Bear Market Has Arrived

Bear Market Has Arrived

Stocks continued their slide for an eighth week. Friday’s drop now brings the S&P 500 Index down 20% from its recent peak. We are officially in a Bear Market. Tech stocks, in the Nasdaq Index, are down over 30% and have already been in a Bear Market.

Investors have questions and want to know what to do next. I’m going to share five thoughts.

One. Predictions are a waste of time. I’ve spent too much time this past week, reading, listening, and watching “experts” suggest what will happen next. No one knows. Some say the bottom is in, others call for another 20% drop. Some say inflation is here to stay, some say we are already in a recession, other say stagflation. The challenge is Confirmation Bias. Are we really evaluating evidence with an open mind? Or are we only looking for evidence which confirms our point of view? Unfortunately, certainty is one thing which we do not get to have as investors. Luckily, we don’t need a crystal ball to be successful. We know what has worked over time: diversification, index strategies, and focusing on keeping costs and taxes low.

Two. Our Investment Themes for 2022 have been helpful. Year to Date: Value stocks are doing better than growth stocks. International stocks are doing better than US Stocks. Short-Term bonds and Floating Rate bonds have held up better than the Aggregate Bond Index. We are still down an uncomfortable amount, and that is to be expected. However, we are down less than our benchmarks across all our portfolio models. I am not ever happy about Bear Markets, but our asset allocation has been a positive factor.

Three. We are at a 52-week low in many stocks and indices. Look back over the last 10, 20, or 30 years of stock market history and find those 52-week low points. Going forward, were you better off selling those lows or buying those lows? Obviously, you would have done very well by buying historic 52-week lows and selling would have been a mistake eventually. Could the market go lower from here? Of course. We don’t know what will happen next, but market timing via selling 52-week lows has been a poor strategy historically.

Read more: Are We Headed For a Bear Market? (2015)

Four. We have made a few moves in our portfolio that I wanted to share. We sold some of our convertible bonds and replaced them with a Vanguard Commodities fund. This should help us reduce equity-like exposure and add an inflation hedge. We sold one emerging markets bond fund and replaced it with a newer fund (also from Vanguard) with a much lower expense ratio. We sold bond funds and replaced them with individual bonds, laddered from 1-5 years. Although interest rates may rise, we can hold bonds to maturity and receive back our par value. Overall, these trades do not drastically change our asset allocation. But we are always looking for ways to improve our holdings, even in modest, incremental ways. We are not ignoring the market, portfolios, or clients at this time.

Five. Patience. If you are a ways off from retirement, this is a great time to dollar cost average and be buying shares in your IRA, 401(k), or brokerage account. You make money in Bear Markets, you just don’t realize it until later. For those who are close to retirement, or in retirement, we are already diversified and have a withdrawal strategy that anticipates market volatility such as this. We are planning for the next 20-30 years. There will be multiple Bear Markets over your retirement. Although each Bear Market feels like a surprise, they are bound to happen. And like in 2020, we are using the current drop as an opportunity to rebalance portfolios and do tax loss harvesting.

Read more: Stock Crash Pattern (March 2020)

We’ve seen this before. We’ve been here before. Bear Markets are an unfortunate reality of being an investor. They stink and we would all prefer if markets only went up. When times are good, we need to invest with the knowledge that Bear Markets are inevitable. And then when Bear Markets do arrive, like Winter, we need to wait out the storms knowing that Spring will eventually return.

Ignore predictions. Our investment themes are on the right track. Don’t sell a 52-week low. Look for opportunities to make small improvements. Be patient and persevere. That is how we are responding to the Bear.

Why Index Funds Are Better

Why Index Funds Are Better

Twice a year, Standard and Poor’s provides an analysis of why index funds are better than actively managed mutual funds. Their report is known as SPIVA, S&P Index Versus Active. It is compelling evidence that investors would be better off using index funds. We’re going to look at the most recent data, discuss the perils of fund benchmarks, and then explain our approach of using Factor-based strategies.

Most Funds Lag Their Benchmark

Looking at 2021, 79.6% of US stock funds did worse than the overall market, as measured by the S&P 1500 Composite Index. It was a spectacularly bad year for active managers, even worse than most years. I focus on the long-term results, which are fairly consistent from year to year. For the 10 years ending 12/31/2021, 86% of US stock funds under-performed the market. Some of the funds which did out-perform did so by taking on much more risk. When we consider risk-adjusted returns, 93% of funds lagged.

The data is compelling and persistent. 80% or more of actively managed funds cannot keep up with their index over 10 or 20 years. And since that is the time frame that matters for long-term investors, the odds are in your favor if you use index strategies rather than active funds. It is extremely difficult for active managers to beat the index. There are many thoughts why this is the case:

  • Higher expenses. The cost of running a fund seems to wipe out any value they create through research and active management. Overall, market participants add up to the entire return of the stock market. That is the benchmark. But instead of being average (or actually Median) at 50%, the additional costs mean that 80% of funds trail the benchmark
  • Chasing performance. Active managers pay too much for hot stocks and ignore cheap stocks which are out of favor. Or they miss the handful of top performing stocks which are often the biggest drivers of market returns. Stocks, categories, and sectors go in and out of favor.
  • No information advantage. Today, analysts are smarter than ever and information is disseminated instantly online. The markets may have become so efficient that there are no “secret” stocks for active managers to uncover.
  • The 10-20% of managers who do outperform may have done so through luck, as they are typically unable to sustain out-performance from one period to another. Do we have data for that? Yes. It’s the S&P Persistence Scorecard.

Which Benchmark?

There are a lot of benchmarks and unfortunately, this can be confusing for investors. Sometimes, we might be comparing a fund to the wrong benchmark and not be making the most accurate comparison. Consider, for example, the Fidelity Contrafund. At $126 Billion in assets, it is one of the most successful active funds in history. And over the last 10 years, it has slightly beat the S&P 500 Index: FCNTX is up 282% through April 22, 2022, compared to 279% for the Vanguard 500 (VOO).

Unfortunately, that’s not the most accurate benchmark, because the Contrafund is a Growth Fund. As a better benchmark, you could have been invested in the Vanguard 500 Growth Index (VOOG). And VOOG was up 333% over the past 10 years. In this case, the active fund actually trailed the correct benchmark by 50% over 10 years. With Growth strategies dominating over the past 10 years, a lot of Growth funds look good compared to the S&P 500. But when we consider a Growth benchmark, you probably would have been better off in the index fund. (And for taxable accounts, the after-tax return of active funds are very often much lower than an ETF.)

Here’s another poor benchmark situation. This week, I was comparing two US Low Volatility ETFs with very similar strategies: the SPDR Large Cap Low Volatility (LGLV) and the Invesco S&P 500 Low Volatility (SPLV). Looking at a Morningstar report of 5-year performance, it showed that LGLV was in the 60th percentile while SPLV was better, at the 40th percentile. Unfortunately, the report was using two different benchmarks: large blend for LGLV and large value for SPLV. Their actual 5-year annualized returns were 14.01% for LGLV and 11.36% for SPLV. With different benchmarks, LGLV looked worse (60th percentile), even though it had actually out-performed SPLV by 2.65% a year! Which benchmark you use matters.

Using Factors To Look Forward

Although SPIVA shows why index funds are better, the harder part is deciding which index fund you want to invest in. You could just choose a World Index stock fund, like the Vanguard Total World Stock ETF (VT). And I am confident you would do better than most active managers over the next 10 or 20 years.

But, we don’t invest in an “all-in-one” fund.

Rather, my role as a portfolio manager is to determine the asset allocation for each model and level of risk. We decide which categories we want to own (large growth, small value, emerging markets, etc.) and what percentage to invest in each category. And rather than looking backwards at performance, we use today’s valuations to evaluate future performance. Once we have an asset allocation model, I can select an index fund to use to fulfill each category. It starts with the blueprint, not the funds themselves.

Rather than using generic index funds like a Total World Index fund, we buy 5-8 Index funds that invest using a “factor” strategy. This is a quantitative way of sorting stocks, using a characteristic such as Value, Size, Quality, or Low Volatility. They represent an Index or Benchmark, but have an additional screen to create a portfolio with specific qualities. There is evidence that Factors can outperform a benchmark over time, but clearly, they do not do so every year.

Today, we are concerned about some stocks’ high valuations. We have tilted our portfolios away from the large cap growth and technology names which have had such terrific performance that their values are so expensive today. Some of these stocks, such as Facebook (now called “Meta”) are down 45% year to date. That’s what can happen when a stock becomes too expensive and the market winds change direction.

Instead, we are looking ahead in anticipation of a reversion to the mean in categories such as Value, Small Cap Value, International and Emerging Markets. That’s no prediction that any of these will be up this year, it’s a long-term proposition. When I look at the S&P 500 Index today and see how expensive some of the names have become, I find it hard to stomach. And so, we are looking for ways to take advantage of passive, low cost, tax-efficiency of ETFs, but in a smarter manner than just throwing it all in a generic, market cap weighted index fund.

Once we understand why index funds are better, we are still left with two questions. Which benchmark to use and how do we want to invest? We are fortunate today to have easy access to many low cost index funds. Factor-based funds can help us establish potentially positive characteristics to our portfolios even compared to regular index funds.

We Bought An Airbnb

We Bought An Airbnb

In January, we bought a house in Hot Springs, Arkansas and have listed it on Airbnb. This is a new venture for us and I wanted to share my evolving thoughts about debt, inflation, cash, and real estate. Although the stock market has been down so far in 2022, don’t think that this means I am giving up on stocks as an investment. Not at all!

If you want to check out our property, here is the listing on Airbnb. My wife, Luiza, has done a great job of decorating and furnishing the house. And I owe a big thank you to my parents who spent three weeks helping us with renovations. It has been live for one week now, and we have eight bookings in April and May. Let me know what you think about the listing!

We Went Into Debt

Prior to this purchase, we were debt free and we purchased our new property with a mortgage. I could have sold investments and paid cash for the house, but I think that would have been a bad idea. Taking a mortgage is the better choice.

Leverage can be a tremendous tool, when used properly. Taking on debt to buy appreciating assets and cash flowing investments can have a multiplier effect. This is “good” debt. Bad debt would be spending on depreciating assets like cars, or using credit card debt to fund a lifestyle. I eventually realized that being debt-free would actually slow down our growth versus taking on some smart debt.

For Airbnb investors, a property evaluation is often based on the “Cash on Cash” return. What does that mean? Let’s consider a $200,000 house which produces a hypothetical $14,000 a year in profit. If you purchase the property with $200,000 cash, your Cash on Cash return is 7%. But if you put only 20% down ($40,000) and make $8,000 (net of the monthly mortgage), your cash on cash return is 20%. In other words, it can be a fairly attractive investment because of the leverage. Without the debt, the returns are not that compelling compared to stocks, for example. And if you use mortgages, you can buy $1 million of properties with $200,000 down. That could grow your wealth much faster than just buying one property for $200,000.

Debt, Inflation, and Government Spending

Beyond the numbers for this particular house, I think the world is now favoring debtors. Our government spending has been growing for years. And then when the pandemic hit, spending shot up dramatically and shows little sign of returning to its previous trajectory.

Our government, and many others, are running massive deficits and have no intention or ability to reduce spending. They will simply never pay off this debt. It will only grow. (See: the US Debt Clock.) We now have inflation of over 7%. I don’t think inflation will stay this high, but I also don’t think it will go back to 2%. Governments will have to inflate their way out of debt. There is an excellent video from billionaire hedge fund manager Ray Dalio: the Changing World Order. He documents historical civilizations who expanded debt and saw resultant inflation. It is a brilliant piece if you want to understand today’s economy.

Inflation favors debtors and penalizes holders of cash and bonds. 7 percent inflation over 5 years will reduce the purchasing power of $1000 to $600. The holder of a bond will see a 40% depreciation of the real value of their bond. And the debtor, such as the US government or a mortgage holder, will benefit on the other side.

I reached the conclusion that I should be a debtor like our government. Staying in cash and a lot of bonds, would be a poor choice long term. I didn’t sell any stocks to buy our investment property, but I did reduce cash and bonds. Today, we can borrow at 3-5% while inflation is at 7%. And if interest rates do come back down to 2%, I can always refinance the mortgage.

Read more: Inflation Investments

Thoughts on Real Estate Investing

  1. Real Estate is a business, not a passive investment. Managing an Airbnb is time consuming and can have headaches of dealing with people and problems. We have spent a huge amount of time (and about $14,000) improving our property and furnishing it for Airbnb. Buying an Index Fund does not carry as much risk or time commitment!
  2. It is the leverage which makes real estate attractive. Without the mortgage, not so much. (Imagine if we could buy $100,000 of an S&P 500 Index fund with only 20% down. That would be incredible over the long term.)
  3. Higher inflation can help real estate prices and rent prices, while our mortgage stays fixed. Besides the cash flow, we also benefit from: 1. Paying down the mortgage and building equity. 2. Increasing home value over time. 3. Some tax benefits such as depreciation.
  4. Your personal residence is still an expense, not an investment. More pre-retirees should be looking into House Hacking. This will enable many to retire years earlier.
  5. I like the returns on short-term rentals. With elevated prices today, many long term rentals have mediocre cash flow potential. Especially if we have some repair expenses and vacancy.

So far, we are happy to have bought an Airbnb. It fits well with our willingness to take risks, start a business, and do repairs ourselves. We are looking to buy another. But we know it’s not for everyone. If this is something which interests you, I am happy to discuss it with you and share what I know.

5 Ways to Buy The Dip

5 Ways to Buy The Dip

Right now, we are talking to investors about ways to buy the dip. From the highs of December, it is pretty remarkable how quickly markets have reversed. Stocks were already down in January as fears of inflation and rising interest rates took hold. The war in Ukraine has shocked the world and we are seeing tragic consequences of this inexcusable aggression. Inflation was reported at 7.9% for February and that was before we saw gas prices surge in March following the Russia sanctions.

This past Tuesday, we saw 52-week lows in international stock funds, such as the Vanguard Developed Markets Index (VEA) and the Vanguard Emerging Markets Index (VWO). Here at home, the tech-heavy NASDAQ is down 20%, the threshold used to describe a Bear Market. It’s ugly and there’s not a lot of good news to report.

Ah, but volatility is the fundamental reality of investing. Volatility is inevitable and profits are never guaranteed. In December, when the market was at or near all-time highs, everyone was piling into stocks. And now that many ETFs are near their 52-week lows, investors are wondering if they should sell.

Market timing doesn’t work

Unfortunately, our natural instinct is to do what is wrong and want sell the 52-week low rather than buy. Back in December, there were a lot of people hoping for a correction to make purchases. Now that a correction is here, it’s not so easy to pull the trigger on making purchases. The risks seem heightened today and nobody wants to try to catch a falling knife. Unfortunately, the market isn’t going to tell us when the bottom is in place and it is “safe” to invest.

Last week was the 13-year anniversary of the 2009 Lows. Most reporters say that the low was on March 9, 2009, because that was the lowest close. But I remember being at my desk when we saw the Intraday low of 666 on the S&P 500 Index on 3/06/09. Today, the S&P 500 is at 4,200 (down from a recent 4,800). Even with the 2022 drop, we have had a tremendous run for 13 years, up 530%.

A prospective client asked me this week what I had learned from being an Advisor back in 2008-2009. And I told her: First, you can’t time the market. Clients who decided to ride out the bear market did better than those who changed course. Second, individual companies can go out of business. You are better off in diversified funds or ETFs rather than trying to pick stocks.

Buying The Dip

While you shouldn’t try to time the market, we do know that “buying the dip” has worked well in the past. Since 1960, if you had bought the S&P 500 Index each time it had a 10% dip, you would have been up 12 months later 81% of the time. And you would have had an average gain of 12%. That’s a pretty good track record.

I feel especially confident about buying index funds on a dip. While some companies will inevitably become smaller or go out of business, an index like the S&P 500 holds hundreds of stocks. Over time, an index adds emerging leaders and drops companies on their way down. That turnover and diversification are an important part of managing an investment portfolio.

So with the caveat of buying funds, what are ways to buy the dip today? What if you don’t have a lot of cash on the sidelines? After all, if we don’t time the market, we are likely fully invested at all times already.

5 Purchase Strategies

  1. Continue to Dollar Cost Average. If you participate in a 401(k), keep making your contributions and buying shares of high quality, low cost funds. If you are a young investor, you should love these market drops. You can accumulate shares while they are on sale!
  2. Make your IRA contributions now. If you make annual contributions to an Traditional IRA, Roth IRA, 529 Plan, or other investment account, I would not hesitate to proceed. Make your contribution when the market is down.
  3. Rebalance your portfolio. Do you have a target allocation, such as 70% stocks and 30% bonds? With the recent volatility, you may have shifted away from your desired allocation. If your stocks are down from 70% to 65%, sell some bonds and bring your stock level back to 70%. Rebalancing is a process of buying low and selling high.
  4. Limit orders. If you do have cash, you could dollar cost average. Or, with your ETFs you can use limit orders to buy at specific prices.
  5. Sell Puts. Rather than just use limit orders, I prefer to sell Puts for my clients. This is an options strategy where you get paid for your willingness to buy an ETF at a lower price. We have been doing this for larger accounts with cash to deploy, but this not something most investors would want to try on their own.

Uncertainty, Risk, and Sticking to the Plan

There is always risk as an investor. Whenever you buy, there is a possibility that you will be down and have a loss in a week, a month, or a year from now. Luckily, history has shown us that the longer we wait, the better chance of a positive return in a market allocation. We have to learn to accept volatility and be okay with holding during drops.

We can go one step further and seek ways to buy the dip. To me, Risk means opportunity, not just danger. So, which is riskier, buying at a 52-week high or at a 52-week low? Well, neither is a guarantee of success, but given a choice, I would rather buy at a low. And that is where we are today.

I think back to March of 2020, when the market crashed from the COVID shut-downs. And I recall the horrible markets in March of 2009. In both cases, we stuck to the plan. We held our funds and didn’t sell. We rebalanced and made new purchases with available funds. That is what I have been doing with my own portfolio this month and it’s what I have been recommending to clients. We don’t have a crystal ball to predict the future. But we do know what behavior was beneficial in the past. And that is the playbook I think we should follow.

Amazingly, I have had only a couple of calls and emails from clients concerned about the market. None have bailed. We are in it for the long-haul. Market dips are inevitable. It is smarter to ignore them than to panic and sell. And if we can make additional purchases during market dips, even better.

Past performance is no guarantee of future results. Investing includes risk of loss of principal and Dollar Cost Averaging may not protect you from declining prices or risk of loss.

How to Reduce IRMAA

How to Reduce IRMAA

Many retirees want to find ways to avoid or reduce IRMAA. Why do retirees hate Irma? No, not a person, IRMAA is Income Related Monthly Adjustment Amount. That means that your Medicare Part B and D premiums are increased because of your income. We are going to show how IRMAA is calculated and then share ways you can reduce IRMAA.

Medicare Part A is generally free at age 65, and most people enroll immediately. Part A provides hospital insurance for inpatient care. Part B is medical insurance for outpatient care, doctor visits, check ups, lab work, etc. And Part D is for prescription drugs. When you enroll in Parts B and D, you are required to pay a monthly premium. How much? Well, it depends on IRMAA.

IRMAA Levels for 2022

IRMAA increases your Medicare Part B and D premiums based on your income. There is a two year lag, so your 2022 Medicare premiums are based on your 2020 income tax return. Here are the 2022 premiums, based on your Modified Adjusted Gross Income, or MAGI.

2020 Single MAGI

$91,000 or less

$91,001 to $114,000

$114,001 to $142,000

$142,001 to $170,000

$170,001 to $500,000

$500,001 and higher

2020 Married/Joint MAGI

$182,000 or less

$182,001 to $228,000

$228,001 to $284,000

$284,001 to $340,000

$340,001 to $750,000

$750,001 and higher

2022 Monthly Part B / Part D

$170.10 / Plan Premium (PP)

$238.10 / PP + $12.40

$340.20 / PP + $32.10

$442.30 / PP + $51.70

$544.30 / PP + $71.30

$578.30 / PP + $77.90

How to Calculate MAGI

I have written previously about how the IRS uses a figure called Modified Adjusted Gross Income or MAGI. MAGI is not the same as AGI and does not appear anywhere on your tax return. Even more maddening, there is no one definition of MAGI. Are you calculating MAGI for IRA Eligibility, the Premium Tax Credit, or for Medicare? All three use different calculations and can vary. It’s crazy, but our government seems to like making things complex. So, here is the MAGI calculation for Medicare:

MAGI starts with the Adjusted Gross Income on your tax return. For Medicare IRMAA, you then need to add back four items, which you may or may not have:

  • Tax-exempt interest from municipal bonds
  • Interest from US Savings Bonds used for higher education expenses
  • Income earned abroad which was excluded from AGI
  • Income from US territories (Puerto Rico, Guam, etc.) which was non-taxable

Add back those items to your AGI and the new number is your MAGI for Medicare.

Why Retirees Hate IRMAA

The IRMAA levels are a “Cliff” tax. Make one dollar over these levels and your premiums jump up. Many retirees plan on a comfortable retirement and find out that their Social Security benefits are much less than they expected because of Medicare Premiums. For a married couple, if your MAGI increases from $182,000 to $228,001, you will see your premiums double. And while young people think it must be so nice to get “free” health insurance for retirees, this couple is actually paying $8,164.80 just for their Part B Premiums every year! And then there are still deductibles, co-pays, prescriptions, etc.

Sure, $228,001 in income sounds a lot for a retiree, right? Well, that amount includes pensions, 85% of Social Security, Required Minimum Distributions, capital gains from houses or stocks, interest, etc. There are a lot of retirees who do get hit with IRMAA. And this is after having paid 2.9% of every single paycheck for Medicare over your entire working career. That’s why many want to understand how to reduce IRMAA.

10 Ways to Reduce MAGI for IRMAA

The key to reducing IRMAA is to understand the income thresholds and then carefully plan out your MAGI. Here is what you need to know.

  1. Watch your IRA/401(k) distributions. Avoid taking a large distribution in one year. It’s better to smooth out distributions or just take RMDs.
  2. Good news, Roth distributions are non-taxable. IRMAA is another reason that pre-retirees should be building up their Roth accounts. And there are no RMDs on Roth IRAs.
  3. Be careful of Roth Conversions. Conversions are included in MAGI and could trigger IRMAA.
  4. If you are still working, keep contributing to a Traditional IRA or 401(k) to reduce MAGI. If you are self-employed, consider a SEP or Individual 401(k). The age limit on Traditional IRAs has been eliminated.
  5. Itemized Deductions do NOT lower AGI. While State and Local Taxes, Mortgage Interest, Charitable Donations, and Medical Expenses could lower taxable income, they will not help with MAGI for IRMAA.
  6. However, if you are 70 1/2, Qualified Charitable Distributions (QCDs) do reduce MAGI. If you are younger than 70 1/2, donating appreciated securities can avoid capital gains.
  7. Avoid large capital gains from sales in any one year. Be sure to harvest losses annually in taxable accounts to reduce capital gains. Use ETFs rather than mutual funds in taxable accounts for better tax efficiency. Place income-generating investments such as bonds into tax-deferred accounts rather than taxable accounts. Consider non-qualified annuities to defer income.
  8. If you still have a high income at age 65, consider delaying Social Security benefits until age 70.
  9. Once you are 65, you cannot contribute to a Health Savings Account (HSA). However, you may be able to contribute to an FSA (Flexible Spending Account), if your employer offers one. The maximum contribution for 2022 is $2,850 and you may be able to rollover $570 in unused funds to the next year.
  10. Avoid Married filing separately. File jointly.

Life-Changing Event

Medicare does recognize that situations change and your income from two years ago may not represent your current financial situation. Under specific circumstances, you can request IRMAA be reduced or waived if you have a drop in income. This is filed using form SSA-44, as a “Life Changing Event”. Reas