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

By Chris Chen CFP | Financial Planning , Retirement Planning

Made by Foreign Nationals Living in  America

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

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

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

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

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

1. Failure to understand US reporting requirements

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

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

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

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

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

2. Get overwhelmed by US tax complexity

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

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

3. Not being aware of tax treaties

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

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

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

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

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

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

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

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

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

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

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

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

Last Word

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

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

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

Quarterly Capital Market Perspectives

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

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

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

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

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

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

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

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

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

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

Making Your Post-Divorce Portfolio Reflect the New You

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

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

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

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

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

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

Why do you need a new portfolio once you divorce?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is the role of these “buckets”?

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

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

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

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

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

Conclusion:

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

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

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

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

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

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

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

 

Other posts you may find interesting

Pension Division in Divorce

4 Risks of Pension Plans in Divorce

Post-Divorce Investments 

 

 

4 Risks of Pension Plans in Divorce

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

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

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

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

What is a pension plan and how does it work?

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

Risk of Valuation

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

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

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

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

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

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

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

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

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

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

Risk of Default

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

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

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

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

Personal Risk

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

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

And what about inflation risk?

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

A Last word

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

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

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

 

Other posts that you may find interesting:

Pension Division in Divorce

Post-Divorce Investments 

In Divorce, Can We Share a CDFA?

 

 

3 Mistakes DIY Investors Are Prone to Making in a Crisis

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

1. Selling Everything in a Panic

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Figure 1

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

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

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

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

Figure 2

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

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

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

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Conclusion:

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

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

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

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

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

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

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

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

Interested in talking? Please schedule a complimentary consultation here.

 

Doing the Solo 401k or SEP IRA dance

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

If you are self-employed, one of your many tasks is to plan for your own retirement. While most Americans can rely on their employer’s 401(k) for retirement savings, this is not the case for self-employed people.

In some respects, that is an advantage: most employees barely pay any attention to their 401(k). It is an opportunity for the self-employed to make the best choices possible for their business and personal situation.

The most obvious benefit of saving for retirement is that you will have to retire anyway, one day, and you will need a source of income then. With a retirement account, most people appreciate that it is specifically meant to save for retirement. People also appreciate the tax benefits of the SEP IRA and Solo 401(k).

The more immediate benefit is that retirement savings in tax-deferred accounts help reduce current taxes, possibly one of the greatest source of costs for small businesses. Of course, the tax saved with your contribution will have to be paid eventually when you take retirement distributions from the SEP-IRA.

When it comes to tax-deferred retirement savings vehicles for the self-employed and owner and spouse businesses, two of them stand out due to their high contribution limits and flexible annual contributions: the SEP IRA and the Solo 401(k). These two vehicles provide a combination of convenience, flexibility, and efficiency for the task.

SEP IRA

The SEP IRA is better known by its initials than its full name (Simplified Employee Plan IRA). For 2018 the SEP IRA contribution limits are the lesser of 25% of compensation up to $275,000, or $55,000 whichever is less. You may note that this is significantly higher than the limit for most 401(k)s plans, except those that have a profit sharing option. SEP IRA rules generally allow contributions to be deductible from the business’ income, subject to certain SEP IRA IRS rules.

One of the wrinkles of SEP IRA eligibility is that it applies to employees: you have to make a contribution of the same percentage of compensation as you are contributing for yourself. So if you have employees, another plan such as a Solo 401(k) might be a better choice.

And for fans of the Roth option, unfortunately, the SEP IRA doesn’t have one. When comparing the SEP IRA vs Roth IRA, the two clearly address different needs.

Solo 401(k)

The Solo 401(k) also known as the individual 401(k) brings large company features to the self-employed. It generally makes sense for businesses with no common law employees. One of the Solo 401k benefits is that just owners and their spouses, if involved in the business, are eligible. Employees are not. So, if you are interested in just your own retirement plan (and your spouse’s), a Solo 401(k) may work better for you than a SEP IRA. If your business expands to include employees and you want to offer an employer-sponsored retirement plan as a benefit to them, then you should consider a traditional company 401(k) option.

The Traditional Solo 401k rules work in the same way as the SEP IRA: it defers income taxes to retirement. It makes sense if you believe that you will be in an equal or lower tax bracket in retirement. Those who think that they may be in a higher tax bracket in retirement should consider a Roth option for their Solo 401(k): it will allow you to contribute now on an after-tax basis, and you will benefit from tax-free distributions from the account after retirement. A Roth 401k calculator may be required to compare the benefits. Again, the Roth option is not available in SEP accounts.

Solo 401k contribution limits permit you to contribute the same amount as you might in its corporate cousins: up to 100% of compensation, up to $18,500 a year when you are younger than 50 years old, with an additional $6,000 annual catch-up contribution for those over 50 years of age.

In addition, profit sharing can be contributed to the Solo 401(k). The Solo 401k limits for contributions are up to 25% of compensation (based on maximum compensation of $275,000) for a maximum from all contributions of $55,000 for those under 50 years of age and $61,000 for those over 50 years of age.

Another difference with the SEP IRA is that the Solo 401(k) can be set up to allow loans. In that way, you are able to access your savings if needed without suffering a tax penalty.

So Which Plan Is Best for You?

The SEP IRA is simpler to set up and administer. However, the Solo 401(k) provides more flexibility, especially for contribution amounts. Given that the amount saved is one of the key factors for retirement success, that should be a consideration.

Comparing the Solo 401k with the traditional employer 401k, you may no longer have to ask how to open a Roth 401k.  You will have control of that. On the other hand you will be entirely responsible for figuring out your Roth 401k employer match.

As could be expected, administration of the Solo 401(k) is slightly more onerous than that of the SEP IRA.

Solo 401(k) and SEP IRA

A Last Word

If you don’t have a plan get one. It is easy. It reduces current taxes. And it will help you plan for a successful retirement. The SEP IRA and the Solo 401(k) were designed specifically for small businesses and the self-employed. Although we have reviewed some of the features of the plan here, there are more details that you should be aware of. Beware of the complexities!

Once you decide on the type of plan, it will be time to choose a provider that offers the features that you need, the investment choices that you need, and the guidance to help you maximize your hard earned savings.

At Insight Financial Strategists we help figure out what works for you and your retirement plansand show you how to set up a Solo 401k or a SEP IRA!

5 Symptoms of “Fake” Portfolio Diversification

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

What You Need To Do Immediately Diversification is one of the core concepts of investment management yet it is also one of the least understood .

In many ways diversification is like apple pie and motherhood – good for you and always taken at face value without any real introspection.

Investors throw out lots of platitudes about their portfolios being diversified.  Financial literature often contains allusions to diversification but do Main Street people really understand this important concept?

Understanding the portfolio diversification concept is not an academic nicety. Proper diversification is crucial for growing your wealth and managing through the inevitable ups and downs of financial markets .

Think of portfolio diversification benefits in the same way you think about insurance on your house. When nothing bad happens you go on and maybe for a second you think about whether you really need this form of protection.

But when something bad happens like a stock market crash or a tree falls on your garage, you do not even think for a nano second as to what you paid for the protection.  Whatever the price was, it was well worth it!

The portfolio diversification concept is, however, different from typical insurance in some important ways.  When you buy insurance on your house you have a contract regarding the conditions under which the insurer will pay, how much, and importantly a maximum out of pocket deductible.

With portfolio diversification there is no such contract and especially there is no set deductible capping your losses.  When somebody says “my portfolio is diversified” it can mean a million things .  But does it mean what you think it does?

The devil is always in the details, right?  You may think that your portfolio is diversified because nothing bad has happened yet. Or, you may think that your portfolio is diversified because your advisor said so. Who knows?

Or maybe you read a mutual fund advertisement stating that the fund you own has investments in a large number of industries.  Sometimes people think sprinkling their money across a large number of funds with different names means that they are diversified .

Why the confusion? Without getting too technical, diversification can mean a whole lot of different things depending on the context.

Properly understanding the context and what diversification means is difficult for non-financial people to wrap their hands around.  And that is a big problem and why investors often fail to capitalize on what Nobel Prize winner Harry Markowitz once called the only free lunch in financial markets .

When typical investors hear the word diversification they think protection against portfolio losses. If you are diversified, your losses will be less than if you are not diversified, right? During a stock market meltdown such as 2008 your diversified portfolio should do ok, right?

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Should you just assume that you are diversified?

Probably not. Remember the old saying – assume makes an a** out of you and me!  Better be safe than sorry when it comes to your financial health.

Let’s start with some basics. Very simply put, diversification means that you are not exposed to any one investment type determining the bulk of your portfolio returns.  One investment will neither kill nor make your whole portfolio.

A diversified portfolio contains investments that behave differently. While some investments zig, others zag.  When one investment is up big, you might have another one that is down.  Your portfolio ends up in the middle somewhere.  Never as high as your best performing investment and never as low as your worst nightmare investment.

Asset classes such as bonds and stocks have very different behavior patterns. Sometimes these differences get lost in jargon such as risk and return or the efficient frontier concept.

You don’t need a PhD from MIT or Chicago to understand the concept of diversification but pay attention as the details are important.

Why do you own stocks in your portfolio? Why do you own bonds and, say, real estate? Why do you have some money stashed away in an emergency fund at the local bank?

I know these questions may  seem a bit sophomoric but knowing the “why” for each of your investments is important to understanding how well prepared you are to withstand periods of financial market stress.

Most people already know that when economic times are good, stocks will typically go up more than bonds but when there is a crisis the reverse will often occur.

The whole point of owning stocks, bonds and potentially other major asset classes as a mix is to protect your portfolio from bad things happening.

Sure we would all love to get the upside of stocks without any downside but in reality nobody has the foresight to tell us in advance (please avoid subscribing to that doom and gloom publication that just popped up in Facebook) when stocks will collapse and when they will thrive.  Anybody up to buying some snake oil?

Diversification is not necessary if you have a direct line to the capital market gods. If you are a mere mortal proper diversification is absolutely necessary to ensuring you remain financially healthy.

Spreading your bets around, mixing a variety of asset classes, hedging your bets, not putting all your eggs in one basket – whatever your favorite phrase is you also need to live it. Diversification is one of those good habits that you should practice consistently!

With that warning in mind, what are 5 telltale signs that your portfolio may let you down when you need it the most?

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Symptom 1: Your portfolio is nothing more than a collection of funds you have accumulated over time  

Accumulating investments over time is a very common practice.  People sometimes get enamored with a certain investment type such as tech in the late 90’s and when things don’t pan out they are reluctant to sell the investment.

Not dissimilar to hanging on to that old dusty treadmill in the basement or that collection of Bennie Babies in the attic.  Many individual investors are hoarders without admitting it.

Sometimes it is as simple as when people change jobs leaving behind a 401(K).

Solution: Research each one of your funds. For example if you own the Alger Large Cap Growth fund (ACAAX) use a free tool such as Morningstar to do some basic research.

But let me warn you – looking only at past returns will tell you much about the past but virtually nothing about the future.  Ruthlessly eliminate funds that you don’t understand, have high fees or simply do not fit the style that you’re looking for. Don’t eliminate funds based solely on past performance.

Symptom 2: The more funds and strategies the more diversified my portfolio  

Some people think that if you own a lot of different funds or investments you are automatically diversified. A bit of this and a bit of that. Some growth, some value, a sprinkling of emerging markets and a Lifestyle fund thrown in the mix.  There is no rhyme or reason for any of this, but many people use this approach, right?

This is a very common mistake of investors.  A lot of funds of the similar ilk does not make a diversified portfolio. It makes for keeping track of many more things, but not necessarily things that matter to your financial health.

Owning a large number of investments does not mean that you are diversified.  It probably means that you or your advisor are confused about how to construct a portfolio. You can actually be much more diversified with a small number of uncorrelated investments – the number of investments is immaterial.

Solution: Less is often better when it comes to your investments. Too many funds means extra confusion.  Simplify to a small number of funds that will serve as your core portfolio holdings.  Think of these funds as the pillars holding up your financial house.

Choose low cost funds that you will be comfortable holding for decades.  Hint – focus on a small number of broad based index funds covering stocks and bonds.

Symptom 3: Your portfolio contains lots of investments with the same “theme”

Sounds like you have a fun portfolio when things go well but a nightmare when they don’t.  People fall in love with investment themes all the time.  They ride the theme hard not properly understanding that market sentiment is often fickle and can change on a dime.

In the late 90’s it was all about the internet.  Many people loaded up on the sector and lost their shirt soon after.

We have had more biotech booms and busts than probably for any other sector over the last 30 years .  Many of the biotech stars of old unfortunately were sold for cents on the dollar despite promising early findings.

Starting in mid-2017 the buzz was all about cryptocurrencies.  Many investors especially those too young to have experienced a stock market meltdown went head first into the craze and now probably are licking their wounds.

Solution: Theme investing is risky. Identifying the next emerging technology or the next Amazon or Google has a very low probability of success. Even the most seasoned venture capital firms thread lightly when it comes to the “new, new” thing.  You should too!

If you really understand a theme think about how long it will take for the mainstream to adopt it in mass.   Invest only a small percentage of your portfolio. For the rest of us, best to keep our greed in check and just say, no!

Symptom 4: All your investments are in the same asset class

This is a variation of the previous issue.  Sometimes you hear people say, “I am just a bond guy”. Or, maybe they say “I am a stock jockey”. People come to identify with their investments as a badge of honor without realizing the consequences to their financial health.  As my mother would say, “do things in moderation”. I still think that this is great advice whether it is about eating or investing.

The problem with just owning investments in one asset class is that you do not get the main course of the free lunch. You get the appetizer, but then you are shooed out of the room.

Diversification within an asset class such as stocks or bonds is not nearly as powerful as diversification across divergent asset classes

What do you mean?

Let’s take the case of stocks. In any given day, most stocks tend to move up or down together.  When the overall equity market (say the S&P 500) is up big for the day, you only find a very small percentage of stocks down for the day.  Similarly, when the broad equity market experiences a meltdown you will unfortunately only find a handful of stocks that went up for the day.

Same applies to bonds but the herding effect is even stronger.  Take the case of US bonds of a similar maturity, say 10 years.  This cohort of bonds moves in a pack all taking their lead from the 10 Year US Treasury.  If the 10 Year Treasury moves up, the vast majority of bonds move up in lockstep.  Same on the downside. Just like sheep.

Sure, some stocks or bonds will do better than others. Overall, securities within an asset class tend to move up or down together.  Call it a sister or brotherhood, while major asset classes relate to each other more as distant cousins.

Solution: For most people it makes sense to hold investments in all the key asset classes.  The three main asset classes that you should own are stocks, bonds and real estate.

Don’t get too cute. If you own a home you probably already have enough real estate exposure.

Why should you own stocks? For growing your nest egg over the long-term.  Sure stocks can be incredibly volatile, but if you plan to hold your stock investments for say longer than 10 years, history tells us that you can potentially maximize the growth of your portfolio. For a good review of the long-term power of stock investing read our recent blog.

Why own bonds? Historically, people held bonds for the yield and stability.  In the current low interest rate environment, focus on stability but keep an eye out for a more normal interest rate environment.  In the US we are already moving in that direction as the Federal Reserve hikes rates and Europe is not that far behind.

But, why is the stability of bonds useful? Mainly as an anchor to your stock investments. Bonds tend to do well during period of stock market stress so they tend to offset some of your losses.

Because bonds tend to be less than 1/3 as volatile as stocks holding a combination of bonds and stocks in your portfolio will dampen valuation changes in your accounts.  The value of your holdings will still be heavily influenced by movements in your stock holdings.  Your account values will, however, not fluctuate as much.  Is this worth it to you?

For many people holding bonds allows them to sleep better at night especially when equity markets go through the inevitable corrections.  A good night’s sleep is a prerequisite for a happy life.

A diversified mix of stocks, bonds and real estate is usually a great starting point for building your long-term financial wealth while allowing you to sleep well at night. Don’t overthink it.

Symptom 5: Your portfolio has never gone through a tough market environment

Given the low level of capital market volatility that we have had in the last few years, I would not be at all surprised to see people who dismiss the need for diversification.  After all if you just pick your investments wisely why should you worry?

Somebody that has been riding the FANG (Facebook, Amazon, Netflix and Google) stocks for a number of years probably does not see any need for bonds in their portfolio. Maybe they got a hint that they should diversify a bit during the February 2018 mini-correction but all seems to be forgotten three months later.

Go back to the late 90’s. Investors were riding AOL, Cisco, Dell, and Microsoft.  Very few individual investors saw the implosion that was about to hit and obliterate equity portfolios.

For example, investors in the Technology SPDR ETF (XLK) were riding high on the hog until March 1, 2000 when the XLK hit $60.56.  By July 1, 2002 the price had dropped to $14.32 – a horrific 76% decline from the peak.  It took until late 2017 for the XLK to hit its March 1, 2000 peak. That is a long time to wait to breakeven!

You don’t need diversification when things are going well. You only need it when the bottom is falling out from one of your investments.  Every single investor in the world has gone through a rough performance patch and nobody is immune to the pain and agony of market crashes such as 1987, 2000-2002 and 2008-2009.

Solution: Stress test your portfolio or at a minimum ask yourself what would happen if certain events of the past repeated themselves.

For most people it is far wiser to leave a bit of money on the table by diversifying across asset classes than go head first into a market crash.

Could you withstand a sudden 20% daily loss in the stock market? How about a couple of years of major losses such as over the 2000-2002 period? Would you have the stomach to weather these storms?

Many times the tension is between your rational side and your emotions.  Behavioral research shows that most times the emotional side wins out.  Most investors panic during corrections because they are not properly diversified.

Investing is fun when capital markets are going up and everybody is making money.  Equity market corrections and, heaven forbid, crashes are extremely stressful for the vast majority of investors.

Having a little bit of a cushion can mean the difference between emotionally and financially staying with your investing plan and chucking it all at what may turn out the most painful time.

Recovering from painful events is especially difficult when your state of mind is poor and your pocket book is much lighter than before.

Making decisions under stress is never optimal.  Self-improvement experts always talk about making decisions while in peak states, not when you are emotionally down.

 

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Conclusion:

Nobel Prize winner Harry Markowitz called portfolio diversification in finance its only free lunch.  Most people agree with his statement and attempt to build diversification into their investment strategies.

But the devil is in the details.  Many people remain confused by the term and its impact on their financial health.

But understanding portfolio diversification is not an academic nicety – it materially affects your financial health

For most investors the relevant context for diversification involves the key broad asset classes of stocks, bonds and real estate.

If you like smoother rather than bumpier rides, portfolio diversification is for you. You will sleep better at night especially when equity markets go haywire.

Investors can easily fall in the trap of thinking that their portfolios are diversified or that they do not need any diversification.

Making too many assumptions is not a good investment practice. Better to know in advance whether you have the mental fortitude and financial resources to weather the inevitable storms.

For technically oriented investors Portfolio Visualizer is a great free tool that allows you to estimate correlations among your list of funds.

For a more in-depth analysis of your portfolio’s true diversification consult a professional consultant experienced in portfolio construction issues.  You will get a lot more than simple correlations among your funds. You will get a full picture of the risk profile of your investments but keep in mind that ultimately the portfolio you own must work for you.

Your ideal portfolio must be designed in relation to your goals and needs while allowing you to sleep at night.  Only a comprehensive wealth management assessment can give you the level of detail required.

We are expert portfolio construction professionals and would glad help you assess the quality of your portfolio.  Don’t assume that you are diversified.  Contact the team at Insight Financial Strategists  for a free initial consultation.

At Insight Financial Strategists we are your fiduciaries. Our advice is focused solely on our view of your best interests. As fee only practitioners, our interests are aligned with yours.

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

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

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.

 

 

 

7 IRA Rules That Could Save You Time and Money

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

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.

2. 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.

3. 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.

4. 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

5. 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.

6. 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.

7. 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.   

Capital Market Perspectives – April 2018

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

 

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.