Jonathan Clements's Blog, page 325

Getting Back In

WORKING ON a trading floor has its perks—or, at least, it did back when we were all in the office, instead of toiling away from home. The trading floor where I work is small, but it still houses perhaps 50 people.

As you’d expect, we have TVs all around, tuned to CNBC, Bloomberg and—my personal favorite—The Weather Channel. My colleagues often talk stocks and portfolios. What’s neat is you get a good sense of investor sentiment being out on the floor and among finance folks who are geared to day-to-day market movements.

But even though I haven’t been on the trading floor for a few months, it’s easy to sense that many people are cautious—fearful of the next shoe to drop or that we’ll “retest the lows”—and so they’re holding more cash than they want. If you’re in that camp, you shouldn’t beat yourself up about it. But you need a strategy for getting back in.

One thing I’ve learned about investing: We should always have a plan for what we’ll do if we’re right and—more important—if we’re wrong. It’s the latter situation that a lot of people are unprepared for.

Are you one of those investors sitting with cash on the sidelines and you realize you should put some or all of it into stocks? You’ve probably heard this before: We hate losses 2½ times as much as we enjoy gains. Regret is an emotion we constantly seek to minimize. With that in mind, here are five strategies that I use when putting money to work in the stock market:

1. Run the numbers—and then just do it. I check my personal asset allocation to see where I’m underweight and then, during the trading day, I’ll do some buying if it feels like a good moment to invest. The hard part for me is pulling the trigger, so I’m okay being a little impulsive about when I buy.

2. Use mutual funds, not ETFs. Exchange-traded index funds, which can be bought and sold throughout the trading day, seem to be all the rage right now. But the beauty of mutual funds is you can run your numbers, place your buy orders quietly on the weekend and wait for your order to be executed at Monday’s 4 p.m. ET market close, rather than dealing with the stress of entering a market or limit order during the hectic trading day.

3. Seize the opportunity. With regret minimization in mind, a strategy you might employ is “reverse” asset location—and then fix your asset allocation along the way. With bond yields low and the pullback in many stock market sectors (U.S. large cap growth not so much), you might revamp your portfolio to hold stocks in tax-sheltered accounts and bonds in taxable accounts. My thinking: Bonds will produce little taxable income, so there’s not much tax cost to holding them in a taxable account. Meanwhile, stocks may generate far more capital appreciation now that valuations are lower, so keeping them in a retirement account could be a smart move.

4. Start from scratch. A way to combat “status quo bias” is to ask yourself, “If I were starting out, would I buy the portfolio I own today?” Often the answer is “no.” Consider the current pullback a chance to rid yourself of investments you no longer want to hold. An added bonus: With share prices down sharply, there may be little tax cost to selling these positions—and you might even generate losses that’ll reduce your 2020 tax bill. I’ve been doing some of this.

5. Play the long game. If you’re like me, when you buy an ETF, do you check how it’s doing later that trading day and in the days that follow? This, of course, is completely irrational. I bought the ETF to pay for retirement and yet I’m checking on it after a couple of days to see how my decision panned out. Yes, it’s scary to buy when we know stocks could drop sharply. But the fact is, I’m in my early 30s. I likely won’t touch my portfolio for 30 years or more. Whether I deploy a little cash today, or when prices are 20% higher or lower, hardly matters.

Mike Zaccardi is a portfolio manager at an energy trading firm and a finance instructor at the University of North Florida. He also works as a consultant to financial advisors on an hourly basis, helping with portfolio analysis and financial planning. Mike is a Chartered Financial Analyst and Chartered Market Technician, and has passed the coursework for the Certified Financial Planner program. His previous articles include Riding the Bear, Stepping Up and Where’s My Refund. Follow Mike on Twitter @MikeZaccardi, connect with him via LinkedIn and email him at MikeCZaccardi@gmail.com.

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A World of Problems

WITH EVERYTHING that’s been going on recently, one story that’s received less attention is the ongoing spat between the White House and the board of the Thrift Savings Plan (TSP). As of a few days ago, there had been a ceasefire in the debate, but it isn’t over. It’s worth understanding what’s at stake—because the underlying issue has been a recurring theme in the investment industry.

If you aren’t familiar with the TSP, it’s one of the retirement plans available to federal government workers. In lots of ways, it’s similar to a private sector 401(k). It allows employees to contribute part of each paycheck. The government also makes contributions. Employees can choose from a menu of investment options.

The current debate centers on a proposed change to one of those investment options, called the I Fund, which—as you might guess—invests in international stocks. Currently, the I Fund tracks the MSCI Europe, Australasia and Far East index. But a few years ago, the TSP proposed shifting to a new index called MSCI ACWI ex USA Investable Market index.

While these names might sound similar, there’s a big difference: The old index was limited to major developed economies, including France, Germany, Japan and Australia. Meanwhile, the new index also includes stocks from 26 emerging markets countries, including Russia, Indonesia and China. To implement this change, the I Fund would have to sell a substantial share of its existing developed markets holdings so it could purchase these new emerging markets holdings.

As you might imagine, it’s the addition of China that the administration opposes. But from an investor’s perspective, this is about more than politics. To be sure, I don’t love the Beijing government and that’s a valid reason to oppose this change. Opposition, in fact, has been bipartisan. But the concern I want to address here centers on the investment impact.

To explain my concern, let me first provide some background: People often laud the merits of index funds—for good reason. Year after year, studies show that most actively managed funds lag behind their benchmarks. As a result, many investors now take it on faith that index funds are the better choice. For the most part, I agree.

Unfortunately, index providers are businesses too—big businesses, in fact—and have their own motivations that sometimes put them at odds with the interests of investors. Last year, for example, index provider MSCI made a dramatic change to its Emerging Markets index, boosting its allocation to Chinese stocks. Unlike the I Fund, this index already included Chinese stocks, but this decision increased their representation substantially. Two years ago, China accounted for less than 30% of that index. Today that number is nearly 40% and MSCI has said that it may increase further.

To be clear, the composition of indexes changes all the time, as constituent stocks rise or fall in value. But the change MSCI made last year was different. This was a subjective policy change—like Coca-Cola changing its recipe. Some, including The Wall Street Journal, have argued that MSCI made these changes to suit its own business purposes and not for valid investment reasons. Whatever the explanation, I called it out at the time because of the negative impact on investors in terms of both diversification and taxes.

Indeed, whether its MSCI’s change last year or the TSP’s proposed change, in both cases the governing bodies are imposing big changes on existing shareholders without giving them a chance to vote or the opportunity to opt out. On the TSP website, there’s just a small, innocuous-looking link that reads “Investment benchmark update,” but no option to remain with the old investment strategy. I asked one TSP participant, who is an I Fund shareholder, whether he had received any communication about the change. His response: “Zip nada nil.”

To be sure, the TSP board believes that changing the I Fund in this way will benefit shareholders. “Moving to the new benchmark could improve the expected return and diminish the expected risk for participants,” writes Michael Kennedy, chair of the TSP’s investment board. But that’s merely his opinion. It may be an informed opinion, but in the world of investments there are no guarantees.

In my view, it isn’t right to pull the rug out from under existing shareholders in this way after they’ve already chosen a fund to fill a specific role in their portfolio. This is especially true since there’s such an easy alternative: The TSP could simply create a new fund for investors who want to add emerging markets exposure. That’s very common in other retirement plans. Similarly, MSCI could create a new index for those who preferred a heavier weighting of Chinese stocks in their portfolios.

For now, the TSP board has put the change on hold—and that’s a good thing. But let’s face it: The outcry is only happening because of the TSP’s high profile as a government program with five million participants. In many cases, changes like this sail right through without anyone noticing or objecting.

The lesson: As an individual investor, you can’t take anything for granted. While index funds have a good—and well-earned—reputation, that doesn’t mean they’re infallible. Always be sure to look under the hood of a prospective new investment by checking the fund company’s website. And make it a practice periodically to review existing investments to make sure no one has quietly substituted New Coke in place of the old. 

Adam M. Grossman’s previous articles include Thinking It Through, Regrettable Behavior and Defending Yourself. 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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Take Heart

THIS SHALL PASS—just not as quickly as any of us would like.

I’m talking about the bear market, but the same sentiment applies to both the coronavirus and the economic slowdown. Indeed, the three are inextricably entwined, with share prices the twitchy indicator that tells us the mood of the moment.

Amid the swirl of news—the latest fatality count, the unemployment claims, the Dow’s daily action—it’s easy to get unnerved and start second-guessing our investment strategy. How can we keep ourselves on the stock market train? Here are four thoughts that I find comforting:

1. We all know it’s bad. The number of COVID-19 deaths has been horrifying, and the forecasts even more so. We’ve also had frightening reports about new jobless claims and the unemployment rate, and every expectation that things will remain grim for many months.

And yet, confronted with all this terrible news, the S&P 500 fell just 34% from peak to trough. That’s far less than the 2000-02’s 49% decline and 2007-09’s 57% plunge. Moreover, since the stock market touched bottom on March 23, it’s recouped more than half of its 34% loss.

How can that possibly be justified? The harsh truth: Investors collectively don’t care about the suffering of everyday citizens, whether here or abroad. Instead, what they care about is corporate earnings and—to judge by the market’s recent performance—investors seem to believe those earnings will recover fairly quickly.

2. Nobody’s perfect. We have just one past, but we face all kinds of possible futures—and we don’t know which one we’ll get. Investors are collectively betting that corporate profits will speedily rebound. But they may be wrong.

My advice: We should manage our portfolios as if we’re profoundly ignorant about the future. That means we shouldn’t put money into stocks that we’ll need to spend in the next five years, lest this decline drags on far longer than imagined. We also shouldn’t bet heavily on any one part of the global stock market, because we don’t know which stocks will shine in the years ahead—and which may never recover from the current economic shutdown.

This measured approach comes at a price: We will be at least partially wrong. We might hold too much in bonds and cash, while also owning parts of the global stock market that generate atrocious performance. But this should not perturb us. Remember, we don’t know which future we will get, so we should build a portfolio where we’ll fare okay, no matter what the months and years ahead bring.

3. Opportunities abound. Even though the S&P 500 is just 15% below its all-time high, many parts of the global stock market are down much more, including smaller U.S. companies, emerging markets and developed foreign markets. The upshot: If investors have cash to put to work in stocks, or they haven’t yet rebalanced their portfolio, there’s still an opportunity to buy shares at reasonable prices.

I would also ponder three other opportunities. First, if you have investments in your taxable account that are below your cost basis, consider taking tax losses. Those losses can be used to offset realized capital gains and up to $3,000 in ordinary income—and any unused losses can be carried over to future years.

Second, consider converting part of your traditional IRA to a Roth IRA. At today’s stock prices, you can convert a larger percentage of your traditional IRA—compared to three months ago—and pay the same tax bill. And, to the extent that today’s depressed prices set us up for higher future returns, those gains in the Roth will be tax-free.

Third, look into refinancing your mortgage. If you have other debt that carries a higher interest rate, you might borrow extra through the refinancing and use the money to pay off this higher-cost debt.

4. It’s not if, but when. Eventually, we will almost certainly have both an effective treatment and a vaccine for the coronavirus. The economy will eventually recover. And those positive developments will be heralded by the stock market returning to new highs.

Yes, there is uncertainty—but the uncertainty isn’t so much about whether all this will happen, but when. As I see it, if investors own a globally diversified stock portfolio, that’s the big risk. Will the recovery take a year, three years or perhaps longer? Given the higher return offered by stocks, a modest delay seems like a small price to pay.

Latest Articles

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

Every investor makes foolish choices, even those who ought to know better. Want to improve your decision-making? Marc Bisbal Arias uses a three-step process.
Determined to avoid student loans, Morgen Henderson worked two jobs in college. Her epiphany: Sometimes, going into debt is the smart strategy.
Should you convert your traditional IRA to a Roth IRA? To find out, take a few minutes to answer Rick Moberg’s five questions.
We all make financial mistakes. Dick Quinn lists 10 of his more memorable decisions.
“There was one thing I did right: I was automatically investing part of every paycheck,” recalls Brian White. “At the time, I didn’t know what dollar-cost averaging was. But I was doing it nonetheless.”
Want to make better financial choices amid all of today’s uncertainty? Adam Grossman offers 10 strategies.

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

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The post Take Heart appeared first on HumbleDollar.

Rookie Mistakes

I LIKE TO THINK of myself today as a pretty savvy investor. But I wasn’t savvy when I started out. Despite attending business school and earning a master’s degree in computer science, I knew nothing about managing money or saving for retirement, so I initially made a number of blunders—but also one particularly lucky choice.

My first real job after college was in 1987, as a systems programmer for the University of North Carolina in Chapel Hill. In my first year, I figured I should put away some money for retirement. I started investing through the 457 plan offered by the North Carolina retirement system. That turned out to be a fortuitous choice because, for years, North Carolina had promised its employees that the state wouldn’t tax their retirement savings.

Then, in 1989, the state reversed its position, and decided to start taxing state employee pensions and retirement savings. A 1995 court decision, however, ruled that North Carolina couldn’t tax either the pensions of employees who were already vested—or the retirement accounts of employees who had retirement accounts as of 1989, which included me. While my initial investment in the 457 wasn’t a great moneymaker, it meant I had my foot in the door.

Since then, the plan’s fund choices have improved and, as an added bonus, I can now roll money into this account and thereby avoid paying North Carolina state income tax on it. This has worked out great for me, but I can’t take credit for it. It was sheer luck.

Of course, I made many mistakes along the way, too. In addition to the 457 plan, I put money into a 403(b) plan offered through the university. The plan included a variety of mutual funds. My first big mistake was looking at various investing magazines for tips on which funds to pick. I compared fund performance over time and ignored fund expenses, since that’s what the magazines did.

The magazines focused on currently hot fund managers, which suggested there were people out there who knew a lot more than I did and could beat the market by making clever stock picks. I wound up with several funds that invested in very similar things, mostly large-cap stocks with a few small- and mid-cap stocks thrown in. There was no mention of index funds and, in any case, back then they weren’t among the investment options.

The worst mistake I made was listening to the pitch from a mutual fund salesman. He worked for one of the companies through which university employees could invest. He convinced me to move a good chunk of my investments into several American Funds. At that time, the funds had 5% front-end sales loads. Sure, they had performed pretty well compared to whatever benchmarks were used. But I don’t recall that 5% off the top getting figured into the comparison.

Other mistakes I made involved what I wasn’t doing—not considering my goals or asset allocation (or even knowing what that was), not having an investment plan, not rebalancing and not consciously diversifying. Fortunately, it was early on, with a relatively small amount invested, and I didn’t lose too much money in the process.

With all that, there was one thing I did right: I was automatically investing part of every paycheck. At the time, I didn’t know what dollar-cost averaging was. But I was doing it nonetheless. I was saving regularly without watching the market. Yes, I could have done better. But I could also have done a whole lot worse.

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. He 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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Despite Myself

I OFTEN BLOG about mistakes I’ve made. Why change now? Looking back over my 76 years and the many poor money decisions I’ve made, it’s a wonder I’m in better financial shape than the Social Security trust fund—and yet I am. Here are 10 of my more memorable decisions:

In 1961, when I started working at age 18, I got hooked on the stock market. With little money and earning a bit more than minimum wage, I focused on penny stocks, hoping for that big killing. I’m still hoping.
College was never mentioned in my family. Around 1964 and still an office clerk, I realized I was going nowhere without a degree, so I enrolled in night courses. Before earning credits, I was required to take two years of courses I hadn’t had in high school. After one semester, I quit. I enrolled again in 1969, after a stint in the army. It took me nine years at night, while my wife and I raised four children—with her doing most of the work. Not the best way to get an important piece of paper. College was paid for by the Department of Veterans Affairs, employer benefits and me.
My wife and I married 10 months after our first date, much to the consternation of my parents. During eight of those months, I was away in the army. The following year—with me still in the army—was one of significant financial stress. I was based in Alabama and my wife was on her own in New Jersey. I was trying to send home a little money each month, which meant I barely had enough to telephone my new wife every few days.
We became pregnant a month after I got out of the army. My wife stopped working and didn’t return to part-time work until our youngest child was in high school. That meant even more financial stress.
Even before we were married, my financial planning faltered. In June 1968, I was home on leave. Anticipating the need to buy an engagement ring, I sold some stock at a loss of $7.50 a share. But the jeweler told me not to pay until September, when I was next on leave. By then, I could have paid for the ring with the profits from the stock I no longer owned.
In part because of my own college experience, I told my children they could go to any college where they were accepted. Did I mention the four are five years apart? The net result was one, two or three kids in private college for the next 10 years. In 1988, my oldest entered a five-year program at Carnegie Mellon with an annual cost of $40,000, figured in 2020 dollars.
My strategy for paying college costs was blind faith. First, I borrowed from my 401(k) and quickly decided that was a bad idea. Next up: depleting some modest mutual fund assets. Then I began writing monthly checks on a variable interest rate home equity loan. The first time the interest rate increased, I panicked, rushing to remortgage the house at a fixed rate of 9.75%. To help pay for all this, I started a very small side business updating people on employee benefits—something akin to the blog I write today.
Fulfilling a dream added to my financially hazardous moves: In April 1987, the year before college expenses started, I bought a vacation home on Cape Cod. Yup, that’s what I would call an irresponsible move. But, between renting it most of the summer and the tax advantages of doing so, it worked out.
I’ve written about my latest near fiasco: Simply put, to buy our new condo, I took out a large short-term mortgage at 5.37% that turned out to be not so short.
This one hasn’t materialized yet, but I’m thinking it may have something to do with being confined at home and my growing skill at online shopping. The upshot: There’s a new grill is on its way, along with an array of steaks from Omaha.

Amazingly, over six decades, it’s all worked out. What could have been several disasters weren’t. Unfortunately, many people aren’t so lucky with such risky financial moves, so I don’t recommend the Quinn strategy.

My comfortable retirement is not the result of FIRE-level savings and certainly not the result of exceptionally skilled investing. Rather, I attribute it to working for the same company for nearly 50 years, vesting in a defined benefit pension and accumulating a 401(k)—a trifecta that’s a near impossibility in the 21st century. Oh yes, that plus being frugal or, as my spouse would say, cheap.

Richard Quinn blogs at QuinnsCommentary.com. Before retiring in 2010, Dick was a compensation and benefits executive. His previous articles include Battle Over Benefits, Side Effects and How Not to Move. Follow Dick on Twitter @QuinnsComments.

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To Roth or Not?

SHOULD YOU CONVERT your traditional IRA to a Roth IRA? Below, you’ll find five questions to help you decide. If you answer “yes” to the first three questions, you’re a good candidate for a Roth conversion. If you answer “yes” to all five questions, you’re an outstanding candidate.

Question No. 1: Are you taxed at lower rates today than you will be in future?

Roth conversions make sense if your federal and state tax rates today are below what they’ll likely be when you have to take required minimum distributions (RMDs) from your traditional IRA. Conversions present a tax arbitrage opportunity—paying income taxes today to avoid paying higher taxes later. Here are three common scenarios where converting can be attractive.

First, you’re in the conversion “sweet spot.” This sweet spot begins when you retire and ends when you must take RMDs from your traditional IRA. Tax rates can be lower during this stretch because you have no income from employment, Social Security and traditional IRA RMDs. Once you turn age 72, income from Social Security, traditional IRA RMDs, investments and pensions may push you into higher tax brackets.

Second, you plan to leave a large traditional IRA to your heirs. Your non-spousal heirs will have 10 years to empty an inherited traditional IRA. They may have to pay significant income taxes on your traditional IRA, especially if they’re in their peak earnings years when they draw down the account—and thus the taxable IRA withdrawals are on top of their own taxable income.

Third, converting can be attractive if it’s a favorable tax environment—like we’re enjoying right now. The Tax Cuts and Jobs Act of 2017 reduced the number of federal tax brackets and lowered individual tax rates. The law is scheduled to sunset at year-end 2025. While it’s impossible to predict what will happen to tax rates then, folks with large traditional IRAs should consider converting now in case today’s low tax rates disappear.

Question No. 2: Can you hold Roth assets for a long time?

Conversions are more attractive if you can leave converted assets in a Roth for as long as legally possible. More time means more tax-free earnings growth. Folks who intend to leave Roth assets to their heirs make the best conversion candidates, because tax-free earnings growth can occur over their remaining lifetimes, plus up to 10 years after their deaths.

Meanwhile, people who must withdraw Roth assets to fund their retirement are in a tougher spot, because their tax-free earnings growth may be limited. For these folks, conversions may not make sense.

Question No. 3: Can you pay conversion taxes from a taxable account?

Conversions are more attractive if you can pay taxes from a taxable account, rather than covering the tax bill with funds from your traditional IRA. Why? There are two reasons. It’s a little complicated but bear with me while I explain.

First, if you pay the conversion taxes with a withdrawal from your traditional IRA, you must pull enough money from the traditional IRA not only to make the conversion, but also to pay taxes, which includes taxes on the amount you withdrew to pay taxes. Got that?

Let’s say you converted $100,000 to a Roth and your tax rate was 25%, so the tax on the $100,000 conversion would be $25,000. But if you’re paying the conversion tax from your traditional IRA, you would need to withdraw $133,333—not $125,000, as you might assume. The reason: The extra $8,333 is needed to pay taxes on the $25,000 tax withdrawal. By contrast, if you paid taxes from a taxable account, you could convert $100,000 from your traditional IRA and pay $25,000 from your taxable account, effectively saving yourself $8,333 in taxes.

That brings us to the second benefit of using your taxable account to cover the tax bill: If you do that, you effectively move the money involved from your taxable account into your Roth, where it grows tax-free thereafter. To understand why, consider two scenarios.

In scenario No. 1, you distribute $100,000 from your traditional IRA and make a $75,000 conversion, using the remaining $25,000 to pay the conversion taxes. In scenario No. 2, you distribute $100,000 from your traditional IRA and make a $100,000 conversion, paying the $25,000 tax bill from your taxable account. In each case your traditional IRA declines by $100,000 and you pay the government $25,000. But in scenario No. 2, you wound up with an extra $25,000 in your Roth, because you paid the taxes from your taxable account. In effect, it’s like you made a $25,000 contribution to your Roth.

Question No. 4: Are you married?

Roth conversions can be attractive for married couples because the death of one spouse can have severe adverse tax consequences. Why? The surviving spouse must file taxes as a single individual. The survivor will almost certainly be pushed into higher tax brackets, which means traditional IRA distributions will be taxed at higher rates.

The problem is further exacerbated if both spouses have traditional IRAs, because the surviving spouse must take RMDs from his or her own traditional IRA, as well as from the deceased spouse’s IRA.

Question No. 5: Will your estate owe estate taxes?

Roth conversions may lower estate taxes if your estate will be subject to estate taxes. Estate taxes are levied on the value of an estate. Roth conversions reduce the value of an estate by “pre-paying” income taxes on traditional IRAs. In other words, the value of an estate will be lower if it includes after-tax Roth IRAs versus before-tax traditional IRAs.

Suppose Sandy, a Massachusetts resident, has an estate that’s subject to state, but not federal, estate taxes. If Sandy converted $2 million to a Roth during her lifetime and paid $600,000 of conversion income taxes, her estate would not be taxed on the $600,000. Since the top estate tax rate in Massachusetts is 16%, her estate would avoid that 16% tax on $600,000, equal to a state estate-tax savings of $96,000.

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.

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Saved by Borrowing

IN HIGH SCHOOL, I worked at a local roller-skating rink to save money for college. I calculated that, if I kept working at the same rate once I was in college, I could make it through my four-year degree without taking on any student loans.

I was determined to make it work.

In my freshman year, my plan started with a budget—and that budget included this simple edict: Spend the least amount possible on everything. The grocery store was reasonably close, so I would save on gas by walking. I didn’t go out to eat. I didn’t go to parties. Instead, I stayed home, stressing about how to pay for college.

I started working more—by this time I was a manager at the skating rink—and I also took on a second job at a bookstore. But that took a toll on my grades and further destroyed any chance of a social life. I was completely miserable. I wasn’t making friends, my grades were going downhill and I was always tired. I needed to find a better balance between saving money and leading a happy, fulfilling college life.

After much handwringing, I finally decided to take out student loans. One reason for my hesitation: I’d heard countless stories of people finally paying off their student debt in their 60s. But I concluded there was no reason to feel guilty about borrowing. Education loans are meant to help college students reach their goals without stretching themselves too thin.

Still, to avoid taking on too much debt, I was careful to distinguish between needs and wants—and only borrow for what I truly needed. I still worked jobs to cover basics such as housing, food and gas, while using student loans for tuition, fees and books. Cutting down on the hours I worked helped my overall health and my grades, but I still earned enough to avoid a lot of unnecessary debt.

I was also careful about the type of loans I used. If you have to borrow, the best loans are subsidized, meaning they don’t accrue interest until six months after you stop taking classes. I checked how much in subsidized loans I qualified for each year, and then borrowed as much as I needed. Meanwhile, I limited the amount of unsubsidized loans, where interest accrues immediately.

Even though I took out loans, I still strove to control my spending. I bought off-brand groceries, skipped some of my favorite streaming services, and exercised at home instead of buying a gym pass. But after my initial, excessive frugality, I also learned to cut myself some slack, buying a new item of clothing once in a while, treating myself at my favorite ice cream shop and seeing a movie every few weeks.

Where did all this leave me? I finished school with far less debt than many other students. Nonetheless, I was determined to get my loans paid off quickly, so I continued to keep a tight rein on my spending. Result? Nine months after graduation—and just three months after the end of the grace period for the subsidized loans—I was able to pay off all of my student debt in full.

Morgen Henderson is a writer from the beautiful mountains of Utah. Her previous article for HumbleDollar was Last Questions. When she’s not typing away at her computer, you can find her baking desserts and and watching an excessive number of travel shows. Follow Morgen on Twitter @Mo_Hendi.

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Setting Boundaries

HOW MANY TIMES have you found yourself doing things you don’t want to be doing? It might be binge-watching Netflix, eating junk food or mindlessly scrolling through your favorite app. This is something we all struggle with.

Investing is no different. The behaviors we should avoid are mostly clear, but it isn’t always easy to follow through.

I remember vividly the day I joined my first employer, Chicago-based investment researcher Morningstar, as an intern a few years ago. The first thing I was given was a handbook. “Here is all you need to know,” my manager said as he handed me a 1,000-plus page compilation of articles, studies and reports containing all the basics—and not so basics—about mutual funds and investing. Over the following months, I spent dozens of hours reading that handbook, absorbing as much as I possibly could.

That tome taught me a lot, and most of what I learned was about what not to do. “Avoid high fees.” “More often than not, low-cost index funds will outperform individual fund managers.” “Market timing doesn’t work.” “Past performance doesn’t guarantee or predict future returns.”

I repeated these sentences like a mantra and excitedly shared them with friends and family, hoping they’d make smarter investment decisions. But years later, once I had enough money to start investing myself, I didn’t adhere to the lessons I’d learned. Among my many mistakes: sitting in cash in 2016, waiting for a market correction, and not—until very recently—investing in low-cost index funds.

Why didn’t I follow what I enthusiastically recommended to my family and closest friends? A possible answer: It’s so tempting to do otherwise.

“Surely it will be a better time to invest after a 20% downturn,” I told myself. Except nobody knows when that’s going to happen.

“[Insert famous investor’s name] got a 100% return on [insert hot stock]. I’m going to invest in the latest stock he bought,” you might think.

The financial industry is filled with comparisons, so it’s easy to find people who are doing better and that creates an itch, that impulse to try to find the next tenbagger. We fall for the illusion that it’s easy to earn better-than-average returns and we go hunting for ways to do it—to our own detriment.

Being aware of our shortcomings is the first step toward overcoming them. The second is taking action. That’s why, in an effort to improve my financial decisions and avoid doing the things I know I shouldn’t be doing, I came up with three simple steps to help my future self.

Step No. 1: Automate my investing process, as well as set general guidelines for how much more to invest in stocks if the market falls a specific percentage. This helps me to avoid reacting emotionally and to be more disciplined.

Step No. 2: Create a checklist to aid me in assessing whether doing something makes sense. Two examples: “I am not making a rushed decision based on a hot tip” and “I am not investing just because everyone is talking about it.”

Step No. 3: Start a financial journal where I explain in detail the things I’m doing and why I’m doing them. It’s surprisingly easy to deceive ourselves, so this will serve as proof of my exact thoughts. As I objectively analyze ideas vs. outcomes, I’ll be better equipped to learn.

To be sure, some of the behaviors described above might not seem so bad. For instance, investing in a mutual fund is likely better than not investing at all, even if it’s not a low-cost index fund. Likewise, dollar-cost averaging—something I do—usually results in worse returns than investing right away, but investing gradually can still make more sense from a psychological standpoint.

The other day someone told me, “Thinking that I can successfully pick winning stocks on my own still haunts me.” It is indeed hard to stay course, but we must try and, in trying, we’ll probably be better off.

Marc Bisbal Arias holds a bachelor’s degree in business and economics,  and is a Level 1 candidate to become a Chartered Financial Analyst. He started his professional career at Morningstar, performing research and editorial tasks, and is currently employed by Dow Jones in Barcelona, Spain. Follow Marc on Twitter  @BAMarc .

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Thinking It Through

ON JAN. 10, 2000, America Online co-founder Steve Case stood on stage in New York to announce the largest corporate takeover in American history, buying venerable Time Warner for $165 billion. At the time, commentators called it the merger of the century. But just five years later, Case acknowledged that it was actually “the worst merger in history” and argued that it was time “to take it apart.”

Making financial decisions is difficult even in good times. But when we have a year like 2020, it’s that much harder. And yet it’s precisely at times like this that our financial choices may have the most impact. Here are just some of the questions I’ve been hearing in recent weeks:

Should I take advantage of the CARES Act provision that suspends student loan payments or should I continue paying since every dollar will now go toward principal?
Should I take advantage of today’s low interest rates to refinance to a 15-year mortgage—which will lower my rate but increase my payment—or should I prioritize holding onto cash?
Should I borrow to invest in my business, or should I just hunker down and try to make it through?
Should I buy more stocks while the market is down—or should I wait to see if it goes even lower?

What’s the best way to tackle questions like these? For some, the answer is to “run the numbers.” For others, the solution is to “trust your gut.” But both suggestions seem more like vague platitudes than true action plans. Fortunately, research has identified a number of tools and techniques to help us make better choices in the face of uncertainty. Here are 10 ideas that I find most useful:

As a former professional poker champion, Annie Duke knows a thing or two about making high-stakes decisions under pressure. In her book,  Thinking in Bets , Duke recommends “mental time travel.” The idea is to put yourself in the shoes of your future self and to try to envision the impact of the decision you’re considering. Imagine what the impact would be if it went well—and imagine if it went poorly. Then evaluate the effect on your financial well-being. While this sounds like commonsense, it’s important because everyone is different: Some of us are natural optimists, while others are pessimists. To counter both tendencies, we should force ourselves to consider the full range of outcomes.
Understand what kind of decision you’re dealing with. Specifically, you want to understand the payoff structure. With stocks, the downside risk is 100%, but the upside is unlimited. With bonds, both the upside and the downside are far more limited (most of the time). Meanwhile, stock options and startup investments are closer to lottery tickets: a very high likelihood of loss offset by a gigantic payoff if things work out. Investments in your home—in the form of renovations—or investments in a business partnership carry their own risk-reward structures.
Even when a decision doesn’t seem quantifiable, try to quantify it anyway. That’s the advice of J. Edward Russo and Paul Schoemaker in their book  Winning Decisions . For example, if you’re choosing between two houses, develop a simple scoring system, assigning points for location, price, school district and so on. Similarly, you could use this technique to choose among colleges, job offers or vacation destinations.
Duke recommends conducting a “pre-mortem” analysis. The idea here is to imagine that you’ve made a decision, it’s a year later and things have gone poorly. Now ask yourself why things went wrong. In other words, think rigorously about all the ways something could go wrong, no matter how unlikely. If you’ve ever bought a house and done a home inspection, that’s exactly the idea. Do a head-to-toe examination. Look under every rock for potential problems. Then ask yourself if there are ways to mitigate those risks in advance.
To the extent that a decision is emotional, Duke advocates journalist Suzy Welch’s 10-10-10 rule. This simple technique forces you to evaluate a decision by asking how you would feel about it in 10 minutes, 10 months and 10 years. This may help put things in perspective and can be especially helpful with investment decisions, where the time horizon is usually multiple decades.
A variation on the 10-10-10 idea is to conduct this thought experiment: Imagine the worst-case outcome for a decision. Now imagine that it had occurred a year ago and ask yourself whether you would still be feeling the impact. This is another way to put things in perspective.
Try taking your own temperature. If you feel yourself getting stressed as you consider a decision—Duke uses the term “on tilt”—take time to get on an even keel. Go for a walk or sleep on it. In fact, Benjamin Franklin, who invented the pro-con framework for decision-making, recommended taking several days to make any big decision.
If something is particularly difficult, enlist help. Bring in an accountant, a lawyer or some other trusted advisor to help shoulder the load. If something is too hard from an emotional perspective, you might even delegate it entirely. If you’re dealing with a business dispute or the IRS, or with something equally distasteful, hire someone to help with the negotiations. Not only will you sleep better, but also you might get a better outcome.
One underestimated way to get better results when making decisions: Get the timing right. While this may sound hokey, there’s a lot of research to show that you get better results when you align certain types of work with certain times of day—and this varies from person to person. This is known as our chronotype. If you understand yourself better in this way, you can use it to great advantage as you make decisions. In his book When , Daniel Pink describes this in detail.
Finally, Duke cautions against putting too much weight on our own experiences. Yes, it’s important to learn from our own successes and failures. But Duke rightly points out that we’re all working with a “sample size of one.” Because of luck, sometimes good decisions have a bad outcome, and vice versa. As she notes, “Decisions are bets on the future, and they aren’t ‘right’ or ‘wrong’ based on whether they turn out well on any particular iteration.” This advice is particularly applicable to financial decisions, where we’re often bedeviled by the twin biases of overconfidence and lack-of-confidence.

Adam M. Grossman’s previous articles include Regrettable Behavior, Defending Yourself and  As If . 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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No Alternative

IT’S A SCARY TIME to own stocks. But for long-term investors who want their portfolio to clock significant gains, there’s simply no alternative.

To be sure, you could throw in your lot with the market-timing crowd, who are currently hiding out in bonds and cash investments. Their plan: When we get the final climatic plunge in share prices that sends the market back to valuations not seen in four decades, they’ll swap into stocks and ride the next bull market to astonishing wealth.

But for the rest of us—who don’t have nearly as active a fantasy life—the best bet is to hang tough in stocks with the bulk of our long-term investment money. Why? Consider the three major asset classes.

Bonds pay nothing. When you buy a bond or bond fund, the best guide to your likely return is the current yield. Just purchased a 10-year Treasury note yielding 0.7%? If you sell before maturity, you might make more or less than 0.7% a year. Still, that 0.7% is the best guide to your future return.

If you opt for bonds of lower credit quality, you’ll get higher yields and that should translate to higher returns. But there’s also an increased risk of defaults, especially if you dabble in bonds deemed below investment grade.

Bond yields should bear some relationship to nominal GDP growth. Why? Corporations will only borrow if they think they can earn a return that’s greater than the interest rate they pay—and that return should, on average, bear some relationship to the rate of economic growth. As the economy recovers, so too will demand for borrowed money and that’ll likely drive interest rates higher.

Those higher interest rates will push down the price of existing bonds, so today’s bond investors could be in for a rough ride as the economy recovers. But it isn’t all gloom: Bond holders will be able to reinvest their interest payments, as well as any new savings, at those higher interest rates. Indeed, if your time horizon is similar or longer than your bond portfolio’s duration, rising interest rates should bolster your long-run return, thanks to that chance to reinvest at higher yields.

Cash is trash. While bond yields tend to track nominal economic growth, the yield on cash investments is more closely tied to inflation—or, at least, inflation as anticipated by the Federal Reserve. And right now, the Fed has no worries about inflation. Instead, its focus is on reviving the economy, which is why the Fed has cut short-term interest rates pretty much to zero.

That means minimal returns on savings accounts, money market funds and other cash investments. What about longer-term inflation? Based on the difference between the yield on 10-year Treasury notes and that on 10-year inflation-indexed Treasurys, investors expect around 1% annual inflation over the next 10 years. That’ll mean continued meager returns for cash investors.

Still, that shouldn’t surprise anyone. Even when yields on cash investments have been much higher, investors have almost always ended up losing money, once inflation and taxes have taken their toll.

Stocks for the long run. What will stocks return? I fall back on the admirably simple method favored by Vanguard Group founder John Bogle. To forecast the stock market’s “investment” return, Jack would add the S&P 500’s current dividend yield to expected growth in earnings per share.

Right now, the S&P 500 is yielding 2.1%. Meanwhile, over the next 10 years, nominal GDP might climb 4% a year—that’s what we got over the past 10 years—and it would be reasonable to assume that earnings per share will increase at a similar rate. Add those two together and we’d get the S&P 500 clocking just over 6% a year over the next decade.

To this “investment” return, we need to consider a third factor—what Jack called the market’s “speculative” return, as reflected in the rise or fall in the S&P 500’s price-earnings (P/E) multiple. Guessing what will happen to the market’s P/E ratio is always a dicey endeavor, and it’s especially dicey right now.

It isn’t just that investors seem to be terrified one moment and exuberant the next. On top of that, we’re likely to see P/E ratios soar in the short term, as the economic contraction slams corporate profits. We could also see significant dividend cuts. The key is to look beyond this short-term chaos and focus on the decade ahead. And if we do that, I think it’s reasonable to expect something close to that 6% a year investment return.

Could stocks also get a lift from rising P/E ratios? It’s possible. Today, the S&P 500 companies are trading at 21 times 2019’s reported earnings. That compares to a 50-year average P/E ratio of 19.4 times trailing 12-month reported earnings and a 25-year average of 25.1. But even without rising P/Es, notching 6% a year looks pretty attractive when you consider the alternative—next to nothing on both bonds and cash investments. Convinced? Keep these three points in mind:

Even if stocks are the best bet for the decade ahead, don’t ignore your risk tolerance and your near-term need for cash. Bailing out of stocks at the wrong time could devastate your wealth.
Stocks may deliver 6% a year, but your return might be far different—if you aren’t diversified. And the best way to get that broad diversification is (here he goes again) by owning a total U.S. stock market index fund and a total international stock market index fund or, alternatively, by purchasing a total world stock market index fund, such as those offered by State Street’s SPDR and Vanguard Group.
If you buy total market funds, you’ll enjoy rock-bottom annual investment costs. But don’t forget about the other big subtraction: taxes. With that in mind, trade sparingly in your taxable account, so you don’t trigger big capital gains tax bills, and make the most of the retirement accounts available to you.

Latest Articles

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

Medicare doesn’t cover all costs. What should retirees do? James McGlynn explores the ins and outs of Medigap policies and Medicare Advantage.
“In desperation, I rummaged through the freezer and found a fruitcake from 2018,” recounts Richard Quinn. “It was still tasty. Must be the rum.”
When you quit the workforce, should you also cancel your life insurance? Before you do, ask three questions, advises Dennis Ho.
“Since the fall of 2018, the stock market has dropped 20%, gained 30%, dropped 35% and then gained 30% again,” notes Adam Grossman. Result? Ample opportunity for investor regret.
The stock market’s recent performance can seem baffling, given all of the bad news. Dennis Friedman says there are five reasons for the disconnect.
Want to get the most out of your retirement accounts in 2020? Peter Mallouk lists seven things you should—and shouldn’t—do.
The formula for investment success is very simple: Buy stocks. Diversify broadly. Wait patiently.
What’s the future of Social Security? Richard Quinn takes a look at the great debate—and finds plenty of reasons to worry.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include We Need to Talk, Take It Away and Back to Basics.

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