Nov 18

Seven Year End Wealth Management Strategies

By Chris Chen CFP | Financial Planning , Investment Planning , Retirement Planning , Tax Planning

Photo by rawpixel on Unsplash

Seven Year End Wealth Management Strategies

As we approach the end of a lackluster year in the financial markets, there is still time to improve your financial position with a few well placed year-end moves .

Maybe because we are working against a deadline, many year-end planning opportunities seem to be tax related .  Tax moves, however, should be made with your overall long-term financial and investment planning context in mind. Make sure to check in with your financial and tax advisors.

Here are seven important moves to focus your efforts on that will help you make the best of the rest of your financial year .

1) Harvest your Tax Losses in Your Taxable Accounts

As of[ October 26, the Dow Jones is up 1.65%, and the S&P500 is up just 0.98% ]for the year. Unfortunately, many stocks and mutual funds are down for the year. Therefore you are likely to have a number of items in your portfolio that show up in red when you check the “unrealized gains and losses” column on your brokerage statement.

You can still make an omelet out of these cracked eggs by harvesting your losses for tax purposes . The IRS individual deduction for capital losses is limited to a maximum of $3,000 for 2018.  So, if you only dispose of your losers, you could end up with a tax loss carryforward, i.e., tax losses you would have to use in future years. This is not an ideal scenario!

However, you can also offset your losses against gains. For example, if you were to sell some losers and hypothetically accumulate $10,000 in losses, you could then also sell some winners. If the gains in your winners add to $10,000, you have offset your gains with losses, and you will not owe capital gain taxes on that joint trade!

This could be a great tool to help you rebalance your portfolio with a low tax impact. Beware though that you have to wait 30 days before buying back the positions that you have sold to stay clear of the wash sale rule.

2) Reassess your Investment Planning

Tax loss harvesting is a great tactic to use for short-term advantage. As an important side benefit, it allows you to focus on more fundamental issues. Why did you buy these securities that you just sold? Presumably, they played an important role in your investing strategy. And now that you have accumulated cash, it’s important to re-invest mindfully.

You may be tempted to stay on the sideline for a while and see how the market shakes out.  Although we may have been spoiled into complacency after the Great Recession, the last month has reminded us that volatility happens.

No one knows when the next bear market will happen , if it has not started already. It is high time to ask yourself whether you and your portfolio are ready for a significant potential downturn.

Take the opportunity to review your goals, ensure that your portfolio risk matches your goals and that your asset allocation matches your risk target..

3) Check on your Retirement Planning

It is not too late to top out your retirement account!  In 2018, you may contribute a maximum of $18,500 from your salary, including employer match to a 401(k), TSP, 403(b), or 457 retirement plan, subject to the terms of your plan. Those who are age 50 or over may contribute an additional $6,000 for the year.

If you have contributed less than the limit to your plan, there may still be time! You have until December 31 to maximize contributions for 2018, reduce your 2018 taxable income (if you contribute to a Traditional plan), and give a boost to your retirement planning.

Alternatively to deferring a portion of your salary to your employer’s Traditional plan on a pre-tax basis, you may be able to contribute to a Roth account if that is a plan option for your employer. As with a Roth IRA, contributions to the Roth 401(k) are made after tax, while distributions in retirement are tax-free.

Many employers have added the Roth feature to their employee retirement plans. If yours has not, have a chat with your HR department!

Although the media has popularized the Roth account as tax-free, bear in mind that it is not. Roth accounts are merely taxed differently . Check in with your Certified Financial Planner practitioner to determine whether electing to defer a portion of your salary to on a pre-tax basis or to a Roth account on a post-tax basis would suit your situation better.

4) Roth Conversions

The current tax environment is especially favorable to Roth conversions . Under the current law, income tax rates are scheduled to go back up in 2026; hence Roth conversions could be suitable for more people until then.

With a Roth conversion, you withdraw money from a Traditional retirement account where assets grow tax-deferred, pay income taxes on the withdrawal, and roll the assets into a Roth account. Once in a Roth account, the assets can grow and be withdrawn tax-free, provided certain requirements are met. If you believe that your tax bracket will be higher in the future than it is now, you could be a good candidate for a Roth conversion .

Read more about the new tax law and Roth conversions

5) Pick your Health Plan Carefully

It is health insurance re-enrollment season! The annual ritual of picking a health insurance plan is on to us. This could be one of your more significant financial decisions for the short term. Not only is health insurance expensive, it is only getting more so.

First, you need to decide whether to subscribe to a traditional plan that has a “low” deductible or to a high deductible option.  The tradeoff is that the high deductible option has a less expensive premium. However, should you have a lot of health issues you might end up spending more.  High deductible plans are paired with Health Savings Accounts (HSA).

The HSA is a unique instrument. It allows you to save money pre-tax and to pay for qualified healthcare expenses tax-free. Unlike Flexible Spending Accounts (FSAs), balances in HSAs may be carried over to future years and invested to allow for potential earnings growth. This last feature is really exciting to wealth managers: in the right situation clients could end up saving a lot of money.

If you pick a high deductible plan, make sure to fund your HSA to the maximum. Employers will often contribute also to encourage you to choose that option.  If you select a low deductible plan, make sure to put the appropriate amount in your Flexible Spending Account. FSAs are used to pay for medical expenses on a pretax basis. Unlike with an HSA, you cannot rollover unspent amounts to future years.

 

Gozha net on Unsplash

6) If you are past 70, plan your RMDs

If you are past 70, make sure that you take your Required Minimum Distributions (RMDs) each year. The 50% penalty for not taking the RMD is steep. You must withdraw your first minimum distribution by April 1 of the year following the year in which you turn 70 ½, and then by December 31 for each year after.

Perhaps you don’t need the RMD? You may want to redirect the money to another cause. For instance, you may want to fund a grandchild’s 529 educational account. 529 accounts are tax-advantaged accounts for education. Although contributions are post-tax, growth and distributions are tax-free if they are used for educational purposes.

Or, you may want to plan for a Qualified Charitable Distribution from the IRA and take a tax deduction. The distribution must be directly from the IRA to the charity. It is excluded from taxable income and can count towards your RMD under certain conditions.

7) Plan your charitable donations

Speaking of charitable donations, they can also be used to reduce taxable income and provide financial planning benefits. However, as a result of the Tax Cut and Jobs Act of 2017 (TCJA), it may be more complicated than in previous years. One significant difference of the TCJA is that standard deductions went up to $12,000 for individuals and $24,000 for married filing jointly. Practically what that means is that you need to accumulate $12,000 or $24,000 of deductible items before you can feel the tax savings benefit.

In other words, if a married couple filing jointly has $8,000 in real estate taxes and $5,000 of state income taxes for a total of $13,000 of deductions, they are better off taking the standard $24,000 deduction. They would have to donate $7,000 before they could start to feel the tax benefit of their donation.  One way to deal with that is to bundle your gifts in a given year instead of spreading them over many years.

For instance, if you plan to give in 2018 and also in 2019, consider bundling your donations and giving just in 2019. In this way, you are more likely to be able to exceed the standard deduction limit.

If your thinking wheels are running after reading this article, you may want to check in with your wealth manager or financial planner: there may be other things that you could or should do before the end of the year!

 

Check these other wealth management posts:

Is the TCJA an opportunity for Roth conversions?

New Year Resolution

How to Implement a New Year Resolution

Tax Season Dilemna: Invest ina Traditional IRA or a Roth IRA 

 

 

 

Note: The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice. We make no representation as to the accuracy or completeness of the information presented.  To determine investments that may be appropriate for you, consult with your financial planner before investing. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions.

We make no representation as to the completeness or accuracy of information provided at the websites linked in this newsletter. When you access one of these websites, you assume total responsibility and risk for your use of the websites to which you are linking. We are not liable for any direct or indirect technical or system issues or any consequences arising out of your access to or your use of third-party technologies, websites, information, and programs made available through this website.  

Nov 18

Market Perspectives – October 2018

By Chris Chen CFP | Capital Markets

Market Perspectives

Third Quarter 2018

Should we panic yet?

September 2018 marked the 10 year anniversary of the Lehman Brothers bankruptcy in 2008, that ushered several months of extreme activity in the financial markets. The market slide from December 2007 to March 2009 was one of the steepest and scariest that we remember.

Yet, ten years later, the S&P 500 has enjoyed the longest bull market in US history, having lasted 3,453 days from March 9, 2009, until the end of September 2018. (footnote: Dow Jones Indices and Washington Post) As has been the case throughout its history US markets have recovered and more than made up the losses of the last downturn. According to Morningstar, the S&P 500 returned an annual 12% from October 1, 2008, to September 30, 2018. On a cumulative basis, the S&P 500 has returned by 210%.

This rally has been largely fueled by the easy monetary policy of the Federal Reserve, which moved short-term interest rates effectively to zero in the wake of the 2008-2009 bear market, promoting risky behaviors, especially with corporate borrowing, which have helped drive the U.S. stock market upwards since then.

We all want to know when the next market downturn will occur. Some may think that it has started already with the October 2018 volatility. Since we cannot predict the future with any accuracy, we’ll stipulate that it may well have. However, we believe that the October market reflects a reversal to the greater volatility that the financial markets have historically displayed instead of the placid pace that we have been accustomed to since the Great Recession. We should get used to more of the same in the future.

We are likely to be in the late innings of the current economic expansion. However, there are reasons for a cautiously positive outlook for the short term. Either for the short or long run, it continues to be important to match the risks of your investments with the need you will have for the funds.  (If you are not sure what I am talking about here, drop me a line). If your needs for your money is in the short term, invest appropriately.

With proper matching of asset risk and liability timing, you can be well prepared for the downturns that will inevitably come.

A New Round of Tariffs

In late September, the U.S. placed an additional round of tariffs on $200B of Chinese goods. They are expected to affect a wide range of products, from computer electronics to forestry and fishing.

In response, China accused the Trump administration of bullying and applied their own tariffs on $60B worth of goods. If the Chinese response looks weak, it is only because China imports a lot less from the US than we do from them!  That should not be reassuring as China has many other tools to retaliate with besides imposing tariffs on American goods.

According to Fitch, the rating agency, these trade escalations will have a negative impact on global growth. As a result, they lowered their economic growth forecasts slightly from 3.2% to 3.1%.

In its simplest form, a tariff is a tax imposed on imported goods. Eventually, it gets paid by consumers. There are already anecdotes of the effects of the tariffs on the price and availability of some products. Coupled with the tariffs imposed by China, we expect that they will work themselves in the numbers in quarters to come.

Consumer Confidence Near All-time High

American consumers continue to be oblivious to the effects of trade and tariff risks. The Conference Board’s Consumer Confidence Index hit an 18-year high and sits very close to an all-time high, due in part to a strong outlook on economic growth and low unemployment.

Speaking of unemployment: it fell to 3.7% in September 2018, well below the 50- year average of 6.2%. Normally, we expect low unemployment to be associated with wage inflation. Fortunately for employers, although not for workers, wage growth has remained stagnant well below historical averages.

The Era of Easy Money is Coming to an End

In each of the last four quarters, the Federal Reserve increased the Fed Funds rate 25 basis points (bps). It now stands at a level of 2.00% – 2.25%. We have had three increases already in 2018 and 8 since 2015. It is possible that the volatility that we experienced in October 2o18 may delay the projected December 2018 increases. However, at this time, owing to the otherwise strong economy, we expect that the increase will come through, and will be followed by two more increases in 2019.

Inflation Is Stable

The Core PCE (Personal Consumption Expenditures), a measure of inflation, is running right around the Fed target of 2%. From the Federal Reserve perspective, that is good news, as inflation has persisted below this mark for the last several years. Inflation is one of the key economic measures that the Fed watches very closely. When interest rates climb faster than anticipated, it may signal an overheating economy and inflation. The Fed may then increase interest rates more quickly.  

U.S. Equity

Reversing last quarter when small-cap stocks outperformed large-cap stocks, this quarter saw large-cap stocks outperform their small-cap counterparts as trade and tariff talk dissipated. In addition, large-cap stocks are still benefiting from the effects of the tax cut. Even so, on a year-to-date basis, small-cap stocks have still outpaced large-cap stocks 11.5% to 10.5% as of the end of September.

From a style perspective, the last quarter continued to increase the gap between growth and value stocks. On a year-to-date basis, large-cap growth stocks, as represented by the Russell 1000 Growth, have outperformed large value stocks, as represented by the Russell 1000 Value by 13.2% (17.1% vs. 3.9%).

Non-U.S. Equity

International equities have continued to lag their U.S. counterparts in 3Q2018. In fact, the MSCI EAFE was the only major international equity index we follow that earned a positive return during the quarter (1.4%). Additionally, each of the four major international equity indexes we follow have fallen on a YTD basis.

During 3Q, much of the conversation in emerging markets surrounded Turkey and Argentina. Turkey’s direct impact on the overall return of the MSCI Emerging Markets index was minimal as it comprises only 0.6% of the MSCI Emerging Markets Index. However, because Argentina comprises almost 16% of the MSCI Frontier Markets Index, its troubles certainly had a greater impact on returns. We expect that MSCI will reclassify Argentina into the MSCI Emerging Markets Index in mid-2019.

Emerging markets continue to have strong growth and attractive fundamentals. Specifically, they are considerably less expensive from a P/E ratio perspective and pay higher dividends.

However, the Fed rate increases have hurt, as US rate hikes have a tendency to increase the value of the dollar, and decrease the attractiveness of emerging market investments. Also, while the U.S. comprises 55% of global market capitalization, 45% continues to come from outside our borders.

Therefore, despite occasional challenges, we believe that it is important for investors to be diversified in markets outside the U.S. Investors should keep in mind that investing domestically vs. internationally should not be an all-or-nothing endeavor. We continue to believe that global diversification is important.

Fixed Income

Fixed income investments continue to be challenged in a rising rate environment. Specifically, Treasury investments have yielded negative returns over the last 12 months. The picture worsens with longer maturities and most other fixed-income categories.

We continue to keep an eye on the shape of the yield curve. When the 2 year and 10 year Treasuries (the yield curve) come to close together, it is often a precursor of recession. That happens when investors no longer believe that they are being adequately compensated for holding longer maturities. This year the gap between the two has continued to narrow and therefore has fueled speculation. As of now, the curve has not inverted (ie short-term rates are still lower than long-term rates). Therefore, the best we can say is that this indicator is inconclusive at this time.

In anticipation of continued fixed income market turmoil due to rising rates and other factors, our fixed income portfolio is weighted toward shorter maturities and floating rate instruments. We believe that this provides an adequate return at an acceptable risk.

 

Check our blog post on the Seven Year End Wealth Management Strategies

 

Note: The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice. Views expressed are the opinions of Insight Financial Strategists LLC as of the date indicated, based on the information available at that time, and may change based on market and other conditions. We make no representation as to the accuracy or completeness of the information presented. This communication should not be construed as a solicitation or recommendation to buy or sell any securities or investments. To determine investments that may be appropriate for you, consult with your financial planner before investing. Market conditions, tax laws, and regulations are complex and subject to change, which can materially impact investment results. Index performance information, financial conditions, inflationary and future risk and return information is provided for illustrative purposes only. One cannot invest directly in an index. Past performance is no guarantee of future results. Individual investor performance may vary depending on asset allocation, the timing of investment, fees, rebalancing, and other circumstances. All investments are subject to risk, including the loss of principal.

Insight Financial Strategists LLC is a Massachusetts Registered Investment Adviser.

Oct 15

Financial Planner or Estate Planner: Which Do You Need?

By Anna Byrne | Financial Planning , Retirement Planning , Tax Planning

Financial Planner or Estate Planner: Which Do You Need?

Financial Planners and Estate Planners are two different professions that are often confused. There is some overlap between professionals in these fields, but their roles are rather distinct. When you are striving to make a long-term plan for a strong financial future, both financial planners and estate planners play a crucial role.

In fact, when you consider some of the most recent personal finance statistics, it becomes very clear that many Americans could really benefit from retaining the services of both a financial planner AND an estate planner. For instance, 33% of Americans have no money saved for retirement, 60% lack any form of an estate plan, and only 46% have money saved for emergencies. Better planning starts with understanding what both types of planners do.

What is a Financial Planner?

A financial planner is a professional who offers a wide range of services that can assist both individuals and businesses to accomplish their long-term financial goals and accumulate wealth. They fall into two categories:

  • Registered Investment Advisor
  • Certified Financial Planner

Certified Financial Planners (CFP) are required to comply with the Certified Financial Planner Board of Standards, which means they have a basic level of expertise backed by a larger organization. Ethically they have to work in your best interest.

Services provided by both financial advisors and CFPs include:

What is an Estate Planner?

The goal of a financial planner is to assist with wealth accumulation. On the other hand, an estate planner can help you to make financial plans associated with your passing, which includes protecting the wealth that you have accumulated .

While you might believe only wealthy individuals need to work with an estate planner, you should consider the fact that everything you have accumulated in your life comprises your estate. Accumulated assets such as vehicles, furniture, bank accounts, life insurance, your home, and other personal possessions are all included in your estate.

Your assets become the property of the state if you die without a will or an estate plan in place , and your family members will not be able to claim them without paying legal fees and taxes. They will also have to face the stress of potential disagreements with other family members over how your property should be divided.

Besides planning for your passing, estate planning also involves creating a clear plan for your care if you become disabled , and it also covers naming guardians for underage children. Estate planning is a way to protect your family and your assets while reducing taxes and legal fees .

Which Do You Need?

The roles of financial planners and estate planners are unique, and for this reason, you will benefit from working with both . While your financial planner helps you accumulate wealth, he or she can also prepare you for a meeting with an estate planner as part of your long-term strategy. This includes providing the estate planner with lists of beneficiaries, tax return documentation, lists of investments and a breakdown of income and expenses.

When you work with both a financial planner and an estate planner, they will keep you accountable by periodically reviewing your documentation and beneficiaries and making sure everything is updated and reviewed as necessary. By taking the time to work with both these professionals, no important decisions will be overlooked, and you will take control of your financial future.

 

Note: This article was authored by Kristin Dzialo, a partner at Eckert Byrne LLC, a Cambridge, MA law firm that provides tailored estate planning. Eckert Byrne LLC and Insight Financial Strategists LLC are separate and unaffiliated companies. This article is provided for educational and informational purposes only. While Insight Financial Strategists LLC believes the sources to be reliable, it makes no representations or warranties as to this or other third party content it makes available on its website and/or newsletter,  nor does it explicitly or implicitly endorse or approve the information provided.  

Sep 18

3 Simple Ways to Avoid Ruining Your Retirement

By Eric Weigel | Investment Planning , Retirement Planning , Sustainable Investing

3 Simple Ways to Avoid Ruining Your Retirement

 

Photo by Melvin Thambi on Unsplash

 

What’s your “Probability of Ruin”?

Many people considering retirement or in the early phases of this new stage in life worry about outliving their assets.  

These individuals no longer have the luxury of a steady paycheck, and unless they are one of the lucky ones with a defined benefit plan and/or a large portfolio of liquid investments, they will have to dip into their 401k’s and savings to fund their lifestyle.

Somebody in the de-accumulation phase will naturally worry about how long their money will last and whether they can maintain their lifestyles.

People are living longer these days and it is not unheard of for a newly minted retiree to live another 30 years.  

Let’s look at the data. According to the Social Security Actuarial Life Table (2014) estimates, life expectancy for a 65 male is 17.81 years and for a female 20.36 years.  Somebody in above average health may live even longer – these are just median numbers. If you want to conduct your own calculations, you can refer to How Long Will You Live?

David Blanchett of Morningstar uses the 2012 Society of Actuaries annuity table to estimate the likelihood of living to a certain age using the methodology outlined in his 2013 FPA journal article. This cohort of individuals comes from a higher than average socio-economic group and tends to live longer than average.

Table 1 highlights the calculations from the perspective of a 65-year-old. There is a 50% chance that a male lives to age 89 with a female living to age 91.

Table 1

 Life Expectancy

Source: David Blanchett, Morningstar

The point of these projections is that most people should plan for a long period in retirement. The good news is that we are living longer today but the bad news is that we need to make our retirement savings last longer if we are to maintain a certain lifestyle.

Some people retire with very healthy nest eggs that, barring a cataclysmic event, will provide plenty of cash to fund their lifestyles.  They need not worry much as long as assets vastly outstrip expenses.  They have a high margin of safety.

For most retirees, however, the margin of safety provided by their financial assets in relation to their expenses is slimmer.  They do need to worry about how much they are spending, how their investments are performing and how long they may need their portfolio assets to last.  They may have other sources of income such as Social Security but still need to make their investment portfolios work hard to bridge the gap between lifestyle expenses and sources of income.

Most people in retirement face a balancing act

They can control their expenses to some extent (putting off non-essential expenses).  They can plan and make sure that their investment portfolios are structured in accordance with their appetite and need for risk-taking (maybe requiring the help of a financial professional). But what they can’t control are capital market returns and how long they need to tap into their retirement accounts (how long they will live).

One way to identify the various trade-offs required to ensure the sustainability of an investment portfolio is to come up with a CHRIS, a Comprehensive Holistic Retirement Investment Strategy with the help of a financial professional.  A good plan should clearly outline what actions you need to take and what type of minimum portfolio return you will need to achieve to ensure that the probability of running out of money before you or your partner/spouse die is within your comfort zone.

Another alternative is to forego a formal financial plan and utilize some sort of rule of thumb such as William Bengen’s 4% rule. According to this highly popular rule published in 1994, you can safely withdraw 4% of your capital every year in retirement.  The research contains a number of key assumptions (such as a 50/50 stock/bond allocation) often ignored in the popular press, but the Bengen rule is not only well known but popular among many retirees.

Should one just jump ahead in and rely on the Bengen 4% rule? Our view is that before you do so, you really should understand the probability of running out of money.

Milevsky and Robinson provide a simple approach in their highly touted article A Sustainable Spending Rate without Simulation to calculating what they call the “probability of ruin.”

Milevsky and Robinson identify three important factors: your rate of consumption, the risk/reward structure of your portfolio, and how long you live. Visually, these concepts can be illustrated in a Retirement Finances Triangle as depicted in Figure 1.

Without going into the mathematics of the Milevsky and Robinson approach for calculating a “probability of ruin” lets us think a bit more deeply about what makes retirement planning complicated in the first place.

 Figure 1

The first aspect that makes retirement planning difficult is the uncertainty surrounding how long you and your spouse/partner are going to live. People are living longer, on average, than in previous generations. But an average does not necessarily help you.  Your physical and mental health could be dramatically different from the “average” individual.

The other variable that is highly uncertain and makes retirement planning more difficult relates to the variability of investment outcomes on your retirement portfolio.  While history is a guide as to what to reasonably expect in terms of key asset class returns and risks over the long-term, in any given year returns could fall within a wide range.

As most people already know, stock returns exhibit more variability in outcomes than bonds.  The “probability of ruin” calculation using the Milevsky and Robinson formula incorporates the ability of individuals to evaluate the implications of various forms of asset allocation with varying levels of expected risk and return.

As you have probably figured out by now, calculating the “probability of ruin” is extremely important in planning your retirement.

The Setting:

To make the situation more realistic let’s look through the eyes of George and Mandy, both aged 65 and about to retire from their corporate jobs.  They have saved diligently over the years and now have a portfolio worth $1,000,000 that they will tap to fund their lifestyle in retirement.

The Problem:

George and Mandy estimate that they will need $90,000 a year to maintain their lifestyle.  Their Certified Financial Planner has also told them that their Social Security income will be $50,000 a year.  They face an annual gap of $40,000. They expect to tap into their retirement portfolio to fund this gap.

They are in reasonably good health and based on discussions with their financial planner they assume that they will live to age 90. To be safe, they assume a retirement horizon of 30 years.

Their starting portfolio value is $1,000,000 and they wish to withdraw $40,000 a year to fund their living expenses.

Capital Market Assumptions:

We assume that inflation will run 3% per year, on average.  Currently, inflation is running a bit lower than 3% in the US but the historical average is only slightly north of 3%.

What sort of investment risk and return assumptions should people use to calculate the probability of running out of money under this scenario?

Past returns are often a poor guide in forecasting returns and George and Mandy decide as a starting point to use the current Insight Financial Strategists long-term capital market assumed risk and return numbers as outlined in Table 2. These numbers are derived from expected long-term growth, profitability and starting valuation relationships.  They should be viewed as purely hypothetical and subject to great variation.

For illustrative purposes only, Insight Financial Strategists has aggregated all the asset class risk and return numbers into six multi-asset class strategy portfolios according to investment risk – Conservative, Moderate Conservative, Moderate, Moderate Aggressive, Aggressive and the industry convention of a 60/40 balanced strategy.

Table 2

Source: Insight Financial Strategists

Let’s start out gently – the Case of No Uncertainty:

It always helps to start off with a hypothetical scenario where all decision elements are known with certainty up front. We assume that George and Mandy own a 60/40 portfolio returning 4.9% per year and an annual inflation rate of 3%.

If they were to withdraw the equivalent of $40,000 a year in inflation-adjusted terms what would the required distribution look like over their retirement years?

Figure 1

Source: Insight Financial Strategists

The red line in Figure 1 depicts what would happen to their expenses in retirement if inflation were to rise every year by 3%.

What started off as a withdrawal of $40,000 turns into a much larger number over time. For example, after ten years they would need to withdraw $52,000 each year to fund their lifestyle (assuming that their Social Security checks are adjusted annually for inflation as is the current practice).

After 20 years they would need to withdraw $70,000 from their portfolio each year and after 30 years (their last year in their calculations) the number would increase to $94,000 annually. Inflation can sure take a bite!

In terms of George and Mandy’s portfolio, the assumption is that it will yield 4.9% per year or in inflation-adjusted terms, 1.9% per year. After withdrawals are taken out of the portfolio by George and Mandy to fund their lifestyle net of portfolio returns (the assumed 4.9% nominal return per year) the assumed value of the portfolio is depicted in Figure 2.

 Figure 2

Source: Insight Financial Strategists

At the end of the 30th year, the portfolio is expected to be worth $277K.  As long as George and Mandy only live 30 years in retirement and the assumed inflation and portfolio returns prove spot on (accurate) then things should be ok.  They will glide through retirement and even have some assets left over.

The problem occurs if either George and/or Mandy live past age 95. According to the actuarial data in Table 1, there is a 25% chance that George will live to age 99 and Mandy will live to age 101.

Now what? Their current $1,000,000 portfolio is now insufficient to fund their retirement expenses past the age of 97.  They will run out of money and not be able to rely on portfolio income anymore.

What could they do to prevent such an unpleasant outcome?

For starters, they could spend less. For example, they could cut back their annual spending to $30,000.

They could also shoot for higher portfolio returns by taking on a bit more investment risk.  George and Mandy understand that higher portfolio returns are not generated out of thin air.  Higher prospective returns are tied to higher risks.

But does the real world work like this?

Is it just a matter of pulling some levers here and there and voila you have wished for the perfect outcome?

Unfortunately, referring to the Retirement Finances Triangle depicted in Figure 1 although there are some things that George and Mandy can control such as their expenses but when it comes to how long they will live and how their portfolio will actually perform over their retirement years there are lots of unknowns.

Let’s deal with the real world – Introducing Uncertainty:

What if George and/or Mandy live longer than the assumed 30-year lifespan? This is what professionals refer to as longevity risk.  Living a high quality, long life is a very noble and common goal. Outliving your assets is a real fear.

What if portfolio returns do not measure up to our assumed returns? This is referred to as investment risk. What happens if investment returns are significantly below expectations and portfolio income proves insufficient to maintain your desired lifestyle?  Most retirees seek some margin of safety in their investments for this exact reason.

The Milevsky and Robinson formula is designed to take these uncertainties into account by modeling the likely distribution of portfolio returns and longevity.  The end output is a probability of running out of money at some point in time over the retirement horizon.  They refer to this number as the “probability of ruin”.

Let’s start by looking at the implications of the various portfolios strategies presented in Table 1. The Conservative strategy is the least risky approach but also has the lowest prospective returns. This strategy is exclusively composed of bonds.

The Aggressive strategy is exclusively composed of equities and is expected to have the highest returns as well as the highest risk of all of our strategies.

The 60/40 strategy falls along the middle in terms of prospective portfolio returns and risk.

What do the different risk and return profiles of the strategies imply in terms of the probability of ruin of George and Mandy’s portfolio?

Figure 3 depicts graphically the output from the Milevsky and Robinson formula.

Figure 3

Source: Insight Financial Strategists

What immediately jumps out from the bar charts is that the probability of ruin for the various portfolios is quite high. No longer assuming that everything is perfect creates, not surprisingly, more difficult likely outcomes.

For example, if George and Mandy were to employ the Conservative strategy yielding an assumed 2.3% annual return there is an 80% probability of them running out of money at some point in retirement.  Being conservative has its drawbacks!

What if they had the internal fortitude to employ the all-equity Aggressive strategy yielding a prospective return of 6.8% with a volatility of 17%? Their probability of ruin would drop to 37%.

Even if they employed the conventional 60/40 strategy, their probability of ruin would still exceed 45%.

What if the probability of running out of money is too high? 

Well, for starters they could reduce their rate of consumption, i.e. spend less. Maybe not what they wanted to hear but possible.

Let’s assume that instead of taking out $40,000 a year from their investment accounts they withdraw only $30,000? Let’s also assume that they invest in the traditional 60/40 portfolio. The only thing that has changed from the previous scenario is that now George and Mandy are spending only 3% of their initial portfolio to fund their lifestyle.

By spending less and thus depleting their investment assets at a slower rate, they lower their probability of running out of money at some point over their remaining lives to 30%. George and Mandy start thinking that maybe searching for a more inexpensive vacation option makes sense and allow them to worry less about outliving their assets.

 Figure 4

Source: Insight Financial Strategists

 

What else can they do to shift the odds in their favor?

Besides spending less, another option is to work a bit longer and postpone their retirement date. Let’s say they both work five years longer than originally planned.   What would happen assuming that they still intend to withdraw $40,000 in portfolio income and they invest in the 60/40 strategy?

Figure 5

Source: Insight Financial Strategists

By delaying retirement for five years George and Mandy lower the probability of running out of money to below 38%. Not bad but maybe not quite to their satisfaction.

Could George and Mandy restructure their investment portfolio to improve their odds?

Yes, that is certainly a feasible approach as we already outlined in Figure 3.  Higher return strategies carry higher risk but when held over the long-term tend to lower the probability of running out of money.

But not everybody is equally comfortable taking investment risk even if it is likely to result in higher ending portfolio values over the long-term.

Is there another approach to design a more suitable retirement portfolio?

While risk and return are inextricably intertwined, recent financial research has identified the “low volatility” anomaly where lower volatility stocks outperform their higher volatility cohorts on a risk-adjusted basis.  See this note for an introduction to the low volatility anomaly.

Let’s say that instead of assuming a 10.4% volatility for the 60/40 portfolio we are able to utilize a mixture of similar investment vehicles designed to exhibit lower levels of volatility but equivalent returns. Say the volatility of this strategy is now 8.4% and uses a range of lower volatility fixed income and equity approaches plus possibly an allocation to a guaranteed annuity.

Figure 6 illustrates the implications of using the lower volatility investment strategy.  The probability of ruin goes down marginally to below 42%.  Good but not great in the eyes of George and Mandy.

Figure 6

Source: Insight Financial Strategists

What else can George and Mandy do? 

After all, they have evaluated the impact of lowering their expenses, deferring their retirement date and structuring a more suitable investment portfolio and they still are uncomfortable with a probability of ruin in the 30% range.

The short answer as in many areas of life is to do a bunch of small things.  They could elect to just lower their spending from 4% to 3% and the probability of running out of money would drop to about 30%.

But George and Mandy realize that they could do even better by doing all three things:

  • Spending less
  • Working a bit longer
  • Structuring a more suitable investment portfolio

Figure 7 highlights the various alternative courses of action that they could take to increase the odds of not running out of money in retirement.

Figure 7

Source: Insight Financial Strategists

There are no guarantees in life, but spending less, delaying retirement and designing a more suitable portfolio lowers the probability of running out of money to about 20%.

While we all strive for control, George and Mandy are comfortable with this approach and the sacrifices required. To them leading a fulfilling life in retirement is more than just about money and sacrificing a bit in order to gain peace of mind is a worthwhile trade-off.

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What does calculating the probability of running out of money in retirement teach us?

Is the trade-off that George and Mandy are making appropriate for you? Maybe, but maybe not. At the very least, understanding your own circumstances and your own probability of running out of money may lead to vastly different choices.

Your retirement could extend for 30+ years. Having enough resources to fund your retirement is important to maintain your lifestyle and achieve peace of mind.

While much of life is beyond our control, everybody can still exert some influence over their retirement planning.  In this article we highlighted three general strategies:

  • Adjusting your spending
  • Delaying when you tap your retirement resources
  • Designing an investment portfolio that suitably balances risk and reward

As people enter retirement, they can’t eliminate either longevity or investment risk. What they can do is manage the risks and remain open to adapting their plan should things change.

At Insight Financial Strategists we don’t believe in shortcuts. A CHRIS, a Comprehensive Holistic Retirement Income Strategy, gives you the best chance of full understanding your circumstances and what needs to happen to fund your lifestyle in retirement.

Barring a full financial plan, at a minimum people should evaluate the likelihood of running out of money. Applying the Milevsky and Robinson formula represents a starting point for an in-depth conversation about your needs, goals and especially your attitude toward risk and capacity to absorb losses.

Interested in having the professionals at Insight Financial Strategists guide you? Please request a complimentary strategy session here.

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Disclaimer:

Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. References to specific investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.

This piece may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Stock and bond markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Investing involves risk, including the risk of loss.

 

Aug 13

Is Your Caution Today Hurting Your Tomorrow?

By Eric Weigel | Financial Planning , Investment Planning , Retirement Planning , Sustainable Investing

Photo by Goh Rhy Yan on Unsplash

A Hypothetical Case of Fear vs Greed Tradeoffs

How our brain works:

We all think that we are fully rational all the time but in reality the way our brains operate that is not always the case.

One of the key functions of the brain is self-defense. When the brain perceives danger it makes automatic adjustments to protect itself.  When it perceives discomfort it seeks to engage in an action that removes the stress.

In his book “Thinking Fast and Slow” Nobel Prize Winner Daniel Kahneman explains how we all have a two way system of thinking that we use to make decisions.  He labels the two components as System 1 (Thinking Fast) and System 2 (Thinking Slow).

System 1 is automatic, fast responding and emotional. System 2 is slower, reflective and analytical.

Think of your System 1 as your gut reaction and your System 2 as your conscious, logical thought.

While we all like to think that our key life decisions are governed by our logical thought (System 2) research has shown that even major decisions are often driven by our gut feel.

Which System do we use to make a decision? That depends on the problem. If we have seen the problem many times before such as what to do when see a red light we default to our automatic System 1 thinking.

When we face a challenge or issue that we have not seen before or maybe infrequently we tend to use System 2, our more reflective and analytical capabilities.

Kahneman’s research shows that we spend most of our time in System 1. While most people think of themselves as being rational and deliberate in their decision making, the reality is that we often employ “short-cuts” or heuristics to make decisions.

Most of the time, these “short-cuts” work just fine but occasionally for more difficult or complex problems the impressions arrived from System 1 thinking can lead us astray.

Why? Above all else, System 1 thinking seeks to create quick and coherent stories based on first impressions.  These impressions are a function of what our brain is sensing at that moment in time.

According to Kahneman, conclusions are easily reached despite often contradictory information as System 1 has little knowledge of logic and statistics. He calls this phenomenon – WYSIATIfor “what you see is all there is”.

The main implication from WYSIATI is that people often over-emphasize evidence that they are familiar with and ignore evidence that may be much more relevant to the problem at hand but that they are not fully aware of.

System 1 conclusions therefore may be biased and lead to decision “short-cuts” or heuristics that seriously impair the quality of a decision.

What makes making “money” decisions so hard?

When it comes to investing people often rely too much on System 1 or automatic thinking. The research shows that we are not infallible and we in fact often make behavioral mistakes. Sometimes we over-rely on our gut feel without properly evaluating the consequences of our actions.

Often our brain perceives of the dangers first and sends us a warning signal to be careful.  Losing money puts us on red alert.

Behavioral finance research (for example in the book Nudge) has shown that losing money makes you twice as miserable as gaining the same amount makes you happy. People are loss averse.

Loss aversion makes people overvalue what they have due to a reluctance to incur any losses should they make a change. What they give up, sometimes unknowingly, is potential upside.

Loss aversion creates inertia. Inertia often works against investors that overvalue the attractiveness of their current holdings.

There are different degrees of loss aversion.  According to Prospect Theory, all investors value gains less than losses but some exhibit an extreme dislike for potential losses that significantly hinders their long-term wealth creation potential.

Nobody likes to lose money, but taking on risk in order to compound your hard earned savings is an integral feature of how capital markets work.  You don’t get a higher reward unless you take additional risk.

Most investors know that stocks do better than bonds over the long-term but that the price of these higher returns is more risk.  Investors also understand that bonds do better most of the time than simply purchasing a CD at the local bank or investing in a money market mutual fund.

But knowledge stored in your logical and analytical System 2 thinking does not always make it through in the face of stress or uncertainty.

People can become too risk averse for a couple of reasons:

  • Case A: They let their fears and emotions guide their investment decision making and give disproportionate importance to avoiding any losses
  • Case B: They fail to calibrate their expectations to the likely frequency of outcomes.

In Case A, investors seek the perceived safety of bonds often not realizing that as interest rates go up bonds can lose money.  Or they simply pile into CD’s not realizing that their returns most often fail to keep up with inflation. Stocks are frowned upon because you can lose money.

Investors in Case A let their decisions be driven by emotion and fear and will over-value the importance of safety and under-value the importance of future portfolio growth.  Their account balances will not go down much when capital markets experience distress, but neither will they go up much during equity bull markets.

In Case B investors mis-calibrate their expectations for various investment outcomes and the consequences can be as dire as in the first situation.  Behavioral finance research has shown that investors frequently over-estimate the likelihood and magnitude of extreme events such as stock market corrections.

Investors often become fixated on what could happen should an equity market correction occur, but they fail to properly evaluate the likelihood and magnitude of such a correction in relation to historical precedents.  They also importantly fail to properly calibrate the probability of observing a recovery after going through such a correction.

What are the implications for investors playing it too safe?

Let’s consider the case of investors currently working and saving a portion of their income to fund a long-term goal such as retirement. These individuals are in the accumulation phase of their financial lives.

Somebody in the accumulation phase will naturally worry more about how fast they can grow their portfolio over time and whether they will reach their “number”.  People in the accumulation phase care primarily about their balances going up year after year. They are in “growth” mode.

The Hypothetical Setting:

To better illustrate this situation let’s look through the eyes of a recent college grad called Pablo earning $40,000 a year. Pablo is aware of the need to save part of his salary and invest for the long-term.  He just turned 22 and expects to work for 40 years.

Pablo will also be receiving annual 2.5% merit salary increases which will allow him to save a greater amount each year in the future.

The Problem:

Pablo faces two key decisions – what percentage of his salary to save each year and the aggressiveness of his portfolio which in turn will determine its most likely return.

He is conflicted. He has never made this much money before and worries about losing money. He also understands that he alone is responsible for his long-term financial success.

Pablo knows that there is a trade off between risk and return but he wants to make a smart decision. His System 1 thinking is saying play it safe and don’t expose yourself to potential loses.

At the same time his rational and informed System 2 thinking is influenced by a couple of finance and economics classes he recently took while in college.

Pablo can succumb to automatic System 1 thinking and invest in a very conservative portfolio. Or he can rely on his System 2 thinking and invest in a higher risk and commensurately higher return portfolio.

 

One Alternative – Save 10% of his Income and play it safe investing

For simplicity sake assume that Pablo decides to put 10% of his salary into an investment fund. The fund consists primarily of high grade bonds such as those contained in the AGG exchange traded fund.

From the knowledge gained in his econ and finance classes Pablo estimates that this portfolio should return about 4% per year – a bit below the historical norm for bonds but consistent with market interest rates as of August 2018.

Pablo also understands that such a portfolio will have a bit of variability from year to year. He estimates that the volatility of this portfolio is likely to be about 6% per year. Again, this estimate is in line with current bond market behavior as of August of 2018.

He knows that this is a low risk, low return portfolio but the chances of this portfolio suffering a catastrophic loss are negligible. He is petrified of losing money so this portfolio might fit the bill.

How large could his portfolio be expected grow to over 40 years of saving and investing in this conservative manner?  We built a spreadsheet to figure this out. We assumed a 4% portfolio return on principal, 2.5% annual salary increases and a half year of investment returns on annual contributions also at 4%.  Remember that this is a hypothetical example with no guarantee of returns.

At the end of 40 years Pablo’s salary is assumed to have grown to $107,403 and his portfolio, invested in this conservative manner, would have a balance of $575,540.  The growth of this portfolio (identified as 10_4) is shown in Figure 1. The naming convention for the portfolios corresponds to the savings rate followed by the assumed hypothetical rate of return on the strategy.

Figure 1

Source: Insight Financial Strategists, Hypothetical Example

Pablo knows that his portfolio will not exactly return 4% every year. Some years will be better, other years much worse but over the next 40 years the returns are likely to average close to 4%.

But Pablo does not feel comfortable just dealing in averages.  If things go bad, how bad could it be?

Given the volatility of this conservative portfolio there is a 10% chance of losing 3.6% in any given year. These numbers are calculated by Insight Financial Strategists based on an approximation of a log-normal simulation and are available upon request. Not catastrophic but nobody likes losing money.

Figure 2 shows the 90th and 10th probability bands for this conservative portfolio. These bands are estimated based on the expected average return of the portfolio and its volatility.

The actual portfolio return would be expected to lie about 2/3 of the time within these bands. In the short-term, say 1 to 2 years out, the portfolio returns are more unpredictable.  Over longer horizons, the average return to this conservative portfolio should fall within much tighter bands given the assumed risk and return numbers in the log-normal simulation.

Based on the calculations, the average returns over ten years should range between 6.3% and 1.4% per annum. Clearly, even this conservative portfolio has some risk especially in the short-term, but over longer holding periods returns should smooth out.

Figure 2

Source: Insight Financial Strategists, log-normal simulation using 4% assumed return and 6% volatility

Another Alternative – Save 20% of his Income and continue investing in a conservative portfolio

Assuming the same 2.5% annual salary increases, the final salary would have been the same but his nest egg would have grown to $1,151,080. Pablo keeps looking at Figure 1 (the 20_4 line representing a 20% savings rate invested at an assumed 4%) and starts thinking that maybe a bit of extra saving would be a very good thing.

He still has a 10% probability of being down 3.6% in any given year, but if his budget allows, he feels that he can forego some frills until later.

Now, Pablo is starting to get excited and wonders what would happen if he invested more aggressively, say in a variety of equity funds?

Yet Another Alternative – Keep saving the same amount but invest more aggressively

The likely returns would go up but so would his risk. He estimates that based on current market conditions and the history of stock market returns (obtained from Professor Damodaran of NYU) that this more aggressive portfolio should have about an 8% annual rate of return with a volatility of around 14% per year. These estimates are both a bit lower than the 1926-2017 average reflecting higher current (as of August 2018) valuations and lower levels of overall market volatility.

He is thinking that maybe by taking more risk in his portfolio during his working years he will be able to build a nest egg that may even allow him for some luxuries down the road.

He also knows that things do not always work out every year as expected. Pablo is pretty confident that 8% is a reasonable expectation averaged over many years, but how bad could it be in any given year?

A log-normal simulation was conducted using the assumed risk and return numbers – same approach as before.

Figure 3 shows the 90th and 10th percentile bands for this portfolio.

Figure 3

Source: Insight Financial Strategists, log-normal simulation using an assumed 8% return and 14% volatility

Given the volatility of this equity-oriented portfolio, there is a 10% chance of losing 9.2% in any given year (based on the simulations). Ouch, the reality of equity investing is starting to sink in for Pablo.

But Pablo is also encouraged to see that his returns in any given year are equally likely to be about 26% or higher. That would be nice!

Especially when it comes to equities there is a wide range of potential returns but over time these year by year fluctuations should average out to a much narrower range of outcomes. While our best estimate is that this portfolio will return on average 8% per year over a ten-year window the range of expected outcomes should be between a high of 12.9% and a low of 1.6%.

Pablo decides to research the history of stock, bond, and cash returns by reading our April Blog on Understanding Asset Class Risk and Return and looking at a chart of long-term returns from Morningstar (Figure 4).

Figure 4

Source: Morningstar

He is surprised to find that over the long-term equities do not seem as risky as he previously thought. He is also quite surprised by the wide gap in wealth created by stocks versus bonds and cash.

The research makes Pablo re-calibrate his expectations and he starts wondering whether the short-term discomfort of owning equities is worth it in the long run.

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The “Aha!” Moment:

Pablo’s System 1 thinking is on high alert and his first thought after seeing how much he could lose investing in equities is to run back to the safety of the bond portfolio.

But something tells him to slow down a bit and think harder. This is a big decision for him and his System 2 thinking is kicking in. Before he throws the towel in on the equity-oriented portfolio he glances again at Figure 1 to see what might happen if he invests more aggressively.

What he sees astounds him. It is one thing to see compounding in capital market charts and yet another to see it in action on your behalf. Small differences over the short term amount to very large numbers over long periods of time.

If Pablo were to invest in the more aggressive portfolio there would be more hiccups over the years but his ending account balance should be $1,440,075 if he consistently put aside 10% of his salary every year.

If he saved 20% the ending portfolio balance would double in size.

Decision Time – Picking among the alternatives

Pablo is now faced with a tough decision.  Does he play it safe and go with the conservative portfolio? Or, does he go for more risk hoping to end up with a much larger nest egg but knowing that the ride may be rough at times?

Beyond the numbers, he realizes that he needs to look within to make the best possible decision.  His System 1 thinking is telling him to flee, but his System 2 thinking is asking him to think more logically about his choices.  He also needs to deal with how much he is planning to save from his salary.

Fear versus Greed:

He needs to come to terms with how much risk he is willing to take and whether he can stomach the dips in account balance when investing in riskier assets.  As Mike Tyson used to say, “Everybody has a plan until they get hit in the face”.

In structuring his investment portfolio Pablo needs to balance fear with greed.  Paying attention to risk is absolutely necessary but always in moderation and in the context of historical precedents.  If Pablo lets his fears run amuck he may have to accept much lower returns.

With the benefit of hindsight, he may come to regret his caution. On the other hand, the blind pursuit of greed and a disregard for risk may also in hindsight come back to bite him.  Pablo needs to find that happy medium but only he can decide what is right for him. Risk questionnaires can help in this regard. Try ours if you like!

Consumption Today versus Tomorrow:

Pablo also needs to come to grips with how much current consumption he is willing to forego in order to save and invest.  We live in an impulse oriented society. Spending is easy, saving is hard.

Saving is hard especially when you are starting out.  On the other hand, over time the saving habit becomes an ingrained behavior.  The saving habit goes a long way toward ensuring financial health and the sooner people start the better.

Will Pablo be able to save 10% of his salary? Or, even better will he be able to squeeze out some additional expenditures and raise his saving to 20%?

If possible Pablo should consider putting as much money in tax-deferred investment vehicles such as a 401(k). He should also have these contributions and any other savings automatically deducted from his paycheck. That way he won’t get used to spending that money. Pablo may come to see these deductions from his paycheck as a “bonus” funding future consumption.

 

“The greatest mistake you can make in life is to continually be afraid you will make one”

— ELBERT HUBBARD

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Lessons Learned:

This has been an eye-opening experience for our hypothetical friend Pablo.  He was not expecting such a difference in potential performance.  He now realizes the importance of maximizing saving for tomorrow as well as not succumbing to fear when investing for the long-term.

He has learned several invaluable lessons that also apply to individuals in the accumulation phase of their financial lives

Lesson 1: The Importance of Saving

  • Delaying consumption today allows you fund your lifestyle in the future
  • Saving even small amounts makes a big difference over the long-term

Lesson 2: The value of patience and a long-term perspective

  • In the early years you may not notice much of a difference in portfolio values
  • Keep saving and investing – disregard short-term market noise and stick to a plan

Lesson 3: Small differences in returns can amount to huge differences in portfolio values

  • Seemingly tiny differences in returns can result in large differences in portfolio values
  • Compounding is magic – take advantage of it when you can

Lesson 4: The importance of dealing with your fear of losing money

  • Letting your first instinct to avoid risky investments dictate what you own will work against you
  • Investing involves risk – best to manage rather than avoid risk
  • The pain and agony of losing money in any given year is alleviated over the long term by the higher returns typically accruing to higher risk investments

Lesson 5: Investing in your financial education pays off

  • Gaining a proper understanding of capital market relationships is an invaluable skill to possess
  • Leaning on financial experts to expedite your learning is no different than when athletes hire a coach

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Now what should you do?

Avoid all risks, save a lot and watch your investment account grow slowly but smoothly? Or, take some risk and grow your portfolio more rapidly but with some hiccups?

Are a couple of restless night’s worth the higher potential returns in your portfolio? On

Also, are you willing to delay some current consumption in order to invest for the future?

The answer depends on you – your needs, goals and especially your attitude toward risk and your capacity to absorb losses.

Interested in having the professionals at IFS identify your risk tolerance, time horizon, and financial needs? Please schedule a complimentary consultation here.

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Disclaimer:

Much of the data used in these illustrations comes courtesy of Professor Aswath Domodaran from NYU and covers US annual asset returns from 1928 to 2017. Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. References to specific investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.

This piece may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Stock and bond markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Investing involves risk, including risk of loss.

 

Aug 09

Top 5 Financial Mistakes Made by Foreign Nationals Living In the US

By Chris Chen CFP | Financial Planning , Retirement Planning

Top 5 Financial Mistakes

Made by Foreign Nationals Living in  America

Approximately 1.5 million foreign nationals move to the US every year to study, work and live. Many come on green card visas, and others on working and other temporary visas.  They come from all walks of life. They are engineers, scientists, physicians, academics.

Anyone who has moved to another country can testify that it is a daunting task. Everything is new. A lot of what was known must be relearned. What number to call for emergencies? How much to tip at restaurants if at all? And how to deal with investment and other financial matters?  

Engineers, scientists, physicians, academics, and business people moving to the US often continue to hold assets in checking,  investment accounts and in real estate in other countries. Some may even inherit assets in other countries while living in the US.  Eventually many move back to their home country or a third country.

All newly arrived people in the US  face the common dilemma of how to efficiently reinvent their financial lives.  In many ways the US financial system may seem odd. Many of the differences relative to their former home base can be found relatively easily.

However, there are financial pitfalls specific to foreign nationals living in the US to be aware of. Here are five of them.  

  1. Failure to understand US reporting requirements

Unless they have been in a monastic retreat, US citizens will know that their government cares about their foreign income and assets. Ugly acronyms such as FATCA and FBAR have been designed to ensure tax compliance from all Americans.  What is often overlooked is that the reporting requirements of foreign income and assets also apply to all residents of the US, including foreigners living in the US.

Foreign nationals in the US routinely underestimate the impact of necessary reporting requirements.  They do so at their own peril. Whether they are citizens or not, residents of the US are subject to taxation on their worldwide income. In many cases, taxes paid overseas can be offset by credits to US taxes, thus limiting the monetary impact. The real challenge is the obligation to report. Laws, including the aforementioned FATCA and FBAR, obligates all US residents to report foreign income and assets.  

In a routine instance, a foreign national may own a checking account, a brokerage account, or even real estate in their home country. When moving to the US and focusing on the excitement and challenge of a new life, it is easy to forget about these assets or believe that they do not fall under the jurisdiction of the IRS.Such an assumption would be wrong.

All these assets are subject to reporting to US government authorities. Under the Foreign Account Tax Compliance Act of 2010 (FATCA) the US government set up a global reporting infrastructure to mandate foreign banks and governments to report foreign-held assets owned by US residents to the US government. To ensure compliance, foreign institutions are subject to stiff penalties when they fail to report assets owned by US residents.  In other words, if you own a foreign asset, it is unlikely to be a secret to the US government.

Reporting requirements don’t stop with banks and governments. Taxpayers are also responsible for reporting their own information through FBAR and IRS form 8938 filings. Information in those forms is then compared with the bank and government reports. Discrepancies and failures to report can be considered tax evasion and fraud. They are subject to penalties that can be punitive. Ignoring this issue is not a sustainable strategy, because eventually, the government will catch up. If in doubt check with a professional.

  1. Get overwhelmed by US tax complexity

Foreign nationals who come to America are often overwhelmed by the complexity of the U.S. tax system.  As a result, they often become paralyzed by the complexity and end up missing out on taking care of their financial needs. On average, foreign nationals in the US have the advantage of being stronger savers than Americans. However, to gain a sustainable advantage you need to invest your savings to allow the laws of compound growth work for you and fructify your savings. For every problem, there is a solution.

Although it looks daunting, US tax complexity can also be overcome. Because software solutions are not typically designed to handle the complexities of foreign assets and income, it is advisable to hire professionals who have experience with international matters.

  1. Not being aware of tax treaties

The US maintains tax treaties with some 68 foreign countries that determine rules and exceptions for the treatment of various taxable events. The treaties provide a framework to avoid or minimize double taxation on a variety of active and passive income. Failure to be aware of the tax treaties, their provisions, and their implementation can result in unnecessary withholdings and taxes.

Tax treaties can also provide benefits. If you have worked in the US for a while, you will have accumulated social security credits, potentially qualifying you for social security retirement benefits. Through “totalization” agreements with 26 countries, those credits can be transferred to a number of social security peer systems in those countries, thus improving retirement benefits in those countries.  The reverse is also true. If you have social security equivalent credits in those 26 countries and retire in the US, they could be counted towards your US social security benefits. In the case where there is no totalization agreement and the foreign national has contributed to US social security for 10 years or longer (technically 40 quarters), the foreign national is usually eligible for a US social security retirement benefit.

  1. Cashing out retirement accounts upon leaving the U.S.

Foreign nationals often accumulate substantial U.S. retirement account balances during their American career. Most companies offer a 401(k) retirement plan; foreign national employees are also eligible to participate.  It is often an easy decision: 401(k) plans provide an easy saving mechanism and an immediate tax reduction. It allows a maximum annual saving for people under 50 of $18,500 a year including the company match, if applicable.

When they look to return to their home country, people are often conflicted about how to handle those accounts. Broadly speaking the choices are to leave the accounts unperturbed or to cash out and go home. Often the decision is to cash out.

Cashing out of a deferred tax retirement account such as a 401k or an IRA before age 59 ½ results in punitive taxation.  The distribution is taxed as income. Usually, it propels the account owner to a higher tax rate resulting in additional costs. For instance, a taxpayer that was in the 24% tax bracket could find himself or herself in the 32% bracket as a result of a retirement account distribution.  

To add insult to injury, the distribution is also subject to a 10% penalty for those who take when they are younger than 59 1/2.  It is easy to see that cashing out is an expensive proposition that robs you of the benefits of saving and tax-deferred growth.

The other possibility is to leave the account in the US or roll it over to an IRA if it is in a 401k or other company sponsored plan.  The immediate advantage is that there is no immediate income tax or penalty. In addition, the investment options are usually much stronger and less expensive than in other countries. The downside is that the assets may be subject to estate taxes if the foreign national dies owning the asset.  And, as with Americans, distributions in retirement are subject to income taxes. For those who choose to leave the retirement accounts in the US, a plan can be built to optimize income and estate taxes to ensure that you can benefit from the fruits of your savings.

  1. Not recognizing the advantages of keeping U.S. investment accounts when leaving.

The US investment environment is more favorable to individual investors than most others.  Mutual fund and ETF expense ratios are lower, transaction costs are lower, and management fees are lower.  Market liquidity is usually higher even for many investments that are focused on specific foreign markets. And the range of investment options available to individuals is wider. For instance, there are 80 ETFs listed in Singapore and 134 listed in Hong Kong, compared with 1,707 in the US (August 2018).

It should be noted that although financial assets held by foreigners are not `subject to US capital gains taxes, dividends and interest are subject to withholding taxes of 10% to 30%, depending on whether there is a tax treaty.  Often tax treaties can help mitigate the impact of income and estate taxes, including the withholding tax. Again this is an area where financial professional familiar with the intricacies of cross-border families can really help.

On balance, when they leave the US, foreign nationals can continue to enjoy the generally stronger US investment climate.

Last Word

Moving to the US to continue a thriving career is often a dream of many foreign nationals. A new lifestyle, upward progress and a taste of American culture. What is there not to like about such an adventure? But that dream may not turn out to be that great in real life if you don’t properly address the complexities and uniqueness of the US tax system. However, the five mistakes outlined in this note can be easily addressed with the help of the right professional. Do so, and you will reap the rewards

Jul 19

Don’t Ignore the Chatter – a Trade War represents a Major Risk

By Eric Weigel | Capital Markets , Portfolio Construction , Risk Management

Quarterly Capital Market Perspectives

There’s been a lot of sideways action in this year’s capital markets. We have had a couple of mini-corrections already but equity markets have done a remarkable job of ignoring some clouds on the horizon.

The big elephant in the room that investors have chosen for the most part to ignore is the possibility of an all-out global trade war.

What started back in February as aluminum and steel tariffs has delved into a war of words and escalation of tariffs between the world’s three largest economies of the US, China and Europe.

There is almost a sense of disbelief that this could be happening after decades of globalization.  We are so used to the free flow of goods and services across borders that we hardly ever stop and think about where things are made.

Is a Toyota Camry Japanese or a “Made in the USA” car from a company that so happens to be domiciled in Japan? Is your iPhone an American product or a product made in Asia for a US-based company?

Global companies such as Apple or Toyota operate in highly inter-linked global supply chain and sales channels. A trade war will be highly disruptive to global trade and manufacturing.

Ultimately, an all-out trade war creates massive uncertainty and significantly lowers global economic growth going forward. According to Oxford Economics a trade war could cost the global economy $800 Billion.

To read more about our views on key risk factors facing investors for the rest of 2018 and our intermediate-term outlook for major asset classes please read our Quarterly Capital Market Perspectives.

Jul 19

Post-Divorce Investments – What do I need to plan for now?

By Eric Weigel | Divorce Planning , Investment Planning , Portfolio Construction , Risk Management

Making Your Post-Divorce Portfolio Reflect the New You

Divorce is the final step of a long process. Whether the marriage was long or short, the end of marriage brings about the conclusion of an important phase of your life.

Divorce is an emotional event sometimes anticipated years in advance and at other times coming totally out the blue.

In all cases whether anticipated or not, divorce is a stressful event. According to the Holmes-Rahe Life Stress Inventory Scale divorce ranks as the second most stressful event that a person can experience in a lifetime.

Typically when you divorce you end up with an investment portfolio that is ½ of your old couple’s portfolios. Invariably, your new portfolio will not be suitable anymore.  If you haven’t been the “financial” person in your marriage you may not even know what you own.

Most likely you will need to make changes to your portfolio to suit your new situation. You are now also solely responsible for your financial health.

Your post-divorce portfolio should reflect your updated needs, objectives and comfort level with investment risk.  This may not be what you bargained for or you may feel ill-prepared to handle this on your own.  You may feel that your life is out of your sync, but aligning your financial assets to your new situation is entirely under your control.

Why do you need a new portfolio once you divorce?

For one, the dollar amounts are less than before and your current investment strategy reflects your goals as a couple rather than your own objectives going forward.

Moreover, most likely your confidence is a bit shot and your desire to take much investment risk is lower than before.

Ok, are you with me? You can control this aspect of your new life. What steps should you take to get the ball rolling?

We suggest an approach rooted in our P.R.O.A.C.T.I.V.E methodology.

The first step involves thoroughly examining your new situation from a non-financial standpoint.  Where do you want to live? What type of lifestyle are you looking for? If you have children what type of issues do you need to account for?

The second step is to re-evaluate your comfort with taking investment risk.  Now that you are solely in charge of your financial life how do you feel about taking on risk? Are you comfortable with the inevitable stock market swoons that occur periodically? Are you able to think as a long-term investor given your recent divorce?

The next step is really important. Your post-divorce portfolio needs to work for you. Establishing a hierarchy of financial objectives will drive the type of strategy that is most appropriate for you.

Is your primary objective to save for retirement? Do you have any major objectives besides retirement? Maybe you need to fund college tuition for your two kids.  Maybe you plan on buying a new home in 2 years once your life has settled down?

Next you need to deal with the nitty gritty of figuring out exactly what you own and cash flow budgeting.  What you own should not be difficult to figure out as you have just gone through the divorce process.

The second part of cash flow budgeting is often highly sensitive for people not used to budgeting during their marriage.  If you have never had a budget or stuck to one this step seems like a major imposition. But unless money is so plentiful you have no choice.

At least for a period of time you will have to keep track of your expenses and gain an understanding of where the money is going. The reason this is important is that you may need to tap into portfolio gains to fund your living expenses. If that is the case, your portfolio should be structured to write you a monthly check with a minimal amount of risk and tax consequences.

The next step in the P.R.O.A.C.T.I.V.E process is to evaluate your tax situation. If you are in a high tax bracket you might want to favor tax-advantaged investments such as municipal bonds. If your income is going to be taking a hit post-divorce you probably will end up in a lower tax bracket increasing the attractiveness of a Roth conversion to your traditional individual retirement account.

The last three steps all involve figuring out how best to construct your investment portfolio.  Going from your pre-divorce portfolio to something that fits your needs and goals will usually require some major re-adjustments in your strategy.

Going through our P.R.O.A.C.T.I.V.E process or a similar approach is probably the last thing you want to do on your own.  Most likely you will need the help of an advisor to work through this.

Keep in mind that the reason you are doing this is to regain control over your financial life. You sought the help of a lawyer during your divorce. Now is the time to move forward and seek the help of financial professionals with an understanding of your situation and new set of needs.

What is the best way to implement a portfolio strategy for newly divorced people?

The most important aspect of post-divorce portfolio is that it fits you and your new circumstances and desires.  Using our P.R.O.A.C.T.I.V.E methodology as a framework for evaluating your needs and desires we suggest implementing a portfolio structure that encompasses three “buckets”.

A “bucket” is simply a separate portfolio and strategy that has a very specific risk and return objective. Each bucket in our approach is designed to give you comfort and clarity about its role in your overall portfolio.

What is the role of these “buckets”?

Each “bucket” has a very specific role in the overall portfolio as well as very explicit risk and reward limits.

We label our three “buckets” as the Safe, the Purchasing Power and the Growth portfolios.

The role of the Safe Bucket is to provide liquidity and cash flow to you to meet your short-term lifestyle needs. How much you have invested in your Safe portfolio is a function of how much money you need to fund your lifestyle over the next few years.

The second bucket – the Purchasing Power portfolio – is designed to allow you to enhance your lifestyle in terms of real purchasing power.  What this means is that every year your portfolio should have a return exceeding inflation.

Finally, the third bucket – the Growth portfolio – is designed to grow your portfolio in real terms. This portfolio is designed to maximize your returns from capital markets and will be almost exclusively invested in higher risk/higher reward equity securities.

Conclusion:

Going through divorce is one of the most stressful situations anyone can face. Transitioning to a new beginning may take a short term for some but for most people the period of adjustment is fraught with uncertainty and doubt.

People often worry about their finances and whether they can maintain their lifestyle.  A life event such as divorce also tends to shorten people’s horizon as their outlook in life often lacks clarity.

The implications from an investment standpoint are primarily a temporarily diminished desire to take on portfolio risk and a shortening of time horizons.  In English this translates to searching for greater certainty and not looking too far out.

As wealth managers our first goal is to first understand the client’s circumstances and needs once the divorce is finalized. Our P.R.O.AC.T.I.V.E process serves as the framework for initiating and exploring client concerns and issues.

Our P.R.O.A.C.T.I.V.E approach is designed to make your money work for what you deem important.  Divorce is difficult and transitioning to a new beginning takes time.  As you adjust to your post-divorce life your financial assets will also need to be managed consistent with the new you.

At Insight Financial we are experts at guiding you through this difficult adjustment period and transition into a new beginning. To read our full report on our approach for managing your post-divorce investments please click here.

Our wealth management team at Insight Financial Strategists is ready to help you in your transition.  To set up an initial consultation please book an appointment here.

 

Other posts you may find interesting

Pension Division in Divorce

4 Risks of Pension Plans in Divorce

Post-Divorce Investments 

 

 

Jun 15

4 Risks of Pension Plans in Divorce

By Chris Chen CFP | Divorce Planning , Financial Planning , Retirement Planning

4 Risks of Pension Plans in Divorce

Although the number of pension plans has significantly declined over the years there are still many of them out there, and many divorcing couples have to figure out how to deal with them. The prime benefit that a pension plan provides is a fixed lifetime income.  A stream of income in retirement could well be a pension synonym. It used to be that fixed income was considered a negative. However, nowadays it is the lucky retiree who benefits from a pension plan!

In case of divorce, issues surrounding who is entitled to the pension present a challenge especially in the case of grey divorces (usually defined as people over 50).  Divorce and pension plans can sometimes generate conflict as the owner of the asset will often feel more proprietary about it than with other assets. Employees are often emotionally vested in their pension. They feel, more than with other assets, that they have really earned it. And that their spouse has not.  They often will have stayed in a job that they may not have liked for the privilege of qualifying for a higher paying pension. Couples look forward to getting that income when they retire. And so spouses will want to make sure that they get their share of it as part of the divorce.

Pension rights after divorce are determined as part of the overall divorce process. In a negotiated divorce, the parties can decide, within limits, how to divide their assets. In the worst case, the courts will make the decision.

What is a pension plan and how does it work?

The value of a pension benefit can be difficult to determine. Unlike other accounts, pensions don’t come with a statement that makes them easily comparable to other assets; they come with the promise of a benefit (the monthly payment that someone might get at retirement). So the number one priority when a pension is involved in a divorce is to get a valuation. The financial consequences of divorce are serious, and not getting a valuation may lead to struggling financially after divorce

Risk of Valuation

Even when valued, the number provided on a report may lead to a false sense of security. Unlike other retirement statements, the value of a pension is estimated using the parameters of the beneficiary and of the pension. In most cases the divorce pension payout is calculated with a predetermined formula based on the employee’s length of employment and income.  In some cases, the benefit may vary depending on a few other factors.

The next step is to estimate how long the benefit might be paid. That is done using actuarial tables. Based on periodic demographic studies, actuarial tables predict our life expectancy. Some actuarial tables include those produced by the Society of Actuaries, the Internal Revenue Service, and the Pension Benefit Guaranty Corporation (PBGC). A pension valuation will normally use the estimates from the actuarial tables representing  an average life expectancy of a cohort of people born in the same year. The estimates are usually accurate within their parameters, as individual variability is smoothed out  for large populations. However, individual longevity is harder to predict as it may fall within a wider range.

With the amount of the payment and the length of time that the payments will be made, how much is all of that worth?   Pension valuators use a “discount rate” to approximate the value of a future payment. The principle is that the value of a dollar paid next year will be less than the value of a dollar paid today. Hence you should be willing to accept less than a dollar for the promise of a payment next year, and even less for the promise of payment the year after.  

Financial analysts will use the concept of the prudent rate of return, the rate that a prudent person would invest at in order to receive that dollar next year or beyond. That of course could be subject to interpretation. Often the standard that is used is the government bond rate for the duration of the payment.  US government bonds are often considered to be risk free by economists and the public, although that too is subject to debate (Currently US government debt is rated at AA+ (below AAA) by Standard & Poor’s, the leading debt rating agency). Nonetheless that rate is often used for individual pension valuations.

The PBGC, on the other hand, has developed its own rates. The PBGC uses different rates before retirement, and rates during retirement. The former are significantly higher than the latter and assumes a rate of return that is in excess of the risk free rate.  That may be a better model for actual human behavior, as people will normally be tempted to take more risk for a better return, rationalizing, of course, that the incremental risk is not significant. On the other hand, for rates during retirement the PBGC uses rates that are well below the norm, reflecting the reality that retirees are even more risk averse than the average population.

Financial analysts will determine the value of the pension by taking a present value of the pension payments over the expected longevity of the individual at the determined discount rate(s). The number that comes out is usually a single number assuming a date of retirement.  

Understanding that we are working with an estimate, people usually ignore the fact that the magic number does not take into account the likely variability of  the inputs, in particular longevity.

If you will be the alternate payee (ie, if you are the spouse aiming to get a share of the other’s pension), it is important to pay attention to the fact that the real value of your share of the pension will fall within a range. It will not be a single number Hence when you trade that pension for another asset that has a fixed value, you want to make sure that you are not short changing yourself.

On the other hand if you are the beneficiary of the pension, it is painful enough to give up a share of it.  You don’t want to give up part of that asset if it will not be fully used. If it is the alternate payee that passes away early, his or her stream of payments stops, and, in most cases, does not revert back to you, the initial beneficiary.  If that were to happen you will have wasted a potentially substantial asset.

In summary it is important for divorcing couples to fully understand the value of their pensions for themselves and for their spouse.  Divorce already destroys enough wealth. There is no need to destroy more.

Risk of Default

Pensions have a risk of default or reduced benefits in the future. According to the Society for Human Resources Management  114 pension funds are expected to fail in the next 20 years. That is true even for pensions that do not look like they are in trouble currently. Some people may think that this is farfetched. Yet you only have to look at the Pensions Right website to convince yourself that benefit reductions do happen. When you consider that retirement can last 20, 30 or 40 years, you will want to evaluate if your pension plan is robust enough to last that long, and continue making payments for that long.

The risk of benefit reductions or outright default may apply mostly to the private sector. Yet public sector plans may be at risk also. For instance, Social Security has a trust fund that, together with payroll deductions, funds its retirement benefits (social security retirement benefits are effectively a pension). According to the 2009 Social Security Trustees Report, the Social Security trust fund will run out in 2037. When that happens, the Trustees project that retirement benefits will be cut by 24%.  

It should be noted that Social Security benefits are not divisible in divorce  The beneficiary keeps his or her benefits. The ex-spouse can get 50% of the beneficiary’s benefits (if married 10 years or longer) or 100% of his or her own, whichever is higher, but not both. That happens without prejudice to the prime beneficiary.

However, in 2037, both parties can expect a Social Security retirement benefit cut of 24%, unless Congress remedies the situation beforehand.

Personal Risk

People also underestimate personal risk. If you receive a pension as an alternate payee (ie the spouse who is getting a share of the pension from the former employee), you will want to consider the risks that your payments may be interrupted due to issues with your ex-spouse. Many pensions stop spousal payments when the beneficiary passes. When that happens, the alternate payee will have to find an alternate source of income to compensate.

It is worth remembering that our life expectancies are random within a range. The expected longevity of women reaching 65 years of age is to 85 years of age.  We often anchor on this or other numbers forgetting that few women pass away at 85. Most will pass away either before 85 or after 85. According to a paper by Dr. Ryan Edwards for the National Bureau of Economic Research, the standard deviation for longevity is 15 years. That means that most women will live to 85, +/- 15 years. From 70 to 100 with an average of 85. That is a wide range! What if the beneficiary of the pension passes away 10 years before his her life expectancy, and the alternate payee lives 10 years longer than life expectancy? That means that the alternate payee may have to do without his or her share of the pension for 20 years or longer (if the two ex spouses have the same expected longevity).

And what about inflation risk?

Most pensions do not have a Cost of Living Adjustment (COLA). That does not apply to all of them. For instance, the Federal Employee Retirement Systems (FERS) has a limited COLA. Effectively, when there is no inflation adjustment, the value of a pension payment is reduced every year by the amount of inflation. How bad can that be, you ask? Assuming a 3% inflation rate the value of a fixed payment will decrease by almost 50% over 20 years.  . What is the likelihood that expenses will have reduced by 50%?

A Last word

Pensions are a very emotional subjects in divorce. Perhaps because we are naturally risk averse, and perhaps because our risk aversion is exasperated by divorce related anxiety, we like to cling to what we perceive as solid. People will often want to keep the marital home, even if they cannot afford it, or take a chunk of a pension even when it may make better sense to trade it for another asset. Worse yet they will want to know whether to keep the house or pension in divorce.

What other asset you may ask? You could trade the pension for a tax- deferred retirement asset, such as an IRA or a 401k.  Or any other asset that you and your spouse own. The right decision will end up being different for everyone.

As a Divorce Financial Planner, it is my task to make sure that each side understands exactly what is at stake, and to help prepare them for rebuilding financially after divorce. In many cases it makes sense for both parties to get a share of the pension. In others it does not.  How to keep your pension in a divorce is a vital question. Even more important is to understand the true value of the pension, and its ambiguities.  It is a difficult task in a process that is already filled with anxieties and uncertainties to focus effectively on yet one more ambiguity. Yet for successfully managing finances after divorce it must be done.

 

Other posts that you may find interesting:

Pension Division in Divorce

Post-Divorce Investments 

In Divorce, Can We Share a CDFA?

 

 

Jun 14

3 Mistakes DIY Investors Are Prone to Making in a Crisis

By Eric Weigel | Investment Planning , Portfolio Construction , Risk Management

Photo by Robert Metz on Unsplash

Do-It-Yourself (DIY) Investors have been cropping up everywhere since the end of the 2008 Financial Crisis.

DIY investors tend to be well-educated professionals of reasonable means that prefer to build their own portfolios without the help of an investment professional.

They educate themselves about investing by reading a number of investment books (here is a popular one for Bogleheads) and subscription-based services espousing the benefits of the DIY approach.

 

A lot of DIY investors identify strongly with Jack Bogle, the founder of Vanguard for his dedicated approach to index investing.

One thing that distinguishes today’s crop of DIY investors from the original crop back in the 90’s is that today’s investors are much more focused on exchange-traded funds (ETF) as compared to individual stocks.  A large number of inexpensive and liquid ETF’s have made this possible.

The primary appeal of DIY investing revolves around gaining control over your portfolio.

You are in charge and make all decisions. From selecting a specific ETF to all buy and sell decisions.  A secondary appeal of DIY investing is cost – if you are the manager of your own portfolio you save yourself the fee that would have gone to your investment advisor. Typically this fee amounts to about 1% of the value of your portfolio.

DIY investors tend to do well when capital markets exhibit low volatility and the trend in price is well established.  Everybody loves up-trending markets that don’t fluctuate much.  But as Humphrey Neill, a famous contrarian investor used to say “Don’t confuse brains with a bull market”.

The analogy I like to use is that of a pilot. When everything is calm even a novice will look good. But when the friendly skies become turbulent, a novice pilot will likely tense up and the odds of making a mistake will increase significantly.

DIY investors face the same situation. During periods of calm, portfolio decisions will come easily. The cost of a poor decision is not likely to have major consequences in such a benign environment.

But when the capital markets get dicey, the implications of one’s actions increase dramatically.  A poor decision could decimate the value of your portfolio and seriously harm your overall financial health.

My contention is that when the rubber hits the road, many DIY investors are ill-equipped to deal with extreme capital market uncertainty. 

Stock market corrections are not fun for anybody, but experienced investment managers have the real benefit of having seen a movie of the same genre before.

I have lived through the 1987, 2000-2002 and 2008 stock market meltdowns.  None of these were fun but I learned valuable lessons in each of these crises.  Mainly I learned not to panic but also ways to course correct once it became clear that action was required. A key insight is that changing fundamentals require changing portfolio compositions.

Many DIY investors have not seen a real crisis in their investment lifetimes.  While everybody can read about stock market crashes unless you live through such a period it is hard to truly assimilate their impact both on your pocketbook but more importantly on your psyche.

A crisis such as 2008 is extremely disorienting even for professional investors, but the advantage that experience and knowledge of capital market behavior afford you is a game plan honed by the school of hard knocks.

Without the benefit of having lived through previous periods of real capital market stress and the knowledge of how markets typically behave, DIY investors are at a significant disadvantage.

The potential for errors during a crisis goes up exponentially.  Three common reactions or mistakes that we have seen from DIY investors involve:

1. Selling Everything in a Panic

No questions asked, just get rid of everything that is taking a hit before it gets even worse.  Taking action by selling everything may give the DIY investor a sense of relief.  But making decisions in a highly charged emotional state is asking for trouble.

If the decision to sell is based on solid research and is well thought out, fine.  But if it is based on impulse and an immediate need to get rid of the stress then it is most likely that the portfolio was not appropriate for the individual in the first place.  Investing comes with volatility, there is no way around this!

Oftentimes when an investor sells in a panic the most troubling decision is when to buy in again. Even worse if the decision to sell turns out to be wrong, the investor will endlessly question themselves and lose confidence in their ability to navigate on their own.

DIY investors tend to focus on the initial portfolio composition or asset allocation but often fail to plan ahead should market conditions change.  And if there is one thing that holds true is that change is inevitable and an ongoing part of financial markets. Planning ahead for changing market conditions is an integral component of a well-designed investment plan.

Fortunately, most DIY investors know that impulsively selling everything in a panic is not a good wealth creation strategy. But don’t kid yourself – in a market meltdown you will want to sell everything and more!

You will have to control your emotions and have the stomach to weather the inevitable periods of market turbulence.

Photo by Goh Rhy Yan on Unsplash

 

2. Becoming extremely risk-averse and freezing up even if action is clearly needed

Most market corrections are short-lived and while painful in the short-term they barely register on the long-term map. For example, in 2018 we have already had a couple of equity market corrections but in each case, the market recovered its losses fairly quickly.

No harm, no foul! Doing nothing or standing pat works just fine when markets recover.

The bigger problem for investors is when corrections take on a bigger life and become outright market crashes.  For example, the S&P 500 was down three straight years from 2000 to 2002.  What do you do when the roof seems to be caving in?

Many DIY investors close their eyes and pretend that this is not happening to them. They get frozen and choose to ignore reality.  This is not an abnormal reaction at all for us humans, but we also know that small problems many times lead to big problems if we do not address the underlying issue.

Wishing the problem away does not work.  From the field of behavioral finance, we know that investors tend to hang on to their losing investments way too long.  The flipside is that research has also shown investors to sell their winners way too soon. This effect is known as the disposition effect.

The price of financial assets such as stocks is a function of fundamentals (growth and profitability), the fair price of those fundamentals (investment multiples) and the sentiment of buyers and sellers.

During a period of crisis, the tendency of DIY investors is to focus almost exclusively on sentiment. When sellers want out now and buyers are scarce the price will automatically come down.

You observe falling prices and you get more and more uncomfortable.  But is there any real economic information in investor sentiment?

Experienced investors while not immune to the same feelings of fear will look at the underlying fundamentals and the value of those fundamentals. Experienced investors know that investor sentiment is fickle and lacks much predictive ability.

Has something changed recently to warrant this drop in market values? Are growth rates and profitability permanently impaired, or is the market overreacting? Are investors reacting to the perception of market over-valuation? These are all questions that require some real expertise and most importantly an understanding of context.

There is no cookie cutter way to analyze market action making the experience in similar conditions coupled with knowledge of historical market behavior all that much more valuable.

DIY investors often lack an understanding of context and an assessment of prospective fundamentals in the face of wildly fluctuating capital market conditions. The tendency by many is to stand pat, but what if changing market fundamentals require a change in portfolio positioning?  Intentional investing often requires action.

3. Failing to assess the changing risk levels of their portfolios

A frequent mistake made by DIY investors is to focus almost exclusively on returns and ignore the risk and correlation structure of their portfolios.

Much of the thought behind DIY investing hinges on ideas derived from Modern Portfolio Theory (MPT) but somehow you hardly ever hear DIY investors justify changing allocations based on the volatility structure and composition of their portfolios.

A related mistake is to often assume diversification benefits that often are not there when you need them most.  A good read on “fake diversification” can be found here.

Ignoring changing asset volatility and correlation is a serious mistake made by many non-professional investors.  In fact, one could say that by ignoring the volatility structure of portfolios DIY investors are ignoring some of the lowest hanging fruit available.

As Nobel Prize Winner Harry Markowitz once said: “diversification is the only free lunch provided by capital markets”.

As capital markets change over time so will the risk characteristics of a portfolio even if rebalanced periodically to static weights. 

In a study done a couple of years ago on portfolio rebalancing, I showed just how much stock and bond volatility and correlations can change over time.

Figure 1

Source: Global Focus Capital LLC

Stock volatility, in particular, can move quite a bit around. Bond volatility while still variable shows much lower variability.  And, correlations between stocks and bonds can move between positive and negative values implying large changes in diversification potential for a portfolio.

Say, a DIY investor has a portfolio composed of 60% US stocks and 40% US Bonds. The DIY investor diligently rebalances this portfolio every month so that the weights stay in sync. What would this 60/40 portfolio look like in terms of volatility?

Using the above study over the 2000 to 2016 period, the average volatility of this 60/40 portfolio would average 8%.  Assuming that the average volatility would not change much would be a mistake. The range of volatility goes from 4% to 15% as shown in Figure 2.

Even the old standby 60/40 portfolio exhibits wildly fluctuating levels of portfolio risk.  A 4% volatility level implies a much lower level of potential downside risk compared to a portfolio with a volatility of 15%.  Experienced investment professionals inherently understand this and often seek to target a narrower pre-defined range of portfolio volatility.

Figure 2

Source: Global Focus Capital LLC

DIY investors do not often construct portfolios targeting an explicit range of risk. Instead, the often hidden assumption is that over the long-term asset returns, volatilities and correlations will gravitate toward their “normal” levels. These assumptions are not supported by the empirical evidence.

For DIY investors, changing levels of volatility and correlations can cause significant changes to the risk/returns characteristics of their portfolios. For example, volatility tends to spike up during periods of capital market stress and remain low when markets are trending up.

Also, correlations among investments within the same asset class (broadly speaking equities, bonds and alternatives) tend to also jump up during periods of crisis leading many to question the benefits of asset diversification.  What investors should be questioning instead is why they did not re-adjust their portfolios to reflect the changing conditions.

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Conclusion:

DIY investing is here to stay. Many non-investment professionals have educated themselves as to the virtues of retaining control over their portfolios. After all, DIY investors are saving themselves the fee that they would normally pay their advisor for managing their portfolio.

When markets trend up and volatility is low, DIY investors will typically fully participate in the gains.

But there is another “cost” that DIY may be incurring on their own that often rears its ugly head especially during periods of capital market turbulence.

We are all human and we suffer from the same biases and fears. The difference is that experienced professional investors have the advantage of having seen similar periods of capital market stress before and possess a more nuanced perspective of normal capital market behavior.

DIY investors tend to make three types of mistakes during a crisis – they chuck it all in a panic, they freeze up and do nothing, and, lastly, they ignore changing levels of portfolio volatility.

Professional investors while prone to the same fears as the DIY crowd are better positioned to focus their attention on the fundamentals of investment performance -growth, profitability & valuation – that ultimately drive portfolio values.

Experience and knowledge gained over many market cycles are at a premium when your portfolio most needs it.  At Insight Financial Strategists we are experts in integrating your financial planning needs with your investments.

You do not have to go at it alone and compete against the pros.  Our investment approach is rooted in the latest academic research and implemented using low-cost investment vehicles.

Interested in talking? Please schedule a complimentary consultation here.

 

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