Thursday, June 18, 2015

How To Use Deposits and Withdrawals To Rebalance Your Portfolio

The benefits of rebalancing a portfolio are well documented. Constant rebalancing forces an investor to lighten the portfolio positions that have recently performed well and use the resulting funds to buy more shares of the assets in the portfolio that have remained flat or even declined in value. In other words, rebalancing causes the investor to sell high and buy low.

Most financial professionals recommend rebalancing your portfolio at least once a year (I rebalance my clients’ portfolios on a semi-annual basis). However, the tax status of an investment account can have a significant impact on a rebalancing strategy. While investments within a tax-advantaged account like a traditional or Roth IRA can be sold without tax implications, selling appreciated assets in a taxable investment accounts will create a capital gains liability. Consequently, while rebalancing within a tax-advantaged account should be a no-brainer, investors should carefully consider the tax implications that may result from rebalancing a normal investment account.

For this reason, investors should view every deposit to or withdrawal from a taxable investment account as a chance to rebalance. Depositing new money is a free opportunity to buy more of the positions in which the portfolio is underweight. For example, suppose an investment account of $100,000 has a target asset allocation of 50% stocks and 50% bonds ($50,000 invested in both). After a year in which stocks made 10% and bonds were flat, the portfolio would consist of $55,000 of stocks and $50,000 of bonds, for a total account balance of $105,000. If at this point the investor would like to invest an additional $5,000, the entire contribution should be placed in bonds, bringing the actual portfolio allocation back to 50% stocks and 50% bonds ($55,000 invested in each).

Of course, this same strategy can be implemented regardless of the size of the additional contribution. If the investor wanted to contribute $10,000 in year two, the total account value would be $115,000 ($105k current balance + $10k new money). In order to get back to our 50% stock and 50% bond targets, we would want $57,500 in each position. With $55,000 already invested in stocks, we would only want to invest $2,500 of the new money into stocks and place the remaining $7,500 into bonds, bringing both portions of the portfolio up to their targets.

Taking withdrawals from a taxable investment account should also be viewed as an opportunity to rebalance. Rebalancing via withdrawals may not be free as it is when rebalancing is done when new funds are deposited because appreciated assets are likely sold, creating a tax liability. However, when a withdrawal is taken from a taxable account, it is still wise to sell overweight asset categories to produce the funds needed for the distribution.

Let’s return to our previous example of a 50% stock and 50% bond target portfolio that had grown to $55,000 of stock and $50,000 of bonds. If the investor then wanted to withdraw $10,000, he could take the entire distribution out of bonds which would allow him to free up the amount needed without creating a tax liability. However, the resulting portfolio would consist of $55,000 of stocks and $40,000 of bonds – a ratio of approximately 58% stocks and 42% bonds.

This is a significantly more volatile portfolio than the target 50% stock and 50% bond portfolio. For example, in 2008 a portfolio that consisted of 50% large cap stocks and 50% long term government bonds lost -7.16%. Meanwhile, a portfolio of 58% stocks and 42% bonds lost -11.93% over the same time period – a 66.6% increase in volatility.

Alternatively, I’d suggest using the $10,000 withdrawal to rebalance the portfolio, bringing the resulting $95,000 portfolio back to 50% stocks and 50% bonds ($47,500 in each). Of course, to do this, the investor would liquidate $7,500 of stocks and $2,500 of bonds. Although this could potentially create a small capital gains tax liability, this is a tax bill that will need to be paid at some point anyhow, and the investor will maintain a portfolio with the target amount of volatility.

Further, remember that the long-term capital gains rate (which applies to any capital assets held for over a year) is a favorable tax rate. For single filers with a taxable income of less than $37,450 and joint filers with a taxable income of less than $74,900, the capital gains tax rate is actually 0%! Additionally, for single filers with a taxable income of between $37,450 and $406,750 and joint filers with a taxable income of between $74,900 and $457,600, the capital gains tax rate is only 15%. Consequently, the investor can likely rebalance the portfolio back to the target allocation via the withdrawal while incurring only a nominal tax bill.

While rebalancing provides a significant increase in investment return over long time periods, tax implications should be considered when determining whether or not to rebalance a taxable investment account. However, depositing money to or withdrawing money from these accounts provides a favorable opportunity to obtain the return premium rebalancing creates while minimizing tax implications.

Tuesday, June 9, 2015

Investment Risk May Not Be What You Think

A new logic has been surfacing amongst the top minds in the financial planning industry. Many of my favorite financial authors – Warren Buffett, Josh Brown, Nick Murray, Howard Marks, and others – have proposed the need to redefine the work “risk.”

Most investors and financial advisors tend to utilize the words “risk” and “volatility” interchangeably. We measure how risky a portfolio is by examining its potential downside performance. For example, we review how much a similar portfolio lost during 2008 or when the tech bubble popped in 2000-2002. When doing this, we are really talking about volatility rather than risk. Volatility – usually measured by standard deviation – reflects how much a portfolio is likely to increase or decrease in value when the market as a whole fluctuates. Risk, however, is quite different.

Josh Brown characterizes risk as the possibility of two threats:
  1. The possibility of not having enough money to fund a specific goal, which includes the possibility of outliving your money
  2. The possibility of a permanent loss of capital.
In a dramatic example of how volatility is different from risk, consider a retiree with a $10 million portfolio who only spends $50,000 a year. Next, assume the investor experiences a two-year period in which during the first year his portfolio loses 50% of its value and in year two the portfolio earns a 100% return. Thus, after year one the portfolio would only be worth $5 million and after year two it would again be worth $10 million.

Clearly, this is a very volatile portfolio that is subject to a wide range of potential performance outcomes. However, is this portfolio truly risky to the investor? According to Mr. Brown’s first factor, the portfolio is not risky because the investor will have enough money to fund his $50k per year retirement regardless of whether his portfolio is valued at $10 million or $5 million. Additionally, the portfolio is also not risky according to the second factor in that the investor didn’t experience a permanent loss.

Investors tend to view stocks as risky assets because they have a large standard deviation of returns. Similarly, we tend to view money market equivalents such as CDs and savings accounts as very safe investments because they are not likely to experience a large loss. However, rather than considering stocks to be risky and cash equivalents to be safe, it would be more accurate to consider stocks an investment with high volatility and cash to be a holding with low volatility.

What is the difference? Suppose it is determined that you need an average rate of return of 6% over time to achieve your retirement goals. Historically, over a sufficiently significant period of time, stocks have returned an average of about 10% per year while cash equivalents have returned about 3% per year. Consequently, if these averages continue in the future, you actually have a very low chance of reaching your retirement goal of not outliving your money if you place money in the “safe” investment of a cash equivalent, while you would actually have a pretty high probability of reaching your retirement goal if you place money in a more volatile basket of stocks.

By this metric, cash is actually the more risky investment because investing in it would increase the probability of outliving your funds. Meanwhile a basket of stocks, if given enough time to achieve its historically average rate of return, is actually the safer investment as it gives you a higher probability of not outliving your nest egg.  Thus, while a portfolio of stocks will almost certainly experience more short-term volatility, over an extended period of time it very well may be a safer investment for ensuring your retirement goals are met.

Warren Buffett recently addressed this issue in his annual letter to shareholders:

Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

Further, Josh Brown proposes that the muddying of definition between risk and volatility is something a portion of the financial service industry has done on purpose. Mr. Brown suggests that the easiest way to sell someone a product is to first convince them they have a need. If hedge fund managers, insurance agents, and annuity salesmen can make consumers believe that volatility is equal to risk, and that since their products minimize volatility they must also minimize risk, they can achieve more sales. However, even if an annuity can eliminate downside volatility, if it limits potential return to a figure that is insufficient to achieve the investor’s long-term goals, the investment is still likely more risky than an investment with more short-term volatility but a higher probability of long-term success.

Next time the market goes through a correction, remember that the drop in your portfolio’s value is a reflection of the potential volatility your portfolio is capable of experiencing. Yet, recall that as long as you don’t sell your assets and suffer a permanent loss of your investment capital, you can allow the market time to recover and achieve its historical rate of return. Doing so will ultimately make your investment strategy less risky than utilizing investment options that experience less volatility because it maximizes the probability you will eventually achieve your long-term financial goals.

Thursday, May 28, 2015

1099 Income - A Potential Retirement Savior

You have likely seen reports about how financially unprepared the average American is for retirement. According to the Federal Reserve, the median balance of retirement accounts held by Americans who are saving for retirement totals less than $60,000. The same report states that the median value of retirement accounts for families whose head of the household is between ages 55-64 is $103,200, while the median value of retirement accounts for families whose head of the household is between ages 65-74 is $148,900.

Clearly, these median account balances are insufficient to fund a retirement. A 65-year old with a retirement account balance of $148,900 who is withdrawing 4% of that balance each year (a common withdrawal rate) is receiving less than $500 per month. Although most individuals will have Social Security and perhaps a pension to supplement this retirement income, it is likely that many people will need to significantly scale back their standard of living during retirement in order to not outlive their retirement savings.

So what is the best way to give your retirement accounts a boost? Obviously, the basic answer is to save more. However, this is easier said than done for most people.  First, many people simply don’t have money left to save after subtracting expenses from their income. Second, even those who have extra funds face a restriction on the amount of tax-advantaged money that can be saved each year because retirement accounts have contribution limits: individuals under the age of 50 can only contribute $5,500 per year into traditional or Roth IRA accounts (individuals over age 50 can save an additional $1,000). Similarly, employees under the age of 50 who have access to an employer-sponsored 401k plan can only contribute $18,000 to the plan each year (individuals over age 50 can contribute an additional $6,000). These 401k contribution amounts are in addition to any deposits made by the employer.

Due to both a lack of income and retirement account contribution limits, it may be hard for some people who feel behind on their retirement savings to get caught up. However, allow me to suggest a potential way to bump up your retirement account balances – 1099 income.

Income from self-employment is classified as 1099 income. Self-employment income can come from sources ranging from consulting, to providing a service in which you possess a unique skill, to driving for Uber. It is frequently a perfect second source of income in that by definition, you can earn 1099 income on your own schedule. While an employer can require you to work at a certain time, you can literally earn 1099 income whenever your schedule allows. Of course, assuming your expenses remain constant, a second source of income would create more money that can be saved for retirement.

More importantly, 1099 income allows you access to unique retirement plans such as a Solo 401k or a SEP (simplified employee pension). These retirement plans enable you to save a tremendous amount in tax-advantaged retirement accounts – up to $53,000 in 2015! This is incredibly useful, particularly to individuals who don’t have access to employer-sponsored retirement plans like a 401k or 403b. In these instances, the amount that can be saved in tax-advantaged retirement accounts suddenly increases from $5,500 (the IRA contribution limit) to as much as $53,000 per year.

A Solo 401k enables the person who generated the 1099 income to make a tax-deferred contribution to the retirement account as both an employee and an employer. Contributions as the employee are limited to the lesser of the amount of income earned by the individual or $18,000, the 401k contribution limit ($24,000 for people over age 50). Additionally, as the employer, the individual can contribute up to 25% of the employee’s compensation. Combined, the contributions as both the employee and the employer can’t exceed $53,000 in 2015.

For example, consider a 55 year-old that can’t afford to save any of the income from his primary job but also generates an additional $30,000 of 1099 income. This individual would be able to contribute $24,000 of this income to a Solo 401k as the employee, and would be able to contribute the additional $6,000 to the plan as the employer (as $6,000 is less than 25% of $30,000, the employee’s compensation). Consequently, this individual would be able to save the entire $30,000 earned for retirement in a tax-deferred account, which would prevent their tax bill for the year from increasing.

It should be noted that the individual would still need to pay the payroll tax, which consists of both the Social Security and the Medicare tax. Further, as both the employer and the employee, the individual would have to pay the entire amount of both taxes, which totals 15.3%. However, the point remains the same – the additional 1099 income created a significant amount of extra money, of which an unusually high percentage could be saved in tax-advantaged retirement accounts.

For those not looking to save such a large additional amount, a SEP may be sufficient. While a SEP doesn’t allow you to make the $18,000 employee contribution (or $24,000 for workers over age 50), you still have the ability to make the employer contribution of 25% of income. A SEP is slightly more simple to create and maintain than a Solo 401k. Additionally, for individuals who already have the ability to contribute to a primary employer’s 401k plan, a SEP may be a better choice. Such an individual could make the full employee contribution of $18,000 ($24,000 for individuals over 50) to the primary employer’s retirement plan, but still make the 25% of 1099 income contribution to their private SEP plan.

If you are looking to ramp up your savings rate and increase your retirement account balances, creating 1099 income may be an ideal solution. Of course, most people would welcome the second source of income, but the fact that the income can be generated on your own schedule makes this option particularly viable. Further, the access that 1099 income grants to unique retirement plans like a Solo 401k or a SEP, which have unusually high retirement account contributions limits, makes this type of income particularly appealing.

Friday, May 8, 2015

The Market Has Been Flat For Six Months -- Why This is Great News

Investors have experienced a very uneventful 2015. In fact, at market close on 5/7/15 the Dow Jones Industrial Average was at essentially the same value as it was on 12/5/14, up a total of just 0.72% over the six-month period. This lack of fluctuation has been even more pronounced over the last two months. As of the market close on 5/7/15, the S&P 500 has closed between 2,040 and 2,120 for 66 days in a row. Further, between 4/9/15 and market close on 5/6/15, the DOW hasn’t experienced a 1-month high OR low and has traded within a 2% range the entire time (always between -1% and 1%).



Believe it or not, this may be the best pattern possible for the U.S. stock market. History tells us that the market is likely to increase in value over time. If we were to plot the market's value from the time the market first opened to the current day, a chart of those two points would illustrate a return as such:


However, we all know that the market doesn’t provide a consistent return. On individual trading days, the market can either increase or decrease in value, and the range of potential gains or losses is wide. Over extended periods of time, the market’s actual value may be above or below the expected trend line. In fact, the market’s actual historical return may look more like:


Anyone who knows me or reads my blog is likely aware that I am not one to make market predictions. I have no idea whether the market is near a temporary top or is still experiencing an upward trend after hitting the bottom of an S curve in 2008. However, let’s assume the market has reached the top of an S curve and is currently above the trend line that would represent consistent growth (similar to the illustration above).

If that is the case, there are two ways the market could get back in line with the trend line representing consistent long-term growth. The first and most obvious way this could happen is for actual market performance to curve downwards towards the trend line. This would represent a market correction or even crash.


The second, and perhaps less obvious way that actual returns could become aligned with the long-term trend line is for time to allow the trend line to catch up to the actual returns we have experienced since 2008. In this scenario, the market doesn’t slump but remains stable while time enables price-to-earnings ratios, valuations, and the economy a chance to catch up.


Very few investors enjoy or take advantage of a market correction. In fact, most investors lose control of their emotions when the market experiences a drastic downturn, and do exactly the opposite of what they should do: they sell at market lows – hardly a profitable investment strategy. Consequently, if we are to avoid an over-heated market, it is likely better for most investors if the market realigns itself with the long-term growth rate by remaining flat for awhile and allowing the trend line time to catch up.

Allow me to reemphasize that I am not predicting that the market is in fact at a temporary high and above where it should be. I have no idea what the market will do tomorrow, over the next month, or over the next year. That is why I believe investors should have a well diversified portfolio that represents their risk tolerance and that they stick to through thick and thin.

However, let’s look at the other side of the coin and assume the market is still at the bottom of an S curve, below the long-term trend line, and needs to experience further growth in order to catch up. Even in this scenario, an extended period of flat market performance is hardly a bad thing – it would simply make the potential upside needed to get back to market norms all the greater.


It turns out that an extended period of flat market performance may very well be a positive for investors in any environment, regardless of whether the market is currently over or under-valued.

Friday, April 24, 2015

Attention Investors: Don't Get Soft



Do you realize how easy investors have had it lately? There is almost always something happening in the world that can serve as justification for selling investment positions or not investing new dollars. Yet, there hasn’t been many spooky events impacting the markets during the last several months. Let’s examine the investment environment we’ve recently enjoyed.

There is almost always geopolitical current events that are capable of scaring investment markets. While this generation will always have concern about ISIS, North Korea, Iran, Afghanistan, and terrorism, we haven’t recently experienced the kind of negative political event that has immediately sent the stock market into a tailspin. Even stories regarding missile strikes in Gaza have been few and far between. The most relevant international political event of late is the United States’ increased cooperation with Raul Castro and Cuba -- a positive event.

Global economic situations also have the ability to increase volatility in the stock market. Yet, we haven’t recently been bombarded with headlines about excessive debt in Argentina or other countries on the doorstep of financial collapse. Actually, international markets are the big investment story thus far in 2015, with Europe, Asia, and emerging markets outperforming U.S. stocks.

Social tragedies also have the ability to move the markets. I believe the most dominant story regarding social issues of late has been the horrific stories of potential racism and excessive police violence. Of course, these events are shocking and unfortunate, but they aren’t usually the type of stories that impact investment markets. Fortunately, I’m not aware of any school shootings, mass suicides, or broad violent attacks on U.S. soil that have caused a national mourning in 2015. 

Further, there have been relatively few natural disasters such as hurricanes, earthquakes, or tornados that have significantly set back a geographic area or the nation as a whole. In fact, the Weather Channel announced that the tornado count is 59 percent below average year-to-date. There were some large snow storms in the North-East earlier this year, but they had a nominal impact on the direction of the stock market.

Even the U.S. economy hasn’t produced any data that has been particularly frightening to investors. It was all the way back in October that the Federal Reserve announced the ending of its quantitative easing (QE) program, which caused some to wonder if the economy would start to dry up (it hasn’t…). The concern about potentially higher interest rates has been present for so long that it is now old news, and people seem less and less convinced that higher interest rates would significantly stall the economy. Meanwhile, the unemployment rate continues to decline.

Lastly, the stock market itself has hardly provided reason for heartburn. The total return of the S&P 500 has been positive every year since 2008. The index hasn’t even had a temporary pullback of more than -7.27% (9/18/14 – 10/16/14) since 2011, even though the market historically goes through a -10% correction approximately once per year, on average. In fact, the biggest investment concern of 2014 was that small cap and international stocks didn’t make as much as large cap stocks, causing most diversified portfolios to under-perform the larger market indexes such as the S&P 500 and Dow Jones Industrial Average. If your largest investing disappointment is that every part of your diversified portfolio didn’t perform as well as the best performing asset category in the market, you should really focus less on your portfolio and more on enjoying life as a whole.

When we examine the factors that typically lead to volatility in the market, we’ve had a relatively tame past couple of months. My purpose in pointing out this fact is not to imply that the market is in a prime position to continue to do well nor on the verge of dropping drastically when the next sign of uncertainty appears. I simply hope to remind investors that the stock market is not always such a smooth ride.

The most counter-productive action an investor can take is to liquidate their positions after the market drops. I believe the best way to avoid this mistake is to constantly remind yourself that you are investing for long-term results and that short-term (and potentially drastic) volatility is certain to occur. Reminding yourself of this fact now, before the volatility arrives, is likely to increase the probability that you will be able to stick to your long-term investment strategy during both the good and bad periods of market performance.

As Carl Richards points out in his new book The One-Page Financial Plan, no skydiver would try to figure out how a parachute works after jumping out of a plane. Sooner or later, an unfortunate event that will negatively impact the stock market is certain to occur. At that time, remember that just as it always has, the world will continue to turn. Further, remember that the longer you allow the world to turn, the more positive your investment results are likely to be. Don’t let this unusually quiet investment period make you more susceptible to short-term instability once it returns.

Monday, April 20, 2015

Living and Dying on Averages



Never forget the six-foot tall man who drowned crossing the stream that was five feet deep, on average.

We want to abide by averages because they make our lives simple and manageable. A couple on a date night assumes a movie will be an average of two hours long so they know when to schedule dinner with friends. The entrepreneur wants to think in terms of making an average profit of $100,000 per year so he has a guideline regarding the standard of living he can enjoy. The 65-year old retiree wants to assume he will live to the average age of 84.3 so he knows at what pace he can enjoy his nest egg.

However, when we rely too heavily on averages, our planning can go awry. If the movie runs longer than two hours, the couple will be late for their dinner date. If the entrepreneur has a slow year and earns less than $100,000, he may end up taking out short term debt to pay his bills. If the retiree lives past age 84.3, he may outlive his money.

The use of averages is essential in financial planning. A range of assumptions is required in the development of a financial plan – how long will you live, how much will you spend each year, what rate of return will your investments achieve, what tax rate will you pay, what will the rate of inflation be, etc. Without these assumptions, retirement projections can’t be constructed. Further, the best method for making these assumptions is to use averages – an average life expectancy, an historical average rate of return, an historical average inflation rate, etc.

So how do we prevent the use of averages from destroying us? By allowing enough time and repetitions for the law of averages to come into effect. Just because a basketball player shoots free throw shots at a 90% success rate doesn’t mean he will necessarily make the next free throw shot he takes. It does, however, mean that if he shoots 100 free throws he is likely to make 90 of them.

A financial plan may assume you achieve an average annual rate of return of 7% per year. Of course, this doesn’t mean it is impossible that your portfolio will actually lose 10% over the next 12 months. It is critical to remember that the financial plan assumes you achieve a 7% return over the entirety of your retirement, which may be 30 years. Consequently, if a loss of 10% occurs in the first year of retirement, your portfolio still has another 29 years to achieve returns that average out to 7% per year. Thus, a 10% loss is far from catastrophic to your retirement projections.

In fact, the primary way a 10% loss could become catastrophic to your portfolio is if it motivated you to make changes to your investments that would prevent the law of averages from applying. If an investor sold their portfolio after suffering the 10% loss, it would essentially guarantee that the anticipated average rate of return won’t be achieved, and consequently, the financial plan would be likely to fail.

For this reason, while it is true that over an extended period of time the market has averaged an annual return of 10%, we should always remember that there is a significant chance of the market taking a loss during any given year (or three-year) period, and it is possible that the market could endure a decade without any significant gains (similar to the 2000’s). Still, if the financial plan requires an average investment return over an extended period of time such as a 30-year retirement, even these setbacks are far from certain to dislodge your secure retirement as long as time is granted for the average to work itself out.

As famed writer and investor Howard Marks said, “We can’t live by the averages. We can’t say ‘well, I’m happy to survive, on average.’ We gotta survive on the bad days. If you’re a decision maker, you have to survive long enough for the correctness of your decision to become evident. You can’t count on it happening right away.” The use of averages has a purpose in financial planning, and in other aspects of life. We simply need to be confident that the figures we use for our averages are achievable over time, and allow time the opportunity to prove us right.