96% of Stocks Are Losers – How to Buy the Winners

Have you ever dreamed about going back in time? What would you do if you could? Other than telling Rick to guard Grant Hill to prevent the pass to Christian Laettner during the 1992 NCAA tournament, I would buy Apple stock. Why Apple? Because in the history of the markets since 1926, Apple has generated more profit for investors than any other American company – $1 Trillion. Hendrik Bessembinder, a name built for Pig Latin if I ever saw it, is a professor of Finance at Arizona State who has studied stock return data and concluded that most stocks aren’t good investments at all – many don’t even beat the paltry returns of one-month Treasury bills. What?

In fact, only 4% of all publicly traded companies have accounted for 100% of the net wealth earned by investors in the stock market since 1926. That means 96% of stocks are losers. Dr. Bessembinder defines net wealth as total stock returns in excess of 1-Month Treasury bills, which averaged 3.38%, so the total actual returns of Apple and these 4% are even higher than indicated.

So, all we have to do is figure out which stock will do the best over the next 20-30 years and we will be set! Or, of course, travel back in time and pick Apple – which may actually be easier to do. Dr. Bessembinder said, “In a market where most of the big gains are attributable to a few big winners that are hard to identify in advance, it makes a lot of sense to diversify to avoid the danger of omitting the big winners from your portfolio.”

Consider this: If a non-diversified portfolio has $500,000, all in U.S. stocks, and the market declines by 20%, the portfolio will decline approximately $100,000 to $400,000. If you are within a few years of retirement, that can be quite frightening. Now, in order for your investment assets to grow back to their pre-downturn amount, the stock market must gain 25% to reach their original value of $500,000. Even scarier.

But, if your portfolio is properly diversified, it shouldn’t match the ups and downs of just the U.S. stock market and it shouldn’t decline as much when the market declines.

Here is how to ensure you own the big winners over the next 20 years and are properly diversified: First, pick funds that contain a large number of stocks rather than purchasing individual stocks themselves. Second, pick funds that are attempting to generate returns by using different strategies. For instance:

Growth Funds seek to purchase stocks of companies that they believe have the potential to increase sales and earnings;
Value Funds seek to purchase stocks of companies where the current stock price doesn’t reflect the company’s value;
Small Cap Funds invest in companies with small market capitalizations;
Mid-Cap Funds invest in, you guessed it, mid-sized companies;
Large Cap Funds invest in, of course, larger companies.

Furthermore, to truly diversify a portfolio one must also invest in asset classes that aren’t closely correlated with the stock market. In other words, they zig when the market zags, and vice versa. Asset classes such as:

Long Term Income assets that are designed to generate income, not necessarily appreciate in value;
Real Estate funds that invest primarily in the stocks of real estate companies and seek growth through both capital appreciation and current income and are often a good hedge against inflation;
International funds that invest in non-U.S. companies and seek returns through the growth of those companies.

As always, your financial plan should guide your actions and your portfolio should be constructed so it supports your long-term goals. Diversifying properly will help you achieve those goals faster and with fewer ups and downs.

 

 

How the Trump, House Tax Proposal Affects You

Back in late September the Lexington Financial Planner blog wrote about how President Trump’s tax proposal would affect you. Now, the House Ways and Means Committee has revealed their tax bill so let’s take another look. No talking points, no politics, just math. Uh, fun math. No, seriously.

While the income subject to tax may be higher for many of us, at least those of us with those pesky kids, our overall taxes may be changed little because the tax rates are spread out farther among brackets. See below for the proposed new rates based on taxable income:

While it’s impossible to capture every person’s circumstances, let’s take a middle of the road example and apply the new proposal. So, as in September, let’s start with our fictitious couple and how much they pay under current tax law:

Current law:

Chandler and Monica earn a combined $125,000 in salary and each contribute 5% pre-tax to their employer’s retirement plan. For simplicity sake, we’ll ignore other pre-tax deductions like their pre-tax cost of their employer’s health insurance plan, and call their Adjusted Gross Income (AGI) $118,750. (Gross income minus their retirement contributions) Unlike our friends on TV, they have two children.

Under current law Monica and Chandler have a choice between subtracting the standard deduction of $12,700 from their AGI or itemizing deductions. As you can see below, their itemized deductions are more than their standard deduction, so they obviously deduct the larger amount:

• Mortgage interest deduction – $5,578 (Interest paid on their $200,000 house where they still owe $150,000)
• State and Local Income tax deduction – $9,797
• Property tax on their home – $2,000
• Charitable contributions – $1,000
Total: $18,375 (clearly more than the standard deduction of $12,700)

In addition to their itemized deductions, Monica and Chandler are also allowed to deduct $4,050 each as personal exemptions plus dependent exemptions for each of the kids, for a total of $16,200.

Finally, their AGI of $118,750 minus their itemized deductions of $18,375 minus their personal exemptions of $16,200 equals Taxable Income of $84,175 and Tax Liability of $12,521.

New Proposal:

Although mortgage interest and charitable contributions are still allowable as itemized deductions, state and local income tax deductions are not allowed. Property tax up to $10,000, however, can be included as an itemized deduction.

• Mortgage interest deduction – $5,578 (Interest paid on their $200,000 house where they still owe $150,000)
• Property tax on their home – $2,000
• Charitable contributions – $1,000
Total: $8,578 (now less than the new standard deduction of $24,000)

Monica and Chandler are no longer allowed to deduct $4,050 for their 4 personal and dependent exemptions because those have been rolled into the proposed standard deduction.

As a result, Chandler and Monica find their itemized deductions are lower than the proposed new standard deduction – $8,578 is lower than $24,000 – so they use the higher number.

Finally, their AGI of $118,750 minus the standard deduction of $24,000 equals their taxable income of $94,750. Based on the new, compressed tax brackets it appears their tax liability would be $11,988 – a tax savings of $533.

In addition, the tax plan highlights indicate an increase in the Child Tax Credit but it doesn’t contain details about how those credits will apply. The credit for their two children could lower their tax liability further.

Key Takeaways:

• Thankfully, and correctly, the proposal keeps the current deduction levels for retirement plans such as 401(k)’s, 403(b)’s, 457(b)’s ($18,000 for those under 50, $24,000 for those 50 and over) and IRA’s and Roth IRA’s ($5500 for those under 50, $6500 for those 50 and over). That’s very good news and good for those of us without a traditional pension (most of us).
• Although a married couple with two children will likely have lower overall deductions than they do now, the lower tax rates may very well lower their overall tax liability.
• Those without children will likely see their deductions increase, and their overall tax liability decrease.
• For those of us with children under age 17, the child tax credit increases but details are still sketchy about any phaseouts based on income.
• The tax rates on capital gains and investment income from taxable investment accounts remains the same.
• For those high earners and those with stock grants from their employers, the Alternative Minimum Tax is eliminated.
• The mortgage interest deduction only applies to mortgages of $500,000 and less where the current amount is $1M.

 

Should Cal and Rick Pay Down Debt or Save for Retirement?

There is a natural, and understandable, instinct in most of us to want to pay off our mortgage as soon as possible. In fact, it’s considered a kind of rite of passage. Yep, the missus and I paid off the house and finally have the kids off the payroll, now we can save for our retirement! But, is paying down your house or other debt early really the right thing to do for your long-term best interest?

Let’s take a closer look at a couple of common situations people face:

1. Cal owns a home for him and his family that is reasonably-priced for his family’s income with a monthly payment that allows them to pay all their expenses with a little left over. What should they do with that “extra” money each month? Pay down their mortgage or save and invest for their future? From a math perspective, Cal’s decision should be based on his after-tax cost of borrowing versus his after-tax return on investing. So, let’s assume Cal has a 30-year mortgage at 4% interest and he and his wife are in the 30% tax bracket. The true cost of that debt is 2.8% because mortgage interest is tax-deductible. So, 4% rate minus 30% equals 2.8%.

Cal’s financial planner tells him that his investments – in his 401(k) and his wife’s 403(b) – should earn a 7% annual average return, if averaged over the long term. Since that rate of return is in tax-deferred accounts, we won’t deduct income taxes from the 7% return.

So, comparing where to put that “extra” money is quite simple, right? 7% is more than 2.8%, so that’s where the dollars should go. Carrying a low-interest mortgage and investing extra dollars into your retirement is a wise decision since your investments will have a better return than what the debt is costing you. In other words, Cal will be better off investing at 7% than avoiding a cost of 2.8%.

2. Rick has a good income because he went to a good university and graduate school but he has student loan debt. Should he put his “extra” money into paying down his student loans or into his retirement accounts? First, we would tell Rick to, at the very least, put enough into his retirement accounts to receive the match from his employer. Don’t give away the free money. After that, the calculation is the same as above. This time let’s assume the student loan interest rate is 6.5%. Let’s also assume that Rick’s financial planner tells him he can expect to earn an average of 7% over the long term from his investments. As a high-earner, Rick is in the 35% tax bracket. As most student loan debt is not tax-deductible, we won’t lower the interest rate for comparison. And, as above, Rick’s investments are in his work 403(b), we won’t lower the return number either.

So, should Rick pay down his loans or sock more into retirement? Although the student loan interest rate is lower than the rate of return from his investments, it is close enough that he should put that “extra” money into paying down his student loan debt. (We would recommend he explore refinancing his student loans to get a lower rate but that’s for another discussion)

Student loan debt is a deterrent to saving enough for retirement for many young people and all options should be explored in order to put your money to work for your future self as soon as possible.

Like many things, debt is okay in moderation and under the right conditions, if it helps us purchase things that will help us. Debt for a home with a competitive interest rate at a payment that allows you to pay your expenses and save for retirement – probably good. Six-month old credit card debt for Chinese food you can’t even remember eating – probably bad. As always, having a plan to retire debt and reach your goal of financial freedom will help get you to both faster.

If you want to examine your own personal situation, use the online calculator here: https://www.calcxml.com/calculators/pay-off-debt-or-invest.

 

FOMO or LA – What Type of Investor Are You?

Last week the economist Richard Thaler won the Nobel Price in Economics for his work that explains that people behave irrationally. Well, duh, right? Anyone who has ever been to a frat party can tell you all about irrational behavior. What Thaler did was apply this to economics by trying to measure and predict how humans will “misbehave”, or not act in their own best interest. Thaler believes most individual investors have behavioral biases that get in the way of rational decision-making and can have a negative effect on the long-term growth of their assets. Some of us have FOMO – Fear of Missing Out – and others have LA – Loss Aversion. In fact, most of us have both! Long-term investing success requires us to overcome those natural biases. But how?

We’ve all heard that we’re supposed to Buy Low and Sell High but, in fact, many of us, if left to our own devices, do just the opposite. When the market is rising, and the media talks about it a lot, we tend to get FOMO. If everybody else is getting rich, I want some of that too! Buy! Conversely, when the market is diving, we acquire Loss Aversion. I can’t stand to see my investments go down! Sell, sell!

In fact, this fear of losing money seems to be hard-wired in almost all of us. Thaler said, “…losses sting more than equivalently-sized gains feel good.” The sage philosopher and former boxer, Mike Tyson, said it this way – “Everyone has a plan until they get hit in the mouth!” In other words, we make poor decisions such as selling when the market dives and making paper losses permanent, even when we really know better.

Now, it should be noted the U.S. stock market is in the midst of an 8-year Bull run where there has been little volatility since the recession in 2008. So, many of us may not even remember how we reacted when the market last tumbled.

To see how our personal biases can negatively affect performance, the chart below shows how individual investors, the do-it-yourselfers, have fared much worse than they should have over a 20-year period (JP Morgan Market Insight):

To quantify this further, $100,000 invested in 1994 in the S&P 500 would be worth $581,370 by 2013, but only $163,862 if managed by the average investor on their own. That’s because most of us get influenced when the markets rise and fall and do the opposite of what is in our best interest when facing gains and losses – FOMO or LA hits us – and we irrationally Buy High and Sell Low.

So, how do you remove your emotions and invest with success?

• Analyze your long-term needs;
• Quantify your financial goals;
• Develop a plan with annual savings and investment returns goals;
• Structure a portfolio to support your plan;
• Rebalance your portfolio quarterly to stick to your plan.

Having a financial plan supported by a well-designed portfolio that allocates your investments appropriately for your individual circumstances will help remove your emotions and personal biases from the equation, resulting in better returns.

 

The Financial Issues of Divorce

“Divorce is like death, but without life insurance!” As usual, our clients express their feelings more articulately than we ever could.

Here are our stories of Ethel and Desi – fictional composites of people who have faced divorce.

Ethel first came to us when she and her husband decided to divorce. As you might expect, she was sad, anxious, uncertain, eager and even scared. Most of all, Ethel just wanted the divorce process over so she could start her new life. In fact, she wanted the process over so much that she was willing to make concessions to her husband in order to just move on. “He can have everything, I just want the house and the kids!” Whoa, whoa, let’s not do anything you’ll regret for the rest of your life.

If marriage is about love, divorce is about money. Crass, but true. While Ethel was understandably emotional at times, it was our job to remove the emotion from the financial decisions we were about to help her navigate. So, we started the process with a few, key items:

1. Assemble all of your family’s financial data – assets, liabilities, tax returns, retirement accounts, checking, etc. The more you understand the pre-divorce financial position of the household, the better your negotiating position;

2. Do not cash out your retirement plan in order to purchase your husband’s half of the house – this is a common emotional mistake one should avoid for the sake of your future self;

3. Start creating your own financial identity – establish your own credit rating by getting a credit card in your name only; or take out a small loan and pay it back quickly;

4. Create a budget based on your new income and expenses;

5. Before the divorce is final close all jointly held credit cards, checking accounts;

6. Change your life insurance and retirement account beneficiaries, insure your car and home, determine how your children receive healthcare insurance and update your will;

7. Get emotional support, not just from family and friends but perhaps a counselor or a support group. Taking care of your emotional needs will help you manage the difficult, but critical, negotiation phase.

We helped prepare Ethel so she would be well-informed for the divorce settlement process. Even during that process, we helped her quantify her financial needs for after the divorce so she would be prepared to begin the next phase of her life.

Desi, unrelated to Ethel, first visited us a few months after his divorce was final. His share of the marital assets were now in his possession and it was time to think about his financial future as a single person. This part of the process can be intimidating as well, especially since financial decisions will now be made by Desi alone without benefit of his former wife’s wisdom. Here is how we helped him with his new financial life:

1. Developed a new budget based on his new, single income and expenses. It can be difficult to maintain the same standard of living with just one income while possibly paying alimony and/or child support;

2. Created a financial plan – fear of uncertainty is quite common but a plan can ease that burden. Desi has to plan to save and invest enough so he will have investment assets sufficient to provide enough income to maintain his standard of living throughout his retirement;

3. Desi was 50 when he came to us so he had less time until retirement and, in some ways, he was starting over. As a result, the margin for error was smaller, making planning even more important;

4. Designed an investment portfolio to support his new financial plan, given his new challenges;

5. Desi and his wife sold their former home and liquidated some other assets so we helped him plan for the tax consequences.

Divorce is difficult. Most of us don’t like to even imagine having to create a complete new life for ourselves. But, as with most things in life, a well-thought out plan will make the unknown a little more certain – both during the settlement process and after.

 

 

 

 

5 Keys to Building Wealth – #3 Compound Earnings

The book The Millionaire Next Door revealed, for the first time, that there were strangers living among us. No, not zombies or even Tennessee fans, but rich people, only disguised as you and me. The authors assumed the rich in this country were those living in the most expensive neighborhoods and driving the fanciest cars but, after extensive interviews and research, they discovered many of those that had actually accumulated $1 Million or more in actual wealth – meaning savings – were leading more prudent lives. And, as a lesson for all of us, these regular, everyday millionaires had followed five key strategies to build that wealth.

My post titled, You Aren’t What You Drive covered the first key strategy of living beneath your means. My post titled, How Much Do You Really Need for Retirement emphasized the importance of having a financial plan to guide how much to save. Now, we discuss a third key called the magic of compound earnings, which could also be called, start saving and investing at an early age.

Albert Einstein supposedly said, “Compound interest is the eighth wonder of the world.” Simply put, compound interest or earnings means one earns not only a percentage on your original investment, but also earns on the earnings from last period too. Huh? If you invest $1000 and make 10% in a year you will then have $1100, an increase of $100. Now, if you also make 10% on your new total investment of $1100 the following year, you will then have $1210, an increase of $110. Cool, huh?

Why is this important? Because compounding really only achieves amazing results over time, so start early. Take two examples:

1. Phoebe is 35 years old and makes $50,000 per year. She decides she will contribute 15%, or $7,500 per year, into her retirement account until she retires at age 65. During that time, she will earn raises of 2% each year while continuing to contribute 15% of her salary. Assuming an average rate of return on her investments of 7%, when Phoebe turns 65 she will have accumulated wealth of $1,022,306.

2. Joey is 55 years old and makes $80,000 per year. Joey spends almost all his money on clothes and sandwiches but decides he should probably get ready for retirement in 10 years. He, too, decides to save 15% of his salary, $12,000, over the next ten years and also receives raises of 2% each year. When Joey turns 65 he will have accumulated wealth of $182,315. Uh oh. So, Joey decides to save extremely aggressively and puts back 30% of his salary, $24,000, over the next ten years. Now, when Joey turns 65 he will have accumulated wealth of $364,630. Better, but not enough to live on for another 20 years.

The lesson learned here is, don’t be Joey, be Phoebe and start saving and investing early. You don’t have to save as much out of your paycheck each month if you have time on your side. If you’re closer to retirement and don’t have enough saved, you’ll have some tougher choices to make such as working longer than you wanted and/or cutting expenses dramatically in retirement.

 

How President Trump’s Tax Proposal Affects You

If you are expecting a political assessment of the President’s tax proposal, change the channel. It is our job at Moneywatch Advisors to analyze policy changes, assess the impact on our clients and help them change strategies, if warranted. So, in that spirit, here is our initial assessment on the framework released this week.

The first principle of the tax proposal framework is to simplify the tax code. Hallelujah! As I completed the coursework in the Certified Financial Planner process and studied for the exam, it became crystal clear that the tax code is the proverbial camel – a horse made by committee. No sane person would ever build a tax system like this from scratch. Enter your own Congress joke here.

As part of the effort to simplify, the framework decreases the number of tax brackets – the percentage of tax one pays – from seven to three. They are proposed as 12%, 25% and 35%. What we don’t know yet is what amount of taxable income fits into each bracket. So, let’s examine how the proposal compares to current tax law.

Chandler and Monica earn a combined $125,000 in salary and each contribute 5% pre-tax to their employer’s retirement plan. For simplicity sake, we’ll ignore other pre-tax deductions like their pre-tax cost of their employer’s health insurance plan, and call their Adjusted Gross Income (AGI) $118,750. (Gross income minus their retirement contributions) Unlike our friends on TV, they have two children.

Under current law Monica and Chandler have a choice between subtracting the standard deduction of $12,700 from their AGI or itemizing deductions. As you can see below, their itemized deductions are more than their standard deduction, so they obviously deduct the larger amount:

  • Mortgage interest deduction – $5,578 (Interest paid on their $200,000 house where they still owe $150,000)
  • State and Local Income tax deduction – $9,797
  • Property tax on their home – $2,000
  • Charitable contributions – $1,000
  • Total: $18,375 (clearly more than the standard deduction of $12,700)

In addition to their itemized deductions, Monica and Chandler are also allowed to deduct $4,050 each as personal exemptions plus dependent exemptions for each of the kids, for a total of $16,200.

Finally, their AGI of $118,750 minus their itemized deductions of $18,375 minus their personal exemptions of $16,200 equals Taxable Income of $84,175. Again, we don’t know yet what tax rate to apply to this, and that could make a huge difference between Monica and Chandler’s actual tax bill under current law and the proposal.

Under the President’s proposal Monica and Chandler’s tax computation does become simpler:

Although mortgage interest and charitable contributions are still allowable as itemized deductions, state and local income tax and property tax are not allowed. As a result, Chandler and Monica find their itemized deductions are lower than the proposed new standard deduction of $24,000, so they choose to use the lower, standard deduction. And, the personal and dependent exemptions have been rolled into the proposed standard deduction, so those aren’t deducted separately either.

Their AGI of $118,750 minus the standard deduction of $24,000 equals Taxable Income of $94,750. A much simpler calculation but a larger amount of taxable income, under this example.

Conclusion: There are currently more questions than answers as this proposal has not wound its way through the legislative process yet, but taxable income for Monica and Chandler is higher under the proposal than under current law – by $10,575. Yet, we don’t know the impact on what they will actually owe because the applicable tax rates haven’t not been released yet. Their actual tax bill could be lower, we don’t know. In addition, they may benefit from a higher Child Tax Credit beyond the current $1,000, as the framework refers this issue to Congress to work out the details. The framework also doesn’t mention capital gains rates or the treatment of dividends. These can be significant issues for those who have large amounts in taxable investment accounts.

While there is much left to be decided, those of us in Kentucky need to watch closely if the elimination of the deduction of state and local income tax as well as state property tax becomes law. For states with personal income tax, the elimination of these deductions can be impactful. As more details become clear, we will update this assessment.