Performance Chasing Versus Diversification

Posted On January 25, 2024 By Admin In Behavioral Finance, Portfolio Management /

The chart below highlights the perils of performance chasing versus the benefits of diversification. This chart from JP Morgan shows the annual performance of major investment categories from 2008 through 2023. It includes US Stocks (large and small), Developed Markets, Emerging Markets, Fixed Income, Cash, Real Estate, and even Commodities.

The results are all over the place. What is often the best investment in one year turns out to be the worst investment the next year. Consider:

Commodities were the best category in 2022 and the worst in 2023.
Real Estate Investment Trusts (REITs) went from worst in 2020 to best in 2021, and back to worst in 2022.
Cash was the worst investment in 2016 and 2017, then the best in 2018, and back to the worst in 2019. It was however, positive, in each of these years!
Emerging Markets Stocks were the worst category in 2008 then the best in 2009. EM was the best in 2017 and then the worst in 2018.

Past Performance Is…

Today a lot of investors are experiencing FOMO because they didn’t own enough Tech stocks in 2023. A small number of stocks (seven, in fact) crushed the rest of the US stock market as well as the other categories. There is a palpable frustration to have a diversified portfolio and lag funds which are concentrated in a few growth names.

This January, investors are looking at their 401(k) or IRA statements and wondering if they should make a change. They see that the XYZ Growth fund was up 40% last year, and it is tempting to drop their diversified portfolio in favor of a fund that performed better last year.

This is performance chasing. It is abandoning the benefits of diversification in favor of betting on what has been hot recently. And it is hazardous to your wealth. Often, what is at the top one year will under-perform in the following years. If you chase performance, you will often buy a hot sector just as it is about to go cold. And then you find that you are switching funds every year because there is always a “better” fund. Just remember, past performance is no guarantee of future results!

Valuations Matter (Eventually)

Today’s market has some similarities with the Tech Bubble in 1999. People got very excited about a relatively small number of Tech companies and bid them up to expensive valuations. Those stocks became quite bloated and drove up the multiple of the entire US stock market. In the frenzy, there were a lot of people who bought tech funds at or near the top. They were late to the party and missed the big gains in 98 and 99, but were invested very aggressively when the bubble burst in 2000.

Stocks were so overvalued that we had three years of subsequent losses in the S&P 500: 2000, 2001, and 2002. That had never happened before. The amount of wealth that was wiped out in the Tech Bubble was truly staggering. The bubble seems pretty obvious in hindsight, but human nature has not improved since 1999. We are prone to make the same mistakes.

I don’t know that we are in a new Tech Bubble, but the lesson remains the same. We don’t chase performance, we invest based on valuation. Our portfolios are diversified across many categories, and rebalanced annually. We use index funds and focus on keeping costs and taxes low.

Our tilts towards areas of greater expected return actually means that we do the opposite of performance chasing. We prefer to buy what is on sale, cheap, and out of favor. We are looking for the categories in the lower half of the chart to return to being in favor. This is a disciplined, long-term process which has worked over time. (See: Our Investment Themes for 2024.)

Reversion To The Mean

In the short run, expensive stocks can still go up in price if there are enough buyers. That’s where we are today, but the party won’t last forever. US Growth stocks are expensive and have a lower expected return going forward. The expensive valuations are expected to gradually revert down towards historical levels. And the inexpensive categories have room to return to more normal valuations. The chart below shows Vanguard’s projected returns over the next 10 years.

Over the next decade, Vanguard forecasts US Equities to have an annualized return of 5.2%, versus 8.1% for International Equities. With performance chasing is investors are looking backwards. They project recent returns into the future (Google “recency bias“), rather than recognizing that returns average out over time. Instead of piling into the hot stocks, sectors, or categories, investors should stay diversified and also own the categories which have under-performed.

Performance Chasing is a constant temptation because a diversified portfolio will (by definition) always lag some small subset of the market. There is always a hot category. Unfortunately, no one has a crystal ball to predict what will be the next hot investment and jumping around is more likely to harm than help returns. Thankfully, investors are well-served by ignoring the noise and staying on course with a diversified portfolio designed for their needs and long-term goals.

Investment Themes for 2024

Posted On January 1, 2024 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Each year, I rethink our portfolio allocations and today I am sharing our Investment Themes for 2024. We don’t time the market, nor do we try to predict how the market will perform. I think this is not only impossible, but also likely to cause more harm than good. We remain globally diversified, use index funds, and maintain a buy and hold philosophy. We have a target asset allocation for each investor and rebalance positions when they drift from our targets.

But that doesn’t mean we are completely passive. No, each year we slightly adjust our portfolio models in two ways. First, we look at current valuations and expected long-term returns (typically 10 years). With this information we add weight to the Core categories which have better valuations and expected returns. And we reduce categories which might be overvalued and have lower expected returns. This is forward looking, rather than looking back at past performance.

The second adjustment we make to portfolios is to annually evaluate Alternative holdings for inclusion in our models. Alternative, or satellite, positions are smaller, more niche investments, which I don’t think merit permanent inclusion as a Core position, but may be appropriate at certain times. We will describe our alternative positions more below.

2023, Better Than Expected

2023 ended up being a great year in the stock market, with the S&P 500 up 24%. This was a shocker. A year ago, 85% of economists were predicting a recession in 2023. But it never happened and the consensus was wrong. A year ago, I wrote that in spite of the calls for recession, the bad news may have already been priced into stocks and that we would remain invested. You can read my Investment Themes for 2023 here. And here are links for my 2022 Themes and 2021 Themes.

Although the S&P 500 and NASDAQ had a great year in 2023, it was aften a frustrating year for investors. Market breadth was poor and performance was concentrated in a fairly small number of Growth and Technology stocks. 2/3 of stocks did worse than the S&P 500 average. And other categories, such as International, Small Cap, or Value, lagged the Mega-Cap names.

It was also a strange year for bond investors. Rising interest rates pushed down the prices of bonds, and detracted from their performance. So, unfortunately, bonds did not add much to the bottom line in 2023. But the flip side of rising rates is that we have purchased very attractive yields which we will hold and profit from for years to come.

Economic Expectations and Stocks

Markets had a great 2023 and the US avoided a recession. But I am afraid this is no guarantee that the economy is in the clear now. The Federal Reserve raised interest rates and has managed to bring inflation down to 3% without damaging the economy or causing higher unemployment – yet. In the past, such aggressive tightening by the Fed has led to a recession. Will they finally be able to engineer a “soft landing” and not cause a recession? The strength and resilience of the US economy in 2023 is truly the envy of the world.

Unfortunately, I think we need to remain cautious and recognize that it is possible that 2023 only postponed a slowdown rather than avoided one altogether. Today the consensus is that the Fed is done raising rates and will start cutting interest rates later in 2024 once inflation is closer to their 2% target. But none of this is a guarantee that a recession is off the table. 2024 could be another volatile year.

And where are we in terms of valuations? US stock earnings grew by 3% in 2023, but stock prices went up 24%. That means that now US stocks are even more overpriced and the expected returns going forward are lower. The returns of 2023 are surprising because they are unwarranted. US growth stocks have become more expensive, not better.

Looking at our core stock categories today, we have the same themes, but only more so. US Value is cheaper than Growth and has a higher expected return. International has a higher expected return than US. Small Cap is attractive relative to large cap. Emerging Markets have strong growth potential. We were already tilted towards Value and International at the start of the year, and this was early. US Growth outperformed in 2023, but the case for Value and International has only grown stronger and more compelling. Our outlook is for more than one year at a time, and sometimes that means we have to remain patient to see a reversion to the mean.

For 2024, we will make a small addition to our International funds, from our US Midcap funds. We use Index exchange traded funds (ETFs) for our Core positions.

Source: Vanguard Economic and Market Outlook for 2024, published December 2023

Interest Rates and Bonds

Interest rates rose steadily through October of 2023. We continued to buy individual Investment Grade bonds. Our core bond holdings are laddered from 1-5 years and we generally hold to maturity and reinvest. 2023 offered the best yields available in the past 15 years. We wanted to lock in some of these yields for longer, and so we had extended duration in 2023, adding some longer term 10-15 year bonds.

Interest rates peaked in October with the 10-year Treasury briefly touching 5%. Since then, the 10-year has fallen to 3.9%, a massive move in a very short period of time. (This high demand for bonds, and inverted yield curve, is a red flag for stocks and the economy.) We’ve seen a lot of Agency bonds getting called and refinanced to lower rates. And so it is possible we have seen the peak interest rates for this cycle already.

I am glad we were buying when we did and that we extended duration. Today, it is less attractive to buy longer bonds, and our purchases in 2024 will return to being on the shorter end of the yield curve. We will not be adding to bond holdings in 2024, just aiming to maintain our 1-5 year ladder as bonds mature or are called. But there is a good rationale for holding bonds. Real yields (after inflation) are attractive. We have purchased yields which are comparable to the expected 10-year return of US stocks. And so, the 60/40 portfolio at the start of 2024 looks better than it has in years. And if we have a Bear Market in stocks in the next couple of years, the bonds will be defensive and give us the opportunity to rebalance and buy stocks when (not if) they drop.

Alternatives

Bond yields have been so good in 2023 that the appeal of alternatives is less. Why take on a volatile, complex investment if T-Bills are yielding over 5%? We will not be adding to any alternative or satellite categories in our 2024 models. We have several existing positions, which we will continue to hold.

TIPS (Treasury Inflation Protected Securities) were added in 2022 and they have given us a good inflation hedge. Our largest TIPS holding will mature in 2027 and at this point the plan is to hold to maturity. Inflation is less of a concern now, but our TIPS are still paying a decent yield.

Last year, we trimmed our holdings in Preferred Stocks, which sold off as interest rates rose. Today, they have started to bounce back and offer yields over 6% while often trading at a 30% discount to their Par value. The current 6-8% cash dividends we receive from Preferreds is above the expected return of common stocks. I’m happy to have that cash flow for retirees or to have cash to reinvest throughout the year. There is some potential for price appreciation in the next rate cutting cycle, but I am happy to hold these for the dividends and ignore any price volatility.

Our third satellite holding is a small position in Emerging Markets bonds. We use a Vanguard fund and ETF, which offer low cost diversified access to this high yield sector. I’ve seen that this category often bounces back well after a difficult year. And after being down in 2022, our fund was up nearly 14% in 2023. The fund begins 2024 with a 7% yield.

Staying On Course

We look each year to make some minor changes in our allocations, and communicate these ideas in our “Themes” letter. But, I think the real key for investors is to think long-term and be willing and able to stick with the process. There will inevitably be ups and downs and the markets often surprise us and don’t do what we expect. We have done well to stick to the basics: Don’t try to outsmart the market. Buy and Hold index funds. Keeps costs and taxes to a minimum.

If you have questions about our Investment Themes for 2024, please reach out. Even with these themes, we still have different investment models for our clients’ individual needs, risk tolerance, and time horizon. 2023 was a year full of surprises, and we will have to see what is in store for 2024!

Home Mortgage Strategies

Posted On December 13, 2023 By Scott Stratton, CFP(R), CFA In Financial Planning /

With the 30 year mortgage rate at 7.50% today, it’s time we revisit home mortgage strategies. Loving your home is an undeniable part of the Good Life. In the past couple of months, we’ve had several clients who have moved or looked at buying a second home.

Understandably, the 7.5% mortgage rate is giving many people anxiety about this decision. And that is exactly what the Federal Reserve wants. To slow housing inflation, they needed to drive out buyers and reduce speculation to cool an overheated market. With home affordability problems in many areas, it may be a good thing to slow the rapidly rising house prices of recent years.

In the past, we might have seen real estate prices plummet given how quickly the Fed has raised interest rates. Prices today are not dropping, but at least the prices have stabilized and are no longer growing at double digit rates. We have an under-supply of housing, and there is relatively little construction of single family homes occurring, given the nationwide need. What is unique for 2023 is that sellers are disappearing, unwilling to move out of a home with a 3% mortgage (you will see why, below). There were 300,000 fewer homes on the market in September 2023 compared to one year earlier. Inventory remains very thin and that is why prices do not appear likely to drop anytime soon.

2023 versus 2021

We’re going to look through some mortgage examples and share some of the numbers that are typical today. We will go over a couple of home mortgage strategies that still make sense today. And we will revisit our philosophy and beliefs about home ownership.

The median home price was recently $412,000. For our examples, we are rounding that to $400,000 and putting down 20%, or $80,000, for a mortgage of $320,000. With a 7.5% 30-year mortgage, your monthly payment including taxes and insurance would be around $2,671 depending on your location.

For the rest of our examples, we are going to strip our taxes and insurance from the monthly costs and only look at the principal and interest payments. Your mortgage-only payment would be $2,237.49 a month. Over 30 years, you will pay a total of $805,495.11, in payments. That will repay your $320,000 loan plus $485,495.11 in interest payments. You will, in effect, be paying 150% more in interest than you borrowed. Borrow $320 thousand, pay back $805 thousand. It is just obscene, although not without precedent. Your parents may have had a similar mortgage rate at some point in the previous century.

Staying Put

If you had made the same purchase in 2021 with a 3% mortgage, or refinanced, it is a very different story. Your principal/interest payment would have been only $1349.13 a month, almost $900 less a month. Over 30 years, you would pay total payments of $485,687.85. That is only $165,687.85 in interest plus $320,000 in principal. And it seems much nicer to know that you are primarily paying principal and the interest payments are much less.

If you have that 3% mortgage, you probably don’t want to move to a new house. The 7.5% rates are keeping you out of the market, which again, is just as the Fed wants. There’s no doubt it can be preferable to stay put and enjoy your low mortgage rate. A few thoughts about your 3% mortgage:

Don’t send additional payments to a 3% mortgage. There are money markets, CDs, and government bonds yielding 5-6% today. Only send the minimum mortgage payment. Talk to me if you have extra cash.
Will it cash-flow? Rather than selling, have you considered turning your house into a rental or Airbnb? It is a lot of work and not for everyone. However, if you have a 3% mortgage, you have a much better possibility to turn a profit than a new investor who is going to have a 7.5% mortgage (or higher).
Downsize. If you have built a lot of equity into your home and have more space than you need, I would not hesitate to downsize. If you can take your tax-free gains and buy a small house for cash, this can improve your retirement readiness. Having no mortgage at all can be very freeing.

Jump Starting Your Amortization

Back to our $320,000 mortgage at 7.5%. You’ve just bought this house and now have a monthly payment of $2,237.49. In the first month, that payment includes $2,000.00 in interest and only $237.49 in principal. In the second month, your payment would consist of $1998.52 in interest and $238.97 principal. These high interest rates have a horrible, ugly amortization schedule. Your initial years of payments are primarily interest and you hardly make a dent on your principal.

After three years of payments, you will have made $80,550 in mortgage payments, but only paid $9,555 in principal. If you go to move, you would still owe $310,455 on the mortgage. All this money spent on interest is gone.

Now, let’s take a look at what would happen if you could make a one-time extra payment of $10,000 in the first month. This is probably the last thing any new homeowner is thinking of doing, but let’s run the numbers and talk about why it might be a good idea.

That one early payment of $10,000 will reduce your loan by 37 months, saving you $73,452 in interest over the life of the loan. And it jump starts your amortization, shifting $62 from interest payments to principal payments every month.

Mortgage Strategies:

If you have a 7.5% mortgage, try to make prepayments as early as you can. This can dramatically shorten your loan. Every dollar of principal will save you a multiple of interest in the years ahead.
Evaluate your cash levels. Keeping a ton of money in the bank at 0% while you have a 7.5% loan isn’t helping. Make those prepayments now and avoid excess cash. Here is a Prepayment Calculator to estimate your situation.

15-Year Mortgage

I’ve long been a fan of the 15-year mortgage and have written about it previously. I’ve used 15-year mortgages previously on primary residences and been very happy with the decision.

Back to our example, we buy a $400,000 house and put down $80,000 leaving us with a $320,000 mortgage. With a 15-year mortgage, the interest rate today is 6.75% rather than 7.50% for the 30-year. Yes, the 15-year mortgage is going to be more expensive. It will be $2,831.71 a month, versus $2,237.49 for a 30-year. For less than $600 extra per month, you can cut your mortgage in half, from 30 years to 15 years. I like that, and it will help reduce expenses for retirement.

The 15 year mortgage also allows you to more rapidly build equity in the house, with more of each payment going towards principal. Remember for the 30-year, the first payment of $2,237.49 consisted of $2,000 in interest and $237.49 principal. With the 15-year, your first payment of $2,831.71 consists of $1,800 in interest and $1,031.71 of principal. I prefer this quicker amortization – the payment is $600 more, but $800 more is going towards principal.

After 15 years, you own a house outright with a 15-year mortgage. You might think that after 15-years, you would be halfway through a 30-year mortgage, but that isn’t the case. You would still have a balance of $241,365 of your original $320,000 loan. In the first 15 years, you paid less than 25% of the principal, and will pay 75% in the second 15-years. So, if you decide to move after 15 years on a 30-year mortgage, you have not accumulated a lot of equity to put towards the next home.

Home Perspectives

No doubt that a home is a key to building wealth. Oh no, I don’t mean that a home is a good investment. Not at all. Rather, a home is an expense, your largest liability. Choose poorly and a house can consume all your income and leave nothing left to save and invest. Living beneath your means remains the way to accumulate wealth. Consider House Hacking if you really want to minimize your expenses. So, a few more thoughts, most of which I have shared previously.

Don’t wait for a housing crash. The supply of homes may be well under the demand for many years. I think we are unlikely to have a repeat of the 2008 housing sell-off, at least on the nationwide level. You can buy now, and potentially refinance in a couple of years if interest rates drop. But we also might see house prices rise again with lower interest rates as houses become more affordable. So, waiting for lower house prices or lower mortgage rates is not guaranteed to be beneficial. If you can find a great long-term home today, maybe it still makes sense long-term.
Renting has become more attractive. In most of the country, renting is now much cheaper than buying. Renting gives you fixed expenses, few surprise repair costs, and the flexibility to move. There is too much pressure to own a home in the US. For many people, renting is preferable, especially if you plan to be there for less than 5-10 years.
Your home is not an investment. Over the long-term, house prices only have done a little better than inflation. And that statistic is highly misleading because it doesn’t account for expenses. Don’t buy a home hoping for substantial appreciation. Buy it as a place to live and for your family.
Tax benefits. Sorry, most people are not getting a tax benefit from their homes anymore. And yet, I still see realtors talking about tax benefits. The standard deduction for 2024 will be $14,600, or $29,200 for a married couple. Very few people will actually have enough in mortgage interest and property taxes to take an itemized deduction. Also, there are caps on what you can deduct: State and Local taxes up to $10,000 and interest only up to $750,000 of a mortgage. Most of my clients used to itemize before 2017 and almost none of them do today.

Financial Planning

Financial Planning is more than just investing well, and that is why we talk about things like Home Mortgage Strategies. The 7.5% mortgage rates are hurting home affordability. If you have to buy a house, understand what your amortization looks like and try to be sure to refi if you can save one percent or more. Back in 2020, I saw people who were looking at paying off a 3% mortgage because cash yields were so low. We discussed the opportunity cost of paying off a mortgage, and that still applies today. Unfortunately now in 2023, the expected 10-year return of stocks have not changed as much as mortgage rates have, and so today the weight of leverage at 7.5% is too great to ignore.

If you are thinking about moving, carefully consider the home mortgage strategies we discussed. Staying put can make sense. If you have an expensive mortgage, consider making prepayments in the early years. If you can afford it, choose a 15-year mortgage. I worry a lot about housing because it has become so much more expensive that people risk being House Rich and Cash Poor. And then, there is nothing left to invest. A home is often the biggest purchase of your life, so choose carefully! Think about how will this help to maximize your future net worth.

Taxes Living Abroad

Posted On November 17, 2023 By Scott Stratton, CFP(R), CFA In Financial Planning, Tax Strategies /

Since we moved to Paris in February, we’ve become much more familiar with taxes living abroad. This may be of interest to anyone who is thinking of living or retiring to another country. I will share the situation for me as a US citizen living in France, but the basics will apply to most countries.

If you thought US taxes were complex, things get really difficult when you add in a foreign tax system and then have to figure out how they will interact together. Given this complexity, this article should be considered just a primer on basic terms and not used as individual tax advice. You need a tax professional who has experience with US clients living abroad.

In general, US citizens have to pay US income taxes on their global income, regardless of where you live. You don’t get out of US taxes by going abroad. But you may be able to reduce your US taxes and that is what we will discuss. Also, there are many other tax considerations besides the annual income tax bill to understand.

Tax Residency

If you spend more than one-half of the year in France (183 days), they will likely consider you a Tax Resident of France. This makes you subject to full France income taxes, which is levied on your global income. If you live in France less than half the year and are not a tax resident, you would still be subject to France taxes on any French derived income.

If all your income sources are from the US, you could potentially live abroad for just under half of the year and not become a Tax Resident. And then you would only have to file US taxes. Currently, as a US tourist, you can stay in the European Union for up to 90 days out of the rolling previous 180 days. Make sure you fully understand the “rolling 180 days” part – it is not based on a calendar year. If you can stay a tourist and not become a tax resident, this will make your life much simpler!

Avoiding Double Taxation

For a US citizen living abroad, you have the problem of double taxation. Your income will be taxed by your resident country and then it will be taxed again by the US. Thankfully, there are tax treaties with 70 countries which provide some benefit and there are several ways to reduce or eliminate the double taxation. Still, you will need to file a US tax return even if you don’t end up owing any US taxes.

Foreign Earned Income Exclusion

The US tax code allows for a citizen to exclude up to $120,000 (2023) in Foreign Earned Income from being taxable on your US taxes. This is doubled to $240,000 for couples who are married filing jointly and who both have foreign wages. You must live abroad for 330 out of the past 365 days. For someone whose income is below the FEIE threshold, you could end up with zero taxable income for the US. You would calculate this exclusion on IRS form 2555 “Foreign Earned Income”.

The FEIE does not apply to any US wages or to any US capital gains, dividends, interest, rent, or other US sourced income. So if you have US wages or income, those earnings are still taxable outside of the FEIE amounts.

In addition to the FEIE, there is also a US tax exclusion for foreign housing expenses, which has a cap of 30% of the FEIE, or $36,000 for 2023. If you reduce your US taxable income to zero through the FEIE and/or housing exclusion, please note that you will be ineligible to make any IRA contributions. (Because your taxable income is zero.)

Foreign Tax Credit

Alternatively, you may be able to claim a credit on your US tax return for foreign taxes paid. The FEIE may take many people’s taxable income to zero and you can stop right there. However, US citizens who make more than the FEIE thresholds, or who have some US-sourced income, may still owe US taxes. And in those situations, applying the Foreign Tax Credit may be preferable. Please note that you have to choose either the FEIE or the Foreign Tax Credit, but cannot do both.

In my situation, we will probably end up using the Foreign Tax Credit. That’s because we have both US and France sources of income (US for me and France for my wife). And since the French taxes will likely be higher than the US taxes, it may take our US tax bill to zero.

Except for one thing: although France taxes us on global income, they exclude Real Estate income. They believe that all real estate income should be taxed locally. And indeed, if you buy a rental property in France, they will charge you income tax on that property even if you never set foot in the country or become a tax resident. As a result, our AirBnb Properties in Hot Springs will remain solely taxed in the US.

One challenge with using the Foreign Tax Credit is that it requires that you finish your foreign taxes before you complete your US tax return. For many, this will require filing a US tax extension past April 15th. And once you are beyond April 15th, you have passed the window to make Traditional or Roth IRA contributions or to calculate 401(k) profit sharing amounts. You may not be able to determine your eligibility until you complete your tax return, so you might miss out on some opportunities.

Social Security

In France, the payroll tax for Social Security is 20%. That is much higher than the US contribution of 7.65% for Social Security and Medicare. However, the French contribution includes all social programs, including Health Insurance, unemployment, maternity leave, as well as “retirement” Social Security.

Although 20% is 12% more than what we would pay in the US, we don’t have any health insurance expenses in France. And so it may be fairly comparable to what we would pay in the US for total costs. As a self-employed person in the US, we might pay $1,200 a month for a family plan with a $5,000 deductible. That’s a $19,400 annual expense we don’t have in France. And the medical system here is excellent.

We just had a baby girl a month ago, and I have no complaints about the value we have received. I will say that the social charges here are a great deal if you have a modest income, but if you have a very high income, you may feel that you are paying in more than you are getting back.

Social Security Vesting

There is one problem for us, however, with social security taxes abroad. Just like the US Social Security, the French retirement system has a 10-year vesting period. Only after you have contributed for 10 years do you become eligible to receive a retirement pension. We do not plan to stay in France for 10 years, so all the money we will pay into their Social Security will not come back to us later in retirement.

Our French earnings are not credited toward the US Social Security system either. US Social Security benefits are calculated based on your highest 35 years of inflation adjusted earnings. We are effectively losing these years of contributions. We are paying in France for no future benefit, while losing the years that could have been added to the US benefits. There’s no 401(k) in France, so no other employer retirement contributions, either.

If you are considering working abroad, make sure you understand its impact on your future benefits! We have enough in ongoing savings and investments for this not to be a major problem, but it is an opportunity cost that we are missing by working outside the US.

Pitfalls Abroad

Besides wages, there are other tax events which could become major pitfalls when living abroad. Here are a few things which could become huge tax bills for US citizens in other countries.

Home capital gains. In the US, we have a $250,000 capital gains exclusion on the sale of your primary residency. France does not. If your US house sale closes a week after moving to France, it occurred while you are a tax resident of France! Maybe you have a $100,000 capital gain which is ignored in the US but now taxable in France. Sell your house before you move! Or keep it.
Gift Taxes. Large gifts to children or others are fine in the US with a lifetime Gift/Estate tax exemption of $12.92 million. Not so in France. Gift taxes could be 20% and apply with thresholds dependent on the relationship. There are even gift taxes between spouses! The French gift tax exemption is only 31,865 Euros per 15 years.
Trusts not recognized. Based on Civil, not Common Law, France does not recognize trusts for tax purposes. Don’t set up US Trusts before becoming a tax resident abroad.
Inheritance Taxes. If you are in France for more than six years, you are subject to inheritance taxes. These are paid by the recipient, unlike US Estate Taxes, which is paid by the Estate. The US threshold is $12,920,000 before any Estate taxes are due. In France, inheritance taxes start at 5% at 8072 euros, but steps up to 45% tax on amounts above 1,805,677 euros (2023).

Get Help

If you are contemplating working or retiring outside the US, taxes living abroad can be complex. Luckily, you’re not the first one to do this. You will want to have tax advisors in the US and in your new country who have experience navigating these complex rules. And having a Wealth Manager who understands the tax implications of your portfolio construction is very important, too.

When my wife’s employer offered her a position in their Paris office, it was an offer we could not refuse! It has been a remarkable opportunity. If you could have the chance to live or work overseas, I would encourage you to see if it is possible. The taxes are a headache and will take a bit more time, but I do think it will be worth it for the experience. Certainly part of achieving the Good Life is being able to fearlessly make the choices to live your life as you dream it could be!

Should I Add More Bonds?

Posted On November 3, 2023 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Yields have risen on bonds this year and for many investors it may now make sense to increase their bond exposure. Eleven months ago, I wrote how bond yields had actually crossed above the expected return for stocks. At that time, we could find A-rated bonds with a 6 percent yield. And that compared favorably to the 5.7% expected return of stocks, as projected by Vanguard over the subsequent 10-years ahead.

This past month, we bought some new 10-year government agency bonds with a 7% yield. Now it looks even better to be adding bonds and maybe even reducing some of your stock market exposure. Last November, the Vanguard Capital Markets Model suggested a 5.7% expected return for US stocks over the next 10 years. As of mid-year 2023, they have reduced that to 4.7%.

Even though stock predictions are usually very inaccurate, I do think it is worthwhile to look at these projections. While the historical returns of US stocks may have been 9-10% over the long haul, returns can be above or below average for an extended period. There have been many 10 year periods which have done better or worse than the “average”. There are many factors which can help us estimate returns, including starting equity valuations (such as the Price/Earnings ratio), corporate earnings growth, or productivity gains. It should not come as a surprise that when stocks are expensive (like in 2000), the following 10 years are below average. Or when stocks are beaten down and cheap (like in 2009), the next 10 years are often above average in return.

Portfolio Models

We manage a series of investment portfolios for our clients with an approximate benchmark blend of stocks and bonds. Our Premiere Wealth Management Portfolio Models include:

Ultra Equity (100% stocks / 0% bonds)
Aggressive (85/15)
Growth (70/30)
Moderate (60/40)
Balanced (50/50)
Conservative (35/65)

In the 4th quarter of each year, we analyze our portfolio models and make tactical adjustments based on where we perceive relative value. We overweight the segments or categories which have better expected returns and we reduce the categories which have a lower expected return. In addition to our Core holdings of Index Funds and investment grade bonds, we consider satellite investments in alternative categories.

But this year is different. We are now looking at bond yields that are above the expected return of US stocks. I think it may make sense for a lot of my clients to consider a healthy increase in their bond holdings. For the last 15 years, since the 2008 global financial crisis, bond yields have been absurdly low. Today, we have a chance to lock-in longer yields at a time when the stock market looks potentially mediocre for the next several years of returns.

I have thought for a long time about how to increase bond holdings. If we move a 60/40 portfolio from 40% to 50% bonds, we probably shouldn’t still call it a 60/40 model. So, instead of making large changes on the model level, I will be discussing with each client if we now want to consider reallocating from the 60/40 to the 50/50 model, for example.

Pro / Con of Adding Bonds

The hope, by adding more bonds, is to reduce volatility and have a smoother, more consistent return each year. If the 4.7% expected return of stocks is correct, bonds could out-perform stocks and improve the return of the overall portfolio. For investors close to retirement, adding bonds could reduce the impact of a large drop in stocks, right before income was needed. And for retirees taking distributions, the now high income from bonds means we can better meet your need for cash flow versus selling shares of stocks.

Of course, there is no guarantee stocks will under-perform as projected. The 10 year projection from Vanguard is an annualized average – the stock market will undoubtedly have years with very different performance than the annual average. Investors with FOMO may be unhappy in bonds, even 7% coupons, if stocks are up 20% in one year. Young investors who are making monthly deposits may prefer dollar cost averaging and not worry as much about stock market fluctuations.

Understand Callable Bonds

Many of the Agency, Corporate, and Municipal bonds available today are “callable” bonds. That means that the issuer has the right to pay off the debt early. “Calls” happens when interest rates fall and the issuer can replace their 7% debt with a lower yield bond. It’s just like refinancing a mortgage to a lower rate.

We don’t necessarily have to hold a 10-year bond to maturity. Here is how past economic cycles worked: Eventually, the economy will slow and fall into recession. At some point, the Federal Reserve cuts interest rates and we often see both short and longer term interest rates drop. At that point, the issuer of the 7% bond may be able to refinance down to 6% or 5%. So, they will call their bonds early and redeem them at full value.

If we are in a recession, it’s also possible that the stock market could be down 20% or more in that period. And that may be a good time to rebalance – to take the proceeds from the called bond and invest it back into a stock market that is beaten up. That certainly worked well in March and April of 2020. If interest rates drop, we are likely to get called and might not be able to find another 7% bond. But that may be okay, if we are willing to rebalance the overall portfolio and buy other investments when they are on sale. And of course, regardless of when a bond is redeemed, we made 7% a year, since we bought these bonds at Par.

Reducing Call Risk

Why not just buy non-callable bonds? I would if they were more available and at the same yields. Most bonds today are callable, with the main exception being US Treasury bonds. But the yield on the 10-year Treasury is 4.7%, not 7%. So, I am willing to take some call risk for the extra 2% in return. Still, there are some things we are doing:

Buying discount bonds. Older bonds with a lower coupon often trade at a similar yield to maturity as new issue (and high coupon) bonds. These are less likely to be called. And if we buy a bond at 90 and they call it at 100, that is great.
Preferred Stocks are also now trading at sizable discounts, often 60-70 cents on the dollar. If we are comparing a bond from Wells Fargo versus their Preferred Stock, there may be advantages of the Preferred. While they may have similar current yields, the preferred has upside to its $25 price. The bonds, trading near Par, have no price appreciation potential.
Fixed annuities (multi-year guaranteed annuities or MYGAs) generally are not callable. And since there is no 1% management fee on the annuity, a 5.5% 5-year annuity may net the same return as a 6.5% 5-year corporate bond. Except the annuity is guaranteed, unlike a corporate bond. So, if you aren’t needing flexible liquidity, MYGAs can reduce your call risk and lock in today’s interest rates.

Your Bond Strategy

We’ve waited 15 years to have bonds with these juicy yields. I think now is not a time to be too defensive with a money market or short-term T-Bills. Those are fine for your immediate needs. But at some point in the future, rates could drop. The risk is that when today’s 5.5% T-Bills mature, the new T-Bills might only yield 3% or 2%. Then we will regret not locking in the longer duration yields available to us now at the end of 2023.

These last four years have been quite a roller coaster for investors. A huge crash in March of 2020, followed the fastest recovery of stocks ever. Then unprecedented inflation. A Bear Market in 2022 brought a 20% drop. A recovery in 2023 that was limited only to a handful of tech stocks. A lot of stock funds have little or almost no gains to show for all this commotion. Stocks have been disappointing.

Bonds today offer a higher yield than the 4.7% expected return of US stocks over the next decade. That’s quite a shift and investors should pay attention – yields will not stay at these levels forever! We are always cautious in making large changes, but would generally prefer bonds over stocks if they had the same return.

Stocks are supposed to have an Equity Risk Premium to compensate you for their added risk and volatility. Not today. Bonds offer lower volatility, a more predictable return of “yield to maturity”, and current income. For retirement planning, these are very desirable qualities that can improve the outcomes of our planning simulations both before and during retirement years. These are the reasons will are looking to add more bonds today.

Do I Need A Trust?

Posted On October 3, 2023 By Scott Stratton, CFP(R), CFA In Estate Planning /

If you’re thinking about your estate planning, you might ask Do I need a Trust? And to answer that question, we have to first ask why you might want a trust. There are many types of trusts and it is not as simple as a generic Yes or No. Many people do not need a trust, but for other families it may be valuable or even essential.

In this article, we are going to talk about the reasons for wanting or needing a trust. If you are clear on the reasons, you can help your estate attorney make sure you have the best type of trust for you. These can be slightly different from state to state. Or you can determine that you don’t need a Trust to accomplish your Estate planning objectives. The taxation of trusts is often overlooked and sometimes misunderstood, even by attorneys.

Every small town offers estate planning, but if you have a complex situation, I would suggest you seek out an attorney who is board certified in Estate Planning. They are often better up to date with all the trust pros and cons for your needs. You don’t see your family doctor for a hip replacement, you see a specialist. Do the same for your Estate Planning.

Avoid Probate

One of the most common reasons to establish a trust is to avoid having to go to Probate Court to distribute your assets upon your death. Probate can take a year or longer in some states and has a number of costs, including court fees and attorney expenses. A Revocable Living Trust (RLT) can sidestep the probate process, potentially saving some time and expense for your heirs.

These types of trusts are generally fairly harmless. But they are not always necessary. Remember that some assets already do not go through the probate process. Non-probate assets include:

Joint accounts with rights of survivorship
Retirement accounts (IRAs, 401k, 403b, etc.) with a named beneficiary
Life Insurance and Annuities
Transfer on Death or Payable on Death accounts

If you have a house, car, boat, etc., with a title or deed, those assets MUST be retitled so that the trust owns the asset. Otherwise, those assets will still have to go through Probate. So, unfortunately, what often happens is that someone has a RLT but has one or two items which were not titled correctly, so they still have to go to Probate for those items. Please note that real estate goes to probate in its home state. So if you have a home in Texas and one in Colorado, you would need to go through Probate in both states. That is also a good reason for a RLT.

Spendthrift Trust

Another reason to have a trust would be to have a Spendthrift provision. A “Spendthrift” is someone who spends in an irresponsible way. Sometimes that may mean a gambling, alcohol or drug problem, or a mental illness. If you are concerned that one of your heirs is going to waste the money and squander their inheritance, than you may want a trust. The trust can stipulate how much a beneficiary can withdraw or present them with an allowance rather than a lump sum. Or you can establish a trustee to oversee the distribution of money to ensure that the beneficiary is doing okay.

Family Considerations

There are other family reasons for establishing a trust. First, consider minors. If an minor is a beneficiary of an estate, they cannot receive the money. Instead, the probate court will appoint a trustee, based on their rules. Then when the child reaches the age of majority, 18 or 21 depending on the state, they will have access to 100% of the money. You might prefer a trust to hold this money and provide access at a later age or for specific reasons (such as education, medical, buying a first home, wedding, etc.).

Second, a trust may help keep money in the family in case of divorce. You may love your kids but not be certain about their spouses or future spouses. Some states, like Texas, can preserve inheritance money as a separate asset, not subject to division in a divorce. Other states do not. The risk is that the funds are commingled or squandered. So a trust may again be appropriate in these situations. Half of all marriages are ending in divorce and that may well include your kids.

Third, you may have future grandchildren or great-grandchildren. A trust could provide for a longer inter-generational transfer to unborn generations. It might also be helpful in preventing some heirs from deciding not to work and to spend the inheritance on lavish cars, houses, and vacations. Many successful entrepreneurs worry about how an inheritance could de-motivate their heirs from pursuing their own careers. Why go to Medical School if you are already a multi-millionaire at 18? A trust can set some rules.

Fourth are Special Needs Trusts. If you have an heir who has a physical or mental disability, you may want to establish a Special Needs Trust. Generally, these trusts are created to provide a supplemental benefit while still allowing the beneficiary to qualify for Medicaid or state funded care.

Fifth, What if you are remarried and have a blended family with children from previous marriages. You may want to leave income to your spouse but leave the remainder or principal to your children. Otherwise, there is potentially a possibility that your spouse could remarry after you are gone or decide to cut your children out later. One solution is a Qualified Terminal Interest Property Trust, called a QTIP.

Estate Tax and Asset Protection

We wrote extensively last week about the Estate Tax and how the exemption is set to be cut in half in 2026. A lot of families who are not thinking about the Estate Tax could be subject to a 40% tax in the future. And that risk is a very real reason to consider an Irrevocable Trust today – to lock in the very generous Estate and Gift exemption we have in 2023 through 2025. Today, a couple could put in almost $26 million into a Trust, without gift taxes, and avoid a future estate tax, even if Congress later lowers the Estate Tax Exemption.

Moving assets out of your name and into a trust could also protect those assets from creditors. If you are concerned about a lawsuit or bankruptcy, moving assets out of your name may be a good idea. For some professions and businesses, this is a very real risk.

Trust Taxation

Be sure to ask and understand how any proposed trust will be taxed in the present and future. Taxes can be misunderstood by families who thought a Trust was doing a great thing for heirs. Some trusts are pass-through entities, where the income taxes are payable by the grantor or the beneficiaries.

Other trusts are their own entity and have to file their own tax return. And this type, you need to be very careful. Trust and Estate tax rates are much worse than individual tax rates. Both trusts and individual have the same top rate of 37% in 2023. But the Trust reaches that 37% tax rate at only $14,451 of income versus $578,126 for an individual (2023).

Billionaires don’t care about trust tax rates because they and their heirs are always going to be in the top tax bracket. To them, the trust tax rate doesn’t matter. But for most beneficiaries, there will be a large increase in taxes if the trust is a taxable entity.

For example, consider $100,000 ordinary income to an individual versus a Trust (2023):

Individual taxpayer (after $13,850 standard deduction) = $14,261 tax
Trust with same income = $35,144 tax

It may be that the other goals: spendthrift, family, estate planning, etc., outweigh the additional tax costs. But you should fully understand what the taxes will look like while you are alive and also for your heirs.

Two other questions to ask about taxes before entering a trust:

Will my heirs receive a step-up in cost basis if the trust owns this asset when I pass away? In many cases, this answer alone may dissuade you from certain types of trusts.
What will happen if I name the trust as beneficiary of my retirement account or life insurance policy? In some cases, certain benefits may be lost if a trust is a beneficiary rather than a natural person.

Conclusion

Do I need a trust? To answer that question, we’ve outlined two areas of focus. First, be very clear about why you need a trust. Is it to avoid probate, for a spendthrift, for family reasons, to reduce estate taxes, or protect assets from creditors? These require different approaches. Second, be sure you understand how the trust will be taxed today and in the future. Some are simple and some are complex and can be costly for your heirs. There are no tax-free trusts, someone is always liable for taxes and you need to understand how this works.

Every family should have a Will and related estate planning documents: a Durable Power of Attorney, a Physicians’ Directive, and Health Care POA. Keep these up to date, especially if you have a change in your beneficiaries, executors, or trustees. If you don’t have a specific need for a trust, it’s quite possible that you don’t need one. I am not of the opinion that everyone must have a trust. In many cases, the majority of their assets can pass outside of probate, just through beneficiary designations or TOD accounts. There are pros and cons to that approach, too.

If you do establish a trust, please share it with your financial advisor. It may even be beneficial to set up a meeting or call with you, your attorney, and your financial planner to ask questions about account titles, beneficiary designations, and taxes. That way, we can work together to make sure your estate plan will work as intended. Our Wealth Management process is often planning for several generations and not just for this year or even for just your retirement. If you are thinking about how your money can benefit your family long-term, let’s chat.

What Is The Estate Tax?

Posted On October 1, 2023 By Scott Stratton, CFP(R), CFA In Estate Planning /

Many investors are unclear about exactly what is the estate tax in the United States. Thankfully, very few people currently have exposure to the estate tax. However, for wealthy families, the estate tax can be significant. Even if you are not currently subject to the estate tax, you might be in the future, and you need to read this article. Here’s what you need to know about the estate tax and key planning strategies to reduce a future estate tax liability.

Estate Tax in 2023

Today, for 2023, the estate tax exemption is $12,920,000 per person. This is the amount that you can pass on to other people without paying any estate tax. If your estate is above this amount, your estate pays tax on the amount above the $12,920,000 threshold. The tax begins at 18% and increases to 40% once you reach $1 million above the threshold.

Spouses have separate exemptions, so a couple can effectively have an estate of $25,840,000 before owing any estate taxes. The exemption is indexed to inflation and is increasing each year. The tax must be paid by the estate before the assets are distributed to your heirs. There is no estate tax for leaving assets to your spouse, provided that your spouse is a US citizen.

Please note that the estate tax has nothing to do with “probate”. Items which are excluded from probate, such as retirement accounts, life insurance, TOD accounts, and revocable trusts, are still included in your assets for the calculation of the estate tax.

When I became a financial advisor two decades ago, the estate tax exemption was only $1 million. A lot of people were getting hit by the tax and planners were much more focused on the estate tax. Over the past 20 years, we’ve seen the exemption expanded greatly. Today, there are relatively few families who are subject to the tax, but that is likely to change.

The Future of The Estate Tax

The estate tax exemption is set to be cut in half in 2026. The current exemption amount is scheduled for sunset as part of the Tax Cuts and Jobs Act of 2017. On January 1, 2026, the exemption will drop to around $6.5 million or so (depending on inflation over the next couple of years). And immediately, people with over $6.5 million will be subject to the estate tax.

For example, if you have $11 million as an individual, your estate tax would be $0 today. But in 2026, if the exemption is $6.5 million, your heirs would owe estate tax on $4.5 million. The tax bill would be $1,745,800.

Of course, Congress could act to extend the exemption amount or even increase it. We don’t know what will happen. Personally, I don’t think there is much appetite in Washington for continuing or expanding the estate tax limits. Given the increased perception (and reality) of wealth disparity in our country, it seems unlikely to me, especially with our growing debt and deficits. It is easier to raise taxes on the 1%. There were candidates in the previous presidential election who proposed lowering the threshold to $3.5 million and increasing the tax to 45%. So, it will definitely depend on who is in control in Washington in 2025-2026, but the writing is on the wall. I think the estate tax threshold is likely going lower, maybe a lot lower. It’s a real risk.

Wealthy Americans who have $3 million to $26 million as a couple presently don’t have to think about the estate tax. But that seems likely to change, and families in this range could have a different situation in the future. Also, make sure to consider a calculation of future growth. With a hypothetical 7% annual return, $5 million will become $20 million in 20 years. Just because you don’t have an estate tax liability today is no guarantee you will not in the future.

Thankfully, there are a number of planning opportunities to reduce your future estate tax exposure.

State Estate Taxes

Before we get to estate tax strategies, there’s more bad news. A number of US states impose their own estate tax or Inheritance tax, on top of the US estate tax. And all of these states have a MUCH lower exemption, ranging from $1 million in Massachusetts to $5.9 million in New York, meaning that even if you don’t pay a federal estate tax, you could end up owing estate tax to your home state. Residents of these states will pay both the state and the federal estate tax.

States with an estate tax include: CT, DE, DC, HI, IL, MA, MD, ME, MN, NE, NY, OR, and WA. The following states impose an inheritance tax, which is similar, but imposed on the beneficiary rather than on the Estate: IA, KY, MD, NE, NJ, and PA. State estate tax rates are up to 20%. This is in addition to the Federal estate tax, so the combined estate tax could be over 50% in certain states.

Planning for the state estate tax can be very simple. Move to another state without an estate tax or an inheritance tax.

Ways to Reduce the Estate Tax

Below are ways to reduce the estate tax and it is by no means a complete list. Each of these strategies below could be a full article. There are many planning strategies we could use, depending on your individual situation.

Charitable giving. Your gifts to charity reduce your estate and if done in advance can also provide income tax benefits. Don’t forget Qualified Charitable Distributions from your IRA if you are over age 70 1/2. Better to gift over time, rather than at death, to maximize income tax deductions, which are limited to 50% of Adjusted Gross Income annually.
Use your annual gift tax exclusion of $17,000 (2023) per person. You can also pay an unlimited amount for medical and educational expenses. Pay for your grandchildren’s college directly.
Give your heirs $12,920,000 now and use up your lifetime unified exemption today. Or establish an Irrevocable Trust with this amount. When you give away or fund the trust now, the IRS cannot later charge you gift or estate taxes if the future exemption drops. You have locked in your gift at $12,900,000. And next year, if the exemption does increase, say to $13,050,000, you could give away another $150,000. This strategy is essential to do before 2026.
Establish a family limited partnership (FLP) and gift shares to your heirs. They may receive a minority discount on the FLP shares, reducing the value of the gift. This is especially helpful if you have a closely held business which is growing in value.
Establish 529 College Savings Plans for children or grandchildren. 529s pass outside of your estate, even if you control them. You can fund five years in advance ($85,000 from a single donor or $170,000 from a married couple) per beneficiary, without touching your lifetime unified exemption.
Irrevocable Life Insurance Trust. Purchase a permanent life insurance policy through the trust and the trust owns the policy. Then there is no estate tax (or income tax!) on the death benefits paid to your heirs. (If the life insurance is owned by you directly, the death benefits will be included in your Estate.)
Roth Conversion. Pre-paying the taxes on your IRAs will reduce your Estate by the amount of taxes paid. And you will leave a tax-free account to your heirs. It’s better than your estate paying 40% and then your beneficiaries having to pay another 39.6% in income taxes on the distributions from your IRA.
Other trusts can reduce your taxable estate, including charitable trusts and intentionally defective grantor trusts.

Hopefully now you have a better idea “What is the estate tax”. Unfortunately, there is uncertainty about what the future estate tax will be. And that is a big risk for families who are thinking that they are safe because today they are below the estate tax thresholds. It’s not too early for families to start planning for 2024 and 2025 before the estate tax exclusion is cut in half in 2026. If you have concerns about how the estate tax might impact your family, contact me to discuss.

Index Funds vs Mutual Funds

Posted On September 21, 2023 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Twice a year, Standard and Poors updates their comparison of Index Funds vs Mutual Funds, called SPIVA (S&P Index versus Active report). I have written about SPIVA a number of times, and it is worth repeating, because the data is remarkably consistent.

The majority of actively managed funds do worse than a benchmark or index. The newest report was published today, covering all US Funds through June 30, 2023. When we look at long-term returns, here are the percentage of active mutual funds that performed worse than their benchmark:

Category	5-yr	10-yr	15-yr	20-yr
All Domestic Stock Funds	89.08%	90.19%	93.15%	93.12%
International Stock	81.84%	84.78%	85.33%	92.50%
Emerging Markets	70.70%	87.56%	89.58%	92.42%

Source: SPIVA US Mid Year 2023

The evidence comparing index funds versus mutual funds is clear: Index funds are the hands down winner. While past performance is no guarantee of future results, there continues to be overwhelming evidence that index funds do better than the vast majority of active funds over the long-term. And this finding is remarkably consistent, regardless of whether we are in a Bull or Bear market.

Equal Weight Index

2023 has been a strange year in the market, with narrow breadth of performance. Looking at the S&P 500, performance has been concentrated in a small handful of names, with five large stocks up more than 100% in the first half of the year. So for strategies which didn’t own these high flyers, it was tough to keep up. Value, Small Cap, and other strategies have lagged the Large Caps this year.

But that is likely to reverse, as it has been quite extreme. I’ve written previously about Equal Weight funds, specifically the S&P 500 Equal Weight. It owns the same 500 or so stocks as the S&P 500, but in equal proportion. The standard S&P 500 which weights each stock on its size (“market capitalization”).

Over the very long-term, the Equal Weight strategy (EW) has outperformed. From 1991 through 6/30/2023, the EW S&P 500 index has a return of 11.82% a year, versus 10.55% for the regular S&P 500. That is a noteworthy, long-term improvement in performance, and is typically attributed to the idea that EW has less of the “over-valued” stocks and more of the “under-valued” stocks.

While EW has outperformed over 30+ years, it has not done so consistently or every year. But what is interesting is that when EW has underperformed to an extreme level, it has historically snapped back. And that is where we are today: EW lagged by 9.9% for the first half of 2023. In the chart below from S&P, previous 6-month periods of EW underperformance were followed by periods of strong EW outperformance. The returns have been mean reverting, with EW providing long-term returns in excess of the cap-weighted index

Mean Reversion Ahead?

This would suggest that the outperformance by the Mega-Cap names of the S&P 500 is unlikely to continue. We own some Value and Mid Cap funds which have not kept up with the S&P 500 this year. That can be frustrating and make investors want to pile into those high flying stocks. But the reality is that the outperformance of the biggest stocks versus EW may be overdone. In fact, it is in the 2nd percentile for the first half of the year, more extreme than 98% of previous 6-month periods. Generally, I believe mean reversion is more likely than an extreme trend continuing indefinitely.

We diversify our portfolios broadly and tilt towards areas of better relative value. This has us owning Value funds, multi-factor strategies, small and mid-cap, and Emerging Markets. Why? Our belief in the two topics we discussed today:

Passive, index strategies are better than active management over the long-term
We count on mean reversion rather than performance chasing

Both of these approaches are well-grounded in research, but require patience and discipline to stay the course. That’s where we are today. And the data reminds us that this still makes sense. The question of Index funds vs mutual funds is just the beginning. There will be ups and downs, which no one can predict or time, so our focus is on having a good investment process and understanding the fundamentals.

Growth, The Big Picture

Posted On September 18, 2023 By Scott Stratton, CFP(R), CFA In Financial Planning, Portfolio Management /

With all the noise in today’s markets, it is easy to miss the big picture about growth. 2022 and 2023 have been two of the strangest years in a generation for investors. As a result, it is easy to feel uncertain about investing right now. And that uncertainty often leads investors to make bad choices. So, we are going to step back and look at the 30,000 foot view of what really matters for investors.

In 2022, we saw inflation rise to 9% and the Federal Reserve start the process of slowing the economy. As the Fed raised interest rates, stocks dropped 20%, briefly entering Bear Market territory. In the bond market, rising interest rates snipped the price of bonds, sending the US Aggregate bond index down double digits. For diversified investors, 2022 was a perfect storm where diversification failed and both stocks and bonds were down an uncomfortable level.

Now in 2023, we have seen the Federal Reserve continue to raise rates up to the present moment. At the start of the year, I saw one report that said the probability of a recession in the next 12 months was 100%. 100%, a certainty! And while the full 12 months are not up yet, we have not had a recession. In fact, the S&P 500 Index is up 15.83% this year. While the yield curve remains inverted, a favorite predictor of recessions, it now appears that the likelihood of a 2023 recession is diminished and might not happen at all.

Don’t Time The Market

Comparing 2022 and 2023 doesn’t make sense. The market “should” not be up 15% this year. And yet here we are, with a very welcome gift of an amazing performance in the first seven and a half months of the year. The consensus economic forecasts at the start of 2023 were lousy. If we had listened to them, we would have sold our stocks and hid out in cash. We would have missed out on the gains that we have had for 2023!

There are often compelling historical precedents to entice investors to think we can predict what is going to happen over the next 12 months. Making changes to your investments feels obvious, a smart choice, and low-risk. Unfortunately, history shows us that it is hubris to try to time the market and more often detrimental than beneficial.

It is a challenge to actually stay the course and maintain your discipline. It is difficult to ignore the forecasters and not think that there is an opportunity for you to either protect your principal or rotate into a better performing investment.

Timing the market continues to be a bad idea. I didn’t hear any forecasters in January predict that stocks would be up 15% by August. If we had listened to their predictions, although well-intentioned, we would have made a mistake. Thankfully, we didn’t try to time the market this year. Here is how we manage a portfolio:

Establish a target asset allocation for each client’s individual needs and risk tolerance.
Rebalance portfolios when they drift from the targets.
Adjust our portfolio models annually based on the valuation and expected returns of each category.
Use Index Funds and manage each client’s portfolio to keep costs down and minimize taxes.

Rebalancing

The funny thing about rebalancing is that it often means doing the opposite of what you might expect. When stocks were down 20% last year or in 2020, we were buying stocks. Now, when stocks are up 15-20% and there is a lot of optimism for a soft landing, we are trimming stocks and buying bonds. In hindsight, this looks pretty logical. However, in real time, rebalancing often feels like not such a good idea. And sometimes it isn’t – there’s no guarantee that rebalancing will improve returns. But, what it does offer is a disciplined process to managing an investment portfolio, versus the behavioral traps of trying to time the market. The bizarre markets of 2022-2023 certainly reinforce the potential benefits of rebalancing.

Average Versus Median

Do you remember from high school algebra the difference between Average and Median? Average is the total sum divided by the number of items. Median is the data point in the middle. And there can be a big difference between Average and Median. Stock markets are cap weighted, so the larger stocks move the index more than the smaller stocks. Still, let’s consider how the “average” return of an index can be quite different from the median returns of its component stocks.

The year to date return of the S&P 500 Index ETF (SPY) is 15.83% as of August 16. But that is not the median return of the stocks. Of 504 components of the S&P 500, only 135 have done better than 15.83% YTD and 369 have done worse than the overall index. If you had picked a random stock from the S&P, there was a 73% chance that you would have done worse than “average” this year.

And what is the Median performance of the S&P 500 this year? Only 3.36%, an under-performance of more than 12% than the overall index. Even worse, 212 stocks in the S&P 500 are down, negative for the year.

What is the big picture of growth in stocks? Trying to pick individual stocks is extremely difficult. Don’t think that using an index fund means “settling for average”, the reality is that over time, the index return has done much better than the median stock.

This year has been such a frustrating year for investors because stocks are all over the place. If you don’t own a few of the top performers, you are likely lagging the benchmark by a wide margin. What is a way to make sure you own the winners today and tomorrow? Own the whole market with an Index Fund. Realize that if you pick a stock from the S&P 500, it is not a 50/50 coin toss that you will beat the market average. The chance is lower than 50% because the market average typically does better than the median stock. The stocks which do outperform will move the index disproportionately and they will be fewer in number.

There is a lot of noise and confusion in the markets today, and that’s okay. We are in uncharted waters and seem to be going from one “unprecedented” event to another. Thankfully, I don’t think we need to have a crystal ball to be successful as long-term investors. What I believe can help is stepping back to remember the big picture: don’t time the market, stick to an allocation and rebalance, and use index funds. That’s our roadmap. When in doubt, we can recheck our directions and keep going.

What You Can Control

In the short-term, stock markets can be very volatile. As a result, I believe a lot of inexperienced investors mistakenly think that their success depends on their ability to game the markets. They think that growth is achieved through trading or superior returns.

Unfortunately, trying to outsmart the market often makes your performance worse, rather than better. Active management doesn’t work, at least not consistently over 10 or more years. We stick to passive, low-cost index funds or ETFs for our stock market exposure. And we remain invested in a long-term asset allocation.

Once that investment decision is out of the way, the main determinant of success is your savings rate. How much are you investing each month? That is what you can control. If you want to be more successful in accumulating your wealth, you don’t need to worry about the Jobs Report this week, or what was in the Federal Reserve meeting notes. You need to focus on how can you can save an extra $100, $500, or $1000 a month and make that a habit.

Instead of worrying about your YTD performance, calculate how much wealth you will have in 10 or 20 years, with an average rate of return. Because in the long-run, an average rate of return is excellent. And then what you can control – your savings – is what actually matters more. Growing your wealth is largely a factor of savings and time. Chasing investment performance is a distraction.

Develop Your Saving Habits

Make savings automatic. Put your investing on autopilot with monthly contributions to your 401K, IRA, and investment accounts.
Save More. Don’t just do the 401(k) match, try to put in the maximum to each account. And then ask where else can you invest? Do the math of how much money you want to accumulate. (I can help with that.)
Keep the big expenses down. Living beneath your means is easy if you are smart about your housing costs and your cars. Many Americans who are not frugal in those areas do not have anything leftover to invest.
Develop your career. If you can expand your income without increasing your expenditures, your savings can increase dramatically. If you ever have a chance to work for a company with stock options, go there. I have seen over the years, tremendous wealth accumulated from stock options.
Be an Entrepreneur. This can be high risk, but when they are successful, entrepreneurs earn and save much more than employees. Besides a salary, an entrepreneur is growing a business that has value.

As a financial planner over the past 19 years, I’ve gotten to look at a lot of families’ finances. The difference between those who were struggling and those who were wealthy was seldom just income. I’ve seen a lot of high income folks who were living hand to mouth. Other families who had similar incomes were millionaires or well on their way. The difference was their saving rate. You can’t grow what you don’t save.

There is no substitute for saving. We have to make savings automatic and increase our savings whenever possible. It may help to work backwards: start with your goal and determine how much you need to save and for how long. Then you can see saving as the solution and beneficial process rather than as a sacrifice. Some Americans are saving very well. But the Big Picture is that the average American isn’t saving enough. We need to be talking more about saving, because for too many families, it is the step that they cannot get past.

Our recipe for Growth is simple. Save monthly and dollar cost average into Index funds. You can do this in your 401(k), IRA, or taxable account. The account is less important than the process. The more you save, the more wealth you can accumulate. The younger you start, the better. The faster you increase your saving, the sooner you can reach your goals. Saving is growth and investing is secondary.

Investment Taxes Eat Your Growth

Taxes matter. We work hard to establish a good portfolio and get a respectable rate of return. And then the government wants their cut. How about 37% for Federal Income Taxes (increasing to 39.6% in two years). And another 5% for state taxes. Don’t forget 15.3% for self employment taxes for Social Security and Medicare (or half that number if you’re an employee). Then, if you do well, how about an extra 3.8% in Medicare surtax (“Net Investment Income Tax”).

Once you have your “after-tax” money, it’s all yours, right? Well, not quite. You get to give the government another $5,000, $10,000, or more in property taxes. And when you want to buy something with your after-tax money, you get to pay 8% in sales tax.

The point is that it doesn’t matter how much you make, it matters how much you keep. That is why tax planning is such a big part of our wealth management process. As your portfolio grows, the tax implications can become a significant annual expense and a drag on returns.

What continues to shock me is how many Advisors are making huge mistakes with client portfolios and creating tens of thousands of dollars in unnecessary taxes. Taxes which could have been avoided or reduced substantially through better planning. Sometimes this is because they use a model portfolio that doesn’t attempt to have any tax efficiency. But other times, it is laziness and having too many clients to manage individual portfolios in a tax-efficient way. It’s easier to stick people into a model and let the computer automatically rebalance the portfolio.

This is the big picture for wealthy Americans: Your after tax-return matters more than your pre-tax returns. You have very little control over taxes on a monthly basis, but a great deal of control over taxes in the long run. Here are the mistakes we often see and how we can do better:

Portfolio Tax Efficiency

Mistake 1: Mutual Funds in Taxable Accounts. Mutual Funds have to distribute capital gains annually. Each December, many investors get a surprise tax bill from their funds. BETTER: hold Exchange Traded Funds (ETFs) in taxable accounts. ETFs rarely, if ever, have capital gains distributions.

Mistake 2: Short-Term Capital Gains. Short-Term Capital Gains (less than 1 year) are taxed as Ordinary Income, up to 37%. BETTER: Hold for Long-Term Capital Gains (more than 1 year), which are taxed at lower rates (0, 15 , or 20 percent). Trading which creates ST Gains should be avoided in a taxable account. We are very careful about the tax implications of our rebalancing trades, as well.

Mistake 3: Bonds and REITs in Taxable Accounts. Bond income is taxed as ordinary income (up to 37%). BETTER: Hold bonds in IRAs, which are tax-deferred. Also, IRA distributions will be taxed as ordinary income, so bond income isn’t treated worse in an IRA, unlike capital gains. When you have a LTCG on a stock ETF in an IRA, all that growth will be taxed as Ordinary Income. Traditional IRAs will have the highest tax rate, so it is better to allocate the low growth bonds to IRAs and high growth stocks to Roths and taxable accounts. This process is called Asset Location.

Mistake 4: Not harvesting losses. BETTER: Harvest losses annually in taxable accounts. Losses can be used to offset gains that year, and $3,000 of losses can be applied against ordinary income. Unused losses will be carried forward without expiration.

Mistake 5: Not asking about charitable giving. 90% of Americans are not itemizing and not getting any tax benefit from charitable donations. BETTER: We can get a tax benefit two ways, without itemizing: A) make donations of appreciated securities from a taxable account. Or B), if over age 70 1/2, make Qualified Charitable Distributions (QCDs) from your IRA.

Mistake 6: No Plan for Managing IRA Distributions. BETTER: Do Roth Conversions in low income years before RMDs start at age 73.

Mistake 7: Not understanding Taxes that will be owed by Beneficiaries. BETTER: Working with your Advisor to consider inter-generational taxes in your Estate Plan. For example, taxation of trusts, step-up in cost basis, charitable giving, and Beneficiary IRAs.

Mistake 8: Not doing a Backdoor Roth IRA. I’ve had advisors tell me it’s not worth their time to move $13,000 to $15,000 into a TAX-FREE account each year for a married couple. Not worth it for the advisor, I guess (no additional revenue). BETTER: Although the numbers are small annually, we have been doing back-door contributions for clients for many years, and it does add up.

The Changing Retirement Picture

Did your parents retire with a Pension? Maybe they worked for 30-40 years for the big company in town, or for a municipality, school district, military branch, or government agency. When they retired, they had a pension and Social Security which fully covered their expenses. They might have also had retirement health benefits which paid for deductibles and co-pays which were not covered by Medicare.

You probably don’t have the same benefits. How much is a Pension worth? Well, we can easily compare a Pension to the cost of a Single Premium Immediate Annuity, or SPIA. A SPIA works the same way as a Pension – it is a guaranteed monthly payment for life. For example, let’s consider a 65 year old female who has a pension which guarantees her $2500 a month for the rest of her life. We could buy a SPIA with the same guaranteed $2,500 a month for life, for a cost $437,063. So, a $2,500/month pension is worth $437,063.

To have the same retirement funding as your parents, you may need $400,000 or more in assets than they had. And that is just to replace one modest pension. If your parents had two pensions or had a bigger pension, you might need much more than $400,000 to get the same retirement income.

And you probably won’t buy a SPIA and would prefer to keep your money in an IRA. At a 4% withdrawal rate, you would need $750,000 in your IRA to get $2,500 a month. So maybe you need $750,000 more than your parents, not $437,000, to replace their pension! These pensions were worth a lot. It will take a worker 30 years of saving to build up their 401(k) to $750,000. It’s not impossible, but the big picture is that most Americans aren’t doing a good job of saving. The average 401(k) balance for workers age 55-64 is $207,874. The median balance at 55-64 is only $71,168, meaning that half of all 401(k) accounts are less than $71,168.

I’m afraid the promise of becoming wealthy through your 401(k)s has proved elusive for the average American. It’s a wedge that is driving wealth inequality in our country. But I don’t think Pensions are coming back – retirement preparation rests squarely on the individual’s shoulders. You certainly can get to $500,000 to $1 million in a retirement account, but you have to aim to put in the maximum, not just get the company match. Then you have to not withdraw it and let it compound for 30 to 40 years. That recipe will work, but it’s not easy, it requires some sacrifice and a lot of discipline.

Counting on Social Security

The Social Security Trust Fund will be depleted by 2033. After that, revenues will only cover about 70% of promised benefits. After kicking the can down the road for 20 years, Washington needs to get its act together soon. We can either reduce benefits or increase taxes. It may be a combination of both, but one thing is for sure: keeping the status quo is not going to be an option. The Social Security budget for 2023 is $1.30 Trillion. The Department of Health and Human Services (Medicare, Medicaid, and other health agencies) have a budget of $2.10 Trillion for this year. These two programs, largely for Retirees, have become the biggest portion of government spending.

There will have to be a reckoning in the years ahead about these programs. Something has to change, they are unsustainable in their present form. I think there will be changes in inflation adjustments, a gradual increase in the full retirement age, and probably some means testing which will reduce benefits for high net worth families. Or there could be a whole new system. As difficult as it is to imagine, the system is so broken that starting over from scratch might be better than continuing to try to put new band-aids on this fiscal cancer.

The big picture for the future of government retirement programs is very uncertain. These are not the only issues facing the government. Our debt is growing. This year, the interest payments alone on US Treasury Debt will be $964 Billion. We may top $1 Trillion in interest payments next year. And there is no plan to ever repay this debt, only to grow it every single year. When you look at debt projections, it only reinforces the need to reign in the expenses which are growing the fastest.

In our planning process, we include Social Security projections. But we had better be prepared for benefits to potentially be a bit less than promised. So, once again, it may be that more of your retirement income needs to be self-funded. If you don’t have a pension, the burden of funding your retirement has been shifted to you. Have you calculated what that will cost? That’s what we do with our retirement planning software, MoneyGuidePro. We create an ongoing plan for your retirement needs, which adjusts over time, and where we can continue to refine assumptions and expectations.

I hate to be such a downer, it’s really not my nature. But a lot of Americans are going to have worse retirements than their parents, because they don’t have a pension. The burden of saving for retirement has shifted from the employer to the employee. Now instead of everyone getting a good outcome, many Americans are under-prepared for retirement. And then we have to look ahead at the uncertainty that is facing Social Security and Medicare. It looks like we will have more individual responsibility for our outcomes and less universal assistance.

The Forest For The Trees

The Big Picture for Growth can be hard to see because the fog of current events makes it hard to see the long-term horizon. Here are our four pillars of The Big Picture:

Don’t time the market. Stick to your asset allocation and rebalance. Use index funds.
Once you’ve made the shift away from performance chasing, focus on what really matters: how much you save.
Taxes hurt returns. Tax planning helps.
You are responsible for your own retirement savings and financial security.

I’m sure things are going to change. We don’t really know how, when, or why they will change. While some may find uncertainty to be paralyzing, it doesn’t have to be. Even if the future is a moving target, planning is not a waste of time. Not at all! Being well prepared also includes the flexibility to adapt and evolve.

A lot of my day to day work is focused on the small details of implementing our plans. But the growth is created when we step back and take a long, hard look at The Big Picture. We should all be having more of those conversations, with our spouses and children, our bosses and colleagues, and especially with your financial professional.

US and French Social Security

Posted On April 14, 2023 By Scott Stratton, CFP(R), CFA In Retirement Planning /

We are in Paris and several clients have reached out to make sure we are doing okay, given the demonstrations and riots regarding France’s retirement system. Yes, we are fine and actually never saw any of these events other than on the news. Day to day life in Paris is normal, and thankfully the garbage strike is over. It has been perfectly tranquil in our neighborhood and we are enjoying life in the city.

Why are the French upset? Currently, if you are 62 and have worked for 42 years, a French citizen can receive their full retirement benefit of 50% of the average salary of their highest paid 20 years of work. If you don’t have 42 years of contributions, you will receive less than 50%, or you can work for longer to increase your benefit up to 50%. So, if you had been making $60,000 (Euros actually), you could potentially retire at 62 with a $30,000 pension. Under the new rules, the full retirement benefit will not become available until age 64 with 43 years of work. There are some interesting parallels between US and French Social Security.

The French Connection

In a recent interview, France’s President Macron defended the changes, which have been enormously unpopular. Macron explained that the program has always been an entitlement program, where current benefits are paid by current taxes. It is not a personal savings or investment account. When Macron took office, there were 10 million retirees receiving benefits, out of France’s 67 million population. Today, there are 17 million retirees and that number will grow to 20 million by 2030. 20 million pensioners out of a total of 67 million people. There are 1.7 workers in France for each retiree.

1.7 workers cannot provide an average monthly benefit of 1300 Euros for each retiree. There are only two options, increase taxes or decrease benefits. France already has high taxes, 20% just for social programs (this also includes health insurance, unemployment, maternity benefits, and other programs). 14% of France’s GDP is just retirement pensions. France compared their program and expenditures to similar countries and recognized that their retirement age was too low, given how much longer people are living today.

Macron tried to work with representatives in their Parliament on a solution. But when no agreement could be reached, he issued an executive order to make the changes without a vote. He noted that he had to do what was in the country’s best interest in the long term and preserve the program for their children and grandchildren, even if it was not the most popular thing to do. I was impressed by his directness, intelligent explanation of a complex problem, and courage to do the right thing even when it is not easy or popular.

The US Conundrum

I’ve been writing about the problems facing US Social Security since 2008. Back then, the 2036 projected collapse of the Social Security Trust Fund seemed like a lifetime away. Today, Social Security projects that the Trust Fund will be depleted by 2033. At that time, taxes will only cover about 70% of promised benefits. And every year, the Social Security Trustees report tells us how much we need to increase taxes or decrease benefits to keep the program solvent for 75 years.

Unfortunately, over the last 15 years no changes have occurred. It has been political suicide for any politician to suggest reforming Social Security. The easiest attack ad has always been to say that your opponent wants to “take away your Social Security check”. So we keep on marching towards that cliff with no change in direction. Shame on our politicians for not being willing to save the foundation of our retirement.

When Social Security started, there were 16 workers for every retiree and the average life expectancy was 65. Today, there are 2.8 workers for every retiree and that ratio continues to shrink. The typical 65 year old, in 2023, will live for at least 20 years. Like in France, it doesn’t matter what “you paid into Social Security”. That’s not how the program ever worked. Current taxes pay current beneficiaries. Your past contributions were spent on your parent’s or grandparent’s check.

No Easy Solution

Compared to France, the US demographics may look better. However, France actually is running a smaller deficit on their retirement program – only a 10 Billion Euro average annual shortfall for the next decade. They actually ran a surplus in 2022 and are proactively making these changes looking forward to the decade ahead. They’re making changes before there is a deficit! (Social Security spent only $56 Billion of the Trust Fund last year, but this will accelerate and deplete the whole $2.8 Trillion over the next 10 years.)

For the US, if we we wait, it will magnify the size of the changes needed. It would be better to start today to save Social Security. We can either increase taxes or reduce benefits. Those are the only two options. No one wants to do either, so we have to reach a compromise.

Thankfully, there are actuaries at Social Security who study all proposals. Their annual report estimates how much of the shortfall could be reduced for each change. Here are some of their calculations, looking at the improvement of the long-range actuarial balance. (We should be looking for some combination which equals at least 100%.)

Impact of Possible Changes to US Social Security

Reduce COLAs by 1% annually: 56%
Change COLA to chained CPI-W: 18%
Calculate new benefits using inflation rather than SSA Average Wage Index: 80%
Reduce benefits for new retirees by 5% starting 2023: 18%
Wage test. Reduce SS benefits from 0-50% if income is $60k-180k single/$120k-360k married: 15%
Increase Full Retirement Age from 67 to 69 by 2034, and then increase FRA by 1 month every 2 years going forward: 38%
Increase the Payroll Tax from 12.4% to 16% in 2023: 103%
Eliminate SS cap and tax all wages: 58%
Eliminate SS cap, tax all wages, but do not increase benefits above the current law maximum: 75%
New 6.2% tax on investment income, for single $200k / married $250k: 29%

I don’t have an answer for what Washington will do. But we can look at what will actually work. And what is perhaps even more interesting is what doesn’t work. It is shocking, for example, that wage testing SS only improves the shortfall by 18%. Or that Reducing COLAs by 1% every year only will cover half the shortfall. Unfortunately, we may need to increase taxes. Moving to 16% payroll tax would fully cover the shortfall. That would be a relatively small increase from 6.2% to 8%, each, for an employee and the employer. But that is a regressive tax, which would impact low earners more than high earners. For reforms to work, it might require a combination of both increased taxes and reductions in the way benefits increase.

Kicking The Can Down The Road

Will the US take action to save Social Security, or will the reaction in France scare US Politicians? It’s hard to imagine our divided Congress reaching a compromise on an issue as difficult and controversial as changing Social Security. But any politician who is still talking about the other side as “trying to take away your Social Security” is now part of the problem and not part of the solution. Kicking the can down the road is not going to help America.

What is certain is the need to save Social Security. It is the largest source of retirement income for most Americans. And the lower your income, the more Social Security is needed to cover retirement expenses. We can’t keep ignoring the future of Social Security, it’s not going to get better on its own. The status quo is not an option.

I hope the US won’t see the same riots as Paris. But I also hope US politicians will do their job and have the courage to make the tough choices that are in the best interest of the public. US and French Social Security are both in the same precarious state. Let’s hope Winston Churchill was right: “You can always count on Americans to do the right thing, after they have exhausted all other possibilities.” That day is coming soon.