May 14

4 Counter-Intuitive Steps to Take Now to Make Your 401(k) Rock

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

4 Counter-Intuitive Steps to Take Now to Make Your 401(k) Rock

With the demise of traditional defined benefit plans, 401(k)’s provide the most popular way for individuals to save for their retirement.

401(k)’s are also the second largest source of US household wealth right behind home equity.

According to the Investment Company Institute there were over 55 million active participants in 401(k) plans plus millions of former employees and retirees as of the end of last year. The amount of money is staggering at $5.3 trillion as of the end of 2017.

Given the importance of 401(k)’s to US household financial health you would think that plan participants would watch their balances like a hawk and actively manage their holdings.

Some people do, but the vast majority of people do not truly understand what they own or why.  Most people know that the more they contribute to their 401(k) the higher their ending balances are going to be, but beyond that there is a lot of confusion.

Many people do not make 401(k) choices naturally. Many participants do not even know where to begin when it comes to:

  • What funds to select

  • How much to allocate to each fund

  • Deciding on the proper amount of risk to take

  • Understanding how their 401(k) fits in with the rest of their financial picture

When given a choice, people usually start with the issue or problem that they perceive as the easiest to figure out, not necessarily the one of greatest importance.

Many  people approach the problem of how to invest their 401(k) in a simplistic manner.

Many  401(k) participants start off by selecting funds. For most participants this is not an easy choice, but in comparison to the other issues this one appears manageable.

But sadly, 401(k) participants are getting it backwards by picking funds first. They are not framing the problem correctly.

Picking funds before figuring out your goals and objectives is like picking furniture before you know the size and shape of your dining room.  It might work out but it would involve a lot of luck.  Do you want to count on luck when it comes to your financial future?

A different way of addressing the challenge  is to start the other way around. Start with the end goal in mind.

Re-frame the problem to first figure out what you are trying to do.  You want your 401(k) to work for you and your family, right? Sound like a better starting point?

Without knowing what you are trying to do and what really matters to you putting money into your 401(k) loses meaning.

 

What funds to select

First figure out for yourself why you are taking money out of your paycheck to put into your 401(K).  What is your “why”?

The answer may be obvious to you, but when money gets tight due to some unforeseen life event you will be glad that you have a tangible picture for its ultimate use.

Visualize what you are going to do with that money. Is it for a retirement full of adventure? Is it for buying that dream sailboat that you’ll take around the world? Or, is it simply to preserve your lifestyle once you retire? Money has no intrinsic value if you don’t spend it on things that matter to you and your family.

 

 “Money cannot buy peace of mind.

It cannot heal ruptured relationships, or build meaning into a life that has none.”

Richard M. DeVos, Billionaire Co-founder of Amway, Owner of Orlando Magic

 

So, if starting with the end in mind makes sense to you, let’s take a look at the four counter-intuitive steps that you can take now to make your 401(k) work for you. Figure 1 lays it all out.

Figure 1

Step 1: Define what matters to you and inventory your resources

Visualize your goals and objectives for the type of life you and your family want to lead.  Don’t just think about your retirement – think as broadly as possible.

Close your eyes, visualize, pour a nice glass of cabernet for you and your partner before you have the “talk”, write it down in your journal – whatever approach gets you out of your everyday busy persona and makes you focus on what you really want out of life.

How do you want to use your money to accomplish this lifestyle?

Maybe you and your spouse want to engage in missionary work  in 10 years. Maybe you also need to fund college expenses for your children? Maybe you see a lakefront house in the near future?  There is no cookie cutter approach when it comes to people’s dreams! It’s up to you to make them up.

Your 401(k) assets are just one component of your household wealth .  Think about your other assets and financial obligations.  And don’t forget to include your partner’s or spouse’s.

Your house, your emergency fund, investments in mutual funds, possibly a little inheritance, company stock. Almost forgot, your spouse’s 401(k)  and that condo that he/she bought before you met.  Take a comprehensive inventory of your assets.

How much debt do you have? That is part of your financial picture as well. Do you anticipate paying your mortgage off in the next few years?

Wealth managers talk about a concept called the household balance sheet. It’s the same idea that financial analysts use when evaluating a company.  In the corporate world you have assets, liabilities and the difference is net worth.  In your own world you have assets, obligations and unfunded goals, and net worth is the difference.

Sounds a bit harsh when it involves you, right? Don’t take it personally. The key idea is taking an inventory of what you own, what you owe and then matching that up to your goals and aspirations.

 

Step 2. How aggressive do you need to be while being able to sleep at night

The whole idea of saving and investing is about making your goals and aspirations a reality.  If you already have enough assets to fund your desired lifestyle into perpetuity then you don’t really have to worry too much about investing.  Just preserve what you got!

If you are like most people, you need to make your investments work for you. You need a return on your assets.

It’s a good idea to be realistic about goals and objectives.  Are your goals reachable? Is there only a tiny probability of reaching them?

Are your goals a stretch, reachable with some effort, or a slam dunk?

Your answer will dictate how aggressive you will need to be in your investment strategy.

  • If your goals are a stretch you need high return/high risk investments – be ready for a volatile ride and many highs and lows
  • If your goals are within reach using conservative asset class return assumptions you need a moderate return/moderate risk portfolio – you will still experience fluctuations in your portfolio that will leave you feeling anxious at times, but the periods of recovery will more than make up for the periods of stress
  • If your goals are a slam dunk, you are lucky and you will only need low return/safe investment strategies – your portfolio values will not fluctuate much in the short-term but your portfolio will also not grow much in size

To some extent this is the easy part.  There is a link between risk and return in the capital markets. Higher risk usually translates over long periods of time into higher returns. Equities do better on average than bonds and bonds in turn do better than money market investments. So far so good.

Figuring out the required rate of return to fund your goals and objectives given your resources involves math but little emotional contribution.

But what about your emotions?

This is the tricky part.  Many people are able to conceptualize risk in their heads, but are entirely unable to deal with their emotions when they start losing money.

They think of themselves as risk takers but can’t stand losing money.  They panic every time the stock market takes a dip. It does not matter why the market is tanking – they do not like it and run for the exits.

But an honest assessment of both your need to take risk as well as your comfort level with investment fluctuations is necessary in managing your long-term financial health. You will see massive cracks if these two dimensions of risk are not aligned.

Let’s examine a simple situation where we classify your need and comfort level with investment risk in three states: low, medium and high.

Figure 2 lays out all the possibilities.  Ideally, your two dimensions of risk will match up directly.  For example, if your need for risk is low and your comfort level with taking risk is low you are all set. Same if you need a high risk/high return strategy to meet your goals and objectives and you are comfortable experiencing significant fluctuations in your portfolio.

Figure 2

The real problem for you is, however, when the two dimensions of risk are not aligned. You’ll need to resolve these differences as soon as possible to regain any hope of financial health.

Let’s say you are really risk averse. You fear losing money. Your worst case scenarios (bag lady, eating cat food) keep popping up in your nightmares.  If your goals and objectives are ambitious in relation to your resources (high need for risk) those nightmares will not go away and you will live in fear.

You can do one of two things – learn to live with fear or, scale back your goals and objectives.  There is no right or wrong answer – it’s up to you but you must choose.

What if you are comfortable taking on lots of investment risk? Would you like a low risk/low return portfolio? Probably not. In fact, such a portfolio would probably drive you crazy even if you did not need any higher returns.

People comfortable with investment risk frequently suffer from fear of missing out (FOMO). They think that they should be doing better. They want to push the envelope whether they need to or not.

FOMO is as damaging of an emotion as living in fear.  Both states spell trouble. You will need to align both dimensions of risk to truly get that balance in your financial life.

 

Step 3. Determine the asset allocation consistent with your goals and risk preferences

Sounds like a mouthful, right? Let’s put it in plain English.  First of all, the term asset allocation simply refers to how much of your investment portfolio you are putting into the main asset classes of stocks, bonds and cash/bills.

Sure, we can get more complicated than that.  In our own research we use ten asset classes, but in reality breaking up the global equity and bond markets into finer breakouts is important but not critical for the average individual investor.

Figuring out the right range of stocks, bonds and cash is much more important than figuring out whether growth will outperform value or whether to include an allocation to real estate trusts. Do the micro fine tuning later once you have figured out your big picture asset allocation.

All right, since we are keeping things simple let’s look at some possible stock/bond/cash allocations. We are going to use information from our IFS article on risk and return. As a reminder the data used in these illustrations comes courtesy of Professor Aswath Domodaran from NYU and covers US annual asset returns from 1928 to 2017.

Table 1

The top half of the table shows the performance and volatility of stocks, bonds and cash/bills by themselves. From year to year there is tremendous variability in returns but for the sake of simplicity you can use historical risk and returns statistics as a rough guide.

Here is what you should note:

  • If you need high risk/high portfolio returns and you can take the volatility go with a stock portfolio with average historical returns of 12%. On a cumulative basis nothing comes close to stocks in terms of wealth creation but you should expect a bumpy ride
  • If you only need low risk/low returns and you are extremely risk averse go with cash/bill type of portfolios returning, on average, 3%. This portfolio is probably just going to keep up with inflation
  • If you have a medium tolerance for risk and medium need for taking risk then you will likely gravitate toward a combination of stocks, bonds and cash
  • There is an infinite number of combinations of asset class weights – the three asset allocations in the bottom panel of Table 1 may very well apply to you depending on your risk tolerance, need for return and time horizon

What about the stock/bond/cash mixes?

  • The 60% stock/40% bond allocation has over this 1928-2017 period yielded a 9% return with a 12% volatility. Historically, you lost money in 21% of years but if you are a long-term investor the growth of this portfolio will vastly outstrip inflation
  • The 40% stock/60% bond portfolio is a bit less risky and also has lower average yields. When a loss occurs, the average percentage loss is 5%. This portfolio may appeal to a conservative investor that does not like roller coaster rides in his/her investment accounts and does not need the highest returns.
  • The 25% stock/50% bond/25% cash portfolio is the lowest risk/return asset class mix among our choices. Historically this portfolio yields an average return of 6% with a volatility also of 6%. This portfolio may appeal to you if you are naturally risk averse and have a low tolerance for portfolio losses, but you might want to also check whether these returns are sufficient to fund your desired goals and objectives

 

Step 4. It’s finally time to pick your funds

Yes, this is typically where people start. Many times people pick a bunch of funds based on a friend’s recommendation or simply based on the brand of the investment manager.  Rarely do people dig deep and evaluate the track record of funds.

A lot of people pick their funds and declare victory.  They are making a huge mistake. They are not framing the problem correctly.

The problem is all about how to make your 401(k) work for you in the context of your goals and objectives, your resources and your comfort with investment fluctuations.

Picking funds is the least important part.  You still have to do it but first figure out what matters to you, your need and comfort with risk and your target stock, bond, cash mix.

Once you have your target asset allocation go to work and research your fund options.  Easier said than done, right?

Here are some fund features that you should focus on:

  • Passive or Active Management – a passive fund holds securities in the same proportions as well-known indices such as the S&P 500 or Russell 2000. An active fund is deliberately structured to be different from an index in the hope of achieving typically higher returns
  • Fund Style – usual distinctions for equity funds are market capitalization, value, volatility, momentum and geographic focus (US, international, emerging markets). For bond funds the biggest style distinctions are maturity, credit and geographic focus
  • Risk Profile – loosely defined as how closely the fund tracks its primary asset class. Funds with high relative levels of risk will behave differently from their primary asset class. Accessing a free resource such as Morningstar to study the basic profile of your funds is a great starting point. For a sample of such a report click here
  • Fund expenses – these are the all in costs of your fund choices. Lower costs can translate into significant savings especially over long periods of time.  In general, index funds tend to be lower cost than actively managed funds

Understanding what makes a good fund choice versus a sub-optimal one is beyond the financial literacy and attention span of most plan participants.

For most people a good rule of thumb to use is to allocate to at least two funds in each target asset class.

Let’s make this more concrete. Say your target asset allocation is 60% stocks and 40% bonds.  Most 401(k) plans have a number of stock and bond funds available.

What should you do? A minimalist approach might entail choosing an S&P 500 index fund and an actively managed emerging market equity fund placing 30% in each. This maybe appear a bit risky to some so maybe you only put 10% in the emerging market fund and 20% in a US small capitalization fund.

Same on the bond side where you might allocate 20% to an active index fund tracking the Bloomberg US Aggregate index and 20% in a high yield actively managed option.

Let your fund research dictate your choice of funds.  You should keep things simple.

Know what funds you own and why.  Keep your fund holdings in line with your asset allocation.  Spreading your money into a large number of fund options does not buy you much beyond unneeded complexity.

Most of your 401(k) performance will be driven by your target asset allocation anyway. 

Picking funds that closely match the risk and return characteristics of your asset classes (say stocks and bonds) is good enough.

Trying to micro-manage the selection of funds will not likely lead to a huge difference in overall portfolio returns.

______________________

Conclusion:

The task facing you in managing your 401(k) may seem daunting at times.  You may feel out of your own depth.

You are not alone but if you reverse the usual way in which most participants manage their 401(k)’s you should gain greater control over your long-term financial health.

Start with the end in mind. What is this money for? Think about your life goals and objectives.  Depending on your resources, you will need to figure what type of risk/return portfolio combination you will need as well as how comfortable you are dealing with the inevitable investment fluctuations.

Lastly, keep it simple when choosing your funds.  You have figured out the important stuff already.   Pick at least a couple of funds in each of your target asset classes by performing some high level research from sites such as Morningstar and MarketWatch.

Keep in mind that more funds do not translate into higher levels of diversification if they are all alike. Know what you own and why.

If this is all just too much for you, consider hiring Insight Financial Strategists to review your 401(k) investment allocations.  We will perform a comprehensive analysis of your asset allocation and fund choices in relation to your stated goals and objectives while also keeping your expressed risk preferences in mind.

The analysis will set your mind at ease and make your 401(k) work for you in the most effective manner. We are a fee based fiduciary advisor, which means we are obligated to act solely in your best interest when making investment recommendations.

 

 

 

Apr 13

7 IRA Rules That Could Save You Time and Money

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

7 IRA Rules That Could Save You Time and Money

People often end up with several different retirement accounts that are spread between one or more 401(k)s, 403(b)s, IRAs and other retirement accounts.

Treating these various retirement accounts as one, known as “aggregating”, will often make sense.  IRA aggregation can allow more efficient planning for distributions and more efficient investment strategy management . Note that aggregation means treating several accounts as one, not necessarily actually combining them. Nonetheless, there are situations where aggregating IRAs is not permitted and can cause negative tax consequences and could result in penalties .

In general, when IRA aggregation is permissible for distribution purposes, all the Traditional IRAs, SEP IRAs, and SIMPLE IRAs of an individual are treated as one traditional IRA. Similarly, all of an individual’s Roth IRAs are treated as a single Roth IRA.

The following are seven key aggregation rules for IRAs that could save you time and money . The key learning is that it takes strong recordkeeping and awareness of the rules to avoid the pitfalls of aggregation. You should be aware of the requirements, observe them or get help from your Wealth Manager.

  1. IRA Aggregation does not apply to the return of excess IRA contributions

The IRA contribution limit for individuals is based on earned income. Individuals under 50 years of age can contribute up to $5,500 a year of earned income. Those older than 50 years of age are allowed an additional catch up contribution of $1,000. The contribution limit is a joint limit that applies to the combination of Traditional and Roth IRAs.

When the IRA contribution happens to be in excess of the $5,500 or the $6,500 limit (for people over 50), the excess contributions, including net attributable income (NIA), ie the growth generated by the excess contribution, must be returned before the IRA owner’s tax filing due date, or extended tax filing due date. Those who file their returns before the due date receive an automatic six-month extension to correct the excess contributions.

  1. Mandatory aggregation applies to the application of bases for Traditional IRAs

Contributions to Traditional IRAs are usually pre-tax. Thus, distributions from IRAs are taxable as income.  In addition, distributions prior to 59.5 years of age are also subject to a 10% penalty.

However, individuals may also contribute to a Traditional IRA on a non-deductible basis , ie with after-tax income. Similarly, contributions to an employer-sponsored retirement plan can also be made on an after-tax basis (where allowed by the retirement plan) , and potentially rolled over to an IRA where they would retain their non-deductible character.

After-tax contributions to an IRA, but not the earnings thereof, may be distributed prior to 59 ½ years of age without the customary 10% penalty. Distributions from an IRA that contains after-tax contributions are usually prorated to include a proportionate amount of after-tax basis (amount contributed) and pre-tax balance (pro rata rule).

Some IRA owners will choose to keep non-deductible IRA contributions in a separate IRA which simplifies tracking and administration. However, that has no impact on distributions, because, when applying the pro-rata rule, all of an individual’s Traditional IRAs, SEP IRAs, and SIMPLE IRAs are aggregated and treated as one.

Suppose that Janice has contributed $700 to a non-deductible Traditional IRA, and it has grown to $1,400.  If Janice takes a distribution of $500, one half of the distribution is returnable on a non-taxable basis, and the other half is taxable and subject to the 10% penalty if Janice happens to be under 59½ years of age. You can see why Janice would want to keep accurate records of her transaction in order to document the taxable and non-taxable portions of her IRA.

  1. Limited aggregation applies for inherited Traditional IRAs

Inherited IRAs should be kept separate from non-inherited IRAs . The basis in the latter cannot be aggregated with the basis of an inherited IRA.

In practice, it means that if Johnny inherited two IRAs from his Mom and another from his Dad, Johnny must take the Required Minimum Distributions for his Mom’s two IRAs separately from his Dad’s, and also separately from his own IRAs.

Furthermore, IRAs inherited from different people must also be kept separate from one another. They can only be aggregated if they are inherited from the same person.  In addition, inheriting an IRA with basis must be reported to the IRS for each person.

  1. Mandatory aggregation applies to qualified Roth IRA distributions

Qualified distributions from Roth IRAs are tax-free. In addition, the 10% early distribution penalty does not apply to qualified distributions from Roth IRAs.  

Roth IRA distributions are qualified if:

– they are taken at least five years after the individual’s first Roth IRA is funded;

– no more than $10,000 is taken for a qualified first time home purchase;

– the IRA owner is disabled at the time of distribution;

– the distribution is made from an inherited Roth IRA; or

– the IRA owner is 59½ or older at the time of the distribution.

If Dawn has two Roth IRAs, she must consider both of them when she takes a distribution.  For instance, if Dawn takes a distribution for a first time home purchase, she can only take a total $10,000 from her two Roth IRAs

  1. Optional aggregation applies to required minimum distributions

Owners of Traditional IRAs must start taking required minimum distributions (RMD) every year starting with the year in which they reach age 70½ . The RMD is calculated by dividing the IRA’s preceding year-end value by the IRA owner’s distribution period for the RMD year.

An individual’s Traditional, SEP and SIMPLE IRAs can be aggregated for RMD purposes .

The RMD for each IRA must be calculated separately; however, the owner can choose whether to take the aggregate distribution from one or more of his Traditional, SEP or SIMPLE IRAs.

So, if Mike has a Traditional, a SIMPLE and a SEP IRA, he would calculate the RMD for each of the accounts separately.  He could then take the RMD from one, two or three accounts in the proportions that make sense for him.

As a reminder, Roth IRA owners are not subject to RMDs.

  1. Limited aggregation applies to Inherited IRAs

Beneficiaries must take RMDs from the Traditional and Roth IRAs that they inherit with the exception of spouse beneficiaries that elect to treat an inherited IRA as their own.

With this latter exception, RMD rules apply as if the spouse was the original owner of the IRA.

When a beneficiary inherits multiple Traditional IRAs from one person, he or she can choose to aggregate the RMD for those inherited IRAs and take it from one or more of the inherited Traditional IRAs. The same aggregation rule applies to Roth IRAs that are inherited from the same person.

Suppose again that Johnny has inherited two IRAs from his Mom and one from his Dad. Johnny can calculate the RMDs for the two IRAs inherited from his Mom, and take it from just one.  Johnny must calculate the RMD from the IRA inherited from his Dad separately, and take it from that IRA.

If in addition, Johnny has inherited an IRA from his wife, he may aggregate that IRA with his own.

It is important to note that RMDs for inherited IRAs cannot be aggregated with RMDs for non-inherited IRAs , and RMDs inherited from different people cannot be aggregated together.

  1. One per year limit on IRA to IRA rollovers

If an IRA distribution is rolled over to the same type of IRA from which the distribution was made within 60 days, that distribution is excluded from income.

Such a rollover can be done only once during a 12-month period.

In this kind of situation, all IRAs regardless of types (Roth and non-Roth) must be aggregated. For instance, if an individual rolls over a Traditional IRA to another Traditional IRA, no other IRA to IRA (Roth or non-Roth) rollover is permitted for the next 12 months.

Conclusion: What you should keep in mind

These are some of the more common IRA aggregation rules.  There are others including rules for substantially equal periodic payments programs (an exception to the 10% early distribution penalty), and those that apply to Roth IRAs when the owner is not eligible for a qualified distribution.

Although IRAs are familiar to most of us, many of the rules surrounding are not . It is still helpful to check with a professional when dealing with them.

Lastly, many of the potential problems that people may face with IRA aggregation can be avoided with proper documentation. Recordkeeping is essential. Individuals can do it themselves or they can rely on their Wealth Managers. In the case where you have to change financial professionals, make sure that you have documented the history of your IRAs.   

Apr 13

Capital Market Perspectives – April 2018

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

Capital Market Perspectives - April 2018

 

Photo by Dawn Armfield on Unsplash

The last couple of months have tested investors.  In a sense, we all got lulled by the wonderful returns of last year and any hiccup was bound to create some stress.

The talk at the end of 2017 was all about tax cuts and the short-term boost that lower tax rates would provide to consumer spending and the bottom-line of US corporations.

For the first month of the year, things couldn’t have been going better for equity investors. Bond investors while not exactly sitting in the catbird’s seat were slowly adapting to the inevitable rise in yields.

Emerging market equities, in particular, jumped ahead and the mood among global investors was one of optimism.  Market commentators were even talking about a stock market melt-up!

Two months later the mood has changed drastically. Investors are nervous and we have already witnessed two small corrections in the equity markets.

Figure 1

Source: FRED (Federal Reserve Economic Data), Insight Financial Strategists, April 2018

The first mini-correction attributed to rising inflationary expectations took the S&P 500 from a peak of 2873 on January 26 to a low of 2581 on February 8. The 11% drop while not unprecedented was keenly felt by investors accustomed to the record low levels of volatility seen in the last year. It felt like going from a newly paved highway to a dirt road without any warning signs!
 

Were rising inflationary expectations to blame for the early February stock market fall?  Our research did not support this story.  We had been seeing a slow rise in inflationary expectations for about a year but US Inflation Protected Note prices containing the market’s consensus forecast of inflation over the next 5 and 10 years did not exhibit any significant upward pressure.

Inflation in the US seems to be fairly range bound with the latest year over year reading of 2.3% (February). Inflationary expectations as of April 6 for the next 5 years stand at 2.0% and for 10 years out at 2.1%.

The market implied forecast may turn out to be too benign, but for now, our own view of economic conditions in the US is closely aligned with these market-based expectations.

A number of events could have caused the early February correction, but in the context of long-term capital market history, we think that this episode will appear as a mere blip on price charts. Rising inflationary expectations do not seem a likely culprit for this episode of equity market stress.

Figure 2

Source: Quandl, FRED, Insight Financial Strategists, April 2018

What about the most recent late March equity market drawdown? US equity market markets staged a strong recovery from the February lows with the S&P 500 having recovered all but 3% of the losses from the January 26 peak. Since early March the global markets have, however, been on a roller coaster ride.  Up one day, down big the next. As of April 6, the S&P 500 has lost over 6% since March 9.

The second mini-correction of the year has re-tested the resolve of equity investors. Volatility levels have jumped up and have risen significantly from the lows of 2017. The intraday movement of markets (the difference between the high and low of the day) has been about 2X that of normal periods and 4X that experienced last year.

Figure 3

Source: Quandl, FRED, Insight Financial Strategists, April 2018

Market volatility has been historically low over the last few years but the large intraday swings we have been seeing this year are distressing to even seasoned investors.  John Bogle in a recent interview for Marketwatch commented that he had not seen such a volatile market in his lifetime. He was referring specifically to the huge intra-day moves seen over the last two weeks.

 What has caused this recent bout of stock market volatility? As always there are many possible reasons, but this time around we see a more direct link to the uncertainty surrounding a possible global trade war.

Markets do not react well to uncertainty especially to events that are both hard to quantify in terms of the probability of occurrence and the magnitude of consequences.

Trade wars are not everyday events.  The last time wholesale tariffs were imposed in the US happened in 1930 when the Smoot-Hawley Tariff Act was passed.  While economists will debate whether the Act exacerbated the Great Depression, in general, it is acknowledged that tariffs limit economic growth.

Free-trade has been a goal of most nations for the last 50 years. Gains from free trade provide a win-win outcome enabling producers to focus on goods and services where they enjoy a comparative advantage and consumers to reap the benefits through lower costs is one of the strongest held beliefs of modern economics.

Global trade of goods and services currently accounts for 27% of worldwide output (according to the OECD). Disrupting global trade by imposing tariffs on a large number of items seems reckless.  It is especially reckless when considering that we picked a fight with the world’s largest economy – China.  China also owns 19% of the outstanding supply of US Treasuries.

No doubt Chinese trade practices are unfair to US companies. Forcing US companies to transfer technical know-how to Chinese firms seems especially egregious given the state of China’s economic development.  China is the largest global economy and many of its technology companies are already global powerhouses.

Another bone of contention for some is the under-valuation of the yuan.  An undervalued currency is a huge weapon for increasing the attractiveness of a country’s exports.  However, it is not clear that the yuan is under-valued. According to an IMF report in July of 2017, the fair value of the yuan was roughly in line with market prices and fundamentals.

At first, the tariffs proposed by the Trump administration seemed fairly innocuous – washing machines and solar panels. Then on March 1, the US proposed tariffs on steel and aluminum.  Not good especially since many traditional allies of the US (mainly Canada and South Korea) would be the primary targets. Gary Cohn, the administration’s top economic advisor, resigned in protest sending shockwaves through the financial community. The S&P 500 reacted with a 1.34% loss for the day

However what really got the capital markets in a tissy was the announcement on March 22 of tariffs on $50 billion worth of Chinese imports.  The fight was on and it did not take very long for Chinese authorities to retaliate with in-kind tariffs on US goods.

The S&P 500 dropped 2.55% on March 22 and 2.12% on the next day.  Likewise, Chinese equity markets reacted quite negatively to the possibility of an all-out trade war with the US with the iShares China Large-Cap ETF (FXI) dropping 3.8% and 2.4% respectively on those days.

 

Where is this all going to end up? In an all-out trade war like after the passage of the Smoot-Hawley Act? Or, in serious bilateral negotiations between the US and China?

Our guess is that there are enough rational agents in both the US and Chinese administrations to avert an all-out trade war, but getting the negotiations going will not be easy and will take time.  China has already requested negotiations through the WTO Dispute Settlement Mechanism. Luckily there is at least a 60 day comment period separating talk and action.

The US is not likely to be a winner in a global trade war.  Nobody is really.  The most likely outcome is lower overall global growth and increased uncertainty – not a good recipe for capital markets especially in light of current above-average valuation levels.

 

The main problem for the US is that as a nation we are not saving enough.  The current net savings rate as a function of GDP currently stands at 1.3%. This number has been steadily trending down – the average since 1947 when numbers were first compiled is 6.6%.

The US balance of payments and trade deficits are a function of the imbalance between domestic savings and our thirst to grow and consume.  In 2017, the US had merchandise trade deficits with 102 countries. China is not our only problem!

Let’s hope that cooler heads prevail and that the disruption to global trade proves minimal.  Some of the damage has already been done as uncertainty has engulfed global capital markets.

The real economic damage of a global trade war is likely to be substantial.  Both equity and bond markets would come under significant stress.  Equities would likely take the most immediate hit as earnings growth, especially for multi-nationals, would drop significantly.

Bonds are also likely to take a hit as a likely reaction by the Chinese authorities would be to decrease their investments in the US Treasury market. Interest rates in the US would likely jump up causing pain to fixed income investors as well as worsening the federal budget deficit.

 

What do we expect in the intermediate-term from capital markets? While all this talk about trade wars and inflation scares may fill our daily news capture, it is worthwhile to remember that fundamentals drive long-term asset class performance.

In the short-term, capital markets can be heavily influenced by changing investor sentiment, but over the horizons that truly matter to most investors most periods of capital market stress tend to wash out.

Our current capital market perspectives assume that a trade war will not materialize.  Our views are informed by a number of proprietary asset class models updated as of the end of March.

Our current intermediate-term views reflect:

  • A preference for stocks over bonds despite their higher levels of risk
  • A desire for international over US equity based on valuation differentials and a depreciating US dollar – we especially like emerging market stocks
  • Within the fixed income market, we favor corporate bonds as we believe that economic conditions will remain robust and default risk will be contained
  • Small allocations to commodities as this asset class gradually recovers from the bear market it’s been in since the 2008 Financial Crisis
  • A reduction in our exposure to real estate as the asset class is being heavily penalized in the markets for its interest rate sensitivity
  • Minimal allocations to cash – the opportunity cost of holding large sums of low yielding cash is high especially for investors with a multi-year horizon
  • A return of risk on/off equity market volatility– this will surely stress investors without a solid plan for navigating market turbulence

 

 What should individual investors do while politicians flex their muscles? For starters evaluate your goals, risk attitude, spending patterns and investment strategy.  Make sure that the shoe still fits.  Capital markets are not static and neither are personal situations.

A long-term orientation and tactical flexibility will be a necessity for investors as they navigate what we think will be difficult market conditions over the next decade.

Such an approach will be especially important for individuals near or already in retirement. The sequence-of-returns-risk is especially important to manage in the years surrounding retirement when the individual will start drawing down savings.

Our approach at Insight Financial Strategists explicitly deals with this type of sequence-of-returns-risk by building the individual’s portfolio around the concept of goal-oriented buckets. Each bucket has a distinct goal and risk profile.

The short-term bucket, for example, while customized for each individual, has the overriding goal of providing a steady stream of cash flow to the individual.  This is the safe money designed to exhibit minimal volatility.

The goal of the intermediate-term bucket is different – this part of the portfolio is designed to grow the purchasing power of the individual in a risk-controlled manner. A sometimes bumpier ride is the price of growth for this bucket but the rewards should be more than commensurate with the additional risk taken.

Finally, the long-term bucket is designed to maximize the long-term appreciation of this portion of the portfolio.  This bucket will be the most volatile over the short term and is suitable for individuals with time horizons exceeding ten years and able and willing to withstand the inevitable periods of capital market stress.

Apr 13

Understanding Asset Class Risk and Return – Your Pocketbook and Psyche Will Thank You

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

Investment risk is an inevitable part of capital markets.

 

Markets do not just go up as much as we wish for that to be always the case.

Sometimes capital markets experience stress and the draw-downs can be extremely uncomfortable to investors.

How investors react to periods of capital market stress is incredibly important.

Become too aggressive and you could end up with major short-term losses and your financial survival may be at stake.

On the other hand, become too cautious and you may end up excluded from any future capital market appreciation.

 

So, if risk is inevitable, what can you do about it? Being either extremely aggressive or extremely risk-averse are probably the least desirable options especially if you wait to act until there is a market meltdown.

In the first case, you may not be able to stay invested as short-term losses cripple your psyche and your pocketbook.  Even though you believe in your investments, your emotions will be tugging at you and second-guessing you.  This is the curse of being too early.

In the case where people become too risk-averse, being too cautious prevents you from making up the losses experienced during periods of capital market stress by participating in the good times. Most likely you second guess yourself and by the time you take the plunge back in you have probably already missed out on some large gains.  This is the curse of being too late.

 Investing is not easy especially when things go against you in the short-term. It is best to understand what you are getting yourself in and have a plan for when things go awry. As Mike Tyson once said, “everybody has a plan until they get punched in the nose”.

Getting punched in the nose is not an uncommon experience for stock market investors.  For bond market investors the experience is not as common but it still happens.

Understanding that investing can at times be brutally taxing on your pocketbook and psyche is an essential element of reaping the benefits of any investment plan. A great game plan is useless unless you have the ability to withstand the dark periods.

Investors are frequently confused by capital market behavior.  Over the short-term asset classes can go almost anywhere as investment sentiment is usually a strong driver of returns.  Market pundits attempt to provide some rationale for why things are moving in a certain direction, but in reality, most of what goes on from day to day in capital markets is usually nothing more than noise.

Markets are prone to bouts of over-confidence where all the bad news gets ignored and investors appear overly upbeat.  Other times, markets will be laser-focused on negative short-term events of little economic significance and investors will become overly pessimistic.  Even seasoned investment professionals feel sometimes that there is no rhyme or reason for what is happening to financial asset prices.

Over longer-term horizons, asset class fundamentals start being reflected in prices as investment sentiment becomes secondary.  Profits, valuations, profitability, growth potential become the drivers of prices.  Periods of stress are frequently forgotten and appear as mere blips on historical price charts.

One of the key tenets of long-term investing is that risk and return are inextricably tied together.   Without any risk, you should not expect any incremental returns. Investing is inherently risky as outcomes – short or long-term – cannot be predicted with total certainty.

Most investors understand that, on average, stocks do better than bonds but that the price of these higher returns is a lot more risk.  Investors also understand that longer-maturity bonds will do better most of the time than simply purchasing a CD at the local bank or investing in a money market mutual fund.

But beyond this high-level understanding of capital market behavior, there is lots of confusion. Gaining a better understanding of key asset class risk and return relationships will help you become a better-informed consumer of investment strategies.

Understanding what you are getting yourself in when evaluating different investment strategies could significantly alter your wealth profile for the better and allow you to take advantage of market panics rather than simply react to crowd psychology like most people.

To become an informed consumer of investment strategies the first step is understanding key asset class risk and return tradeoffs.  We use a dataset kindly provided online by Professor Aswath Damadoran at NYU to look at calendar year returns on US stock, bond and bill returns.  Bond returns proxy for a 10-year constant maturity US Treasury Note and bills correspond to a 3 month US t-bill.  US stocks are large capitalization stocks equivalent to the S&P 500. Figure 1 depicts the annual asset class returns since 1937.

The first thing that jumps out from the chart is the much higher level of return variability of stocks.

The second thing that jumps out is the incredible year over year smoothness of T-bill returns.  Bonds are clearly somewhere in between with volatility characteristics much more similar to bills.

The third thing that jumps out are the rare but eye-popping large equity market meltdowns such as during 1937, 1974, 2002 and 2008.  Lastly, of notice are the very large positive spikes in equity returns during years such as 1954, 1958, 1975, 1995 and 2013.

 Figure 1

What is not entirely clear from looking at the yearly return chart is the huge cumulative out-performance of stocks relative to both bonds and bills. Table 1 provides summary statistics on calendar year returns for each asset class.

Table 1


Key highlights:

  • Over the 1928-2017 period, stocks have returned on average 12% per year with an annual standard deviation of 20% year. Bonds are next in line with an average return of 5% and a volatility of 8%. Bills have had the lowest rate of return at 3% with a volatility of 3%. These numbers correspond to the usual risk/reward relationships that investors know all about.
  • In 27% of the years between 1928 and 2017, stocks have had a negative return. The average return when the market has gone down is -14%. Nobody likes losses but even bond investors saw negative returns in 18% of the years and when they happened the average loss was -4%. The only way never to lose money in any given year is to invest in bills.
  • If one had invested $100 in December 1927 and held that investment the ending portfolio value would be $399,886 – a huge rate of growth despite the infrequent yet terrifying equity market meltdowns. Bonds don’t come even close with an ending portfolio balance of $7,310. Playing it safe with bills would have yielded a portfolio value of $2,016.
  • From a cumulative wealth perspective, stocks are clearly the superior asset class but only if the investor is able to stomach the rare but large equity drawdowns and seeing losses in over a quarter of the years.
  • If the investor is seeking stability with no chance of principal loss, T-bills are the preferred asset class. The rewards compared to stocks will be meager, but the ride will be smooth and predictable.

 

What happens when you extend the holding period out to, say 10 years? Does the spikiness of stock market returns disappear? What about the frequency of down years?

Using the same data set as before and forming rolling 10-year holding returns starting in 1927 we observe in Figure 2 that some of the volatility of stocks and bonds has dissipated. Instead of spikes we now have mountains and slopes.

Figure 2

 

The chart on rolling 10-year returns exposes the massive cumulative out-performance of stocks during most ten-year holding periods.  There are instances of negative 10-year stock returns (6% as shown in Table 2) but they are swamped by the mountain of positive returns especially when viewed in relation to bond and bill returns.

We see only three periods when equity investors would have loved to play it safe and be either in bonds or bills – the early years post the Great Depression (1937-39), the Financial Crisis (2008-9), and economic stagnation and inflationary years starting in the mid-70s through the beginning of the equity bull market of 1982.  In the first two instances, equity holders lost money.  In the latter instance, equity investors enjoyed positive returns but below those of either bonds or bills.

Table 2

Some observations are in order:

  • As one extends the holding period from 1 to 10 years some of the spikiness of one-year returns is smoothed out – not every year is fantastic and not every year is terrible, periods of stress are usually followed by periods of recovery and so on
  • Over a ten year holding period stocks do not look as scary – only in 6% of our observations do we see a negative return. When those losses occur the average loss is 10% on a cumulative basis.
  • Rolling 10-year maturity bonds every year over a decade yields no periods in our sample where the strategy exhibits a loss. The same holds true for bills.
  • Investors able to extend holding periods from short to longer maturities such as ten years significantly lower their odds of seeing negative returns as confirmed in the empirical data

 

What happens when we mix and match asset classes? Does that help lower our probability of loss? We look at some typical multi-asset class mixes over one-year holding periods:

  • The 60/0/40 portfolio composed of 60% stocks and 40% bonds – a traditional industry benchmark
  • The 40/0/60 portfolio composed of 40% stocks and 60% bonds – a moderately conservative mix
  • The 25/50/25 portfolio composed of 25% stocks, 50% bills and 25% bonds – a conservative mix for a very risk-averse investor

Mixing asset classes is usually referred to as multi-asset class investing.  The premise for such an approach is based on the diversification benefits afforded by allocating in varying proportions to asset classes with their own unique risk and return characteristics.

It turns out that over the 1928-2017 period stocks were essentially uncorrelated to both bonds and bills.  The correlation between bonds and bills was 0.3.  Building portfolios with lowly correlated asset classes is hugely beneficial in terms of lowering the volatility of the multi-asset class mix.

Table 3

 

What are the main conclusions that we can reach when mixing asset classes with widely different risk and return characteristics?

  • When combining stocks, bonds, and bills in varying proportions we arrive at portfolio results that fall between those of equities and bonds
  • The traditional 60/0/40 portfolio had a lower frequency of negative returns compared to an all-equity portfolio, significantly lower volatility and a cumulative ending portfolio value only about a 1/3 as large. What you gain in terms of lower risk, you lose in terms of compound returns.
  • The 40/0/60 portfolio which represents a lower risk alternative to the investor lowers volatility (to 9%) but at the expense of also lowering average returns (to 8%) and especially cumulative wealth (ending value of $58,090)
  • The lowest risk multi-asset class strategy that we looked at – the 25/50/25 portfolio – had the lowest average returns (6%), lowest volatility (6%) and lowest long-term growth.
  • A key implication of multi-asset investing is by combining asset classes with disparate risk and return characteristics you can build more attractive portfolios compared to single asset class portfolios
  • Comparing two traditionally low-risk portfolios – 100% bonds and the 25/50/25 portfolio – demonstrates the benefits of multi-asset class investing. The multi-asset class portfolio not only has higher average returns but lower risk. The frequency of calendar year loss is smaller (11% compared to 18%) and the long-term portfolio growth is over 2X that of the all-bond portfolio.

 

Three very significant lessons emerge from our study of asset class behavior that can vastly improve your financial health.  The first relates to the holding period.  Specifically, by having a longer holding period many of the daily and weekly blips that so scare equity investors tend to wash away.

Equity investments do not look as volatile or risky when judged over longer holding periods of say 10 years.

The second lesson relates to the power of compounding. Small differences in average returns can yield huge differences in long-term cumulative wealth.  In terms of the multi-asset class portfolios – the 60/0/40 versus the 40/0/60 – yields only a 1% average return difference but a 2X difference over the 1928-2017 period.

Seemingly small differences in average calendar year returns can result in massive wealth differences over long holding periods.

The third lesson relates to diversification. By mixing together asset classes with varying risk and return characteristics we can significantly improve the overall attractiveness of a portfolio. Lower portfolio risk is achievable with proper diversification without a proportional sacrifice in terms of returns.   Properly constructing multi-asset class portfolios can yield vastly superior outcomes for investors.

 

Every investor needs to come to terms with the risk to reward relationships of major asset classes such as stocks, bonds, and bills.  Understanding the risk and return tradeoffs you are making is probably the most important investment decision affecting the long-term outcome of your portfolio.

Some investors can stomach the sometimes wild ride offered by stocks and choose to overwhelmingly use equity strategies in their portfolios. They don’t worry much about the daily vicissitudes of the stock market.  They accept risk in return for higher expected returns.

Not everybody, however, can stomach the wild ride that sometimes comes from owning stocks despite understanding that over the long-term stocks tend to better than bonds and bills.

Some investors are willing to leave a bit of money (but not too much, please) on the table in return for a smoother ride. They may elect to hedge some of the risks.  Or they may mix in varying proportions of risky and less risky asset classes and strategies.

Yet other investors are so petrified of losses and market volatility that they will forego any incremental return for the comfort and steadiness of a safe money market account. They choose to avoid risk at all costs.

 

Which is the better approach for you? Avoid all risks, save a lot and watch your investment account grow slowly but smoothly?

Or, take some risk, sweat like a nervous high schooler when capital markets go bust and grow your portfolio more rapidly but with some hiccups?

The answer depends on you – your needs, goals and especially your attitude toward risk and your capacity to absorb losses to your wealth.  If you already have a financial plan in place great. If you need help getting started or refining your plan, the team at Insight Financial is ready to share our expertise and bring peace of mind to your financial life. Book an appointment here.

Understanding that investing can at times be brutally taxing on your pocketbook and psyche is an essential element of reaping the benefits of any investment plan.  In subsequent articles, we will be exploring different ways of managing risk and structuring portfolios.

 

 

Mar 15

Is the new Tax Law an opportunity for Roth conversions?

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

Is the new Tax Law an opportunity for Roth conversions?

The New Tax Law, known as the Tax Cuts and Jobs Act (TCJA) was passed in December 2017. Its aim was to reduce income taxes on as many constituencies as possible. One of the well known implementations of that desire has been the temporary reduction of individual income tax rates. That provision of the law is scheduled to sunset in 2025. Starting in 2026, individual income tax rates will revert back to 2017 levels, resulting in a significant tax increase on many Americans, following 8 years of reduced tax rates.  

Assuming Congress doesn’t take future action to extend the tax cut, how can the damage of the TCJA’s scheduled tax increase be mitigated? One way to mitigate the damage of the TCJA scheduled tax increase could to switch some retirement contributions from Traditional accounts to Roth accounts from 2018 to 2025 , and switching back to Traditional accounts in 2026 when income tax bracket increase again.  

Another way to blunt the impact of theTCJA is to consider effecting Roth conversions between 2018 to 2025 .

The TCJA has a tax increase built into it

It’s well known that contributions to and withdrawals from Roth IRAs and Roth 401(k)s are taxed differently than their Traditional cousins .  One of the major factors to consider when deciding between a Roth IRA or a Roth 401(k) and a Traditional IRA or Traditional 401(k) are income tax rates during working years and in retirement.  

Generally speaking, Roth accounts are funded post tax, whereas a Traditional accounts are funded pre-tax .  As a result, funding a Traditional 401(k) account reduces current taxable income , usually resulting in lower current taxes. Similarly, you may be able to deduct your contributions to a Traditional IRA from your current tax liability depending on your income, filing status, whether you are covered by a retirement plan at work, and whether you receive social security benefits.   Income taxes must be paid eventually, so retirement distributions from Traditional IRAs and 401(k)s are taxed in the year in which they are withdrawn. In fact, the Internal Revenue Service so wants retirement savers to pay income taxes that it mandates Required Minimum Distributions (RMD) from Traditional accounts after age 70 1/2 . RMDs are taxed as ordinary income in the year they are distributed.

On the other hand Roth accounts are funded with post-tax money and result in retirement distributions that are tax free, provided all requirements are met.  

Roth IRAs and Roth 401(k)s

When working year taxes are lower than projected tax rates in retirement , it usually makes sense to contribute to a Roth account . In this situation, paying taxes upfront results in lower projected lifetime taxes. For instance, assuming that Vanessa is in the 24% tax bracket, she will need to earn $7,236 to make a $5,500 contribution to a Roth IRA. That is because, she will owe federal taxes of $1,736 on her earnings (not counting state taxes where applicable), leaving her with $5,500 to contribute. However, Vanessa’s distributions in retirement would be tax free.  If her marginal tax rate in retirement is greater than 24%, she would have saved on her distributions.

 

Traditional 401(k)

It’s important to note that you can only contribute to a Roth 401(k) plan if your employer offers one as a company benefit . Married individuals filing jointly and  making over $196,000, married individuals filing singly and making over $10,000, and single filers making over $133,000 cannot contribute to a Roth IRA, but may contribute to a Roth 401(k).

Traditional Accounts

When working year tax rates are higher than projected tax rates in retirement, it usually makes sense to contribute to a Traditional IRA or Traditional 401(k) .  Contributing to a Traditional account in that situation generally results in a reduction in taxes in the year of contribution; taxes will be due when the assets are withdrawn from the account, hopefully in retirement. For instance, If Vanessa contributes $5,500 to a Traditional IRA can result in a reduction in taxable income of $5,500. If she is in the 24% federal income tax bracket, Vanessa would save $1,320 in federal income taxes (not counting potential applicable state income taxes).  If Vanessa is in the 12% marginal federal tax bracket in retirement, when she takes $5,500 in distribution, she would then owe federal income taxes of $660.

Traditional IRA

 

Most working people are in higher tax brackets while working than they will be in retirement; hence it usually makes sense for them to contribute to Traditional accounts . That is not true for everyone, of course, as individual circumstances can significantly affect taxes owed.

The New Tax Law

The new Tax law, aka the Tax Cut and Jobs Act or TCJA, passed in December 2017, comes with a number of features, including a permanent reduction in corporate taxes. Most important for individuals and families, it significantly reduces individual tax brackets starting in 2018.  

Roth 401(k)

Table 3: 2018 Federal  Tax Brackets

 

However, while the tax decrease for corporations is permanent, the TCJA tax decrease for individuals and families is temporary. Starting in 2026, individual tax rates will be back to their 2017 levels .

Roth IRA

In practice this will result in a large tax hike in 2026 for many individuals and families.  For instance if Susanna and Kevin make $150,000 and file “Married Filing Jointly”, they might be in the 22% marginal tax bracket in 2018.  With the same income in 2026, Susanna and Kevin would be in the 25% marginal tax bracket. Of course, there are several other factors that will impact their final tax bill, but most people in that situation will stare at a higher tax bill.

So what if Susanna and Kevin project that their retirement income would place them in today’s 22% bracket? Most likely that would put them in the 25% federal bracket in 2026, resulting in a possible tax increase. In fact, depending on the exact situation, a large number of Americans will see their taxes increase in 2026 as the result of the sunset of the TCJA individual tax cuts .

Consider a Roth Conversion while working

Susanna and Kevin could also take advantage of the temporary nature of the TCJA tax cuts to convert some of their traditional tax deferred retirement accounts to Roth accounts.  In so doing, they would take distributions from the Traditional account, transfer to the Roth, and pay income taxes on the conversion. This way Susanna and Kevin would create themselves a source of tax free income in retirement, that could help them stay in their tax bracket and partially insulate them from future tax increases.

Now is the time to take steps to manage your taxes

Because Roth conversions increase current taxable income, many people will find them a limited possibility as only so much funds can be converted without jumping into the next tax bracket.  However, working people can also think in terms of changing their current contributions from Traditional 401(k)s to Roth 401(k)s. That would have the similar impact of increasing current taxable income and income tax due for the benefit of creating a reserve of future tax free assets.

Consider changing from a Traditional 401(k) to a Roth 401(k)

In the case of Susanna and Kevin, they could be in the 22% marginal federal tax bracket in 2018.  If they retire in 2026, and their taxable income in retirement does not change, they may be in the 25% marginal tax bracket. For this couple, it may well be worth switching current contributions from a Traditional 401(k) to a Roth 401(k) from 2018 to 2025 , thereby increasing taxes due from 2018 to 2025, and potentially reducing taxes in retirement.

Of course, it is not always clear where Susanna’s and Kevin’s taxable income would come from in retirement.  That is because their sources of income will likely change significantly. While they would no longer earn income, they may then have social security income, pension income, and retirement plan income which are all taxed as ordinary income. They may also take income from other assets with different tax characteristics, such as savings or investments.  That might make the projection of their taxable income more difficult.

It is possible that Susanna and Kevin’s income needs will influence the tax characteristics of their income when they retire in 2026 or later; that may place them in a different tax bracket altogether. For instance Wealth Managers routinely advise clients to postpone Social Security income as late as they can, preferably until 70 in order to maximize lifetime social security income.  When that happens it is possible that income between retirement and 70 could come from other sources, such as investments. When that happens taxable income could be significantly lower as investments are usually taxed at a lower capital gains rate.

This may sound self serving, but I’ll write it anyway: the best way to know what Susanna and Kevin’s income would look like in retirement, and how it might be taxed, is for them to check in with a skilled Certified Financial Planner. Otherwise they would just be guessing.

Considering a Roth Conversion in Retirement

So what about people who are already retired?  The situation is similar. Take David and Emily, a retired couple with social security income, state pension income, and retirement plan income.  From 2018 to 2025, their $100,000 taxable income places them in the marginal 22% federal tax bracket. With the same income in 2026, they would end up in the 25% tax bracket.  Through no fault of their own David and Emily will see their income tax increase in 2026.

One of the ways that David and Emily can fight that is to convert some of their Traditional retirement accounts to Roth between 2018 and 2025, pay the income taxes on the additional income, and then use distributions from the Roth when their taxes go up in 2026 to stay within their desired tax bracket. In this way, David and Emily could potentially reduce their overall taxes over the long term.

Conclusion

The new Tax Law, aka the TCJA, reduces individual and family income federal tax rates substantially starting in 2018. However in 2026 individual federal income tax rates will go back up resulting in a significant tax increase for many American families .  Roth conversions could help many plan to avoid the pain of this planned tax increase by balancing current lower taxes against future higher taxes. To do this successfully requires careful evaluation of current and future taxable income. Planning Roth conversions from 2018 to 2025 could pay significant rewards by lowering taxes after 2026.

The key challenge for retirement contributors would be to calibrate the right amount of Roth conversion or Roth contributions so as to minimize current and overall taxes owed.

Because each situation will be different, it will pay to check with a Certified Financial Planner to estimate future income and tax rates, and to plan a strategy that will maximize your financial well being.

 

Check out our other posts on Retirement Accounts issues:

Rolling over your 401(k) to an IRA

7 IRA rules that could save you time and money

Doing the Solo 401k or SEP IRA Dance

Tax season dilemna: invest in a Traditional or a Roth IRA

Roth 401(k) or not Roth 401(k)

 

 

Note 1: this post makes assumptions regarding potential individual tax situations. It simplifies the many factors that enter into tax calculations. It omits many of the rules that are applicable to Roth accounts and Roth conversions. It also assumes that the TCJA will be unchanged.  None of these assumptions may be correct. Please check with the relevant professionals for your individual situation.

Note 2: Insight Financial Strategists LLC does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Insight Financial Strategists LLC cannot guarantee that the information herein is accurate, complete, or timely, and  makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

Feb 14

Key Insights Into Understanding Equity Market Corrections

By Eric Weigel | Capital Markets , Investment Planning , Portfolio Construction , Retirement Planning , Risk Management

correctionsCorrections, Recoveries and All That Jazz

Stock Market Corrections are tough on equity investors.  Over the last couple of weeks, there has been nowhere to hide – normally defensive strategies provided little relief.

After a long period of minimal equity market hiccups investors were reminded that the opposite side of the return coin involves risk.

Equities do better than bonds, on average, precisely because investors require compensation for the additional risk of their investments.

If risk and return are tied together why do investors get so nervous when suddenly equity markets go haywire?  Memories of 2008 come flooding back and investors get hyper fixated on relatively small market movements.

As of Friday, February 9, the S&P 500 had dropped 8.8% from its high of January 26.  Granted the drop has been swift and intraday market action (the difference between the high and low of the day ) has been off the charts, but you would have thought that we were on the verge of another Financial Crisis.

Figure 1 depicts the rolling 12 month returns on the S&P 500 as of the end of 2017. There are more periods of positive rather than negative returns as expected. We can also see that the downdrafts in recent years have been painful for investors – the implosion of the Technology Bubble (2000-2002) and the 2008 Financial Crisis still very much linger in investor minds today.

Figure 1

The key insight that investors need to come away with from looking at the history of stock market returns is that to get the good (those returns averaging 10% a year) you must be prepared financially and most importantly emotionally to endure the bad (those nasty corrections).

Investors need to remember that risk and return are the opposite side of the same coin.  They also need to understand the context in which market corrections take place.  While history always rhymes every equity market correction possesses unique elements that shape its ultimate effect on investors.

Understanding the market and economic context is incredibly important for everyday investing.  It is, however, absolutely critical for understanding the implications of equity market corrections and most appropriate course of action.

The point is that not all equity market corrections are made of the same cloth.  Some are deep and lasting. Some are deep and over before the eye blinks. Others last for a year or two and progress at a slower rate. And, finally other corrections turn into cataclysmic events that leave investors bruised for a long time.

Given the events of the last couple of weeks we understand the skittishness of equity investors. Last year was fantastic for investors.  We hardly had a hiccup in the last year. Investors started adapting to the environment – high returns and low volatility.

All the fireworks have come from Washington rather than Wall Street.  Yet, the lingering suspicion is that this party like all others before it must end at some time. Maybe it is just time, right?

We are professional wealth managers, not magicians or fortune readers. Nobody knows when the next big stock market crash will happen and least of all nobody knows the severity of the downturn.

At best, we can analyze the current equity market downturn and attempt to better understand the context in which current equity market prices started heading south.

While all equity market downturns are unique, for simplicity sake we categorize periods of extreme equity market distress into three distinct types of corrections – technical, economic and structural.  Each type of correction has its own distinct patterns and associated implications for investors. Not every moving animal in the woods is a Russian Bear!

stock market

Technical Correction:

This type of correction typically comes out of nowhere and takes market participants by surprise. One bad day for the stock market turns into 2 or 3 in a row and soon enough there is an avalanche of pundits predicting the next global crisis.

Maybe a bit surprising to some, pundits use perfectly logical arguments to justify their bearishness – inflation is about to spike up, the economy is tanking, earnings are coming down, there are no buyers left, and so forth.

All perfectly valid reasons for an equity market correction but the key characteristic of such prognostications is that they are mostly based on speculation and not rooted in contemporaneous economic trends. The arguments are more based on what we fear as opposed to what the current reality is.

Technical Corrections tend to occur on a regular basis especially for higher risk asset classes such as equities.  Long-term equity investors have seen these before and do not seem fazed by the market action.

Newer generations of investors, however, experience great fear and regret.  The immediate response is to sell down usually their most liquid holdings and wait for the market to calm down.  Maybe they will get in again after the panic is over.

Technical Corrections tend to last only about a week or two.  In the context of long-term capital market history they barely register to the naked eye. Boom they are gone, and people quickly forget what they just went through.  Technical corrections are learning opportunities but are most often quickly forgotten until the next blip.

Economic Corrections:

These types of capital market corrections are caused by the economic business cycle, i.e., periods of economic expansion followed by recession and eventual recovery.  Typically, the clues as to whether the economy is heading into a recession are present ahead of time.

Usually a large number of economic indicators will point in the same direction.  For example, the yield curve may become inverted (long rates lower than short-term rates), business confidence surveys start showing some downward trends, companies start hoarding cash instead of investing in plant and equipment and layoffs start accelerating in cyclically sensitive sectors.

In the last half century, business cycle recessions have been mostly shallow and short-lived. Economic recessions are, no doubt, painful but the implications to investors are fairly straightforward.

In the early stages of a recession, equity investments suffer the most while bond market strategies tend to provide the upside.  As the economy starts recovering, equity investments outperform marginally but with significant volatility.

Being early is never comfortable but it beats being late.  Some of the best equity returns happen during the late early stages of a recovery when the average investor is still too snake bitten to put any money at risk.

And finally, as the economy moves into full expansion mode equity investors typically enjoy a nice margin of outperformance relative to safer assets such as bonds.  As the uncertainty regarding the economic recovery fades in the rear view, capital markets tend to become less volatile as well.

Structural Corrections:

These are the most severe type and involve periods of real economic and financial stress.  Something has gone off the rails and public capital markets are the first to feel the brunt of the economic imbalances.

Structural Corrections are not merely stronger business cycle events. The integrity of the entire economic and financial system is at stake.  Without decisive fiscal and monetary policies there is a risk of total economic collapse.  Under these circumstances, equity investors are often completely wiped out and bond holders don’t fare much better.

Structural Corrections happen during periods of total economic unravelling.  The most usual signs of eminent economic collapse are massive unemployment, huge drops in productive output, and the unavailability of credit at any cost.  The financial system is usually at the root cause of the crisis and liquidity in the system suddenly disappears.  Faith in the system dries up overnight – the first stop are banks, next are capital markets.

The Great Depression of 1929-39 and the Financial Crisis of 2007-09 are prime examples of Structural Corrections that were felt across the globe.  History is, however, littered with other instances of more localized cases such as the 1997 Asian Crisis, the 1998 Russian Default and the Argentinian collapse of 1999-2002.

What should investors do during a correction?

The answer depends on the context surrounding the capital markets at that moment.  For example, the implications of a Technical Correction are very different from those of a Structural Correction.

Misdiagnosing what type of correction you are in can have severe consequences for your financial health.  Becoming too risk averse and selling everything can be as harmful as not being risk-aware enough and always expecting the markets to recover irrespective of business and capital market conditions.

Finding the right balance is key. In reality, after many years of watching markets one is never really 100% sure of anything.  In fact, if anybody says that they have perfect certainty all it means is that they either have not done all their homework or that they fail to understand the statistical concept of probability.

Our preferred approach is based on a solid understanding of capital market behavior coupled with hands-on experience under a variety of capital market situations.  Understanding capital market history is the prerequisite but experience is the key extra ingredient to gain confidence in properly evaluating the context in which markets are experiencing distress.

Table 1 provides a checklist as to the type of issues that we consider when evaluating the type of correction we might be in.

Table 1

corrections

Where are we today?

As of February 12 we have already seen signs of recovery, but the S&P 500 is still down 7.5% from its January 26 peak. Investors remain nervous. The CBOE Volatility Index stands at close to 27% which is significantly higher than where it was before the equity market started convulsing.

A 7.5% drawdown on the S&P 500 is not that uncommon. Investors should be wary but also keep their eye on their long game of growing risk-adjusted portfolio returns.

We believe that the current equity market downdraft falls under the category of a Technical Correction. Why? The numbers back up our assertion.  Our view is that equity markets remain healthy and will out-perform lower risk alternatives such as bonds.

equity downturn

Let’s start with a rundown of the negatives about equity markets.  The biggest knock on equity markets is that they are over-valued relative to historical norms such as price-to-earnings ratios. Agreed, the current Shiller P/E stands at 33.6 relative to a historical average of 17.  For access to the latest Shiller data click here.

On an absolute basis the S&P 500 is over-valued.  When considered relative to interest rates the picture changes.  Estimates by Professor Domadoran at NYU, for example, yield fair valuations on the S&P 500.

What else? Interest rates are too low. Agreed again, but low yields are the problem of the bond investor. A low cost of money is actually good for equity investors.

What about rising interest rates? The 10 Year US Treasury Note hit a low of 2.05% in early September and has been rising since. It currently stands at 2.84%.  Higher, for sure.  A real danger to equity markets? Not quite, especially in light of low rates of inflation.

Inflation-adjusted yields (sometimes called real yields) are still significantly below historical norms.

Higher real rates imply lower equity values.  We agree, but we see the current upward progression of interest rates in the US as fairly well telegraphed by the Federal Reserve.

We also still believe that US monetary policy is accommodative.  For example, Federal Reserve Bank of Atlanta estimates generated by the well-known Taylor rule show current Fed Funds rates about 2% too low (read here for a review).

What about the positives regarding equity markets? For one, we have a strong global economy.  Every major economy in the world is in growth mode.  The IMF recently raised their estimate of global GDP growth to 3.9% for both 2018 and 2019.

Inflation seems under control as well. The IMF estimates that global inflation will run 3.2% in 2018, unchanged from last year. Inflation in the US ran at 2.1% in 2017.

Monetary policy remains accommodative.  In the US the Fed reserve is slowly weening investors off artificially low interest rates, while in most other parts of the world (Europe and Japan in particular) central banks have yet to embark on the process of normalization.

The recently enacted lowering of the US corporate tax rate is also a positive for US domiciled companies.  Lower corporate tax rates translate immediately into higher cash flows.  Higher cash flows translate into higher corporate valuations. The main beneficiaries of lower corporate taxes are ultimately shareholders. 

What should investors do today?

Our analysis of the data leads us to the conclusion that the current equity market correction is driven by technical considerations and not fundamental issues.

We do not know how long the equity downdraft may last, but we expect this blip to barely register in the long-run.

Our advice may be rather boring but plain-vanilla seems the best response to the current state of investor panic.

  • If you were comfortable with your financial plan at year-end, do nothing. Don’t obsess over every single market gyration. There is not enough evidence to merit an increase in fear or a significant re-positioning of your portfolio towards safer asset classes such as bonds
  • If you did not have a plan in place, don’t go out and sell your equity holding before figuring out the status of your financial health in relation to your goals. Consult a certified financial planner if you need help.
  • If you have some cash on the sidelines, deploy some of it in the equity markets. Given that all major equity markets have taken a beating spread your money around a bit. We still rate International Developed Markets and Emerging Markets as attractive.  Consider whether it makes sense for you to put some money in the US and some abroad.

Whatever you do don’t panic. Focus on your asset allocation in relation to your needs, goals and appetite for risk. Don’t let that Russian Bear get to you!

Taking risk and suffering the inevitable equity market drawdowns is part of investing. Be cautious but be smart. Talk to your Advisor if you need help. Make your money work for you!

Feb 06

Market Correction? Hold on to your socks!

By Chris Chen CFP | Capital Markets , Financial Planning , Investment Planning , Risk Management

Market Correction? Hold on to your socks!

As of the close of the market yesterday February 5, the S&P 500 has suffered a loss of 6.2% from its high on Jan 26, 2018 .  All other major indices have followed this downward trend. After we have been telling you for months that the market was going to be due for a major correction, has the time come?

One of the ways that we gauge market risk is by observing our proprietary Risk Aversion Index . It has started to show “normal” behavior compared to the last few years when  it was indicating a lot more complacency to risk than average.  Clearly market participants are feeling antsy.  However, according to the risk measure, it is too early to draw conclusions.

We have not experienced meaningful corrections in the recent past. However it is worth remembering that according to American Capital historically 5% corrections happen 3 times a year on average, and 10% corrections happen once a year on average .  The current correction may just be a long overdue reminder that we are not entitled to volatility free financial markets.

Just two weeks ago the consensus was that we were going to experience a continuation of the bull market at least into the early part of this year. This is still our view. Although the stock market is a leading indicator, at this time this correction does not appear to be a recession driven correction.

A Last Word

When it comes to your investments, verify that your investment profile matches your financial planning profile . That would not insulate you from market corrections. However, matching investment and financial planning profiles would help ensure that you are taking the appropriate amount of risk given your goals and time horizon . If you haven’t measured your risk profile in a while, you may do so at this link.  Unlike the stock market, it is risk free!

Jan 16

Is 2018 the Year of the Roth 401(k) or the Roth IRA?

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

Tax Bill Analysis: Is 2018 the Year of the Roth 401(k) or the Roth IRA?

Much of the emphasis of the Tax Cuts and Jobs Act (TCJA) passed in December 2017 affected individual income taxes. However, there are also impacts on investment strategies.

From an individual standpoint, the primary feature of the TCJA is a reduction in income tax rates.  Except for the lowest rate of 10% all other tax brackets go down starting with the top rate which drops from 39.6% to 37%.

2018 MFJ Tax Table

 Table 1: 2018 Tax Rates for Married Filing Jointly and Surviving Spouses

Even then, not everyone’s income taxes will go down in 2018 . That is because some of the features of the bill, such as the limitation on State And Local Taxes (SALT) deductions,  effectively offset some of the tax rate decreases.

However, in general, it is safe to say that most people will see a reduction in their federal income taxes in 2018. Of course, this may prompt a review of many of the decisions investors make with taxes in mind.

Retirement is one area where reduced income taxes may have an impact on the decision to invest in a Traditional or a Roth 401(k) or IRA . The advantages of tax-deferred contributions to retirement accounts, such as Traditional 401(k) and IRAs, are also tied to current tax rates. In Traditional retirement accounts, eligible contributions of pre-tax income result in a reduction in current taxable income and therefore a reduction in income taxes in the year of contribution.

Most people expect to make the same or less income in retirement compared to working life, and thus assume that their retirement tax rate will be equal to or lower than their working year tax rate. For those people, contributing pre-tax income to a Traditional retirement account comes with the possibility of reducing lifetime income taxes (how much you pay the IRS over the course of your life).

Most people are pretty excited to see their taxes go down this year! However, the long-term consequences of the tax decrease should be considered.  While the TCJA was passed with the theory that it would stimulate growth such that tax revenues would grow enough to make up for the increased deficit created in the short term by tax cuts, few serious people believe that.  The most likely result is that we will experience a small boost in growth in the short term and that federal deficits and the National Debt will seriously increase thereafter.

In the opinion of the non-partisan Committee for a Responsible Federal Budget, not even the expectation of additional short-term growth is enough to temper the seemingly irresistible growth in the federal debt.

TCJA impact on the National Debt

Increased deficits will make it more difficult to fund our national priorities, whether it is defense, social security, healthcare, or investment in our national infrastructure.  Therefore, I expect that we will initiate another tax discussion in a few years, most likely resulting in tax increases, in addition to the automatic tax increases that are embedded in the TCJA.

With federal income tax rates down in 2018 and our expectation that individual taxes will start increasing after 2018, now may be the time to consider a Roth instead of a Traditional account. The consideration of current and future tax rates remains the same. It just so happens that with lower tax rates in the current year, it becomes marginally more attractive to consider the Roth instead.

Consider the case of Lisa, a married pharma executive, making $225,000. This places her in the 24% federal tax bracket. In 2018, her $10,000 Traditional 401(k) contribution reduces her income taxes by $2,400. In 2017, Lisa would have been in the 28% tax bracket. Her $10,000 Traditional 401(k) contribution would have resulted in a $2,800 reduction in income taxes. Hence, Lisa’s tax savings in 2018 from contributing to his 401(k) goes down by $400 compared to 2017.

Federal income tax impact on a $10,000 Traditional 401(k) contribution Table 2: Tax savings on a 401(k) contribution with $180,000 taxable income

From a tax standpoint, contributing to a Traditional 401(k) is still attractive, just a little less so.  To optimize her lifetime tax liabilities, Lisa may consider adding to a Roth 401(k) instead, trading her current tax savings for future tax savings. If Lisa were to direct the entire $10,000 to the Roth 401(k), her 2018 income taxes would increase by $2,400 compared with 2017. Why would Lisa do that? If she expects future income tax rates to go back up, she could save overall lifetime taxes. It may be an attractive diversification of her lifetime tax exposure.

For instance, suppose now that the national debt does grow out of hand and that a future Congress decides to increase tax rates to attempt to deal with the problem. Suppose that Lisa’s retirement income places her in a hypothetical future marginal federal tax rate of 30%. In that case, she will be glad to have invested in a Roth IRA in 2018 when she would have been taxed at a marginal rate of 24%: she would have saved on her lifetime income taxes.

Of course, if Lisa’s retirement marginal tax rate ends up being 20%, she would have been better off saving in her Traditional 401(k), saving with a 28% tax benefit in her working years and paying retirement income tax at 20%.

Note also that Lisa would not have to put the entire $10,000 in the 401(k). She could divide her annual retirement contribution between her Roth and her Traditional accounts, thus capturing some of the tax advantages of the Traditional account, reducing the tax bite in the current year, and preserving a bet on a future increase in income tax rates.

Another possible course of action to optimize one’s lifetime tax bill is to consider a Roth conversion. With a Roth conversion, you take money from a Traditional account, transfer it to a Roth account, and pay income taxes on the distribution in the current year.  As we know, future distributions from the Roth account can be tax-free, provided certain conditions are met . A distribution from a Roth IRA is tax-free and penalty free provided that the five-year aging requirement has been satisfied and at least one of the following conditions is met: you have reached age 59½, become disabled, you make a qualified first-time home purchase, or you die. (Note: The 5-year aging requirement also applies to assets in a Roth 401(k), although the 401(k) plan’s distribution rules differ slightly; check your plan document for details.)  Because tax rates are lower in 2018 for most individuals and households, it makes it marginally more attractive to do the conversion on at least part of your retirement funds.

Consider David, a single pharma marketing communications analyst. With $70,000 in taxable income, he is now in the 12% marginal federal income tax bracket, down from the 25% federal income tax bracket in 2017. He is working on his part-time MBA in 2019 and expects his income to jump substantially as a result. Additionally, David, a keen student of political economy expects his taxable retirement income to be higher than his current income and overall tax rates to go back up before he reaches retirement.  David now has a sizeable Traditional IRA.

For David, the opportunity is to convert some of his Traditional IRA into a Roth IRA. To do that, David would transfer some of his Traditional IRA into a Roth IRA. He would pay income taxes on the conversion amount at his federal marginal rate of 22%. David would only convert as much as he could before creeping into the next federal tax bracket of 24%. If he feels bold, David could contribute up to the 32% federal tax bracket. Effectively this means that David would stop converting when his taxable income reaches $82,500 if he wanted to stay in the 22% tax bracket, and $157,500 if he wanted to stay in the 24% tax bracket.

In this example, if David were to convert $10,000 from his Traditional IRA to his Roth IRA, he would incur $2,200 in additional federal income taxes. If David expects to be in a higher tax bracket in retirement, he would end up saving on his lifetime income taxes.

David could combine this strategy with continuing to contribute to his Traditional 401(k), thus reducing his overall taxable income, and increasing the amount that he can convert from his IRA before he hits the next tax bracket.  If he were to contribute $10,000 to his Traditional 401(k) and convert $10,000 from his Traditional IRA to a Roth IRA, you could view this as a tax neutral transaction.

Federal tax impact on a $10,000 Traditional 401(k) contribution and $10,000 Roth conversion

Table 3: Balancing a Traditional 401(k) and a Roth Conversion

This strategy may work best for people who expect to have a reduced income in 2018. Maybe it is people who are back in graduate school, or people taking a sabbatical, or individuals who are no longer working full time while they wait to reach the age of 70 and start collecting social security at the maximum rate.

It is worth remembering that Roth accounts are not tax-free; they are merely taxed differently . That is because contributions to a Roth account are post-tax, not pre-tax as in the case of Traditional accounts. You should note that the examples in this article are simplified. They do not take into account the myriad of other financial, fiscal and other circumstances that you should consider in a tax analysis, including your State tax situation. The examples suppose future changes in taxes that may or may not happen.

If you believe, as I do, that tax rates are exceptionally low this year and will go up in the future, you should have additional incentive to analyze this situation. The decision to contribute to a Roth IRA or 401(k) works best for people who expect to be in a similar or higher tax bracket in retirement , and have at least five years before the assets are needed in order not to pay unexpected penalties. Is that you? The financial implications of whether to invest in a Roth instead of a Traditional account can be complex and significant . They should be made in consultation with your Certified Financial Planner.

 

Check out out other retirement posts:

Is the new tax law an opportunity for Roth conversions

Rolling over your 401(k) to an IRA

7 IRA rules that could save you time and money

Doing the Solo 401k or SEP IRA Dance

Tax season dilemna: invest in a Traditional or a Roth IRA

Roth 401(k) or not Roth 401(k)

 

 

Jan 11

5 Risk Factors for Investors in 2018 – 3 Bad and 2 Good

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

5 Risk Factors for Investors in 2018 – 3 Bad and 2 Good

2017 came and went without nary a whimper. None of the big concerns at the end of the previous year happened or at least global capital markets did not seem to be disturbed by much of anything.

Stocks went up in a straight line, bonds did ok, volatility was super low and at the end of the year exuberant expectations were in full bloom as everybody and their aunt became fixated on Bitcoin.

The global economy keeps doing well and memories of the 2008 Financial Crisis are receding.  Consumer sentiment remains upbeat.

Being an investor is wonderful when markets are calm and statements show gains month after month.  Everybody is an investment genius. We forget how painful  it is when capital markets experience stress and things get a bit crazy.

The mental picture I use is that of flying.  The six hour trip from Boston to LA is great when it is all smooth sailing.  The plane seems to be flying itself and you pay more attention to the movie you are watching than thinking about the age of the aircraft or training of the pilot and crew.

But the first time there is a little air bump and maybe lighting strikes your plane you immediately tense up and fix your gaze on the crew.  Are they calm? Do they seem competent? Is this their first rodeo?

You form a mental image of what you want your pilot to look like.  Calm and collected for starters. But mainly experienced. We all want to see Captain Sully at the helm.

Clearly, we all would love smooth capital markets forever. But the close friend of return is always uncertainty.  The two are inseparable even though they may not always be in direct contact.  In times of turbulence you want experience at the helm and a solid understanding of how the two are intertwined.

How do we think of uncertainty in the capital markets? There are as many ways of defining uncertainty as there are opinions as to who the greatest quarterback in history is (we all know it is Tom Brady, right)  but without hopefully appearing too cavalier we think that it is useful to think of uncertainty as a normal distribution of potential outcomes.

We fear the left tail where things go terribly wrong, we accept the middle of the distribution as textbook risk/return, and we think that our own brilliance (just joking) has led us to the right tail of the distribution.

In 2017 equities, in particular, had a monster year with the S&P 500 up over 25% and many international markets up even more.  The year turned out much better than expected.  What do we expect for this coming year?

Our baseline assessment is fairly benign as we discussed last month in our Capital Market Overview. A quick review is in order.

We expect equities to again do better than bonds.  We also expect international assets to outperform domestic strategies.  We expect robust global growth.  Our most likely scenario for this year is for continued growth, subdued inflation and no major equity or bond market meltdown.  In our judgement there is about an 80% probability that such a scenario plays out in 2018.

On the downside we expect the low volatility that has accompanied capital markets recently to once again revert back to risk on/off.

Our baseline assessment is fairly benign

We expect to see more large jumps in market prices caused by low probability events lurking in the left hand side of the distribution.  The press calls these events Black Swans. Our best assessment is that there is about a 15% probability of seeing a Black Swan event in 2018.

On the other end of the uncertainty distribution you have what we call Green Swans – events, low in probability that when they happen are wildly positive for investors. We attach a 5% chance of experiencing such extreme positive events over the current calendar year

What could cause a Black Swan in 2018?

1. An inflation spike caused by a sustained rally in commodity prices

Inflation in the US is currently running a bit above 2% and market participants do not expect to see any major revisions over the next two decades (see the Philadelphia Federal Reserve estimate of inflationary expectations).

In our view, forecast complacency has set in and the risks are to the upside. Traders would describe the low inflation trade as over-crowded.  Maybe it is time to re-think what happens if the consensus turns out to be wrong.

The immediate effect of an upward spike in inflation would be a rise in bond yields.  Equities would probably take a short-term hit but the primary casualties would be found in the fixed income market.

What could cause a sustained surge in commodity prices? One, could be a supply disruption say in the oil market. Another could be related to the resurgence of global growth and continued demand for commodities such as iron ore and copper.  Third, a depreciating US dollar leading to commodity price inflation.

2. A spike in capital market turmoil caused by a geo-political blowup

The blowup could be anywhere in the world but most political commentators point to North Korea and Iran as the most likely centers of conflict.

Another possibility is a cyberattack endangering public infrastructure facilities especially if it is sovereign sponsored. Third, Jihadi terrorism on a large scale and on high profile targets. And last, the outcome of the Special Counsel investigation into Russian meddling.

All of these events have blowup potential.  While the probability of any of these events happening in 2018 is low, the magnitude of the capital market response is likely to be large and negative especially for equity markets.  Global economic growth would also, no doubt, loose some of its momentum.

3. An avalanche of bond defaults in the apparel and retail industries in the US and/or a debt bomb crisis in China

It is no secret that the US apparel and retail sectors are going through massive consolidation driven in part by the shift to online shopping.  It is widely acknowledged that the US retail market is over-built.

The number of apparel and retail companies expected to disappear is higher today than in 2008 during the Financial Crisis. Read here for a list of apparel and retailers at risk.

According to the Institute of International Finance global debt hit a record last year at $233 trillion.  Debt levels as a percentage of global GDP are higher today compared to 2007.  Figuring prominently in the debt discussion is China.

Global Debt Reaches a Record in Q3 2017
Source: IIF, IMF, BIS

The IMF recently issued a warning to the Chinese authorities about the rapid expansion of debt since the 2008 Financial Crisis.  The rapid expansion in debt has funded lesser quality assets and poses stability risk for global growth according to the IMF.

Estimates by Professor Victor Shi at UC San Diego put Chinese total non-financial debt at 328 percent of GDP. Other estimates are even higher leading to an overall picture of rising liabilities and numerous de facto insolvencies.  The robust GDP growth in China and the tacit understanding of the monetary authorities of the extent of the problem will hopefully keep the wolves at bay.

The implications of a debt scare for investors would be quite dire. Investors have had plenty of experience with debt crisis in recent years – Greece and Cyprus come to mind as Black Swan events that temporarily destabilized global capital markets.  A Chinese debt scare would no doubt be of greater impact to global investors. Emerging market debt spreads would certainly blow up.

What about the right hand tail of the uncertainty distribution – the Green Swans?

These are wildly positive events for investors that carry a low probability of happening.  What type of Green Swan events could we hope for that would lead capital markets to yet another year of phenomenal returns?

1. Positive global growth surprise possibly brought on by the recently enacted US tax reform

The US is the largest economy in the world and still remains a significant engine of global growth.  Could we be surprised by a spurt in US economic growth this year?

According to the Conference Board US real GDP is expected to growth 2.8% in 2018. Could we see 4% growth? The President certainly hopes so.  Not that likely. The last time that US GDP growth was above 4% was in 2000.

What could give us the upside scenario for growth?  Maybe a jump in consumer spending (representing 2/3 of GDP) driven by real wage growth and lower taxes.

Another possibility is a surge in investment by US corporations driven by cash repatriations and recently enacted corporate incentives.

We view both scenarios as likely but providing only a marginal boost to growth. As they say we remain cautiously optimistic, but would not bet the farm on this.

2. A spurt in exuberant expectations driven by the cryptocurrency craze

Fear of missing out (FOMO) takes over repricing all investments remotely tied to the cryptocurrency craze along the way.  We saw a similar scenario play out in 1999 in the final stages of the Technology, Media and Telecom (TMT) bubble.

In those days TMT stocks were no longer priced according to traditional fundamentals but instead on the idea that laggard investors would buy into the craze and drive prices even higher. Lots of investors succumbed to FOMO in the final stages of the bubble.

Photo by Ilya Pavlov on Unsplash

The recent price action of Bitcoin and most other cryptocurrencies has a similar feeling to the ending stages of the TMT bubble.  It is almost as if Bitcoin and its cousins are being discussed along with the latest Powerball jackpot.

No doubt fortunes have been and will continue to be made in cryptocurrencies.  Blockchain technology which underlies the crypto offerings is here to stay, but we worry about the lack of investor education and the speed of the price action in late 2017.  Whatever happened to Peter Lynch’s “buy what you know” approach?

What would be our best estimate for capital markets should the cryptocurrency craze gain further momentum in 2018? First, technology stocks would continue out-performing. Chip suppliers such as Nvidia and AMD would continue to see massive growth.

Companies adopting blockchain technologies would see their valuations increase disproportionally.  In general, animal spirits would be unleashed onto the capital markets making rampant speculation the order of the day.  The primary beneficiary would be equity investors.

Conclusion:

History tells us that it is almost certain that after 8 years of an economic expansion and stock market recovery we should see an outlier type of event in 2018.  What shape and form it will take (or Swan color) we don’t know.

Preparing for tail risk events is very expensive and under most scenarios not worth bothering with.

Black Swans create great distress for investors, but the opportunity cost of playing it too safe is especially high today given prevailing interest rates that fail to keep up with inflation.

The fear of missing out (FOMO) during Green Swan events is also a powerful investor emotion.  Again playing it too safe can result in many lost opportunities for capturing significant market up moves.

Investing in capital markets is all about weighting these probabilities and focusing on a small number of key research-driven fundamental drivers of risk and return.

How you structure your portfolio and navigate the uncertainties of capital markets is important to your long-term financial health. Putting a financial plan in place and having an experienced Captain Sully-type as your captain during times of turbulence should reassure investors in meeting their long-term goals.

 

 

 

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.

Individual investor performance may vary depending on asset allocation, 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 Registered Investment Adviser.

 

 

Dec 13

Doing Good While Also Doing Well

By Eric Weigel | Investment Planning , Sustainable Investing

Incorporating Sustainable Investing Principles Into Your Portfolio

 

The term “sustainable investing” is often used interchangeably with “socially responsible investing”. In general, these terms describe an approach to investing that combines traditional financial methods to portfolio construction with the desire to simultaneously create positive societal outcomes.

What might these societal outcomes be? The industry has gravitated to three broad areas of impact – Environmental, Social and Governance (ESG).

We are all exposed to these various areas in our daily lives and many of us care deeply about some of these issues.  For the most part, we have channeled our beliefs into action through charitable giving and volunteering efforts.

But a new way of “doing good while also doing well” has emerged in the last few years .  Investment strategies have been designed to deliver competitive financial returns while also impacting society in a positive manner.

Sounds too good to be true? Large institutional investors have been able to achieve both financial and societal returns for a long time, but only in recent times have investment strategies been designed to enable individual investors to achieve the same objective.

 

How did sustainable investing get started? In its early days socially responsible or what we now call sustainable investing took an exclusionary view to investing . For example, tobacco companies were often excluded from portfolio mandates. Another, probably more extreme example involved the divestment of South African investments during the apartheid era.  Companies selected under this form of exclusionary screening had to meet a minimum threshold of “do no harm” but that was about it.

How has sustainable investing changed in the last few years? More recently, investors have looked at ways to create positive social outcomes within their financial portfolios.  The focus has shifted toward emphasizing investments with the dual objective of superior risk adjusted financial returns along with demonstrably positive environmental, societal and/or governance outcomes.

Doing well while doing good

“Doing good while doing well” is the basic rationale why investors are increasingly interested in enhancing how they manage their portfolios by including non-financial metrics such as environmental, societal and governance factors.

Besides ethical and moral motivations, why have investors suddenly become so interested in sustainable approaches to investment management?   Simple – self-interest combined with the realization that currently disclosed financial metrics are insufficient to properly account for the long-term sustainability and valuation of companies.

Large and small investors have woken to the fact that environmental issues such as climate change and carbon emissions have significant implications for our global well-being as well as for the long-term financial health of companies. This is the E in ESG.

Investors are also becoming very interested in the societal impacts of corporate behavior. Issues such as workers’ rights, gender and diversity policies and human rights in general. This represents the S in ESG.  For example, recent sexual harassment scandals at various media companies highlight the impact of non-financial events on corporate valuation.

Probably the oldest way of using non-financial criteria to evaluate companies involves the area of corporate governance.  This is the G in ESG.  Board composition, executive compensation practices and sustainability disclosure criteria are just three areas of increasing investor attention.

Is it possible to achieve competitive returns and also deliver a significant impact? Research indicates that “doing good while doing well” is achievable if properly implemented.

One of the concerns of early investors in SRI approaches was that excluding companies deemed to be “bad actors” would significantly restrict one’s investment opportunities and returns would commensurately suffer.

Recent empirical studies show that returns need not suffer especially when risk-adjusted.

Research from Morningstar depicted below highlights a segment of socially responsible funds compared to the broad universe of US equity mutual funds. The general conclusion is that socially conscious funds tend to have a higher representation among 3 and 4 star funds and lower proportions in the tails.

While not a ringing endorsement, the Morningstar research at least points out that there is no empirical reason to suspect that socially conscious funds underperform the general universe of US mutual funds.

 

Research generally shows that sustainable investing strategies do no harm, but can you do better? Yes, when the issues examined have a clear link to financial performance.  This relates to the issue of materiality.

Certain ESG issues are important from a societal standpoint but have a tenuous relationship to financial metrics such as company profitability or asset valuation.  For example, preserving the Costa Rican Toucan is a worthwhile societal goal, but few publicly traded companies have a direct financial link to such an effort.

On the other hand, global warming has a direct effect on the severity of hurricanes and directly impact the financial performance of companies in the insurance and construction industries among others.  Such an effect would be deemed material and of great consequence to individual investors with allocations to sustainable investing strategies.

Recent research by Harvard professors Khan, Sarafeim and Yoon identified a large variation in long-term measures of company financial success when evaluating companies on material ESG metrics.   Their conclusion is that companies with superior sustainability practices outperform companies with poor practices. *

How can individual investors incorporate sustainable investing strategies into their overall portfolios?  Our take is that properly constructed portfolios incorporating financial as well as non-financial ESG criteria are competitive on a risk-adjusted basis over short holding periods while providing significant positive upside over the long-term.

Our belief is that investors will benefit long-term from lower levels of business risk in their holdings as well as potentially higher stock returns.

Companies with superior ESG practices tend to provide greater transparency in their disclosures, be better prepared to deal with adverse events when they happen, and be more open to adapting their business models around environmental, social and governance issues likely to be material over the long-term.

Are sustainable investing strategies different from traditional approaches? The same risk-return balancing issues that apply to any investment portfolio apply to an approach using sustainability criteria. The biggest difference at the moment occurs at the implementation stage.

Implementing ESG portfolios requires additional research and caution.  While a growing universe of investment vehicles exist in the form of mutual and exchange traded funds there are wide differences in liquidity, composition and cost.  Properly conducting due diligence on the various sustainable investing offerings requires an above-average experience and know-how of financial materiality issues.

At Insight Financial Strategists we have done significant research on sustainable investing and believe that these strategies are here to stay and will deliver on the goal of “doing good while doing well”.

Please schedule a time to discuss with us your financial planning and investment needs and how a sustainable investing approach might fit your requirements.

 

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.

*  “Corporate Sustainability: First Evidence on Materiality” by Mozaffar Khan, George Serafeim, and Aaron Yoon, Harvard Business School Working Paper No. 15-073, March 2015.

Individual investor performance may vary depending on asset allocation, 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 Registered Investment Adviser.