Jonathan Clements's Blog, page 435

Lemons Into Lemonade

AROUND THIS TIME OF YEAR, financial advisors and the media start talking about taking tax losses. The notion: You sell underwater investments in your taxable account, and then use those realized capital losses to offset realized capital gains and up to $3,000 in ordinary income.

There’s nothing wrong with taking tax losses, though I think the notion is oversold. Unless you’re an active trader or a really bad investor, you probably won’t have any losses to take. Let’s say you hold a diversified portfolio. Within a few years, all of your investments should be above your cost basis—and, absent a huge bear market, you’ll never again get the chance to take tax losses.

Still, if you do have a losing investment in your taxable account to sell, the math can be impressive—especially if you don’t have any realized capital gains. Let’s say you have a $3,000 loss on your international stock-index fund. You realize the loss. Because you don’t have any realized gains, you can offset the loss against your ordinary income. If you’re in the 25% tax bracket, that would mean $750 in tax savings.

To maintain your foreign stock exposure, you immediately buy another international fund. You can’t buy the fund you just sold, or one that tracks the same market index, or you could run afoul of the so-called wash-sale rule. Instead, you purchase a fund that tracks a different international index. That fund then rebounds, so you make back your $3,000 loss. If you held the fund for more than a year and then sold, your gain would be taxed at the 15% long-term capital gains rate, assuming you’re still in the 25% income-tax bracket. Result: You’d pay $450 in taxes, or $300 less than your earlier tax savings.

Better still, you’d hang on to the fund, so the tax bill is delayed, allowing you to use the money earmarked for Uncle Sam to earn additional gains. Even better, you might bequeath the fund to your kids—at which point the capital-gains tax bill would disappear.

The Two Financial Numbers You Need to Know

WHAT’S THE STATE of your financial health? Forget your credit score, the past year’s handsome increase in your home’s value or how your salary compares to your brother-in-law’s. In the end, financial fitness comes down to two key numbers.

First, there’s your net worth, which is the value of your assets minus your debts. There’s some debate about what should be included. The easy answer: Don’t delude yourself by counting the value of your car, furniture or Beanie Babies collection.

More contentious: I probably wouldn’t include your primary residence, unless you’re committed to tapping home equity in retirement, either by trading down to a smaller house or taking out a reverse mortgage. Instead, when counting assets, I’d stick with true investments, such as rental properties and money in bank and investment accounts.

Even more contentious: If you aren’t adding in your home’s value, maybe you also shouldn’t subtract any outstanding mortgage debt or, if you do, you should include a mental asterisk. Why the asterisk? If folks go from renter to owner, their net worth would immediately plunge if we ignored their home’s value but took into account mortgage debt—and yet, in all likelihood, their house is worth more than their mortgage. Indeed, eventually, homeowners should end up in much better financial shape than those who continue to rent, because owners lock in their monthly housing costs.

What’s the second key number? How much you add or withdraw from savings each month. There are many folks who see great virtue in carefully tracking how much they spend. I’m not convinced. As I see it, as long as you save enough every month during your working years and don’t spend too much in retirement, it doesn’t much matter whether the dollars you spend are lavished on Jack Daniel’s or Ben & Jerry’s.

In midlife, many families are both adding to savings and have a positive net worth—a pleasant position to be in. Matters are often less comfortable for those who are older and younger. Young adults may be spending less than they earn, but often their net worth is negative, thanks to student loans. Meanwhile, retirees are in the opposite situation, with an impressive net worth, but one that might be slowly shrinking, as they gradually draw down their savings.

Neither situation is necessarily alarming. Young adults have 30 or 40 years of paychecks ahead of them, which they can use to get their debts paid off and turn their net worth from negative to positive. Meanwhile, for retirees, dissaving may be unsustainable in the long run—but, if they are careful, they’ll give out before their nest egg does.

Indeed, you can think of your net worth through life as a broad arc. In your early 20s, it might be negative. But as you pay down debt and add to financial accounts, your net worth should gradually climb, so that you retire with a sum equal to perhaps 12 times your final salary. From there, matters go into reverse, but—fingers crossed—it’ll be a slow reversal.

Cloudy With a Chance of More Clouds

FOR THOSE INCLINED to move in or out of the stock market based on Trump's victory, consider this: Forecasting elections should be relatively easy. All you have to do is identify a representative sample of the U.S. population and then ask them how they'll vote.

By contrast, forecasting the stock market is infinitely more complicated, involving a two-step process: First, you have to predict the economic and political news--and then you have to forecast how investors will react to this news. The bottom line: If the pollsters can't accurately predict an election, do you seriously think you can accurately forecast the direction of stock prices?

This Is a Test, This Is Only a Test

The article below appeared in my Oct. 28 newsletter. But after the overnight global market volatility and today's expected steep drop in U.S. share prices, I figured it was worth reposting.

THE CURRENT GRUDGING ECONOMIC RECOVERY is in its seventh year and the stock market rally is in its eighth year. Here I earn nobody’s admiration by stating the obvious: These things don’t go on forever—but nobody knows when the music will stop.

That makes this a good time to hold a financial fire drill. Focus on three key questions. How would you react if the stock market dropped 30% next week? Would a market plunge derail your upcoming financial goals? How would you cope if an economic downturn put your job at risk?

This first question is about emotional fortitude, while the second and third questions are practical ones—but all three have profound implications for how you position your portfolio.

Let’s start with first principles: Most folks should own a portfolio that has healthy exposure not only to stocks, but also to bonds and other more conservative investments. That way, you should earn handsome long-run returns, but your overall wealth shouldn’t be too badly bloodied by a stock market crash and you shouldn’t find yourself selling stocks at fire-sale prices to buy shoes for the children.

Not sure you have the right balance between stocks and bonds? The tricky issue: What counts as a bond—and what counts as a stock?

Looks like a bond

Bonds typically deliver a steady stream of regular income. If that’s the defining characteristic, many parts of our financial life look like bonds. Think about all the income streams you collect: There might be Social Security retirement benefits, income from immediate annuities and any traditional employer pension you’re entitled to. If these provide a hefty portion of your retirement income, that can free you up to invest more heavily in stocks—and potentially earn higher long-run returns.

As you consider the bond-like income you receive, also give some thought to the regular drains on your finances—in the guise of mortgages, auto loans and other debts. You can think of these debts as negative bonds. Got $400,000 in bonds and a $300,000 mortgage? Arguably, your net bond exposure is just $100,000.

Between student loans, car loans and mortgages, many folks reach their 30s with what seems like an alarming amount of debt. But typically, their net position in bonds is still substantial—thanks to their paycheck, which can be viewed as another bond-like source of income.

Indeed, among academics, the four decades of income that we collect from our so-called human capital provides the intellectual justification not only for taking on debt early in our adult lives, but also for investing heavily in stocks. By taking on debt in our 20s and 30s, we can buy items—think college degrees, cars and homes—that we couldn’t afford if we had to pay cash. This has the added benefit of smoothing out our consumption over our lifetime. Meanwhile, the debt involved shouldn’t be of great concern, because we know we have plenty of paychecks ahead of us to service these debts and pay them off by retirement.

Those paychecks, with their steady bond-like income, also free us up to invest the bulk of our portfolio in stocks. We don’t need income from our portfolio while we’re in the workforce, so we can go light on bonds and instead shoot for higher returns with stocks. But as we approach retirement and the last of our paychecks, most of us will want to cut back somewhat on stocks and invest more in bonds.

Are you a stock?

Keep in mind that not everybody’s paycheck is bond-like. Let’s say you work on commission, you’re a Wall Street trader or you’re involved with a Silicon Valley startup. Your income isn’t bond-like. Instead, it looks more like a stock. Maybe you will have a huge payday—or maybe you won’t be so lucky, and you will find yourself with far less income than you had hoped and perhaps even out of work. To reflect this risk, you might want a healthy stake in bonds and other conservative investments, even if you’re in your 20s.

Whether it’s bonds, a regular paycheck, a pension, an immediate annuity or Social Security, you’ll likely discover that much—and maybe most—of your assets are in bonds and bond lookalikes. And, of course, you likely own other assets, notably a home and perhaps even a second home.

The implication: Even if the stock market tumbled 30% tomorrow, the hit to your overall net worth would probably be modest, so there’s scant reason to panic. But to avoid feeling unnerved, it’s important to stay focused on your overall net worth, or you won’t get the emotional benefit that comes with spreading your money across a broad array of assets.

Owning multiple assets doesn’t just make for a less unnerving financial life. It also has a practical benefit: If the stock market plunges, you can draw on these other financial resources to buy groceries and pay the mortgage.

For retirees, those resources might include their monthly Social Security check and their bond portfolio. For those in the workforce, they have a paycheck. What if that paycheck is at risk, because there’s a chance you’ll get laid off if the economy turns down? This may be the moment to accumulate cash and set up a home-equity line of credit—so, if the need arises, you can get your hands on enough money to make it through a long spell of unemployment.

Keep the Faith

FOREIGN STOCKS have become the investment that folks love to hate—and it’s easy to understand why. In the current decade’s first six full calendar years, foreign shares trailed the S&P 500 by almost nine percentage points a year—and they’re on track to lag behind the U.S. again in 2016.

But is this recent performance a good guide to the future? Almost certainly not. Foreign stocks are far less expensive than U.S. shares, as you’ll discover at StarCapital.de. On top of that, history tells us that there are plenty of decades when foreign stocks outpaced U.S. shares. I’ve been perusing the “big picture” chart from Investments Illustrated that shows the performance of different asset classes since year-end 1925.

At first blush, foreign stocks look like a dubious choice, returning 7.9% a year over the past nine decades, versus 9.8% for the S&P 500. But that huge performance gap was driven in large part by the 1940s, when some foreign markets were devastated by the Second World War, and by the 1990s, when the U.S. market was driven to giddy heights by the technology boom. Foreign stocks lagged behind the U.S. market by 13.9 percentage points a year in the 1940s and by 11.1 points in the 1990s.

What if you look at the other six full decades depicted in the chart? There was only one decade—the 1960s—when U.S. stocks outpaced foreign shares. Indeed, foreign shares occasionally proved to be a great diversifier for U.S. stocks, notably in the wretched 1970s, when foreign markets scored 10.1% a year, while U.S. stocks eked out an inflation-lagging 5.8%.

Moreover, if you look at the past 50 years, you find U.S. stocks clocked 9.8% a year, barely ahead of the 9.4% notched by foreign markets. My advice: Keep the faith—and keep those foreign stocks in your portfolio.

A Better Financial Life—With Three Verbs

REFLECT. PAUSE. FOCUS. That’s my three-pronged strategy for getting more out of your money, whether you’re investing it or spending it. Want to learn more? Check out my latest newsletter.

Meanwhile, with the economic recovery in its seventh year and the stock market rally in its eighth year, this is a good time to hold a financial fire drill. How would you cope if the stock market dropped 30% next week or you lost your job because of an economic downturn? That topic is also tackled in the newsletter.

Don't Be Yourself

WE’RE OFTEN ENCOURAGED to follow our instincts. But if we did that, many of us would sit on the couch drinking margaritas, eating Cheez Doodles and cruising online shopping sites, when we should be eating less, saving more and heading to the gym. Often, the key to a better life—financially and otherwise—is to get ourselves to take action we instinctively resist.

This is obvious advice if we’re overweight, rarely exercise, panic when the stock market declines and find our credit-card balances balloon with every passing month. But fighting our instincts can also be good advice for folks with habits that typically receive a societal seal of approval.

For instance, your employer isn’t likely to raise any objections if you work seven days a week. Quite the contrary: You’ll likely find yourself showered with pay raises and promotions.

I think there’s great pleasure to be found in work, while endless relaxation can quickly turn to endless boredom. Still, a life devoted solely to work is an unbalanced life. To steal a line that others have used, “Nobody’s dying words have ever been, ‘I wish I’d spent more time at the office’.” If you’re working seven days a week, you probably aren’t as productive as those who take regular breaks, plus you’re missing out on so much—friends, family, nature and the amazing accomplishments of others that are on display in concert halls, books, museums, sports arenas and elsewhere.

Another example: if you’re a great saver and you amass a healthy amount of wealth, you’re unlikely ever to be a financial burden to others and, indeed, you may enjoy the admiration of family and friends. Yet, in the end, the rationale for saving now is so we can spend later.

Countless financial planners have told me that the clients who are best at accumulating money for the future are often the worst at making the retirement transition from saver to spender. If you can’t bring yourself to use a healthy portion of your wealth for your own enjoyment and that of others, your great savings habits seem less like a virtue—and more like an obsession. 

Sobering Thoughts

IF YOU DROVE DRUNK but got home unscathed, you wouldn’t wake up the next morning and think, “I guess it’s okay to get behind the wheel after 13 beers.” Yet, when handling our finances, we do that all the time.

“Markets generate a lot of data, but they don’t generate a lot of clear feedback,” writes academic Terrance Odean in his foreword to Michael Ervolini’s thoughtful book, Managing Equity Portfolios. “Outcomes are noisy. Good decisions may have bad outcomes. Bad decisions may have good outcomes.”

The problem: We typically judge our financial choices by a single, crude yardstick—whether they make or lose us money. But that measure of success or failure can result in faulty feedback that validates bad behavior. Consider three examples:

We bet everything on a single stock and it soars in value. We imagine we’re great investors. But in all likelihood, it was dumb luck—and our next big bet could wipe us out. We don’t bother with homeowner’s insurance, saving roughly $1,000 a year in premiums. Our home hasn’t burned down, so it seems like a wise decision—until we smell smoke wafting up from the basement.We dump bonds and foreign shares, because they’ve posted seven years of mostly lackluster returns. Instead, we make a big, undiversified bet on highflying U.S shares. The market cycle turns—and you can guess the rest.

What’s the lesson here? Dispassionate contemplation is a better teacher than personal experience—because contemplation leads us to consider the range of possible outcomes, while our personal experience represents a sample of one. So what happens if we consider the range of possible outcomes? We become focused not on whether a particular strategy has made us money in the past, but on how to improve the odds that we’ll make money in the future.

That's Rich

WHEN SHOULD WE CONSIDER OURSELVES RICH? Sure, income and wealth are important. But don’t focus just on dollar signs. Instead, think about money in terms of how it makes you feel, what it allows you to do and what your lifestyle costs. Here are eight possible definitions of rich—not all of which I agree with:

1. You almost never worry about money. This is a good one—but it probably has more to do with you than with the sum involved. Some folks would get a tremendous sense of security from $50,000 in the bank, while others warily watch the world from behind their $5 million cash mountain.

2. You’re satisfied with what you have and you’re never envious of others. This may not make you rich in the eyes of other folks. But it’s an admirable quality—especially when we consider the next definition.

3. You have more than your neighbors. Research suggests that we care less about our absolute level of wealth or income, and more about how we compare to others. This is unfortunate: Unless you’re the world’s richest person, there will always be somebody who is better off, so maybe you’ll never be satisfied with your lot in life.

 4. “Annual income twenty pounds, annual expenditure nineteen [pounds] nineteen [shillings] and six [pence], result happiness,” opines the character Wilkins Micawber in Charles Dickens's David Copperfield. “Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” In other words, if you have enough to cover your living costs, you’ll be happier—and, presumably, you should consider yourself well off.

5. The Dickens quote packs a punch, but it begs the question: What are you spending your money on? I think it’s important to distinguish between needs and wants. That brings us to an alternative definition of rich: You can pay for what you need—and you aren’t consumed by what you want but can’t afford.

6. You don’t have to work. This is a good litmus test, though it raises a crucial issue: If you aren’t working for a living, what are you doing with your time—and are these other things making for a happier life?

7. You need a paycheck, but you have a job you love. This is closely related to definition No. 6: If pretty much every day is a pleasure, you have a rich life, even if you don’t currently have enough to retire and even if others wouldn’t consider you wealthy.

8. You have enough to lead the life you want. This is my preferred definition of rich, and it encompasses many of the definitions above: If you have the financial wherewithal to spend most days engaged in activities you enjoy and find fulfilling, you should consider yourself rich, no matter what your net worth.

A Distinction Without Merit

MY HOPE: THE DISTINCTION between work and retirement--between being productive and suddenly being unproductive--gets a whole lot murkier. I make that argument in How to Think About Money and also in a new Money magazine article, which was posted online this morning. Want a happier retirement? Forget days of endless relaxation, and instead think about what will give a sense of purpose to your final decades. You might find that sense of purpose in part-time work, which may also ease the financial strain of retirement.