Jonathan Clements's Blog, page 439

Avoiding Indigestion

RESTAURANT MEALS are my biggest discretionary expense. Want me as one of your customers? Here are my seven rules for restaurants:

If I made a reservation, don’t make me wait 10 minutes for a table.Dim the goddamn lights. I look better in the dark. So does your restaurant.Never sell a wine I can find in the liquor store. It’s one thing to suspect you’ve marked up the bottle by 300%. It’s another thing to know with absolute certainty.Never offer a choice of salad or French fries. That’s just cruel.Of course we want to see the dessert menu.I was looking forward to that last sip of wine in the glass you just took away.Thanks for not telling me that you automatically added the tip.

No Joke

THIS WEEKEND, I have been clearing out old computer files that contain half-baked column ideas that never saw the light of day. One such file contained jokes that brokers tell about everyday investors.

My goal was to illustrate the disdain with which Wall Street views its clients. Indeed, I can’t think of another business that is so scornful of its customers, regularly belittling their intelligence and viewing them not as clients to be helped but as sheep to be shorn. But most of the jokes I managed to collect were, alas, pretty lame, which was probably why I never finished the column. Still, here are two jokes that just about pass muster:

Broker pitches a stock to a client. “Put me down for 100 shares,” the client grudgingly agrees. “But for goodness sake, as soon as I get back to even, sell.”How many small investors does it take to change a light bulb? Two. One to unscrew it and drop it, and the other to buy it just before it crashes.

Moving Slowly

IF THERE’S MONEY you’ll need to spend in the next 12 months, you don’t want to put it at risk, so savings accounts, money market funds and similar cash investments are the only prudent choice. But as your time horizon lengthens, holding cash becomes less and less appealing. The reason: Your money’s purchasing power is pretty much guaranteed to shrink, once inflation and taxes take their toll.

Got cash in your long-term investment portfolio? You should move it into something that offers a higher return. For instance, shifting from Vanguard’s prime money market fund to its short-term corporate bond index fund would give you an extra 1.4 percentage points in annual yield. The danger: If interest rates climbed one percentage point, the short-term bond fund would suffer a 2.8% price drop—a loss you would eventually recoup through the higher yield, but it would take two years.

Of course, if you’re a truly long-term investor, you would probably want to opt for something with the prospect of even higher returns—meaning stocks. Suddenly, the potential short-term loss is a whole lot larger, as we know from the S&P 500’s 49% price drop during the 2000-02 bear market and its 57% swoon in 2007-09.

That possibility is enough to paralyze many investors. How can you unfreeze yourself? Start by deciding what percentage of your portfolio you want in stocks. How can you get from here to your target stock allocation? History tells us that you’ll clock the highest return by moving everything into stocks right away. This is no great surprise: The broad market rises over time, so buying sooner will, on average, give you a better result.

Problem is, you won’t get an average result. Instead, you get just one shot at moving all that cash into stocks, and buying all at once risks buying just before a major crash. The older you are and the bigger the sum involved, the more cautious you’ll want to be.

My suggested strategy—which regular readers have heard before: Take the money you want to move into stocks and divide it into 24 or 36 chunks. Move one chunk into stocks every month, with the goal of being fully invested within two or three years. If share prices drop 15% from current levels, double your monthly purchases. If the market falls 25%, triple your purchases.

What if you settle on a target stock allocation—and discover you currently have too much in stocks? While I favor the low-risk strategy of buying stocks slowly, I advocate selling quickly.

Many folks, of course, do just the opposite: If they discover they have too much in stocks, they will often slowly ease out of the market. This is all about aversion to regret: They hate the idea that they’ll sell a big chunk of stock and the market promptly rockets higher. But remember, while buying stocks slowly reduces risk, selling slowly increases it—because you stay over-weighted in stocks for longer and the market could go against you.

Worse Than Greece

HOW DO OUR FINANCIAL HABITS STACK UP? Academics Cristian Badarinza, John Y. Campbell and Tarun Ramadorai compared U.S. households with those of 12 other developed nations. Here are some highlights:

Almost 50% of U.S. households are invested in the stock market, versus 34% in Finland, 25% in Spain, 24% in Germany and 23% in France.Defined contribution retirement plans—think 401(k) plans and their ilk—are widespread in Australia, the U.K. and U.S., but are far rarer in continental Europe.When investing outside a retirement account, folks in Australia, Spain, France, the U.K. and U.S. are far more likely to own individual stocks than mutual funds.In 12 of the 13 countries, more than half of all households own their main residence. The outlier: Germany, where just 44% of households own their principal home.Fixed-rate mortgages are the overwhelming choice of U.S. and German home buyers, while adjustable-rate mortgages are far more common in Australia, Finland, Italy and Spain.Almost 75% of U.S. households are in debt—the highest of the 13 countries. Canada, Australia and the Netherlands aren’t far behind. Meanwhile, Italians are surprisingly prudent, with just 25% of households in debt.Homeownership is widespread in Greece and Italy—but mortgage debt isn’t. Just 10% of Italians have a mortgage on their primary residence and just 14% of Greeks, versus 47% in the U.S.Australian and U.K. households boast the highest median net worth, as measured by the value of their homes, financial accounts and other assets, minus all debts. What about those poor southern Europeans, with their rocky economies? Thanks to widespread homeownership and an aversion to debt, the typical household net worth in Spain, Italy and Greece is higher than in the U.S. or Germany. So where do the U.S. and Germany rank among the 13 countries studied? Citizens of these two economic powerhouses may enjoy relatively high incomes—but, if you look at the typical household, they’re at the bottom in terms of net worth. While the typical U.S. household—meaning the family that’s halfway down the wealth spectrum—doesn’t look so good in terms of net worth, it’s a different story if you look at average net worth. This average, which measures total household net worth divided by the number of households, is boosted by the hefty holdings of America’s wealthy. Result: Among the 13 nations, the U.S. ranks 12th on typical household net worth—but fourth on average net worth.

There's Nothing Like Nothing

YOU WOULDN’T WANT to spend your entire life in the 0% tax bracket, but it’s a nice place to visit. Got stocks or stock funds in your taxable account? If you sell them in the right year, you could realize capital gains of almost $100,000 and perhaps more—and pay a 0% federal capital gains rate.

I was reminded of this loophole as I was flipping through Phil DeMuth’s latest book, The Overtaxed Investor, an amusing and easy read—not words often used to describe a tome on taxes.

Let’s say you’re out of work or you just retired and haven’t yet claimed Social Security. As things stand, you don’t expect any taxable income in the current year. To take advantage of the situation, you might convert a portion of your traditional IRA to a Roth. Part of the conversion won’t be taxed, thanks to your personal exemption and your standard or itemized deduction. But if you convert more than a modest sum, you’ll owe at least some income taxes. Nonetheless, that tax bill may be a small price to pay to get the money into a Roth, where it’ll grow tax-free thereafter.

But here’s an alternative way to exploit your low-tax year: You might sell stocks or stock funds in your taxable account that have unrealized capital gains. This isn’t worth doing if you’re happy with the holdings and plan to hang on to them until you die, at which point the embedded capital gains tax bill will disappear, thanks to the so-called step up in basis. But if you aren’t happy with the stocks or stock funds, or you know you’ll have to sell eventually, this could be the chance of a lifetime.

How so? In 2016, if you’re single and you claim the standard deduction, you could have income of as much as $48,000 and stay within the 15% federal income tax bracket. If you’re married filing jointly, the threshold would be twice as high—$96,000. Itemize your deductions? These figures may be higher still. The beauty of this tax situation: If your total income stays within these limits, any income would be taxed at 15% or less—but your long-term capital gains would be dunned at 0%. That isn’t a typo. Keep in mind that, to qualify for this 0% rate, you have to hold your stocks or stock funds for more than a year.

To be sure, there could be some tax cost involved. For instance, depending on your total income, you might have to pay taxes on your Social Security benefit, you could lose various tax credits and you might have to pay state income taxes. Still, the tax hit will likely be fairly modest—and the benefit substantial.

May Newsletter

THE GLOBAL FINANCIAL MARKETS consist of four sectors of roughly equal size: U.S. stocks, U.S. bonds, foreign stocks and foreign bonds. Why would you bet on just one of those four sectors--specifically U.S. stocks? That's the topic I tackle in my latest free newsletter. The newsletter also discusses my enthusiasm for emerging stock markets and offers a slew of intriguing statistics. Want to view earlier newsletters? Check out the articles page. Want to be on the distribution list for future issues? Shoot me an email. 

Cover Up

I AM WRAPPING UP WORK on my new book, How to Think About Money, which is scheduled for publication Sept. 1. Over the weekend, my designer--David Glaubke--delivered the book's cover. He initially suggested the dashing but flawed Andrew Jackson, I countered with the renowned Broadway rapper Alexander Hamilton and we ended up settling on Benjamin "Penny Saved" Franklin--a character less often seen because he's found not on the $10 or $20 bill, but on the $100. Check out the cover and a description of the book, as well as some overly kind endorsements. 

Happy Thoughts

THINK ABOUT THE BAD STUFF that didn’t happen. Very few of us will have a year when we crash the car, our home burns down, our employer goes belly up and our big bet on a single stock goes way down. Yet all of these things could happen, which is why we buy auto and homeowner’s insurance, keep an emergency reserve and avoid big bets on a single stock.

Sound sensible? There are two great dangers. First, we might be lulled into complacency by good times. Not many of us would drop our homeowner’s insurance because we haven’t ever had a fire. But a string of good years in the stock market can cause folks not only to question the value of bonds, but also to toss out fuddy-duddy notions of diversification and instead bet their life’s savings on an increasingly narrow selection of stocks.

Second, we might fail to address some risks, either out of ignorance or denial. For instance, many folks head into retirement without realizing there’s a decent chance they’ll live into their 90s, and also without a plan for how they’d cope with nursing-home costs.

How can we get a better handle on the risks we face? Try wrestling with these four questions:

How would our families cope financially if our paycheck disappeared? That might happen because of a layoff, ill-health, disability or premature death. To fend off these various threats, we should have an emergency fund and health insurance, and perhaps also disability and life insurance.How would we cope financially if our major possessions were damaged or destroyed—or we were held responsible for harm done to others? This is a reason to buy auto, homeowner’s and umbrella-liability insurance.What would it mean for our portfolio if some part of the global financial markets had devastatingly bad performance? I’m not talking about a temporary dip in prices. Instead, at issue is a permanent loss of value—or a bear market that drags on for so long that it might as well be permanent. Think about the 86% loss suffered by shareholders of Valeant Pharmaceuticals over the past eight months—or the 55% loss suffered by Japanese stocks over the past 26-plus years. Is your portfolio sufficiently diversified to withstand losses like that?How would we cope financially if we lived extraordinarily long lives? Among affluent 65-year-olds, the median life expectancy for women is age 90 and for men it’s age 88—which means half of these folks will live to these ages or beyond. What to do? Delaying Social Security to age 70, so you get a larger monthly check, is a great place to start.

It’s a Big World

IF YOU WANT TO FEEL SHORT, stand next to somebody tall. Want to feel badly about your portfolio? Compare it to the Standard & Poor’s 500-stock index.

Over the five years through March 31, the S&P 500 notched an annualized total return of 11.6%, versus 7.2% for the Russell 2000 index of smaller U.S. stocks, 2.3% for MSCI’s Europe, Australasia and Far East index and a loss of -4.1% a year for MSCI’s Emerging Markets index. The credit for the S&P 500’s robust performance belongs to U.S. blue chip growth-company stocks, which have climbed 13.1% a year over the past five years, three percentage points a year better than the bargain-priced shares of slower-growing “value” companies.

All this is reminiscent of the late 1990s, when the S&P 500 was all but unbeatable and those with globally diversified stock portfolios had their prudence rewarded with relatively lackluster returns. But lest we forget, this is the fate every year of those who diversify: You never do as well as the best-performing asset class—but you also avoid the drubbing suffered by those who put all their eggs in the basket that turns out to have the worst results.

Still, owning a globally diversified stock portfolio feels especially foolish when the S&P 500—and also the Dow Jones Industrial Average—post strong results. These aren’t the yardsticks against which we should measure the performance of a global stock portfolio. But they are the indexes whose performance we hear about every day—and those two indexes also contain the stocks we’re most comfortable owning.

That sense of comfort, however, comes at a price. Forget the past five years—and think about the past 15. Over that stretch, the S&P 500 climbed 6% a year. That was better than developed foreign markets’ 4.4% annual gain, but far behind the 7.7% scored by small U.S. stocks and the 9.4% enjoyed by emerging markets.

What's in a Name?

WHO WON? Last week, the Department of Labor issued new rules, saying financial advisors have a fiduciary duty when advising clients on how to handle their retirement accounts, such as 401(k) plans and individual retirement accounts. This fiduciary duty means advisors must act in a client’s best interest.

For registered investment advisors, or RIAs, this wasn’t an issue: These advisors, who typically get compensated through fees, were already held to a fiduciary standard. But it was a big deal for brokers, who usually charge commissions and were previously held to a lower standard: Under the old rules, they only had to recommend investments that were considered suitable.

A resounding victory for everyday investors? Maybe not. The Labor Department rules still allow brokers to sell their firm’s own proprietary investment products, an obvious conflict of interest. They can also advise retirement-account clients to buy illiquid investments like non-traded real-estate investment trusts and to purchase tax-deferred annuities, as long as this is somehow in the client’s best interest.

Stuffing a variable or equity-indexed annuity inside an IRA has long been a ploy used by brokers seeking to increase their commissions, because annuity commissions are typically higher than those on regular mutual funds. But the benefit to clients is less obvious, because they end up with an annuity—a tax-deferred investment vehicle—inside an IRA, which is also a tax-deferred vehicle.

Maybe brokerage-firm lawyers and compliance officers will decide it’s hard to justify stunts like this under the new rules, and they’ll put a stop to such transactions. But even if that happens, brokerage-firm clients still need to be leery. Their brokers might act as fiduciaries when handing clients’ IRAs. But when advising clients on their regular taxable account, these brokers may be held to the lower suitability standard.

All of this means the new rules are a mixed blessing for investors. But the biggest loser, I fear, is the term “fiduciary” itself. Before the Labor Department ruling, it was a label proudly worn by registered investment advisors, and signified that—unlike brokers—they acted in the best interest of their clients. But now, it isn’t clear what the label means.