 14.3%. He calculates that a medium-wage worker might see his or her annual retirement benefit fall by $3,900, while the highest earners could see reductions of some $6,500 per year.

The paper goes into a lot more detail about the benefit formula and some secondary impacts of the reduced AWI. I’d recommend reading it if you’re interested in gaining more insight than I’ve provided in this (relatively) simple summary.

We won’t know 2020’s actual AWI until the end of the year. It could go up or down, depending on economic conditions. What’s the fix? That’s in the hands of Congress. My advice: Contact your local senator and member of the House of Representatives, and let them know about the problem.

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 Refi or Not, Working the Numbers and Summer Job . Follow Rick on Twitter  @RConnor609 .

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Life as a Loan Shark

THE SPEAKER was passionate. “You bankers need to understand our culture is not like your culture. In our community, we don’t expect bills to be paid on time. If you’re really interested in serving our community, you need to adjust your expectations and not be asking us to change our culture in order to qualify for your loans.”

Wow, did I get an education some years ago, when my bank attempted to reach out to the town’s minority community. We were prepared to discuss credit scores and the importance of a good track record of paying bills on time. Instead, we walked away thinking we may have done more damage than good. Clearly, the community’s view of our industry didn’t match our own view.

In our defense, our intention to serve every segment of our community, including low income areas, was honorable. But we ran into a wide cultural divide we were ill-equipped to handle.

But as a young community bank chief executive, I was idealistic and not easily discouraged. I was intent on finding a way to serve everyone. We had purchased a wealth management company to cater to our well-heeled customers. The bank itself was well-positioned to serve most of the financial needs of the middle class. But I wanted a way to reach the unbanked. That desire, however noble, set me up for an embarrassing failure.

Freedom Loans—not its real name—sat in the middle of our Midwestern town. The most remarkable feature was a big ugly green sign in front of the tiny store. The sign would come alive at night and blink its bright neon lights spelling out the word, “LOANS…LOANS…LOANS.” It wasn’t subtle marketing—and hardly the image a preeminent bank in town would want to project.

The owner of Freedom Loans—let’s call him Tex—wanted to sell the business. “Perfect,” I thought. We’ll buy Tex’s company and this will be our way to learn how to serve the unbanked in our community, plus I hoped to teach Freedom’s customers how to improve their credit standing and to encourage them to favor the lower-cost loans available from my community bank. And, boy, did I learn a lot. Here are the highlights:

1. The poor don’t pay on time and don’t care about late fees. One of my first conversations with Tex was on his need to bring down his “past due” ratios. My bank kept past dues below 1%, while Tex was around 20%. He just looked at me and shook his head, saying, “You don’t understand what we do at all, do you? We love past due loans. That’s how we build up our late fee income. And nobody ever complains.” As I found out, he was right.

2. The poor don’t care what interest rate they pay. Tex charged an average 28% interest on loans. Tex taught me the poor don’t care about the rate. Only the payment schedule mattered to them.

3. The poor will pay almost anything to maintain one reliable line of credit. Tex gave me an education into the mind of the unbanked. They don’t care about interest rates. They don’t care about late fees. They don’t care about any other debts they were running past due. But they did care about keeping Tex happy, because he was their emergency fund. Tex would always advance them a new loan when needed if they would continue to pay him something from time to time. You could say Tex was a friendly loan shark.

4. It’s hard to find ethical lenders who share Tex’s view of customers. After the sale of the business, Tex only wanted to stay on for a short transition period. We hired a young man to train under Tex, with the intention of making him the new president when Tex retired. This trainee, however, never bought into Tex’s exploitation philosophy. He quit and went to work for a church, where he found more compatible values.

5. The poor suffer from fear and shame. Freedom Loans had a hidden parking lot in the back, which allowed customers to enter without being seen. Tex explained to me that this private rear entrance was a key to business success. The poor will almost never enter a traditional bank lobby, because they don’t feel they belong there. But they also want to hide their poverty from others, which would be revealed if they were seen entering a high-interest loan shop.

The Freedom Loans experiment fairly quickly ended in failure. Our bank’s values were incompatible with the idea of charging exorbitant interest and fees, especially to the poorest among us. Freedom Loans never made any money. The lack of profitability was probably because no one in my company could buy into the Freedom Loans philosophy.

But the failure motivated me to look elsewhere for ideas on how to help the poor. Over time, I’ve found some answers that work much better than my poorly conceived idea to buy Freedom Loans.

Warren Buffett’s partner, Charlie Munger, has a saying: “Invert, always invert.” In other words, turn a problem upside down and look at it backwards. Here are two ideas that appear to be effective in raising the poor out of their mindset of poverty.

Investment clubs. Over time, I became friends with a number of pastors in the minority community. They had formed an investment club that regularly met to pool members’ money and make investment decisions. These wise pastors knew that one path out of poverty was to teach their members to think more like owners and less like debtors. I think the club was successful because the effort came from within the minority community.

Peer micro lending and savings groups. Similar to investment clubs, savings groups have proven successful in developing countries. These savings groups encourage capital formation, without the bureaucracy of bankers like me getting involved. Members can take loans from these savings groups, if approved by their peers, for purposes such as business expansion, home improvements, medical care or other needs—and without paying exorbitant interest rates.

There’s a reason for the biblical prohibition against moneylenders charging interest to the very poor, who are least able to pay it. As far as I know, Freedom Loans didn’t help anyone in my town escape poverty. It most likely kept them poor.

My confession in this article may not have the same impact as the 13 books St. Augustine wrote discussing his confessions. Still, this was an important lesson for this banker to learn. Not every market segment is a profitable niche, nor is it ethical to try to make a profit to the detriment of the poorest among us. But that doesn’t mean there are no alternative ways to bring human flourishing to those who struggle the most.

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.

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My Retirement

AS I PLAN MY retirement, I have the advantage of a strong background in finance. I worked for 35 years in the investment field, primarily managing mutual funds. Early on, I obtained the Chartered Financial Analyst designation, which helped immensely.

Six years ago, when I was age 55, I embarked on a journey to comprehend the myriad rules and strategies surrounding retirement. I studied to become an RICP—a Retirement Income Certified Professional. While the CFA was useful for investment management, the RICP helped me understand how investments fit with insurance products.

From the RICP program, I learned about the 4% rule and planning for a 30-year retirement. But the 4% rule only concerns financial assets. It doesn’t address other income sources, notably Social Security and annuities. I also learned about the “retirement smile,” a term coined by David Blanchett, who analyzed retirees’ spending through retirement. His finding: Retirees’ spending declines steadily in retirement until the later years, when long-term care (LTC) expenses tend to rise.

Another major issue: How will your retirement income be taxed? Retirement account withdrawals are taxed at ordinary income tax rates. Regular taxable accounts currently benefit from a favorable capital gains tax rate. Roth, health savings accounts and cash-value life insurance all offer tax-free withdrawals—if done correctly.

Since the traditional IRA continues to lose its tax advantages relative to other accounts—the stretch IRA has been slashed to 10 years and account holders are forced to take required minimum distributions starting at age 72—I’ve been looking to shrink my traditional IRA.

To that end, I used my IRA to purchase three different deferred income annuities, formally known as QLACs, or qualified longevity annuity contracts. Those will pay me income starting at ages 76, 80 and 85. I also purchased a “period certain” annuity, which will pay me income from age 62 to 69. That will give me extra income until I start Social Security at age 70. In addition, I’ve been converting part of my IRA to a Roth IRA each year, paying taxes along the way.

These various steps will increase my guaranteed income, allow me to delay Social Security and create a tax-free pool of assets. Did I mention that I obtained an insurance license, so I earned commissions on the annuities that I purchased for myself? Still, even if I hadn’t collected those commissions, I would have bought the various annuities.

At age 55, I also purchased a whole-life insurance policy. As an investment manager, I had always bought term insurance, because I knew I didn’t understand whole-life policies. The two major drawbacks to whole-life insurance are the large commissions paid to insurance agents and the large premiums relative to the death benefit. I wrote the policy on myself, so I earned the commission.

Meanwhile, I wasn’t buying the whole-life policy for the death benefit per se, but rather to accumulate tax-free assets, while also investing in a fixed-income investment that wouldn’t decline in value if interest rates rose. This will be my safe haven fixed-income bucket—and it’s potentially tax-free, to boot.

Owning the whole-life policy freed me up to buy the income annuities. How so? When I die, the annuities cease paying income, but the tax-free death benefit from my whole-life policy will be there for my kids instead. I had hoped to be able to get an “LTC rider” on the life insurance policy, but the insurance company turned me down. That lead me to another insurance product.

I attended a presentation explaining hybrid LTC insurance. I had studied the product while obtaining the RICP, but I wasn’t especially excited about it. But as I researched the product further, it seemed like it solved a host of problems. Since I was declined for the LTC rider on my life insurance, maybe I could qualify for this. I did.

The only thing I knew about traditional standalone LTC insurance was that premiums were never guaranteed and, indeed, the policies have seen dramatic premium increases. By contrast, hybrid LTC policies can’t increase premiums. Owning a policy that would offset costs at the far end of the “retirement smile” meant I didn’t have to worry about rising expenses, should I need long-term care.

On top of that, I now count my hybrid LTC policy as an asset, since I can get a full refund at any time and, if I never need LTC, the death benefit is double what I paid for the policy. One other step I’ve taken: I continue to fund an HSA, or health savings account, since I have a qualifying high-deductible health plan.

I’ve found it helpful to use a spreadsheet to project my retirement income. Each year, different streams of income become available. At age 60, my pension began, which covers my mortgage and my health insurance premiums. At age 62, my “period certain” annuity begins, and that will supplement my pension until age 70. This guaranteed income reduces the need for income from my investment portfolio.

At age 70, my period certain annuity stops paying and I plan to start Social Security. Also starting at age 70, I might withdraw from my Roth account over the next five years if I need additional income. At age 75, I plan to withdraw tax-free income from my cash-value life insurance—but again, only if it’s needed. The withdrawals will be tax-free provided I don’t take out more than the total premiums I’ve paid.

As I hit ages 76, 80 and 85, I’ll have additional lifetime income, as the three QLACs start paying. By age 85, I should have sufficient income from the QLACs, Social Security and my pension to cover most of my living expenses. If I need to pay for long-term care, my hybrid LTC policy is available. My brokerage account and Roth account will also be there as backups. Finally, there will be a death benefit from the life insurance as a legacy.

I believe in diversification in retirement planning, just as I do in investments. I know many money managers look askance at insurance products. But I now understand why insurance agents like the guarantees and security of their products. Like my LTC insurance, I find I’ve become something of a hybrid myself. Most of my assets remain invested in the stock market. But I now also have annuities, life insurance and a hybrid LTC policy on my balance sheet—and they’re there for tax reasons, as a hedge against a surprisingly long retirement and as way to pay for the long-tailed risk of needing long-term care.

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 Early Decision, Your 10-Year Reward and Four Simple Tips.

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Don’t Feel Bad

LAST SUNDAY, I discussed six strategies that could help you avoid decisions you’ll regret. But what if it’s too late—and you’ve already made a financial choice that’s left you unhappy? Now what?

Below are six notions to help you manage, and hopefully minimize, your regret over past decisions:

1. Your imagined happy ending likely wouldn’t have happened. Back in 2004, I recall seeing an iPod for the first time. A co-worker had received one for Christmas. It was clear what a great product it was. Apple’s share price at the time? About $4. Today, of course, it’s around $460—more than a hundred times higher. So how many shares did I purchase at $4? Zero.

I don’t spend a lot of time thinking about this. But if I wanted to wallow in regret, the math would be easy. A $1,000 investment back then would be worth some $115,000 today. A $5,000 investment would have put my children most of the way through college. In theory, at least. But here’s the reality: It probably wouldn’t have worked out that way. My guess is that no one short of Rip Van Winkle would have held onto Apple—without selling a single share—over that many years, even as its value multiplied so many times. It just isn’t realistic.

But unfortunately, our minds aren’t perfectly rational. It’s all too easy to compare what actually occurred to an imagined, and highly romanticized, version of what might have been. What we conveniently overlook is all of the other less-than-wonderful ways that things might have turned out. One regret, in fact, might simply have replaced another. Suppose I had bought those Apple shares at $4. That would have been great, but I can imagine what might have happened next. A year later, after the price had more than doubled to $10, I could easily have sold the shares, reasoning that it would be foolish and greedy to hang on for further gains.

The bottom line: A key strategy for overcoming financial regret is to recognize that things might not have—and probably wouldn’t have—turned out to be the fairy tale that our minds imagine.

2. Bad outcomes don’t necessarily result from bad decisions. In recent months, while most stocks have struggled, a group of technology stocks has been seemingly unstoppable. In addition to Apple, this group includes Alphabet (a.k.a. Google), Amazon and Tesla. If you had sold shares in any of these companies this year, you might be regretting it. But what we overlook is that things could easily have gone the other way for these stocks.

Poker champion Annie Duke talks about the concept of resulting. This occurs when our minds mistakenly conclude that a bad outcome was the result of a bad decision. This applies as much to investing as it does to poker. The particular nature of the COVID-19 crisis just happened to benefit technology companies—but that wasn’t preordained.

Imagine if things had developed just a little differently. Imagine if Apple’s production lines in China had been shut down for several months due to the virus, or if Tesla’s production in California had been impacted more than it was. Those things might well have happened. And if that had been the case, those companies might be faring much worse than average, rather than better. The bottom line: We shouldn’t criticize a decision that made sense at the time using the facts then available.

3. Mistakes are part of life. No one moves through life seamlessly, making flawless decisions at every turn. But because most people don’t like to advertise their mistakes, it may appear that others are making all the right moves. Rationally, though, you know that can’t be true. If you find yourself stuck ruminating over a financial mistake, look at it this way: Yes, the circumstances of a particular mistake might be unique to you, but it isn’t unique to make mistakes.

Once you accept that we all make our fair share of mistakes, I think it’s easier to put things in the past—where they belong. In fact, “mistake” may not even be the right word. I always think of Michael Jordan’s comment: “I’ve missed more than 9,000 shots in my career. I’ve lost almost 300 games. Twenty-six times, I’ve been trusted to take the game-winning shot and missed. I’ve failed over and over and over again in my life.” In other words, no one wins them all—not even Michael Jordan.

4. When one door closes, another opens. This may sound like a cliche, but it’s often true. Think of Steve Jobs. Only upon reflection did he see how the setbacks he experienced early in his career benefited him later on.

“You can’t connect the dots looking forward,” Jobs said. “You can only connect them looking backwards…. It turned out that getting fired from Apple was the best thing that ever could have happened to me.” Be careful not to judge anything over too short a time frame. Today’s mistake may end up being an invaluable building block toward something better down the road.

5. It may not even be your fault. One reader visited the World Regret Survey, which I mentioned last week, and then emailed me with the observation that all the regrets seem to fall into one of two categories: mistakes for which we blame ourselves and mistakes for which we blame others. It’s a great observation. What I would add is that it’s easy to confuse the two. Sometimes, we blame others for our own problems. Sometimes, we blame ourselves for things over which we had no control. Both are mistakes.

6. Money matters, but it isn’t the only thing. When all’s said and done, money is just one aspect of our life. In fact, if you read through the World Regret Survey, you’ll notice that a majority of the regrets submitted are not money related. Most regrets have more to do with personal relationships.

It’s an important lesson: Sure, you might have a financial regret or two—or maybe more—but that’s just one piece of the puzzle. If you find yourself ruminating over a financial decision, try to broaden the lens. Ponder everything that has gone well or is currently going well. The past doesn’t care if you ignore it—so go ahead and leave it where it belongs.

Adam M. Grossman’s previous articles include Minimizing Regret, Don’t Be That Person and Skewed Impression. 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.

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