Category Archives: Long-term investing

First Fed Hike & Stock Market

Interest RateGuest post by Contributing Editor, David R. Kotok, Cumberland Advisors.

There has been a lot of discussion about the Federal Reserve (Fed) and when it will move its interest rate to something higher than the present 0 to 0.25%. The Fed has been at the zero bound for years. My friend Jeff Saut at Raymond James noted that there are people who have been in this business over eight years and have never experienced a Fed rate hiking cycle. We have to look back more than a decade to recall what sequential hikes were like.

The questions are, when they will do it, by how much, in what sequence, for how long, to what level, and with what effect on the markets?

Bond market pundits think the Fed may raise rates quickly, as they did in other hiking cycles. Others, like our team at Cumberland Advisors, think they will take gradual steps in view of the fact that the US dollar is the strongest currency in the world. It is getting stronger, and worldwide interest rates are low and going lower. Approximately $4 trillion in total sovereign debt worldwide is now trading at negative interest rates. Additionally, the Fed does not see an inflation threat. It does see gradual recovery in the US and healing labor data.  Today’s employment report will add to the list of monthly improvements.  But the labor markets still have a long way to go to get to normal.  The Fed remembers the 1937 experience when they hiked interest rates too soon and dumped a recovering economy back into recession.

All that said, there is one question that remains. What happens to the stock market when the Fed raises interest rates?

Talley Léger is the co-author of our new book, the second (and revised) edition of From Bear to Bull with ETFs. He has published a study entitled “Don’t be too spooked by Fed rate hikes,” dated January 31, 2015. Talley has given us permission to share this Macro Vision Research piece with our readers. The link to his commentary is here.

We do not know what will happen in this particular cycle, since we are now in uncharted waters. We are coming out of the zero-interest-rate regime. We do know that the market has spent a lot of time and energy fretting about the prospect and the timing of rising rates. Our internal view at Cumberland Advisors is that the first rate hike will not trigger a market selloff. Further, we do not expect the bond market to sell off and interest rates to go shooting up when the Fed raises the interest rate from zero by an eighth or a quarter percent. And we expect the first rate hike to take place in the very latter part of this year or in early 2016.  In a few hours we shall see the newest labor data for the US.  We expect that it will validate this gradualist approach in our Fed forecast.

 

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Cumberland Advisors is not affiliated with FOLIOfn or The Portfolioist.

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Investing: What the heck is a Larry Portfolio?

PortfolioGuest post by Contributing Editor, Matthew Amster-Burton, Mint.com.

Recently, I wrote a three-part series on how to start investing.

Today, I want to look at an advanced topic. Generally, I avoid advanced topics in investing, for two reasons:

  1. Most people don’t even have a grasp of beginner-level investing yet.
  2. The vast majority of “advanced” investing techniques can’t beat a simple, diversified portfolio over time.

Today, I want to look at a possible exception. It’s called the Larry Portfolio, developed by a guy named (you guessed it) Larry Swedroe and presented in his short and readable new book, Reducing the Risk of Black Swans, cowritten with Kevin Grogan.

Like momentum investing, which I explored last week, the Larry Portfolio is a way to attempt to capture more return from your portfolio without taking more risk—the holy grail of investing. Spoiler alert: it’s a promising idea that may or may not be appropriate—or possible—to implement in your own investments.

This is fairly technical stuff, although I’ll leave the math out of it. If you’re interested in investing as a hobby, read on. If you just want a simple portfolio that will beat your stock-picking friends, that’s fine. Go back to my original series.

One kind of risk

Smart investors like to take smart risks.

Investing in just one company is a dumb risk. That company might go bankrupt in any number of unexpected ways. Investing in lots of companies (aka diversification) is a smart risk: you’re no longer exposed to the risk of one company flaming out.

You’re still exposed to the risk of the market as a whole, and that’s the risk that investors can expect to get paid for over time.

Investors call this total-market risk beta. Beta measures the volatility of the stock market as a whole. Generally speaking, to get more return, you have to take more risk: Treasury bonds have low beta and low expected returns; stocks have high beta and higher expected returns. A total stock market portfolio has a beta of 1. (Let’s talk about low-beta stocks another time, please!)

So you might imagine that the best possible portfolio would look something like this:

  • Low-risk bonds (Government bonds from stable governments, high-quality corporate bonds, CDs)
  • A total world stock market fund

Mix them in whatever proportion suits your risk tolerance. One popular formula is 60/40: 60% stocks, 40% bonds.

Many kinds of risk

Then, in the early 1990s, two professors at the University of Chicago, Kenneth French and Eugene Fama, took another look at the data. They found that beta couldn’t explain all of a portfolio’s returns.

Two other factors seemed to be important, too. A portfolio taking these factors into account could, some of the time, beat a total-market portfolio without being riskier. These factors are:

Size. Small company stocks tend to have higher returns than large company stocks.

Value. “Value” stocks, essentially stocks with low prices, tend to have higher returns than growth stocks. How do you decide which stocks are value stocks? Use a measure like price-to-earnings ratio.

Value stocks are essentially stocks in mediocre, boring companies. This seems like an odd way to make money, but it’s a highly persistent effect. (Value is believed to be a stronger effect than size.)

You can now easily buy mutual funds concentrating on small or value stocks, and many investors choose to “tilt” their portfolios toward these factors, hoping for bigger returns without bigger volatility.

It’s a reasonable hope, because beta, size, and value have low historical correlation. When you have multiple stocks in your portfolio that are exposed to different risks, we call that diversification. The same can be said for having multiple factors in your portfolio.

The Larry Portfolio

Now, what if the stock portion of the portfolio was made up of entirely small value stocks?

That would give plenty of exposure to beta (because small value stocks are still stocks, and correlate with the wider stock market), and also maximum exposure to the small and value premiums. It’s also reasonably well-diversified, because there are thousands of stocks that fit the profile.

This sounds like a risky stock portfolio, and it is: high risk, high expected return.

Larry Swedroe’s insight was: what if we mix a little of this very risky (but intelligently risky) stock portfolio with a lot of very safe bonds? Say, 30% small value stocks and 70% bonds?

The result is the Larry Portfolio, a portfolio with similar expected return to to 60/40 portfolio I described, but lower risk, because the portfolio is mostly bonds—the kind of bonds that did just fine during the Great Depression and the recent financial crisis.

Swedroe warns in the book that there are no guarantees in investing. “[A]ll crystal balls are cloudy—there are no guarantees,” he writes. The research behind the Larry Portfolio may be sound, but “we cannot guarantee that it will produce the same returns as a more market-like portfolio with a higher equity allocation.”

Is it for you?

I took a look at my portfolio. It looks almost exactly like the portfolio Swedroe describes in the first part of the book, a diversified 60/40 portfolio with plenty of exposure to beta but no exposure to the size or value premiums.

So I asked him the obvious question: should I have a Larry Portfolio?

“There is no one right portfolio,” Swedroe told me via email. “The biggest risk of the LP strategy is the risk called Tracking Error Regret.”

Tracking Error Regret is a nasty thing. Here’s what it means.

Inevitably, the Larry Portfolio will sometimes underperform a 60/40 portfolio. If the stock market is soaring, it might underperform it for years at a time. A Larry Portfolio holder might look around and say, “Dang, everyone is making a ton of money but me. This portfolio sucks.”

Then you jump off the Larry train and back into a 60/40 portfolio—probably right before a market crash that decimates your stock portfolio. (That’s the Black Swan in the book title.) “Oh no—Larry was right!” you conclude, and buy back in, but it’s too late: now you’re selling cheap stocks to buy expensive bonds.

There really isn’t any cure for Tracking Error Regret. You can write an investment policy statement (IPS) to remind yourself that you’re a long-term investor and shouldn’t be watching the market too closely, because it’ll only raise your blood pressure.

The worst way to address the problem is to assume that you’re too smart or tough to experience it.

Can we build it? Maybe we can

Finally, there’s one other reason the Larry Portfolio might not be for you: it requires using mutual funds that might not be available in your retirement plan.

If most of your money is in a 401(k) plan, and that plan doesn’t have a US small value fund and an international small value fund, you can’t really build a Larry Portfolio. You might be able to build a watered-down version, but it won’t have the same risk-return characteristics as the real thing.

I haven’t decided yet whether the Larry Portfolio is for me. If you’ve read this far, however, you’ll probably enjoy Swedroe’s book. And if you already use a Larry Portfolio or are considering one, please let me know in the comments.

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Mint.com is not affiliated with Folio Investing or The Portfolioist.

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Oil, Markets, Volatility

Guest post by Contributing Editor, David R. Kotok, Cumberland Advisors.

Oil, Markets, VolatilitySharply lower oil prices have occasioned a huge discussion about their impact. We see it play out daily in newspapers, on TV and radio, at websites, on blogs, and in market letters. The range of forecasts runs from one extreme to another.

On one side, pundits predict a recession resulting from a US energy sector meltdown that leads to credit defaults in energy-related high-yield debt. They predict trouble in those states which have had high growth from the US energy renaissance. These bearish views also note the failures of Russian businesses to pay foreign-denominated debt held by European banks. And they point to sovereign debt risks like Venezuela.  These experts then envision the geopolitical risk to extend to cross-border wars and other ugly outcomes.

Geopolitical high-oil-price risk has morphed to geopolitical low-oil-price risk. That’s the negative extreme case.

The positive forecasts regarding oil are also abundant. American’s Consumer Price Index (CPI) drops robustly due to energy-price ripple effects of $50 oil. We are still in the early stages of seeing these results in US inflation indicators. There is a lot more to come as the lower energy price impacts a broad array of products and service-sector costs.

A big change in the US trade balance reflects the reduced imported oil price. We are also seeing that appear in the current account deficit plunge. In fact, both of those formerly strongly negative indicators are reaching new lows. They are the smallest deficits we have seen in 15 years. Action Economics expects that the current account deficit in the first quarter of 2015 will be below $80 billion. That is an incredible number when we think about gross flows history.

Remember that the current account deficit is an accounting identity with the capital account surplus.  Net $80 billion goes out of the US and turns around and comes back.  These are very small numbers in an economy of $18 trillion in size.

Think about what it means to have a capital account surplus of $80 billion, driven by a current account deficit of $80 billion. That means that the neutral balancing flows into the United States because of transactional and investment activity are now small. Therefore the momentum of US financial markets is driven by the foreign choices that are directing additional money flows into the US.

In the end the equations must balance. When there is an imbalance, it affects asset prices. In the present case, those asset prices are denominated in US dollars. They are desired by the rest of the world.  They are real estate, bonds, stocks, or any other asset that is priced in dollars and that the world wants to accumulate. In the US, where the size of our economy is approaching $18 trillion, the once-feared current account deficit has become a rounding error.

How bad can the energy-price hit be to the United States? There are all kinds of estimates. Capital Economics says that the decline in the oil price (they used a $40 price change, from $110 to $70 per barrel) will “reduce overall spending on petroleum-related liquids by non-oil-producing businesses and households by a total of $280 billion per year (from $770 billion to $490 billion).” Note that the present oil price is $20 a barrel lower than their estimated run rate.

That is a massive change and very stimulative to the US non-energy sector. The amount involved is more than double the 2% payroll-tax-cut amount of recent years. In fact it adds up to about 3/4 of the revised US federal budget deficit estimate in the fiscal year ending in 2015.

Let me repeat. That estimate from Capital Economics is based on an average price of $70 a barrel in the US for all of 2015. The current price of oil is lower. Some forecasts estimate that the oil price is going much lower. We doubt that but the level of the oil price is no longer the key issue.  It is the duration of the lower price level that matters.  We do not know how long the price will fall, but there is some thought developing that it will hover around $55 to $60 for a while (average for 2015).

There is certainly a negative impact to the oil sector. Capital spending slows when the oil price falls. We already see that process unfolding. It is apparent in the anecdotes as a drilling rig gets canceled or postponed, a project gets delayed, or something else goes on hold.

How big is the negative number? Capital Economics says, “The impact on the wider economy will be modest. Investment in mining structures is $146 billion, with investment in mining equipment an additional $26 billion. Altogether investment in mining accounts for 7.7% of total business investment, but only 1% of GDP.”

At Cumberland we agree. The projections are obvious: energy capital expenditures will decline; the US renaissance in oil will slow, and development and exploration will be curtailed. But the scale of the negative is far outweighed by the scale of the positive.

Let’s go farther. Fundstrat Global Advisors, a global advisory source with good data, suggests that lower oil will add about $350 billion in developing-nation purchasing power. That estimate was based on a 28% oil price decline starting with a $110 base. The final number is unknown. But today’s numbers reveal declines of almost 50%.  Think about a $350 billion to $500 billion boost to the developing countries in North America, Europe, and Asia. Note these are not emerging-market estimates but developing-country estimates.

It seems to us that another focal point is what is happening to the oil-producing countries. In this case Wells Fargo Securities has developed some fiscal breakeven oil prices for countries that are prominent oil producers. Essentially, Kuwait is the only one with a positive fiscal breakeven if the oil price is under $60 per barrel. Let’s take a look at Wells Fargo’s list. The most damaged country in fiscal breakeven is Iran. They need a price well over $100 in order to get to some budgetary stability. Next is Nigeria. Venezuela is next. Under $100 but over $60 are Algeria, Libya, Iraq, Saudi Arabia, and the United Arab Emirates.

Let’s think about this oil battle in a geopolitical context. BCA Research defines it as a “regional proxy war.” They identify the antagonists as Saudi Arabia and Iran. It is that simple when it comes to oil. Saudis use oil as a weapon, and they intend to weaken their most significant enemy on the other side of the water in their neighborhood. But the outcome also pressures a bunch of other bad guys, including Russia, to achieve some resolution of the situation in Ukraine.

There are victims in the oil patch: energy stocks, exploration and production, and related energy construction and engineering. Anything that is tied to oil price in the energy patch is subject to economic weakness because of the downward price pressure. On the other hand, volumes are enhanced and remain intact. If anything, one can expect consumption to rise because the prices have fallen. Favoring volume-oriented energy consumption investment rather than price-sensitive energy investment is a transition that investing agents need to consider. At Cumberland, we are underweight energy stock ETFs. We sold last autumn and have not bought back.  We favor volume oriented exposures, including certain MLPs.

We believe that the US economic growth rate is going to improve. In 2015, it will record GDP rate of change levels above 3.5%. Evidence suggests that the US economy will finally resume classic longer term trend rates above 3%. It will do so in the context of very low interest and inflation rates, a gradual but ongoing improvement in labor markets, and the powerful influences of a strengthening US dollar and a tightening US budget deficit. The American fiscal condition is good and improving rapidly. The American monetary condition is stabilizing. The American banking system has already been through a crisis and now seems to be adequately protected and reserved.

Our view is bullish for the US economy and stock market. We have held to that position through volatility, and we expect more volatility. When interest rates, growth rates, and trends are normalized, volatilities are normalized. They are now more normal than those that were distorted and dampened by the ongoing zero interest rate policy of the last six years.

Volatility restoration is not a negative market item. It is a normalizing item. We may wind up seeing the VIX and the stock market rise at the same time. Volatility is bidirectional.

We remain nearly fully invested in our US ETF portfolios. We expect more volatility in conjunction with an upward trend in the US stock market.

High volatility means adjustments must be made, and sometimes they require fast action. This positive outlook could change at any time. So Cumberland clients can expect to see changes in their accounts when information and analysis suggest that we move quickly.

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Cumberland Advisors is not affiliated with FOLIOfn or The Portfolioist.

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Saving Through the Ages

Guest post by Contributing Editor, Matthew Amster-Burton, Mint.com.

Saving through the agesReputable financial advisors, websites and your mom say to save for retirement, college, a down payment for a home and emergencies.

  • A typical response might be, “Yeah, but how much?” and “When?”

Libraries of books have been written on this subject. The implication is that determining your proper savings rate involves solving differential equations, brushing up on Excel functions, and reading the entire US tax code. If you’re not ready to do that, just turn everything over to an expert. Right? Not really.

Let’s talk about three things that may get in the way of people saving—and then set those obstacles aside and make it easy to do on your own, no matter your age or stage of life.

  • It’s hard. Perhaps you don’t make enough money to save aggressively or it’s psychologically difficult to set aside money instead of spending it. For most of us, it’s a combination.
  • 401(k). IRA. Roth IRA. 529 college savings plan. Savings account. Savings bonds. Why do we have so many boxes to put our money in? In three letters: the IRS. The government encourages us to save by giving us a tax break when we do.  Unfortunately, we now have so many savings vehicles to choose from that the easiest option is to just say, “I’ll think about it next month.” And we haven’t even talked about investment options yet!
  • Nobody knows the future. What if I save for college and my kid has other plans?  What if I max out my 401(k) and then need the money before I retire? Again, the easiest response is, “I’ll figure this out later.”

Pick a number

But here’s one thing to realize: choosing the wrong type of account or making a wrong guess about the future is a small mistake. Failing to save anything is a big mistake. Here are a few rules of thumb when it comes to saving through the ages.

  • If you’re young, save 25%. That’s 25% of your gross pay, before taxes. You can count debt repayment as savings, and repaying student loans should be a priority. The rest of the money can go toward a down payment fund, college fund, and retirement savings.
  • If you have kids in college, you probably can’t afford to save unless you’re exceptionally wealthy. Get your 401(k) match, avoid parent loans, and send the rest of your money to the bursar’s office.
  • If you’re 50 to 65, save 30% or more. This is the age when most people do most of their retirement savings. Tuition bills are a bad memory. The kids are out of the house. You can downsize. Plenty of families squander this opportunity. But not you, right?

These numbers are probably higher than you’ve seen elsewhere. That’s because they’re not designed for the best-case scenario. They’re designed with enough of a cushion that if everything goes right, you’ll end up with even more money that you’ll need for retirement.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Mint.com is not affiliated with FOLIOfn or The Portfolioist.

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Is the Fed Really “Stealing from Savers”?

Federal ReserveIn a recent article on MarketWatch, Chris Martenson asserts that the Fed’s low interest rate policy and quantitative easing in recent years is deliberately stealing from savers. This article has elicited a big response, with almost 800 comments and almost 2000 likes on Facebook. The key point of the article is that the Fed’s policy of holding down interest rates to stimulate the economy has reduced the income provided by Treasury bonds, savings accounts, and certificates of deposit (CDs) to extremely low levels. In this way, the Fed’s policy can certainly be viewed as harmful to people trying to live on the income from bonds and other very low risk investments. This Fed-bashing rhetoric is far from the whole story, though.

The total impact of very low interest rates on savers and conservative investors is somewhat more complex than the MarketWatch piece suggests. Subdued inflation in recent years, one of the reasons that the Fed cites for keeping interest rates low, also means savers are seeing lower rates of price increase in the goods and services they buy. With very low current inflation, you simply don’t need as much yield as when inflation is higher. It would be wonderful for conservative investors to have low inflation and high yields from risk-free accounts, but that situation is effectively impossible for extended periods of time.  All in all, low inflation is typically a good thing for people living in a fixed income.

Another effect of continued low interest rates is that bond investors have fared very well. The trailing 15-year annualized return of the Vanguard Intermediate bond Index (VBMFX) is 5.4%, as compared to 4.5% for the Vanguard S&P 500 Index (VFINX).  Falling rates over this period have driven bond prices upwards, which has greatly benefitted investors holding bonds over this period.

One interesting related charge leveled by the MarketWatch piece (and also in a recent New York Times article) is that the Fed policy has exacerbated income inequality and that the wealthy are benefitting from low rates while less-wealthy retirees living on fixed incomes are being hurt. Low interest rates have helped the stock market to deliver high returns in recent years and it is wealthier people who benefit most from market gains. In addition, wealthier people are more likely to be able to qualify to refinance their mortgages to take advantage of low rates. The implication here is that less wealthy people cannot afford to take advantage of the benefits of low rates and that these people, implicitly, are probably holding assets in low-yield risk-free assets such as savings accounts or CDs. This is, however, somewhat misleading.  Poorer retired households receive a disproportionate share of their income from Social Security, which provides constant inflation-adjusted income.

While investors in Treasury bonds, savings accounts, and CDs are seeking riskless return, money held in these assets does not help to drive economic growth, and this is precisely why the Fed policy is to make productive assets (in the form of investments in corporate bonds and equity) more attractive than savings accounts and certificates of deposit. So, the Fed is attempting to drive money into productive investments in economic growth that will create jobs and should, ultimately, benefit the economy as a whole. One must remember that the Fed has no mandate to provide investors with a risk-free after-inflation return.

It is certainly understandable that people trying to maintain bond ladders that produce their retirement income are frustrated and concerned by continued low interest rates and the subsequent low yields available from bonds.  Given that inflation is also very low, however, low bond yields are partly offset by more stable prices for goods and services. It is true that the Fed’s policies are intended to get people to do something productive with their wealth like investing in stocks, bonds, or other opportunities. It is also the case that older and more conservative investors world prefer to reap reasonable income from essentially risk-free investments. Substantial yield with low risk is something of a pipe dream, though.  Investors are always trying to determine whether the yield provided by income-generating assets is worth the risk. We may look back and conclude that the Fed’s economic stimulus was too expensive, ineffective, or both, but this will only be clear far down the road.

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6 Reasons Why You Don’t Want to Invest Like a Professional Trader

Professional trader market analysisAs everyone with a computer knows, the web is shoulder-deep in brokerages, services, and publications that promise to help you invest just like the pros. That’s no surprise. It’s a logical step in the democratization of information. On a technological landscape where anybody can become a self-made journalist, filmmaker, or detective, what’s stopping anyone from becoming an armchair investment whiz? The availability of bargain-basement commissions on trades, broad access to research, and specialized trading platforms make it seem like Wall Street’s advantage over the individual investor has never been more negligible.

The only problem is, all those bells and whistles can obscure the fact that there’s still a big difference between what professional traders can do and what individual investors can—and should be doing.

Many of us are do-it-yourselfers by nature and find it rewarding to build our own investment portfolios. The key is to be mindful of the following caveats:

1. Individual investors have an awful track record with short-term trading.

There is research suggesting that different tactical strategies can improve returns.  Nonetheless, the performance history of individual investors clearly demonstrates that the majority of investors would be far better off by avoiding short-term trading and just consistently investing.

2. Your tools are no match for the pros.

The short-term behavior of markets is complex and there are thousands of highly-paid PhD quantitative analysts and MBAs spending all of their time figuring out how to gain an edge.  These people have lots of time and limitless computer power at their disposal.  The idea that a nifty new charting tool can somehow help you to beat these people is naive.

3. You need to win in the long-term not the short-term.

Professional traders focus on the short-term because they are judged and compensated based on recent performance.  Many probably realize that short-term trading has low odds of success, but that is the field in which they compete.  Individuals need to perform well in the long-term and don’t need to try to compete for short-term results.

4. Being a savvy consumer doesn’t make you a savvy investor in consumer stocks.

Peter Lynch famously advocated that people should ‘buy what they know.’  If you are an avid Facebook user and you see the growth potential, this might be a good reason to invest.  On the other hand, stocks of companies with great products often trade at very high prices relative to earnings.

5. Excessive short-term trading can leave you with a huge tax bill.

As detailed in last week’s blog, selling an investment that you’ve held for less than a year at a profit triggers short term capital gains, and you want to avoid that as much as possible. That’s because short term gains are taxed as ordinary income, while long-term gains are taxed at lower rates. For investors in the highest marginal income tax bracket, taxes on long-term capital gains top out at 20%, but short-term capital gains can reach 39.6%.

6. It’s tough to know the difference between skill and luck.

Almost everyone who lived through the .com bubble that ended in 1999 remembers people who thought that they were market whizzes because they owned tech stocks when the market was rising and went ‘all in’ on the tech boom.  The true test of expertise was choosing to get out when market levels reached ridiculous highs.  When you keep making winning bets in a rising market, it’s easy to convince yourself that you are a savvy trader.

Individual investors with a DIY approach can achieve superior results. With an up-close-and-personal eye on such issues as risk tolerance, cost, and tax consequences, individual investors may in fact be uniquely positioned to look after their own best interests. The key is in understanding what kind of investing will work best for you.  Investing for the long term with a steady, consistent hand is in your best interest. Trying to compete against Wall Street is not.

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Are My Investment Decisions Tax Efficient?

This is the eighth installment in our series on how individual investors can assess their financial health

Am I Tax Efficient?With investment gains, as with other types of income, it’s not how much you make that ultimately matters, but how much you keep.   In other words, you only get to spend what’s left after you pay taxes.   There are various ways to make your investments tax efficient, and it’s crucially important that you know what they are.

To make sure you don’t incur an excessive tax bill from your investing, take the following steps:

1) Avoid realizing short term capital gains.

2) Make full use of tax-advantaged accounts.

3) Harvest your losses.

4) Match assets to account type.

5) Choose tax efficient mutual funds.

Avoid Realizing Short Term Gains

Selling an investment that you have held for less than a year at a profit triggers short term capital gains, and the tax rate for short term gains is markedly higher than for long term gains. Short term gains are taxed as ordinary income, while long-term gains are taxed at lower rates. The difference between the tax rate on your long term versus short term gains depends on your tax bracket, but it is usually sensible to hold investments for at least a year, although this must be considered in light of the need to rebalance.

Make Full Use of Tax-Advantaged Accounts

There are a number of types of investment accounts that have tax advantages. There are IRAs and 401(k)s, which allow investors to put in money before taxes.   These accounts allow you to defer taxes until you retire, whereupon you will be taxed on the money that you take out.   By paying taxes later, you get what amounts to a zero interest loan on the money that you would ordinarily have paid in taxes.

Another alternative is Roth IRAs and Roth 401(k)s.  In these accounts, you put money in after tax, but you are not taxed on the future gains.   If you have concerns that tax rates will be higher in the future, the Roth structure allows you to essentially lock in your total tax burden.

529 plans for college savings have tax advantages worth considering.  While you pay taxes on 529 contributions, the future investment gains are not taxes at all as long as the money is used for qualified educational expenses.   There may also be additional state tax incentives offered to residents, depending upon your home state.

Harvest Your Losses

If you make a profit by selling a security, you will owe taxes on the gain. However, if you sell security in a taxable brokerage account at a loss, the loss can be used to offset realized gains and can even offset up to $3,000 in ordinary income. If you then wait more than a month, you can buy the same position in the losing security and have reduced or eliminated your tax bill on the gain simply by selling the losing position and then waiting more than a month before buying that security back.   Alternatively, you might buy another similar security to the one that you took a loss on and then you don’t have to wait a month.   The key in this latter approach is that you can buy a similar but not functionally identical security if you want to take a loss and then immediately buy another security back.

It should be noted that tax loss harvesting does not eliminate taxes, but defers them into the future.   In general, paying taxes later is preferable to paying them today.

Matching Assets to Account Type

Different types of investment assets have different tax exposure, so it makes sense to put assets into the types of accounts in which taxes are lowest.   This process is sometimes referred to as selecting asset location.   Actively managed mutual funds are most tax efficient in tax deferred accounts, as are most types of bonds and other income producing assets.   The exceptions are those asset classes that have special tax benefits.   Income from municipal bonds, for example, is not taxed at the federal level and is often also tax free at the state level. Holding municipal bonds in tax deferred accounts wastes these tax benefits.   Qualified stock dividends are also taxed at rates that are lower than ordinary income, so qualified dividend-paying stocks typically make the most sense in taxable accounts.   Real estate investment trusts, on the other hand, are best located in tax deferred accounts because they tend to generate fairly high levels of taxable income.

Choose Tax Efficient Mutual Funds

When mutual fund managers sell holdings at a profit, fund investors are liable for taxes on these realized gains.  The more a fund manager trades, the greater the investor’s tax burden is likely to be.   Even if you, the investor, have not sold any shares of the fund, the manager has generated a tax liability on your behalf.   It is even possible for investors holding fund shares that have declined in value to owe capital gains taxes that result from one or more trades that the manager executed. You can minimize this source of taxes by either investing in mutual funds only in tax deferred accounts or by choosing funds that are tax efficient.   Index funds tend to be very tax efficient because they have low turnover.   There are also funds that are managed specifically  to reduce the investor’s tax burden.   One academic study found that funds engaged in tax efficient practices generate higher returns than peers even on a pre-tax basis.

Don’t Pay More Tax Than You Have To

Everyone needs to pay their fair share of taxes.  But if you manage your investments with a consideration of tax consequences, you can avoid paying more tax than is required.   If the various considerations outlined here seem too complicated, a simple allocation to a few index funds will tend to be fairly tax efficient.  That is a reasonable place to start.

An old adage about tax planning is that a tax deferred is a tax avoided. In general, the longer you can delay paying tax, the better off you are.   The various forms of tax deferred savings accounts are very valuable in this regard.

While it is more interesting looking for productive investment opportunities, spending a little time understanding how to minimize your tax burden can help to ensure that you actually get to spend the gains that you make.

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