THIS WEEKEND, I have been clearing out old computer files that contain half-baked column ideas that never saw the light of day. One such file contained jokes that brokers tell about everyday investors.
My goal was to illustrate the disdain with which Wall Street views its clients. Indeed, I can’t think of another business that is so scornful of its customers, regularly belittling their intelligence and viewing them not as clients to be helped but as sheep to be shorn. But most of the jokes I managed to collect were, alas, pretty lame, which was probably why I never finished the column. Still, here are two jokes that just about pass muster:
- Broker pitches a stock to a client. “Put me down for 100 shares,” the client grudgingly agrees. “But for goodness sake, as soon as I get back to even, sell.”
- How many small investors does it take to change a light bulb? Two. One to unscrew it and drop it, and the other to buy it just before it crashes.
IF THERE’S MONEY you’ll need to spend in the next 12 months, you don’t want to put it at risk, so savings accounts, money market funds and similar cash investments are the only prudent choice. But as your time horizon lengthens, holding cash becomes less and less appealing. The reason: Your money’s purchasing power is pretty much guaranteed to shrink, once inflation and taxes take their toll.
Got cash in your long-term investment portfolio? You should move it into something that offers a higher return. For instance, shifting from Vanguard’s prime money market fund to its short-term corporate bond index fund would give you an extra 1.4 percentage points in annual yield. The danger: If interest rates climbed one percentage point, the short-term bond fund would suffer a 2.8% price drop—a loss you would eventually recoup through the higher yield, but it would take two years.
Of course, if you’re a truly long-term investor, you would probably want to opt for something with the prospect of even higher returns—meaning stocks. Suddenly, the potential short-term loss is a whole lot larger, as we know from the S&P 500’s 49% price drop during the 2000-02 bear market and its 57% swoon in 2007-09.
That possibility is enough to paralyze many investors. How can you unfreeze yourself? Start by deciding what percentage of your portfolio you want in stocks. How can you get from here to your target stock allocation? History tells us that you’ll clock the highest return by moving everything into stocks right away. This is no great surprise: The broad market rises over time, so buying sooner will, on average, give you a better result.
Problem is, you won’t get an average result. Instead, you get just one shot at moving all that cash into stocks, and buying all at once risks buying just before a major crash. The older you are and the bigger the sum involved, the more cautious you’ll want to be.
My suggested strategy—which regular readers have heard before: Take the money you want to move into stocks and divide it into 24 or 36 chunks. Move one chunk into stocks every month, with the goal of being fully invested within two or three years. If share prices drop 15% from current levels, double your monthly purchases. If the market falls 25%, triple your purchases.
What if you settle on a target stock allocation—and discover you currently have too much in stocks? While I favor the low-risk strategy of buying stocks slowly, I advocate selling quickly.
Many folks, of course, do just the opposite: If they discover they have too much in stocks, they will often slowly ease out of the market. This is all about aversion to regret: They hate the idea that they’ll sell a big chunk of stock and the market promptly rockets higher. But remember, while buying stocks slowly reduces risk, selling slowly increases it—because you stay over-weighted in stocks for longer and the market could go against you.
HOW DO OUR FINANCIAL HABITS STACK UP? Academics Cristian Badarinza, John Y. Campbell and Tarun Ramadorai compared U.S. households with those of 12 other developed nations. Here are some highlights:
- Almost 50% of U.S. households are invested in the stock market, versus 34% in Finland, 25% in Spain, 24% in Germany and 23% in France.
- Defined contribution retirement plans—think 401(k) plans and their ilk—are widespread in Australia, the U.K. and U.S., but are far rarer in continental Europe.
- When investing outside a retirement account, folks in Australia, Spain, France, the U.K. and U.S. are far more likely to own individual stocks than mutual funds.
- In 12 of the 13 countries, more than half of all households own their main residence. The outlier: Germany, where just 44% of households own their principal home.
- Fixed-rate mortgages are the overwhelming choice of U.S. and German home buyers, while adjustable-rate mortgages are far more common in Australia, Finland, Italy and Spain.
- Almost 75% of U.S. households are in debt—the highest of the 13 countries. Canada, Australia and the Netherlands aren’t far behind. Meanwhile, Italians are surprisingly prudent, with just 25% of households in debt.
- Homeownership is widespread in Greece and Italy—but mortgage debt isn’t. Just 10% of Italians have a mortgage on their primary residence and just 14% of Greeks, versus 47% in the U.S.
- Australian and U.K. households boast the highest median net worth, as measured by the value of their homes, financial accounts and other assets, minus all debts. What about those poor southern Europeans, with their rocky economies? Thanks to widespread homeownership and an aversion to debt, the typical household net worth in Spain, Italy and Greece is higher than in the U.S. or Germany. So where do the U.S. and Germany rank among the 13 countries studied? Citizens of these two economic powerhouses may enjoy relatively high incomes—but, if you look at the typical household, they’re at the bottom in terms of net worth.
- While the typical U.S. household—meaning the family that’s halfway down the wealth spectrum—doesn’t look so good in terms of net worth, it’s a different story if you look at average net worth. This average, which measures total household net worth divided by the number of households, is boosted by the hefty holdings of America’s wealthy. Result: Among the 13 nations, the U.S. ranks 12th on typical household net worth—but fourth on average net worth.
YOU WOULDN’T WANT to spend your entire life in the 0% tax bracket, but it’s a nice place to visit. Got stocks or stock funds in your taxable account? If you sell them in the right year, you could realize capital gains of almost $100,000 and perhaps more—and pay a 0% federal capital gains rate.
I was reminded of this loophole as I was flipping through Phil DeMuth’s latest book, The Overtaxed Investor, an amusing and easy read—not words often used to describe a tome on taxes.
Let’s say you’re out of work or you just retired and haven’t yet claimed Social Security. As things stand, you don’t expect any taxable income in the current year. To take advantage of the situation, you might convert a portion of your traditional IRA to a Roth. Part of the conversion won’t be taxed, thanks to your personal exemption and your standard or itemized deduction. But if you convert more than a modest sum, you’ll owe at least some income taxes. Nonetheless, that tax bill may be a small price to pay to get the money into a Roth, where it’ll grow tax-free thereafter.
But here’s an alternative way to exploit your low-tax year: You might sell stocks or stock funds in your taxable account that have unrealized capital gains. This isn’t worth doing if you’re happy with the holdings and plan to hang on to them until you die, at which point the embedded capital gains tax bill will disappear, thanks to the so-called step up in basis. But if you aren’t happy with the stocks or stock funds, or you know you’ll have to sell eventually, this could be the chance of a lifetime.
How so? In 2016, if you’re single and you claim the standard deduction, you could have income of as much as $48,000 and stay within the 15% federal income tax bracket. If you’re married filing jointly, the threshold would be twice as high—$96,000. Itemize your deductions? These figures may be higher still. The beauty of this tax situation: If your total income stays within these limits, any income would be taxed at 15% or less—but your long-term capital gains would be dunned at 0%. That isn’t a typo. Keep in mind that, to qualify for this 0% rate, you have to hold your stocks or stock funds for more than a year.
To be sure, there could be some tax cost involved. For instance, depending on your total income, you might have to pay taxes on your Social Security benefit, you could lose various tax credits and you might have to pay state income taxes. Still, the tax hit will likely be fairly modest—and the benefit substantial.
THE GLOBAL FINANCIAL MARKETS consist of four sectors of roughly equal size: U.S. stocks, U.S. bonds, foreign stocks and foreign bonds. Why would you bet on just one of those four sectors--specifically U.S. stocks? That's the topic I tackle in my latest free newsletter. The newsletter also discusses my enthusiasm for emerging stock markets and offers a slew of intriguing statistics. Want to view earlier newsletters? Check out the articles page. Want to be on the distribution list for future issues? Shoot me an email.
I AM WRAPPING UP WORK on my new book, How to Think About Money, which is scheduled for publication Sept. 1. Over the weekend, my designer--David Glaubke--delivered the book's cover. He initially suggested the dashing but flawed Andrew Jackson, I countered with the renowned Broadway rapper Alexander Hamilton and we ended up settling on Benjamin "Penny Saved" Franklin--a character less often seen because he's found not on the $10 or $20 bill, but on the $100. Check out the cover and a description of the book, as well as some overly kind endorsements.
THINK ABOUT THE BAD STUFF that didn’t happen. Very few of us will have a year when we crash the car, our home burns down, our employer goes belly up and our big bet on a single stock goes way down. Yet all of these things could happen, which is why we buy auto and homeowner’s insurance, keep an emergency reserve and avoid big bets on a single stock.
Sound sensible? There are two great dangers. First, we might be lulled into complacency by good times. Not many of us would drop our homeowner’s insurance because we haven’t ever had a fire. But a string of good years in the stock market can cause folks not only to question the value of bonds, but also to toss out fuddy-duddy notions of diversification and instead bet their life’s savings on an increasingly narrow selection of stocks.
Second, we might fail to address some risks, either out of ignorance or denial. For instance, many folks head into retirement without realizing there’s a decent chance they’ll live into their 90s, and also without a plan for how they’d cope with nursing-home costs.
How can we get a better handle on the risks we face? Try wrestling with these four questions:
- How would our families cope financially if our paycheck disappeared? That might happen because of a layoff, ill-health, disability or premature death. To fend off these various threats, we should have an emergency fund and health insurance, and perhaps also disability and life insurance.
- How would we cope financially if our major possessions were damaged or destroyed—or we were held responsible for harm done to others? This is a reason to buy auto, homeowner’s and umbrella-liability insurance.
- What would it mean for our portfolio if some part of the global financial markets had devastatingly bad performance? I’m not talking about a temporary dip in prices. Instead, at issue is a permanent loss of value—or a bear market that drags on for so long that it might as well be permanent. Think about the 86% loss suffered by shareholders of Valeant Pharmaceuticals over the past eight months—or the 55% loss suffered by Japanese stocks over the past 26-plus years. Is your portfolio sufficiently diversified to withstand losses like that?
- How would we cope financially if we lived extraordinarily long lives? Among affluent 65-year-olds, the median life expectancy for women is age 90 and for men it’s age 88—which means half of these folks will live to these ages or beyond. What to do? Delaying Social Security to age 70, so you get a larger monthly check, is a great place to start.
IF YOU WANT TO FEEL SHORT, stand next to somebody tall. Want to feel badly about your portfolio? Compare it to the Standard & Poor’s 500-stock index.
Over the five years through March 31, the S&P 500 notched an annualized total return of 11.6%, versus 7.2% for the Russell 2000 index of smaller U.S. stocks, 2.3% for MSCI’s Europe, Australasia and Far East index and a loss of -4.1% a year for MSCI’s Emerging Markets index. The credit for the S&P 500’s robust performance belongs to U.S. blue chip growth-company stocks, which have climbed 13.1% a year over the past five years, three percentage points a year better than the bargain-priced shares of slower-growing “value” companies.
All this is reminiscent of the late 1990s, when the S&P 500 was all but unbeatable and those with globally diversified stock portfolios had their prudence rewarded with relatively lackluster returns. But lest we forget, this is the fate every year of those who diversify: You never do as well as the best-performing asset class—but you also avoid the drubbing suffered by those who put all their eggs in the basket that turns out to have the worst results.
Still, owning a globally diversified stock portfolio feels especially foolish when the S&P 500—and also the Dow Jones Industrial Average—post strong results. These aren’t the yardsticks against which we should measure the performance of a global stock portfolio. But they are the indexes whose performance we hear about every day—and those two indexes also contain the stocks we’re most comfortable owning.
That sense of comfort, however, comes at a price. Forget the past five years—and think about the past 15. Over that stretch, the S&P 500 climbed 6% a year. That was better than developed foreign markets’ 4.4% annual gain, but far behind the 7.7% scored by small U.S. stocks and the 9.4% enjoyed by emerging markets.
WHO WON? Last week, the Department of Labor issued new rules, saying financial advisors have a fiduciary duty when advising clients on how to handle their retirement accounts, such as 401(k) plans and individual retirement accounts. This fiduciary duty means advisors must act in a client’s best interest.
For registered investment advisors, or RIAs, this wasn’t an issue: These advisors, who typically get compensated through fees, were already held to a fiduciary standard. But it was a big deal for brokers, who usually charge commissions and were previously held to a lower standard: Under the old rules, they only had to recommend investments that were considered suitable.
A resounding victory for everyday investors? Maybe not. The Labor Department rules still allow brokers to sell their firm’s own proprietary investment products, an obvious conflict of interest. They can also advise retirement-account clients to buy illiquid investments like non-traded real-estate investment trusts and to purchase tax-deferred annuities, as long as this is somehow in the client’s best interest.
Stuffing a variable or equity-indexed annuity inside an IRA has long been a ploy used by brokers seeking to increase their commissions, because annuity commissions are typically higher than those on regular mutual funds. But the benefit to clients is less obvious, because they end up with an annuity—a tax-deferred investment vehicle—inside an IRA, which is also a tax-deferred vehicle.
Maybe brokerage-firm lawyers and compliance officers will decide it’s hard to justify stunts like this under the new rules, and they’ll put a stop to such transactions. But even if that happens, brokerage-firm clients still need to be leery. Their brokers might act as fiduciaries when handing clients’ IRAs. But when advising clients on their regular taxable account, these brokers may be held to the lower suitability standard.
All of this means the new rules are a mixed blessing for investors. But the biggest loser, I fear, is the term “fiduciary” itself. Before the Labor Department ruling, it was a label proudly worn by registered investment advisors, and signified that—unlike brokers—they acted in the best interest of their clients. But now, it isn’t clear what the label means.
DISCUSSING AMERICA’S RETIREMENT readiness is almost always dispiriting. A minority are in good shape, but most folks are just muddling along—and many aren’t even managing that. Here are some numbers from the Employee Benefit Research Institute’s 2016 Retirement Confidence Survey:
- 26% of workers say they have $100,000 or more in savings, excluding their home and any defined benefit pension. But the same percentage—26%—say they have less than $1,000. The picture is cheerier if you look at workers age 55 and older, but not that much cheerier: 45% report $100,000 or more in savings, but an alarming 17% have less than $1,000. Keep in mind that even $100,000 will generate just $4,000 in first-year retirement income, assuming a 4% withdrawal rate.
- Among workers currently contributing to a 401(k) or similar employer retirement plan, 23% say they have taken out a loan. Paying off debt and buying a home were the top two reasons cited. What happened to their plan balance when they left their last employer? The EBRI study found that 25% of workers spent the money or used it to pay down debt.
- Our expectations, it seems, are a tad optimistic. For instance, workers plan to retire at age 65, on average. But many are forced to leave the workforce earlier than expected, so the actual retirement age is 62. Similarly, among workers, 67% expect to work for pay once they’re retired, but only 27% of retirees report doing so. And don’t assume retirement will be cheap: 38% of retirees say their expenses in retirement have turned out to be higher than expected, while just 21% say their cost of living has proven to be lower.
ASK NOT WHAT the markets can do for you. Ask what you can do for your portfolio.
After 15 turbulent months for stocks, many folks feel they’re at the mercy of the financial markets. But in truth, we’re far from powerless. We may not be able to control the direction of share prices. But here are seven crucial financial levers over which we have a lot of control:
1. We can figure out how much cash we’ll need from our portfolio over the next five years, and then shift this sum into short-term bonds and cash investments. That way, we know we’re in great shape for the next five years, no matter how crazy the markets get.
2. We can increase our earned income, reducing our reliance on our portfolio. The bigger our paycheck, the less need we’ll have for investment gains, which is why even retirees may want to work part-time.
3. We can cut our spending, which also reduces our need to take money from our portfolio. Reducing spending is one of the great financial levers—and yet it’s given scant attention. My advice: Keep your fixed costs low—we’re talking expenses like mortgage or rent, car payments and insurance premiums—so you can easily trim your spending if the markets go against you.
4. We can keep more of whatever the market delivers, by holding down our investment costs, making full use of retirement accounts and holding tax-efficient investments in our taxable account.
5. We can take advantage of lower stock prices by saving more and by rebalancing our portfolio.
6. We can reduce our exposure to the markets by exploiting one of our great financial advantages—our eventual mortality. The federal government will pay us handsomely to delay Social Security, while insurers offer hefty income to retirees who purchase immediate-fixed annuities. We might live off our savings in our early retirement years, while delaying Social Security to age 66 or even age 70. If we want additional guaranteed lifetime income, we might consider an income annuity.
7. We can choose to do nothing. Market turmoil often scares folks into action. But keeping our trading to a minimum is often the smarter strategy.
CONFRONTED BY A COMPLICATED financial world, the temptation is to fall back on rules of thumb. But are these rules any good? Here are five of the most popular:
1. Save 10% every year. There are two knocks on this rule of thumb. First, the 10% of pretax income is the sum you’re meant to save for retirement—which means those who have other goals, like buying a house and paying for a child’s college education, need to save even more. Second, even if your only goal is retirement, you probably ought to be saving 12% to 15%, given today's modest bond yields and heady stock market valuations. And if you don’t start saving for retirement until after age 35, you likely need to save a whole lot more than 15%.
2. Buy life insurance equal to five to seven times income. This is probably the most dubious rule listed here. If you’re single with nobody who depends on you financially, you likely don’t need life insurance. If you have three young kids and not much in savings, you might need twice as much coverage as this rule suggests—and possibly far more.
3. Set aside emergency money equal to six months of living expenses. If your job is tenuous, this isn’t a bad benchmark. But for those with more secure jobs, a spouse who works or access to a home-equity line of credit, an emergency fund equal to three months’ living expenses might suffice.
4. In retirement, you need 80% of your final salary. This is a tough threshold to hit. The good news: You’ll probably be just fine if—between Social Security, any pension income and portfolio withdrawals—you manage 50% to 60% of your preretirement income. Why? Once retired, the mortgage might be paid off, the kids have moved out and you don’t have to pay Social Security payroll taxes. Most important, you no longer need to save for retirement. Lots of folks make a big push to save in their final years in the workforce, notching a savings rate of 20% or more, so they’re already used to living on far less than their full income.
5. Limit your retirement withdrawal rate to 4%. The idea is to withdraw 4% of your portfolio’s value in the first year of retirement and thereafter increase your annual withdrawals with inflation. Studies have found that, historically, this would allow retirees to make it through a 30-year retirement without running out of money.
Lately, the 4% withdrawal rate has been criticized as too generous in a world where stocks and bonds are so richly valued. That may be true. Still, advocating anything less is unrealistic, because people simply couldn’t afford to retire. My advice: Start at 4% or even 5%—but stand ready to slash your spending if the markets go against you.
WRITING MAY PROVIDE ME with a livelihood—but it also provides me with an escape. Whenever there’s a ruckus in some other part of my life, it can be comforting to power up the computer and spend a few hours wrestling with my latest article or book. Each piece is a world entirely of my making, where I’m fully in charge. Like a puzzle, I can move the sentences and paragraphs around, until I’m happy with the flow of the words, the tone seems right and the argument hangs together.
As readers peruse the result, I wonder whether they realize what a one-sided discussion we’re having. If there’s an inconvenient fact, I can ignore it. If there’s something I’m unsure of, I can dance around it. When I write, I don’t aim to be unfair, and yet that is the inevitable result.
All this has been on my mind as I finish up my latest book, How to Think About Money, which will be out in September. The book describes how I’ve come to view money, including the connection to happiness, the implications of increasing life expectancy, the central role of our human capital, and more. I hope to change the way readers tackle their financial life. It’s an effort at persuasion, where I present the world as I see it. Readers may disagree. They could leave the rest of the book unread or send me a blistering email. But they can’t quibble with me mid-book, because I always get the next word—and the one after that and the one after that.
THE LATEST MUTUAL FUND SCORECARD from S&P Dow Jones Indices had sobering news for buyers of actively managed funds: Just 17% of U.S. stock funds beat the broad market over the past 10 years. But for those who dug into the numbers, there seemed to be a glimmer of hope.
The so-called SPIVA scorecard analyzes actively managed U.S. stock funds in 13 style boxes. There are four categories for value funds, four for growth funds and four for funds that straddle these two investment styles. In each case, the four categories focus on the size of company bought: small-cap, mid-cap, large-cap and multi-cap. Thus, the SPIVA scorecard looks at small-cap growth funds, mid-cap growth funds, large-cap growth funds and so on. In addition, there’s a 13th category, devoted to real estate funds.
The failure to beat the market is flabbergasting. In 11 of the 13 categories, less than a fifth of funds managed to beat their benchmark index over the past 10 years. The worst category was large-cap growth funds, where just 6% of funds outperformed their category’s benchmark.
The best performers were large-cap value funds: 39% of these funds outperformed their benchmark index. Are value managers smarter? Is there hope for buyers of actively managed funds? I wouldn’t count on it.
At issue is a statistical quirk. Funds are almost never as pure in their investment style as the index they’re judged against. That hurts actively managed funds when their part of the market is relatively hot. Funds will often buy stocks from outside their stated area of investment focus—and these stocks will tend to drag down performance, relative to the fund’s benchmark index, when the benchmark index is on a hot streak. Conversely, when their benchmark index has weak performance, active funds often appear to be relatively strong performers, as their results get a boost from the stocks they own from outside their main investment mandate.
Sure enough, over the past 10 years, the S&P 500 Growth index was up 8.7% a year, while the S&P 500 Value index was up 5.8%. Result? If large-cap value managers snuck a few growth stocks into their portfolio, it would have helped their performance—and made them look good relative to the value index.
THE FEDERAL RESERVE just released its latest “Financial Accounts of the United States”—which sent nerdy stock market analysts scrambling to look at table B. 103, which details the “Balance Sheet of Nonfinancial Corporate Business,” and especially line 44. That line compares the stock market’s overall value to the current value of assets owned by corporations. Some of these corporate assets are listed at their market price, while others are valued at their replacement cost.
In the latest Fed release, which reflects data for 2015’s fourth quarter, stocks were at 95% of the value of corporate assets. This is known as Tobin’s Q, named after famed economist James Tobin, who first proposed the measure. At first blush, the current reading suggests U.S. shares are cheap, because stock investors can effectively purchase corporations at a 5% discount to the value of their assets.
Analysts, however, don’t pay much attention to the absolute number, because the replacement values are likely overstated (or, to put it another way, companies could replace their current assets with assets of comparable condition for less than the stated replacement cost). Instead, analysts pay attention to how today’s ratio compares to the historical ratio. On that score, things don’t look so good: The latest reading of 95% is well above the historical average of 68%, which tells us that stocks are most likely overvalued. For a chart of Tobin’s Q over time, head to AdvisorPerspectives.com.
None of this means that stocks are about to crash. Tobin’s Q shouldn’t be used as a short-term trading signal. Indeed, based on Tobin’s Q, stocks have been overvalued for much of the past quarter century, suggesting that perhaps average valuations have moved into a permanently higher range. If that has happened, it’s a mixed blessing, as I have emphasized before: We may not get a big market decline—but, given today’s rich valuations, we also aren’t likely to enjoy impressive long-run gains.