Jonathan Clements's Blog, page 324

Freedom Formula

EARLY RETIREMENT isn’t a common goal among my friends. When I talk about my semi-retirement, many assume I either made a quick buck in the stock market or benefitted from some sort of financial windfall. I counter this misconception by narrating the magic formula: Financial freedom is frugality, multiplied by simplicity, compounded by patience.

My response often seems mysterious until I explain the two basic math concepts behind it. We learn them in school, but rarely internalize them. One is simple subtraction and the other is compounding.

Subtraction tells us that savings equals income minus spending. The more we save, the faster our nest egg piles up. But looking at it from a savings perspective tells only half the story. If we let our lifestyle grow ever more lavish, even regular salary increases won’t get us to financial freedom any sooner.

Indeed, keeping our spending in check has a double benefit. First, a reduction in spending increases our regular savings by the same amount. We can sock away more money and reach our target sooner. Second, lower spending means that we need less to cover our living expenses and that shrinks our target nest egg proportionately. In other words, if we hold down spending, we not only go faster, but also we have less distance to cover.

Consider a 25-year-old man and woman, both earning $75,000 a year. To them, financial freedom is about having enough money so that a conservative 3% annual withdrawal rate can cover half of their spending. The man saves 10% of pretax income, while the woman socks away 25%. Let’s assume their savings earn 6% a year. The two charts below track their progress toward financial freedom, with the green bars showing their nest egg’s current value and the peach-colored area indicating the sum that still needs to be amassed.

The bottom line: Our 25-year-old man takes 60% longer to reach his goal than his more frugal, female counterpart. This is because he not only saves less, but also his higher spending pushes up his target nest egg by 20%. This illustrates the crucial role of frugality in achieving financial freedom. Lower spending equates to both a higher savings rate and a smaller target nest egg.

But frugality alone isn’t enough. The money saved doesn’t go far on its own. It needs to be invested with an eye to growth. The saver must become an investor. This is where the second math concept—compounding—comes into play.

For illustrative purposes, let’s assume a 10%-a-year portfolio growth rate, even though that’s likely unrealistic, given today’s stock market valuations. At 10% a year, a dollar saved at age 25 becomes $45 at age 65. What if we could save even more at age 25? Two dollars would potentially become $90 and $20 would grow to $900.

But making a bigger investment isn’t the only way to speed our financial progress. Both the growth rate and the years of growth also have a big impact on the outcome. If we trim the growth rate by a tenth, so the money we invest at age 25 compounds at 9% a year instead of 10%, that slashes the final amount amassed by almost 31%. Likewise, making our investment four years earlier, at age 21 instead of 25, boosts the final sum by more than 46%. It’s a no-brainer that we can reach our target much sooner with a higher growth rate and a longer period of compounding. But how do we do that?

The two other virtues of the freedom seeker—simplicity and patience—can do the trick. True, we can’t control or predict the investment growth rate. But with a few simple steps, we can improve our odds of getting a higher return. First, we need to start with a realistic list of financial goals.

The next step is asset allocation—how we divide our money between stocks and more conservative investments—which is the surest predictor of our long-term rate of investment growth. Time until our financial goals should play the biggest role in driving our investment mix. Another important factor is risk tolerance. Once we have our financial plan, we can implement it using low-cost, diversified investments that are simple to understand and easy to maintain. Convoluted or expensive investment products usually hinder success. Simplicity is the key.

With our plan in place, the final ingredient is patience. Financial freedom doesn’t come overnight, so patience is essential. The lure of instant gratification is always there to distract us, but a laser-like focus on our long-term goals can act as a shield. With frugality, simplicity and patience joining forces, financial freedom is all but inevitable.

A software engineer by profession, Sanjib Saha is transitioning to early retirement. His previous articles include Feelin’ Groovy, Ready or Not and Spring Cleaning . 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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Betting on Bricks

TOTAL STOCK market index funds have 3% or 4% of their money in real estate investment trusts, or REITs. That means many investors—including many HumbleDollar readers—already have some exposure to REITs. But is it enough? For many, I think not.

I’m talking here about publicly traded U.S. equity REITs, not mortgage REITs or non-publicly traded REITs. Yes, the right allocation to real estate can be complicated by whether you own your home or have other real estate holdings. Still, I think it’s worth overweighting REITs—for seven reasons.

1. Returns have been excellent. REITs were created by Congress in 1960. We have reliable index data going back roughly 50 years. Morningstar recently calculated that REITs outperformed the S&P 500 by more than 1% a year between 1972 and 2019.

2. Real estate may be less risky than stocks. Many commentators have argued that REITs are volatile and therefore less attractive. For instance, Jeremy Siegel noted in Stocks for the Long Run that REITs lost 75% during the 2007-09 financial crisis. REITs have also been volatile during the COVID-19 crisis, with weekly REIT returns on both the upside and downside exceeding stocks for seven straight weeks.

But risk can be measured by various metrics and, while some indicate REITs are riskier than stocks, others imply the opposite. For instance, Craig Israelsen found that REITs had both higher returns than stocks and were arguably less risky, because they had a higher percentage of years with positive returns.

3. Real estate accounts for a large percentage of global wealth. It’s tricky to estimate the total value of worldwide assets. Roger Ibbotson and Laurence Siegel made the first comprehensive calculations in 1983 and estimated that real estate accounted for 52% of “the world market wealth portfolio.”

Gregory Gadzinski, Markus Schuller and Andrea Vacchino provided a more recent estimate in their 2018 paper. As of 2015, they concluded that real estate accounted for 20%—and forestry and agricultural land for an additional 2%—of the global capital stock. “A global market portfolio aiming at including the major economic forces would need to take into account this weight accordingly, instead of only accounting for assets under management held by REITs,” they wrote.

4. Homes—a large component of the real estate sector—have had similar returns to stocks, but with less volatility. Historically, homes only appreciate by a little more than inflation. But that’s not the right comparison to other investments. The authors of The Rate of Return on Everything, 1870–2015 added rental income, concluding that “residential real estate, not equity, has been the best long-run investment over the course of modern history.”

5. High net worth investors target high allocations to real estate. TIGER 21 is a group of individuals with at least $10 million to invest. Real estate was consistently the largest component of their asset allocation during 2016-19. Indeed, wealthy investors had 29% allocated to real estate at the end of 2019’s third quarter.

6. Institutional investors have had much stronger returns with public REITs than other real estate investments. CEM Benchmarking’s 2019 study reviewed asset class returns of public and private sector pensions, and found that their REIT returns over the last 20 years significantly outperformed both private funds and internally managed real estate.

7. This year’s bear market has made REITs even more attractive. REITs give investors the opportunity to buy one of the best long-term investments in a liquid, efficient form. Want to diversify your portfolio better—and perhaps set it up for higher long-run returns? Consider buying an index mutual fund or exchange-traded fund that focuses on REITs.

Gary Karz is a Chartered Financial Analyst, publisher of  InvestorHome.com  and author of  The Peaceful Investor . His previous article was Make Less Keep More . He enjoys skiing, hiking, biking and snorkeling. Gary will present a webinar on June 4 for the AAII’s Los Angeles chapter on “Real Estate vs. Stocks: Which is the Better Long-Term Investment?” A longer version of this article was previously published on InvestorHome.com .  Follow Gary on Twitter  @GKarz  or email him at  host@investorhome.com .

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Less Than the Truth

EARLIER THIS YEAR, before the coronavirus hit, my family visited an amusement park. Everyone had fun—except my nine-year-old, who complained about the injustice of the rigged “down the clown” game.

You have probably seen this sort of thing: You’re given a handful of baseballs. Then, standing from about 10 feet away, the challenge is to knock down as many mechanical clowns as possible for a chance to win a prize. It doesn’t appear difficult—you aren’t that far away and the clowns are tightly spaced—but most people walk away empty-handed.

What’s the catch? Why is it so hard to knock down the clowns? In my son’s opinion, it was the baseballs. In every way, they looked legitimate—same size and shape, same white leather and red stitching—but they weren’t. They felt hollow and nearly weightless, which made them difficult to throw, let alone hit anything.

In the financial world, few things are such obvious frauds. But the phony baseballs got me thinking about some of the financial “truths” that we hear repeated so often that they’re regarded like laws of nature. Here are five such truths—all of which, in my opinion, we ought to question:

1. Modern Portfolio Theory. In 1952, Harry Markowitz introduced a new, statistical approach to building investment portfolios. This approach came to be known as Modern Portfolio Theory and, because of that name, people continue to view it as not only a new idea, but also a good one.

A central tenet is the idea that an investment’s risk can be distilled into a single number. This notion is attractive for its simplicity, but it’s flawed. How so? It rewards stocks with stable share prices and penalizes those with prices that bounce around a lot.

While this seems logical, consider how it might apply in practice. Over the past five years, Amazon’s share price has soared 468%, while one of its hapless competitors, Macy’s, has seen its stock sink 92%. But according to Modern Portfolio Theory, Macy’s is less risky than Amazon—because Macy’s stock has deteriorated slowly and steadily, while Amazon’s stock has moved up quickly. To me, this makes no sense.

2. The VIX. Listen to the financial news and you’ll undoubtedly hear about the VIX, a statistical measure of investor sentiment. It’s often referred to as the market’s “fear gauge.” Commentators love to talk about it, especially when it spikes higher.

But there are two reasons I wouldn’t worry too much about the VIX. First, it’s just a measure of market volatility. It doesn’t say anything about returns. Second, even when it comes to volatility, the VIX can’t predict too far into the future. For the most part, it just extrapolates from today to tomorrow. The VIX knows nothing about what will happen further down the road.

Earlier this year, for example, just before the coronavirus hit, the VIX was near historic lows. There was no indication that the market was about to go off a cliff. As a peer once quipped, “The VIX index is one of those things people mention to sound smart.”

3. Nobel Prize-winning research. For the most part, work that has passed muster with the Nobel committee is worthy of respect. But what about the Nobel prize for economics? It isn’t an actual Nobel Prize and it isn’t awarded by the Nobel committee. It was created 75 years after Alfred Nobel’s death and just borrows his famous name. In the words of a Nobel family member, it was a “PR coup by economists to improve their reputation.”

One incident, in particular, illustrates why investors shouldn’t put too much stock in this prize. In 2013, there were three winners in economics. But what was odd was that two of them were antagonists, with exactly opposite theories, and yet both won. Bottom line: In economics, the prize’s imprimatur means only that the research was deemed innovative—and not necessarily that it was correct. It certainly shouldn’t be seen as an endorsement of any particular investment theory.

4. Retirement accounts. If you’re earning a high income, and especially if you live in a high-tax state, it’s natural to want to stash as much as possible in retirement accounts to defer taxes. If you’re self-employed, you may have even considered a cash balance plan, which might allow you to save $200,000 or more per year in tax-deferred accounts.

Sound attractive? Before you go down this road, remember that tax-deferred doesn’t mean tax-free. After age 72, you’ll have to take money out of your retirement accounts, at which point it will be subject to prevailing income tax rates. While most people assume their tax rate in retirement will be lower, this is just a rule of thumb and not a guaranteed truth. The federal budget isn’t in great shape, so it’s possible that someone with substantial retirement assets might end up paying a rate higher than today’s top tax bracket.

5. Social Security. Google the phrase “Social Security insolvency” and you’ll turn up worrisome commentary. Most frequently cited is the estimate, from the Social Security Administration itself, that the trust fund used to pay benefits will run dry in 2034. Does this mean the program will stop paying benefits? That’s more fear mongering than fact. There are lots of ways to fix the system. While Congress is often dysfunctional, Social Security affects constituents in both parties, so I’m confident they’ll work something out. No, Social Security isn’t going bankrupt.

Adam M. Grossman’s previous articles include No, I’m Better, A World of Problems and Thinking It Through.  Adam is the founder of  Mayport Wealth Management , a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter  @AdamMGrossman .

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At Ease

I REMEMBER the first time we met. Josh—not his real name—and I went to rival high schools in the Washington, D.C., area. During our senior year, we competed in a track meet. Someone mentioned that we would be going to the same college in the fall, so I went over to introduce myself—a little awkwardly, as he had just annihilated me in a race. A few months later, knowing few people on campus, we were happy to discover that we’d both enrolled in the college’s Army Reserve Officers’ Training Corps (ROTC) program.

Josh was garrulous, and he possessed that rare combination of incredible athletic and academic ability. When the U.S. Army decided what jobs we would have, they astutely assigned Josh to the artillery—with its loud guns and adventure, but also need for mathematical precision—while packing me off to law school.

Josh’s career in the Army was cut short when he died in 2010, a result of complications stemming from a brain injury suffered during combat in Afghanistan. At the time of his death, Josh had just decided that his marriage was unsalvageable and headed toward divorce. Within days of that decision, he fell ill, slipped into a coma and eventually passed away.

Josh died before he could change the beneficiary on his life insurance. Though it has been nearly a decade since his funeral, I still viscerally recall standing in Arlington Cemetery with a few of our ROTC classmates and watching Josh’s family sitting alongside his wife. His spouse would be receiving $400,000 in life insurance—the standard amount of coverage for those who serve in the military. I remember thinking about all the movies I had seen where the 21-gun salute rings out. Now, I was living that surreal nightmare here in our own hometown.

Perhaps Josh might have found a way to make his marriage work. Regardless, in the years since his death, I’ve represented numerous clients whose loved one had passed away, only to find that the deceased had never changed an old life insurance beneficiary designation.

It’s a story that many military attorneys have seen play out far too many times. In fact, it became such a problem that the Army began proactively requiring all soldiers to verify life insurance beneficiary designations every year or two. For the rest of America, however, the burden is on the individual to ensure his or her beneficiary designations are up to date.

Slightly more than half of all states nullify a beneficiary designation that names an ex-spouse. While the Supreme Court recently affirmed this process, it’s still possible in many states for ex-spouses to receive life insurance proceeds if they’re listed as the beneficiary. Even in the states that nullify beneficiary designations, that typically only happens when the divorce is final, so it behooves anyone in the process of divorcing to make the change immediately. What if an ex-spouse is named beneficiary through an employer-sponsored plan governed by federal law, such as the military’s life insurance program? The Supreme Court has ruled that the ex-spouse gets the life insurance, regardless of state law.

This Memorial Day, like every Memorial Day since Josh passed away, I will reflect on his passion for life. I’m grateful for every moment we spent together, from competing on the track to those years spent as brothers-in-arms. I am also grateful that the Army now forces soldiers to update their insurance beneficiary designations. If you’re reading this article, and you or folks you know might need to update their records, please make the necessary changes as soon as you can and encourage others to do the same.

John Goodell is a government attorney who has spent much of his career advocating for military and veterans on tax, estate planning and retirement issues. His biggest passion is spending time with his wife and kids. Follow John at HighGroundPlanning.com and on Twitter @HighGroundPlan. His previous articles were Income Isn’t Wealth, Average Is Great and Garbage Time. The opinions expressed here aren’t necessarily those of the U.S. government.

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“No, I’m Better”

CONVERSATIONS on Twitter aren’t known for their civility. Still, it came as a surprise last week when, out of the blue, author Nassim Nicholas Taleb launched a broadside against investor Clifford Asness, calling his work “crap,” along with other insults.

Asness wasted no time firing back, calling Taleb “very wrong and clearly both nuts and a world class terrible person.”

From there, the insults escalated: nasty, overrated, unoriginal, illogical, pretentious, emetic. That last one I had to look up in the dictionary. And those are just the words fit to print.

If you aren’t familiar with them, Taleb is a retired Wall Street trader turned author. He’s best known for his book The Black Swan. Asness is the founder of AQR Capital Management, which runs several public and private investment funds. Both are well respected in the investment field. According to Asness, they used to be friendly.

So why the sudden vitriol? It started when Taleb questioned the track record of some AQR funds, then touted the superior performance of funds managed by Universa, a firm with which he’s affiliated. Over the course of several days, Taleb and Asness debated a number of points but, fundamentally, it was an argument about investment performance.

Of all the topics to debate, investment performance seems like one that ought to be cut and dried. Suppose Fund A gains 5% and Fund B gains 10%. Didn’t Fund B deliver better performance? What’s there to argue about?

It turns out that investment performance is, unfortunately, somewhat in the eye of the beholder. Below are just five of the ways in which performance measurements can be fuzzy:

Choice of benchmark. One of the oldest tricks in the book: A fund manager will choose a benchmark that’s easy to beat. Fund companies have been known, for example, to choose a conservative benchmark and then fill their funds with the stocks of small, fast-growing companies. Result: By comparison, the funds look like stars.

Choice of time period. Measuring performance obviously requires picking a time period. Yet the reality is that almost every investment has periods when it’s in favor and when it’s out of favor. Choose one time period and you could argue that international stocks are superior to U.S. stocks. Choose another time period and you’ll get the opposite result.

Limited data. Try to evaluate an index of emerging markets stocks and you’ll quickly get stuck. Why? For the U.S. market, there’s reliable data going all the way back to 1926. But the most common emerging markets index only started in 1998. How can we best compare emerging markets to other investments, if at all? It’s a judgment call and certainly subject to debate.

A changing world. The world is not a static place. Since 1926, the U.S. stock market has returned some 10% a year, on average. But today, our population is growing at just half the rate it was in decades past, so is that historical average meaningful or misleading? You could make similar observations about other countries, as well as particular industries and companies. In every investment category, it’s very hard to make comparisons across time.

Taxes. For individual investors, one of the more maddening aspects of performance reporting is that taxes are often ignored. If one money manager is pursuing a tax-efficient strategy while the other is not, it’s very hard to compare them. A key problem: Tax rates differ across individuals. For instance, those in the lowest tax brackets pay zero capital gains taxes. That’s why many money managers don’t even try to report after-tax performance, even though that’s what really matters to investors.

Asness summed it up best. In one of his tweets, he accused Taleb of comparing “apples to hippopotamuses.” That’s the heart of the problem. In this case, both Asness and Taleb have a vested interest in defending their own funds’ performance. But even for the individual investor trying to make objective judgments, it isn’t easy. With that in mind, here are three recommendations as you build and monitor your portfolio:

Stick with simple investments. There are two reasons. First, they’ll usually have long track records. Second, it will be easier to choose an appropriate benchmark. A big issue with the Asness-Taleb debate is that they’re arguing over complex investments with track records that go back to only 2017 or 2018. Even if they could agree on a benchmark, a few years is hardly enough time to form a judgment. When you choose investments with longer track records, you can examine how they did during different kinds of market environments—bull markets, bear markets, inflationary periods and so on. That’s much more meaningful.
Avoid package deals.  Even some seemingly simple investments can be complicated. Consider target-date mutual funds, which are popular in many 401(k) plans. Because these funds are comprised of stocks and bonds—and sometimes other asset classes—they’re difficult to judge. My advice: Stick with the simplest funds, those that hold just one asset class—a total stock market index fund, for example—rather than a stew that’s hard to characterize. A bonus: Simple investments usually carry the lowest costs and are most tax efficient.
Focus on what matters. When last I looked, Taleb and Asness were still going at it. Because investment performance is such a fuzzy topic, they could probably go on indefinitely. Fortunately, there’s a simple solution: Ultimately, the best measure of performance for you is whether you’re on track to meet your own financial goals—and that means you should worry less about how your portfolio matches up against some arbitrary benchmark.

Adam M. Grossman’s previous articles include A World of Problems, Thinking It Through and  Regrettable Behavior . Adam is the founder of  Mayport Wealth Management , a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter  @AdamMGrossman .

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Look Forward

IT’S BEEN AN UNHAPPY few months. Stepping outside means risking our health. One out of six U.S. workers is unemployed or soon will be. The stock market has suffered its worst decline since 2007-09. And while we can take steps to help ourselves, the situation is largely out of our control.

Feeling glum? One of my abiding interests is happiness research, and that research offers ideas that can make our current situation a little cheerier. But how? We can think of any occasion—perhaps it’s a fun experience we’re planning or a purchase we want to make—as having three elements: the time before, the event itself and the time after. Each offers the opportunity for happiness, but it takes effort on our part.

1. Before. I’ve stopped asking friends and family whether they have any plans for the weeks ahead, because the question seems almost silly. Many folks are reluctant to, say, eat at restaurants or go to the beach—and, depending on where we live, these things may even be prohibited. But if we can’t make plans, what’s there to look forward to? The fact is, one of life’s great joys is anticipation.

My suggestion: Create two wish lists, one for today’s world and one for our post-pandemic life. The current list might include things like restaurants we want to order from, hikes we’d like to take and items we want to purchase online.

Yes, I realize there’s currently a debate about the ethics of online shopping—and whether we should limit ourselves to ordering essentials, so we don’t put fulfillment and delivery workers unnecessarily at risk. I’m not going to weigh in on that. But if you are inclined to buy online, I’d spend time scouring the internet and considering different items, so you add to your anticipation. And if you decide to make some purchases, lean toward items that can be shared with others, such as kitchen utensils that’ll allow you to make a special meal for your family or games that require multiple players. Most things in life are better when they can be shared with others.

Meanwhile, even if we can’t imagine climbing on an airplane today or going to a concert, we should make a second wish list that includes, say, places we’d like to visit and performers we’d like to see. We might do some research online, and then hatch plans with friends and family. This sort of daydreaming costs nothing but could bring great pleasure: We can muse about countless enjoyable experiences—and, even if we can only make the vaguest plans at this juncture, we’ll get the boost to happiness that comes with anticipation.

2. During. How can we ensure an eagerly anticipated event lives up to its billing? We should remind ourselves how lucky we are to be making this particular purchase or having this experience. And as we enjoy the event, we should put ourselves on sensory high alert, taking in as many details as possible.

Indeed, very deliberately focusing on the positive aspects of an occasion—whether it’s before, during or after—appears to be one of the best strategies for boosting happiness, according to academic research. We should strive mightily to focus on the event at hand, rather than letting ourselves get distracted by, say, the latest COVID-19 news or that annoying email from a colleague.

We should also avoid comparing our purchase or experience to that enjoyed by those around us—because there’s a grave risk that such comparisons will detract from our happiness. This is one reason to favor experiences over possessions. Your neighbors might drive cars that are obviously superior to yours. But it’s much harder to conclude that your neighbors have, say, better hobbies or better family gatherings.

One final suggestion: It seems we get greater pleasure from events if they end on a high note. On vacation, we might plan something memorable for the final day. Making a special dinner? Yes, you should definitely serve dessert.

3. After. We ought to strive not only to remember happy occasions, but also to remember the more enjoyable parts. Forget the annoyances and think about the high points. And as we ponder the good things in our life, we should take a moment to be grateful. We can boost our happiness simply by thinking about how lucky we are to have a beautiful home, good friends or the opportunity to spend a week in Europe last summer.

Indeed, we should take steps to ensure we’re regularly reminded of our good fortune. At dinner, we might mention the pre-pandemic cruise we took, and ask what our spouse and children remember about the trip. Similarly, we could bring up the topic of vacations with friends, so we can regale them with our stories. We might also keep the photo albums out on the coffee table, so we’re more likely to leaf through and remember past events.

One caveat with all this: Focusing on the positive and expressing gratitude won’t be especially effective if we aren’t wise in how we choose to spend our time and money. Research suggests we often misjudge how happy an event will make us—and sometimes much-anticipated occasions don’t make us happy at all.

But with any luck, those wish lists will help. By writing down how we’d like to use our money and spare time, and then regularly revising those lists, we’ll avoid impulsive decisions—and, fingers crossed, end up making wiser choices.

Latest Articles

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

Sitting in cash but wanting to buy stocks? Mike Zaccardi discusses five strategies he uses to minimize his anguish when pulling the trigger.
Work offers the largest cash reward for our time. But if we let that drive our daily schedule, our lives can quickly become unbalanced, says Jim Wasserman.
“Most of us shouldn’t be in the business of making market calls,” writes Bill Ehart. “We have no benchmark to beat, no cable TV time slot to fill. Besides, my batting average with predictions is about .000.”
Index funds are great, says Adam Grossman—until somebody starts messing with the underlying index.
Want to avoid income taxes and a 10% penalty on your Roth withdrawals? Rick Moberg explains the all-important five-year rule.
“Amid all my nervousness, I sat down to write out a worst-case scenario,” says Kristine Hayes. “And when I looked at our accounts, I realized we’d likely be fine even if that worst-case scenario came to pass.”

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Take Heart, No Alternative and We Need to Talk.

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While at Home

WHEN THE COLLEGE where I work switched to a remote learning platform for the remainder of the academic year, I suddenly found myself out of work. The majority of my job responsibilities revolve around preparing laboratory classes for students—students who are no longer on campus.

Thankfully, I’m still receiving a paycheck, but only time will tell whether I’ll be furloughed or have my hours cut back like so many other employees at colleges and universities. In the meantime, spending most of my time at home has given me the chance to tackle several personal finance projects—including these four:

1. Preparing legal documents. Getting my will updated had been on my to-do list since I remarried in 2018. By subscribing to an online legal service, my husband and I were able to create several legal forms quickly and easily. Our goal was simple: create a set of documents allowing us to avoid costly probate proceedings upon our death.

During the first night of our estate-planning project, we created three transfer-on-death deeds, one for each of the homes we own. For less than $400, we were able to create the deeds, have them notarized and file them with the county recorder’s offices in each of the states where we have a residence.

Next up were wills. Our finances are relatively straightforward, so we were able to create simple wills specifying how our assets should be dealt with upon our death. We also made sure the beneficiaries on our retirement accounts and life insurance were up to date, as well as making a list of personal property and specifying how it should be divided up among family members.

2. Organizing financial papers. Using a high-speed scanner, I digitized the tax returns, retirement account statements and mortgage documents we’d accumulated over the past decade. Purging huge piles of paper from our filing cabinet felt good and made me feel productive at a time when productivity feels like it’s at an all-time low.

I also took photos of the credit and debit cards in my wallet. In the event my wallet is stolen, I’ll know exactly who to contact about cancelling my accounts. And after finding out I’d been part of a financial website’s security breach, I enrolled in an identity-theft monitoring program so I’ll be alerted if my personal information is compromised again.

3. Coping with financial uncertainty. Three weeks before our state’s mandatory stay-at-home order was issued, my personal net worth hit a record high. My financial anxiety was low and I felt good about my prospects for retiring early. As I watched my net worth plummet in the month that followed, I spent several nights awake worrying about my job and overall financial health.

Amid all my nervousness, I sat down and started to write out a worst-case scenario. A scenario that found me unemployed. A scenario where my husband and I had no income from our rental house. And when I looked at our accounts, our assets and our lifestyle, I realized we’d likely be fine even if that worst-case scenario came to pass. There’s no doubt our lifestyle would need to be adjusted, but we wouldn’t find ourselves bankrupt overnight, either.

I was able to pause and reflect that, as bad as the economy was just over a decade ago, it bounced back. I made the decision to increase the amount of money I contribute toward retirement, something I didn’t do during the Great Recession.

4. Getting a puppy. Adding a German shepherd to our family certainly wasn’t a planned financial move—and I know it’ll add to our expenses at a difficult time. It has, however, been a decision we haven’t regretted. Having a new puppy to train has helped make the pandemic stay-at-home orders more bearable. Most important, it’s provided me with a much-needed distraction from checking the news and the stock market’s performance throughout the day.

Kristine Hayes is a departmental manager at a small, liberal arts college. Her previous articles include Attitude Adjustment, Few Absolutes and Why FI. Kristine enjoys competitive pistol shooting and hanging out with her husband and their dogs.

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Give Me Five

ARE YOU PLANNING to withdraw funds from your Roth IRA? If you aren’t careful, you could owe both taxes and penalties, even though you’ve already paid taxes on the money that went into the Roth. At issue: the IRS’s five-year rule. How do you sidestep its unpleasant consequences? Bear with me while I explain.

First, a word of caution: You don’t have to take distributions from your Roth IRA during your lifetime. Withdrawals are strictly up to you. Indeed, it’s a good idea to keep assets in your Roth for as long as possible, so you enjoy a long period of tax-free growth. The five-year rule encourages you to do just that.

The rule states that, to avoid income taxes and penalties, you must keep certain assets in your Roth IRA for at least five years. The five-year period is based on calendar years. The clock starts on Jan. 1 regardless of whether you funded your Roth on Jan. 1 or Dec. 31 of that year. For example, if you made a contribution or a conversion on Dec. 31, you only need to wait just over four years.

Your Roth IRA might contain regular annual contributions and conversions from a traditional IRA, as well as the subsequent investment gains earned on these dollars. Think of these as three distinct buckets of money. The five-year rule states that these three buckets come out of your account in a particular sequence—one that actually benefits you.

Regular annual contributions are deemed to come out of the account first. There are no income taxes owed when you pull out your original Roth contributions, because you’ve already paid income taxes on this money. There are also no penalties. The upshot: Contributions may be withdrawn at any time by anyone, including those under age 59½, at no tax cost.

Converted amounts, if any, are deemed to be distributed next. Again, there are no income taxes on converted amounts, because you’ve already paid taxes on these dollars. Conversions may be withdrawn at any time by anyone with no income tax cost, including by folks under 59½. A 10% early withdrawal penalty, however, may apply if you’re under 59½.

The purpose of the 10% penalty is to prevent the under-59½ crowd from using Roth conversions to circumvent the 10% early withdrawal penalty that applies to traditional IRAs. The worry: Folks would convert a traditional IRA to a Roth, simply so they could immediately pull the money out penalty-free.

Still, even if you’re under 59½, there are three ways to avoid the 10% penalty. First, you could leave converted amounts in your Roth for at least five years. Second, money can be withdrawn penalty-free if the distribution is due to your death or disability. Finally, you can avoid the penalty if you use the distribution for what the IRS calls a “qualified purpose.” Those exceptions include a qualified first-time home purchase, qualified medical expenses, health insurance premiums while unemployed and qualified higher education expenses.

That brings us to the third bucket: the account’s investment gains. These earnings are deemed to be distributed last and potentially face the most onerous tax consequences, including both income taxes and a 10% early withdrawal penalty. How do you avoid that one-two punch? The rules are complicated, but much hinges on your age.

To avoid both income taxes and tax penalties on your Roth’s investment gains, you can’t withdraw these earnings until you meet the five-year requirement—and you typically have to be over age 59½.

What if you are indeed over 59½? You won’t be charged the 10% tax penalty. But you could still get hit with income taxes if it’s been less than five years. In most cases, however, that won’t be a problem—because, before you start withdrawing your Roth’s investment earnings, you’ll be pulling out the other two buckets of money: your original contributions and any conversion amounts.

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 article was To Roth or Not.

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In and Out

DID I GET SPOOKED? Or did I respond rationally? Possibly a little of both. After buying as the stock market plunged from its Feb. 19 peak, I sold shares into the rally from the March 23 low, though my portfolio remains strongly tilted toward stocks.

Waving the caution flag may even turn out to be the right call over the short term. Still, most of us—me included—shouldn’t be in the business of making market calls, especially not short-term ones. We have no benchmark to beat, no cable TV time slot to fill. Besides, my batting average with predictions is about .000. Where’s that designated hitter when you need him?

I had a perfectly laid plan, formed late last year, to use market weakness to increase my target weight for stocks. And without much ado, I executed it by early April. I decided that a 76% stock allocation—up from the 72% target I’d been working with for a couple of years—was appropriate for my risk tolerance, especially because I had 10 more years of retirement savings ahead of me, plus my future Social Security benefit.

But at 76% and with stocks roaring back, I quickly began to feel overexposed. Subsequent trades—including turning a quick profit, realizing a long-term loss, and switching more into bonds and conservative target-date funds—have lowered my portfolio’s stock position. The net result is that I made a little money from all the mayhem, but not really enough to justify the effort. What drove my selling? There were three stress factors:

I had long planned to buy opportunistically on a significant market pullback. But it proved more taxing than I expected. Because there were such big market moves in March and April, I found myself glued to my cell phone, my office chair and my computer screen, often from early in the morning, as I read news and commentary, followed market moves and pondered my portfolio options. My game face was always on and my finger on the trigger. I never relaxed.
I came to believe a couple of scary narratives: that the impact of the pandemic would be much worse than investors expect and that the big bounce off the lows was too good to be true.
I decided I couldn’t take as much risk with my retirement savings, for two reasons. First, my employer eliminated the 401(k) match for the rest of the year, which means I have less wiggle room in hitting my target nest egg. Second, my job has become less secure, because my company is heavily dependent on a resumption of face-to-face meetings.

After my selling and repositioning, I now have more in high-quality bond exchange-traded funds—including intermediate Treasurys and Treasury inflation-protected bonds—and less in emerging stock markets. But I haven’t tied a neat bow on my recent moves.

One lingering question: What’s my new target allocation to stocks? I thought of establishing a target range, but that’s fraught with problems. Say I have a range of 70% to 80%, within which I pick a point periodically, depending on my sense of the risks and opportunities in the market. The good part is, the lower bound keeps me mostly in the stock market. The bad part is, the decision-making can be never ending if you’re inclined to portfolio meddling, which I’ve proved to be.

The other lingering question: Should I decouple my taxable account from my retirement accounts? Up until now, I’ve managed them as a single portfolio. But I’ve been reducing the stock market exposure in my taxable account, down from about half stocks to one third. Why? Given that I might need the money for a prolonged period of unemployment, I don’t feel I can take as much risk with my taxable money as I did prior to the pandemic.

William Ehart is a journalist in the Washington, D.C., area. Bill’s previous articles for HumbleDollar include April Fool, Different This Time and Luck of the Irish . 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 .

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A Poisoned Chalice

DUTCH DISEASE. Sound like something that might devastate your garden? In truth, it’s an economic term coined in by The Economist magazine in 1977—and it refers to the economic fallout that followed the 1959 discovery in the Netherlands of Europe’s largest natural gas field.

The natural resource was initially a great boon to the economy, causing the value of the Dutch currency—then the guilder—to rise sharply in the foreign exchange market. All good? Not exactly.

There were many other Dutch industries, from machinery to cheese, that suffered. Their products became too expensive to compete in foreign markets, thanks to the strong guilder. Around the world, buyers turned to substitute suppliers from other countries. The longer-term effect of the Netherlands’ singular focus on its natural resource “boon” was a rise in Dutch unemployment from 1.1% to 5.1% and a decrease in capital investment.

If extreme enough, the Dutch disease can help bring down entire empires. The influx of gold and silver into Spain’s economy in the 16th and 17th centuries helped create the first worldwide empire where the sun “never set.” Problem is, the diversion of so much of the Spanish imperial attention to extracting these natural resources, coupled with the dedication of an inordinate amount of the nation’s economic resources to producing silver goods, caused a rise in the value of Spain’s currency. Result: All other industries suffered, including the bedrock export of Merino wool. English wool was not as good, but it was cheaper and buyers switched.

What’s the lesson of all this? For nations, there’s a need to balance their country’s business output and develop a well-rounded economy, rather than focusing solely on one booming sector. In addition, countries should keep a watchful eye on their currency’s foreign exchange value to make sure it doesn’t become overvalued.

But I think there’s also a lesson here for individuals.

Our “natural resource” is our talents, which we use in our jobs. In return for our industriousness, we might earn a salary, commissions, bonuses and other compensation. Many folks will commit almost every waking hour to their career, with an eye to extracting the biggest reward they can. This rising compensation increases the value of an individual’s ultimate currency, which is his or her time.

So who loses? The parts of a person’s life that can no longer afford that currency. An executive’s family, friends, the executive’s physical health and even the executive’s mental health may suffer, as he or she cuts back on relaxation or is present at events in body but not in mind.

These other activities may not seem as immediately profitable. In the busy executive’s calculus, they might become secondary to what can yield a more immediate and tangible profit. Meanwhile, the people who cannot afford the executive’s time may seek out alternative suppliers of time and attention. One does need to be religious to see the wisdom of the Bible’s rhetorical question, “For what will it profit them to gain the whole world and forfeit their life?”

Just like a nation, it’s incumbent on each of us to achieve a balanced personal economy, with attention, care and time devoted to all the things that give us value, both tangible and intangible—rather than focusing solely on the things that promise the largest short-term reward.

Jim Wasserman is a former business litigation attorney who taught economics and humanities for 20 years. His previous articles include Falling for Flattery, Buying Power and Weighty Decisions. Jim is the author of a three-book series on teaching behavioral economics and media literacy,  Media, Marketing, and Me. His latest book is Summa, a children’s story for multiracial, multi-ethnic and multicultural families. Jim lives in Granada, Spain, with his wife and fellow HumbleDollar contributor, Jiab. Together, they write a blog on retirement, finance and living abroad at YourThirdLife.com.

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