Inflation Investments

Inflation Investments

With the cost of living on the rise in 2021, many investors are asking about inflation investments. What is a good way to position your portfolio to grow and maintain its purchasing power? Where should we be positioned for 2022 if higher inflation is going to stick around?

Inflation was 5.4% for the 12 months ending in July. I share these concerns and we are going to discuss several inflation investments below. Before we do, I have to begin with a caveat. We should be cautious about placing a lot of weight in forecasts. Whether we look at predictions of stock market returns, interest rates, or inflation, these are often quite inaccurate. Market timing decisions based on these forecasts seldom add any value in hindsight.

What we do know for sure is that cash will lose its purchasing power. With interest rates near zero on most money market funds and bank accounts, it is a frustrating time to be a conservative investor. We like to consider the Real Yield – the yield minus inflation. It would be good if bonds were giving us a positive Real Yield. Today, however, the Real Yield on a 10-year Treasury bond is negative 4%. This may be the most unattractive Real Yield we have ever seen in US fixed income.

Let’s look at inflation’s impact on stocks and bonds and then discuss three alternatives: TIPs, Commodities, and Real Estate.

Inflation and Stocks

You may hear that inflation is bad for stocks. That is partially true. Rising inflation hurts companies’ profitability and consumers’ wallets. In the short-term, unexpected spikes in inflation seem correlated to below average performance in stocks.

However, when we look longer, stocks have done the better job of staying ahead of inflation than other assets. Over five or ten years, stocks have generally outpaced inflation by a wide margin. That’s true even in periods of higher inflation. There are always some down periods for stocks, but as an asset class, stocks typically have the best chance of beating inflation over a 20-30 year horizon as an investor or as a retiree.

We can’t discuss stocks and inflation without considering two important points.

First, if there is high inflation in the US, we expect that the Dollar will decline in value as a currency. If the Dollar weakens, this would be positive for foreign stocks or emerging market stocks. Because foreign stocks trade in other currencies, a falling dollar would boost their values for US investors. Our international holdings provide a hedge against a falling dollar.

Second, the Federal Reserve may act soon to slow inflation by raising interest rates. This would help slow the economy. However, if the Fed presses too hard on the brake pedal, they could crash the economy, the stock market, and send bond prices falling, too. In this scenario, cash at 0% could still outperform stocks and bonds for a year or longer! That’s why Wall Street has long said “Don’t fight the Fed.” The Fed’s mandate is to manage inflation and they are now having to figure out how to keep the economy growing. But not growing too much to cause inflation! This will prove more difficult as government spending and debt grows to walk this tightrope.

Inflation and Bonds

With Real Yields negative today, it may seem an unappealing time to own bonds, especially high quality bonds. Earning one percent while inflation is 5% is frustrating. The challenge is to maintain an appropriate risk tolerance across the whole portfolio.

If you have a 60/40 portfolio with 60% in stocks and 40% in bonds, should you sell your bonds? The stock market is at an all-time high right now and US growth stocks could be overvalued. So it is not a great buying opportunity to replace all your bonds with stocks today. Instead, consider your reason for owning bonds. We own bonds to offset the risk of stocks. This gives us an opportunity to have some stability and survive the next bear market. Bonds give us a chance to rebalance. So, I doubt that anyone who is 60/40 or 70/30 will want to go to 100% stocks in this environment today.

Still, I think we can add some value to fixed income holdings. Here are a couple of ways we have been addressing fixed income holdings for our clients:

  • Ladder 5-year Fixed Annuities. Today’s rate is 2.75%, which is below inflation, but more than double what we can find in Treasury bonds, Municipal bonds, or CDs.
  • Emerging Market Bonds. As a long-term investment, we see attractive relative yields and improving fundamentals.
  • Preferred Stocks, offering an attractive yield.

TIPS

Treasury Inflation Protected Securities are US government bonds which adjust to the CPI. These should be the perfect inflation investment. TIPS were designed to offer a return of inflation plus some small amount. In the past, these may have offered CPI plus say one percent. Then if CPI is 5.4%, you would earn 6.4% for the year.

Unfortunately, in today’s low yield environment, TIPS sell at a negative yield. For example, the yield on the Vanguard short-term TIPS ETF (VTIP) is presently negative 2.24%. That means you will earn inflation minus 2.24%. Today, TIPS are guaranteed to not keep up with inflation! I suppose if you think inflation is staying higher than 5%, TIPS could still be attractive relative to owning regular short-term Treasury Bonds. But TIPS today will not actually keep up with inflation.

Instead of TIPS, individual investors should look at I-Bonds. I-Bonds are a cousin of the old-school EE US Savings Bonds. The I-series savings bonds, however, are inflation linked. I-bonds bought today will pay CPI plus 0%. Then your investment is guaranteed to keep up with inflation, unlike TIPS. A couple of things to know about I-bonds:

  • You can only buy I-bonds directly from the US Treasury. We cannot hold I-Bonds in a brokerage account. There is no secondary market for I-bonds, you can only redeem at a bank or electronically.
  • I-Bond purchases are limited to a maximum of $10,000 a year in electronic form and $5,000 a year as paper bonds, per person. You can buy I-bonds as a gift for minors, and the annual limits are based on the recipient, not the purchaser.
  • I-bonds pay interest for 30 years. You can redeem an I-bond after 12 months. If you sell between 1 and 5 years, you lose the last three months of interest.

Commodities

Because inflation means that the cost of materials is rising, owning commodities as part of a portfolio may offer a hedge on inflation. Long-term, commodities have not performed as well as stocks, but they do have periods when they do well. While bonds are relatively stable and consistent, commodities can have a lot of volatility and risk. So, I don’t like commodities as a permanent holding in a portfolio.

The Bloomberg Commodities Index was up 22% this year through August 31. Having already had a strong performance, I don’t think that anyone buying commodities today is early to the party. That is a risk – even if we are correct about above average inflation, that does not mean we are guaranteed success by buying commodities.

Consider Gold. Gold is often thought of as a great inflation hedge and a store of value. Unfortunately, Gold has not performed well in 2021. Gold is down 4.7% year to date, even as inflation has spiked. It has underperformed broad commodities by 27%! It’s difficult to try to pick individual commodities with consistent accuracy. They are highly speculative. That’s why if you are going to invest in commodities, I would suggest a broad index fund rather than betting on a single commodity.

Real Estate

With home prices up 20% in many markets, Real Estate is certainly a popular inflation investment. And with mortgage rates at all-time lows, borrowers tend to do well when inflation ticks up. Home values grow and could even outstrip the interest rate on your mortgage, potentially. I’ve written at length about real estate and want to share a couple of my best pieces:

While I like real estate as an inflation hedge, I’d like to remind investors that the home price changes reported by the Case-Schiller Home Price Index do not reflect the return to investors. Read: Inflation and Real Estate.

Thinking about buying a rental property? Read: Should You Invest In Real Estate?

With cash at zero percent, should you pay off your mortgage? Read: Your Home Is Like A Bond

Looking at commercial Real Estate Investment Trusts, US REITs have had a strong year. The iShares US REIT ETF (IYR) is up 27% year to date, beating even the S&P 500 Index. I am concerned about the present valuations and low yields in the space. Additionally, retail, office, apartments, and senior living all face extreme challenges from the Pandemic. Many are seeing vacancies, bankrupt tenants, and people relocating away from urban development. Many businesses are rethinking their office needs as work-from-home seems here to stay. Even if we do see higher inflation moving forward, I’m not sure I want to chase REITs at these elevated levels.

Inflation Portfolio

Even with the possibility of higher inflation, I would caution investors against making radical changes to their portfolio. Stocks will continue to be the inflation investment that should offer the best chance at crushing inflation over the long-term. Include foreign stocks to add a hedge because US inflation suggests the Dollar will fall over time. Bonds are primarily to offset the risk of stocks and provide portfolio defense. We will make a few tweaks to try to reduce the impact of inflation on fixed income, but I would remind investors to avoid chasing high yield.

As satellite positions to core stock and bond holdings, we’ve looked at TIPS, Commodities, and Real Estate. Each has Pros and Cons as inflation investments. At this point, the simple fear of inflation has caused some of these investments to already have significant moves. We will continue to evaluate the inflation situation and analyze how we position our investment holdings. Our focus remains fixed on helping clients achieve their goals through prudent investment strategies and smart financial planning.

Charitable Giving in 2021

Charitable Giving in 2021

For anyone who is looking at their charitable giving in 2021, there are some important things to know. In 2020 as the Coronavirus started, the government recognized the terrible impact the pandemic would have on charities. As a result, the CARES Act included several new tax benefits to encourage charitable giving in 2020.

  • If you made a cash donation in 2020, you could deduct $300 from your tax return. This was “above the line”, which means you did not have to itemize your deductions to take this $300 deduction. (If your itemized deductions exceed your standard deduction, you could deduct more than the $300.)
  • Normally, your cash donations are limited to 60% of your Adjusted Gross Income. The CARES Act increased this to 100% for 2020. (Excess donations could be carried forward for 5 years.) This means that if your income was $400,000, you could donate $400,000 and reduce your AGI to zero.

CARES Act Provisions Extended

Both of those benefits were only for 2020. But as Milton Friedman said, “there is nothing as permanent as a temporary government program.” So, the government has extended these two benefits under the Coronavirus Response and Relief Supplemental Appropriations Act of 2021.

For 2021, you can still deduct $300 for cash donations as an above the line deduction. Unlike 2020, this is per spouse, so a married couple filing jointly can deduct $600 in 2021. And the 100% of AGI limit is also extended through December 31, 2021. Note that these apply only to “cash” donations and not to donations of stocks or goods. The limit for donating stocks remains 30% of AGI.

I do have to question whether you really would want to deduct 100% of AGI and take your taxable income to zero for one year. Let’s say you have $400,000 in annual taxable income, want to donate $400,000, and are married. Consider these two simplified scenarios. I’m using the 2021 tax rates for both years (we don’t know yet the exact income levels for 2022.)

  • You donate $400,000 in year one. Your taxes are zero. The next year, your income is back to $400,000. In year 2, you would owe $84,042 in Federal Income Taxes.
  • You donate $200,000 in years one and two. In both years, your remaining taxable income is $200,000. You would owe $36,042 in each year, for a total of $72,084 over two years. So, you actually would save $12,000 in taxes by spreading out your donations over two years, rather than doing 100% in one year. That’s because with a graduated tax system, taking your taxes to zero isn’t necessary. You pay only 12% on taxes up to $81,050.

Charitable Strategies for 2021

  • If you do want to make a large donation, consider pairing it with a Roth Conversion. The donation could take your AGI to zero, and then you can choose how much of your IRA/401(k) you want to convert and pay those taxes today. Then, your Roth is growing tax-free.
  • For many individuals or couples, the $300/$600 donation fully covers their charitable giving in 2021. Make sure you keep your receipts and donation letters! Most donors do not have enough deductions to itemize.
  • You can still donate your appreciated securities and save on capital gains tax. Do this if your donations will remain under the 30% of AGI threshold. Even if you are only taking the standard deduction, at least you will avoid capital gains. If you itemize and exceed the 30% threshold, you can carry forward your donations for five years.
  • Pack your donations into one year and establish a Donor Advised Fund (DAF). You get the upfront tax deduction and can then distribute money to charities in the years ahead. This is a good strategy if you are having a year with very high income, such as from selling a business or large asset.
  • If, on the other hand, you anticipate that your tax rate will be going up, spread out your donations or hold off to future years. This could be due to your income going up, tax increases from Washington on the wealthy, or the sunset of current tax rates after 2025.
  • If you are over age 70 1/2, you can give from your IRA tax-free. If you are 72, this counts towards your RMD. While the CARES Act eliminated RMDs for 2020, they are back for 2021. You can make a Qualified Charitable Donation (QCD) of up to $100,000 a year from your IRA.

Tax Smart Giving

No one gives to charity just for the tax benefits. We have causes and organizations we want to support. Giving back is a way of showing gratitude for our success, helping others, and being a positive contributor to making the world a better place. When we have an Abundance mindset, giving with purpose is a joy. Still, if we can be smart about our charitable giving in 2021, there can be significant tax savings. That could mean not only lower taxes for you, but ultimately, more money can go to charities in the years ahead.

Since our founding in 2014, Good Life Wealth Management has donated 10% of profits to charity each year. Additionally, we offer a Matching Gift Program to our clients each fall, in which we match $200 of donations to their favorite charity.

Inflation and Real Estate

Inflation and Real Estate

In recent weeks, people have become more concerned about the possibility of inflation and its impact on Real Estate. This is a complex subject, but certainly important for your financial security. With interest rates near historic lows, now is a great time to get a 15 or 30 year mortgage. And with the possibility of inflation increasing, buying a home now could lock in both today’s real estate prices and interest rates.

Globally, governments are spending at an unprecedented rate, taking on vast amounts of debt. According to the US Debt Clock, we presently owe over $224,000 per US taxpayer. Will we ever repay this debt? There’s no appetite for austerity – reducing spending – or raising taxes to payoff the debt. No, we will need to inflate our way out of debt. With 3% inflation, $1,000 in debt will “feel like” only $912 in three years. Ask someone who borrowed $250,000 twenty years ago for a house. It probably felt like a huge amount at the time, but became easier to pay over the years.

For people who don’t have a house, there is a real fear of missing out. Many are concerned that if they don’t buy right now, real estate prices may soon rise to the point where they can no longer afford a house. In densely populated parts of the country, many people are already priced out of the market. People from California, New York, Seattle, etc. are moving to Dallas, Austin, Nashville, or other places in search of better real estate prices and lower taxes.

I bought a house in January and moved to Little Rock, which is even more affordable than Dallas. We are really enjoying our new neighborhood and city. When you work from home, it’s important to have a place you love. So, I understand the feelings people are having about inflation and real estate today. Here’s my advice to first time homebuyers and to people consider their house as an investment.

Buy Versus Rent

I do think now is a great time to buy a house – at least in theory! Owning can make financial sense versus renting, but primarily with two considerations:

  1. The longer you stay in the house, the better. It takes a long time to really benefit from the impact of inflation on real estate. If you stay in the house less than five years, you may only break even, after you pay realtor fees and closing costs.
  2. Your house is still an expense. There are taxes, insurance, mortgage interest, maintenance, furnishings, etc. When I see people stretch for the most expensive house they can afford, it often means they are unable to save as much in their other accounts. Twenty years later, they have only a small 401(k). Meanwhile, their colleagues who maxed out their 401(k)s could have a million dollar nest egg.

So, if you are ready to put down roots, yes, buy a house now. However, I have a feeling that we may see these low interest rates for a while longer. If the time isn’t right for you personally, then wait. If your career may take you to another location, then wait. Growing family? Get a house you can keep and not out grow. I do think you will have plenty of chances to get in real estate in the future. Renting is not only fine, it may even allow you to grow your net worth when you invest your savings versus owning. Renting provides flexibility and fixed costs, versus the surprise expenses that come with having a home. If anything, we need to remove the stigma from renting that it is somehow a barrier to financial success.

Your House is Not an Investment

If Real Estate is such a good inflation hedge, then it would make sense for everyone to buy a million dollar mansion and get rich off their home, right? Should you buy the most expensive house you can afford? Let’s consider this carefully.

Increasing house prices is not the same as an investment return. To measure inflation of real estate, many people refer to the Case-Shiller Home Price Index. It is great data, but flawed if you are trying to use it for an investment rationale. It simply measures the selling price of a house compared to that house’s previous sale. That’s what your return would be as a homeowner, right? No, the homeowner makes much, much less.

While the Index shows what it costs to buy a house, it does not reflect the return to owners. The index does not include: transaction costs (6% realtor commissions are egregious today, really), ongoing expenses (property taxes, insurance, etc.), or improvements. Taxes and Insurance can run 2.5% to 3% a year. Someone who puts in $100,000 in renovations to a house and adds two rooms? Case-Shiller doesn’t consider any of these costs that may occur between sales of a house.

As of 12/31/2020, the Case-Shiller 20-City Composite shows a 10-year price increase of 5.39%. That’s impressive, but that’s not the net return to home owners. So, let’s not think this data is saying that a house is the same as a mutual fund that returned 5.39% over the past 10 years. (By the way, over that same 10 year period, an investment in the Vanguard 500 ETF (VOO) had a return of 13.84%.) Past performance is no guarantee of future results, but I just want people to understand that comparing the Case-Shiller index to an investment return is flawed and not the purpose of that data.

Remodels and Affordability

Planning to remodel? That’s fine to enjoy your home, improve its usability, and to save you from having to move. However, is it a good investment? According to Remodeling Magazine’s 2020 National Data, no type of remodeling recouped 100% of its cost. The top 10 types of remodels recouped 66.8% to 95.6% as a National Average. It’s fine to improve and update your home, but let’s not try to rationalize that decision by thinking that we are making a great investment. The data suggests this is unlikely.

Home affordability: House prices are based on supply and demand. Demand depends on affordability. With years of slow home building, the supply of houses is tight – at least in states with population growth. In areas of population decline, there may be an oversupply. When there are more buyers than sellers, prices rise. In the long run, however, house prices reflect what people can afford.

We’ve had thirty years of falling interest rates. I think my parents’ first mortgage was at 16%. Today, that would be under 3%. That’s one reason why home prices have grown so much. Affordability isn’t based on the home selling price, it’s based on the monthly payment. And since mortgage eligibility is based on your debt to income ratio, home prices cannot increase faster than income in the long run, without falling interest rates. So, I don’t think we are going to see house prices going up by 10% every year if wages only increase by 2%. Who will be the buyers?

Taxes and Investing

It used to be that home ownership came with a nice tax break. That’s no longer the case. I know it seems unfair, but economists finally got through to Washington that the tax benefits were disproportionally helping the ultra wealthy and not the average home owner. For 2021, the standard deduction for a married couple is $25,100. Very few people will itemize. Your itemized deductions include mortgage interest, state and local taxes (with a cap of $10,000), and charitable donations. You probably will not have more than $25,100 in these deductions. That means that you are getting zero tax benefit for your home’s taxes and interest, compared to being a renter. In 2017, I wrote about this change: Home Tax Deductions: Overrated and Getting Worse.

Don’t think of your home as an investment, but as a cost. It’s probably your largest cost. Treat it as a expense to be managed. Your ability to save in a 401(k), IRA, HSA, 529 Plan, Brokerage Account, etc., depends on your preserving the cash flow to fund those accounts. Buy the most expensive house you can and you will be house rich and cash poor. I don’t think that there will be enough inflation in real estate to make that a winning bet.

Your home equity is part of your net worth, but at best consider it like a bond. In spite of today’s inflation concerns and fear of missing out, your home is not likely to make you rich. I remain a fan of the 15-year mortgage and find that my wealthiest clients usually want to be debt-free rather than use leverage to get the biggest house possible. Read: The 15-Year Mortgage, Myth and Reality. Even as home prices increase, please recognize that inflation in real estate is higher than your return on investment once you include all the costs of ownership.

Thinking Long Term

If you are ready to buy a home, now may be a good time. Low interest rates and rising home prices are going to help you. Buying can build your net worth versus renting, if you are ready to stay in one place. Think of your house as an expense and not an investment, and you will enjoy it more and have realistic expectations. Real estate and inflation are linked, but hopefully you now realize that home prices do not equate to return on investment. Build your wealth elsewhere – through investing, creating a business, and growing your career and earnings.

Don’t be afraid of missing out, supply will catch up to demand eventually. And the rise of remote working in the past year means that more people can work from anywhere. People can move to the location they want and can afford. This will help equalize prices nationally, as more workers move from high-cost areas to places with better value.

Low interest rates should cause inflation to pick up. This is government planned financial repression, and it will penalize savers, like grandparents who want to just park their money in CDs. Those will be Certificates of Depreciation – guaranteed to not maintain their purchasing power and keep up with inflation. Low interest rates will benefit debtors, especially when that debt is used to buy appreciating assets and not depreciating things, like cars. Use leverage wisely and it can help grow your net worth. Financial planning is more than just investments, and my goal is to help you succeed in defining and creating your own version of The Good Life.

Invest $5,466 a month

Where to Invest $5,466 a Month

Why should you invest $5,466 a month? Why that very odd number? Well, at an 8% hypothetical return, investing $5,466 a month will get you to $1 million in 10 years. That’s what we are going to explore today and it is very possible for many professional couples to save this much.

Last week, we looked at where to invest $1,000 a month. That’s a reasonable goal for many people, a 10% savings rate for a couple making $120,000 or 15% for an individual making $80,000. And while saving $1,000 a month may be okay, it will take decades to amass enough for retirement. If you want to accelerate the process or aim for a higher goal, you have to save more.

Saving $5,466 a month is $65,592 a year. For a couple making $200,000, that represents saving 33% of your income. That’s challenging, but not impossible. After all, there are many families who get by with making less than $134,000.

There are many different ways you could invest $5,466 a month, but I’m going to focus on adding tax benefits both in the present and future. Let’s get right to it!

Retirement Accounts

  1. Maximize 401(k), $1,625 a month each. That will get you to the 401(k) annual contribution limit of $19,500. It is surprising to me how many people don’t do this. For a couple, that is $3,250, more than half our goal to invest $5,466 a month.
  2. Company match, $416 a month each. Many companies match 5% of your salary to your 401(k). For an employee making $100,000 a year, that equals $416 a month. I am assuming this couple each makes $100,000. For two, that’s $832 a month. Added to your 401(k) contributions and we are now at $4,082 a month.
  3. Backdoor Roth, $500 a month each. At $200,000 for a couple, you make too much to contribute to a Roth IRA. However, you may still be able to make Backdoor Contributions to a Roth IRA, for $6,000 a year or $500 a month each. Added to 1 and 2 above and your monthly total is $5,082. We only need to find another $384 to invest a month to reach the goal of $5,466.

Additional Places to Invest

  1. Health Savings Account (HSA), $600 a month. If you’re a participant in an eligible family plan, you can contribute $7,200 a year to an HSA. That could be up to $600 a month, and that is a pre-tax contribution!
  2. 529 Plan, $1,250 a month. If you are saving for a child’s future college expenses, you could contribute to a 529 College Savings Plan. A 529 Plan grows tax-free for qualified higher education expenses. Most parents choose to stay under the gift-tax exclusion of $15,000 a year per child, which is $1,250/month.
  3. Taxable Account, $ unlimited. You can also contribute to a taxable account. And while you will have to pay taxes on capital gains, dividends, and interest, we can make these accounts relatively tax efficient.

Other Notes

  1. Tax Savings. While trying to invest $5,466 a month is a lot, you will be helped by the tax savings. A couple making $200,000 a year (gross) will have just entered the 24% Federal tax bracket after the Standard Deduction of $25,100 (2021). Some of your tax deductible contributions will be at 24%, but most will be at 22%. Using just 22%, your joint $39,000 in 401(k) contributions will save you $8,580 in taxes. That is $715 a month back in your pocket. Add in $7,200 to an HSA and save another $1,584 in taxes ($132 a month).
  2. Catch-up Contributions. If you are over age 50, you can contribute more to your 401(k) and Roth IRA accounts. There are also catch-up contributions for an HSA if age 55 or older.

I wish more people had the goal of becoming a Millionaire in 10 Years. We cannot control the market, but we can do our part and do the savings. At an 8% hypothetical return, starting to invest $5,466 a month can put you on track to $1 million in a decade. And if you already have $1 million, saving $5,466 for another 10 years would get you to $3.2 million.

For couples making over $200,000, can you afford to invest $5,466 a month? Can you afford not to? Planning is the process of establishing goals and then creating the roadmap to get you there. If you’re ready to create your own roadmap, give me a call.

Invest $1000 a month

Where to Invest $1,000 a Month

Many investors wonder where they should invest $1,000 a month. Maybe they’re starting out from scratch. Or maybe they have been doing a 401(k) for years and have additional cash they want to invest.

You’ve paid off your credit cards and have an emergency fund with three to six months of expenses. You’ve got a good paycheck, but it all seems to disappear. Unfortunately, many Americans remain on this paycheck to paycheck treadmill, even if they have a decent income. What breaks this cycle is establishing monthly automatic contributions. Make investing automatic and you will adjust your other spending. And then when you do get a raise, aim to increase your saving, not your spending.

Let’s consider a few ways to invest $1,000 a month. I’ll go into some detail in this first scenario and then give a few variations.

Married with Children

With many couples, one has a good retirement plan at work, but the other spouse does not. For example, maybe they’re self-employed, work part-time, or are a stay at home parent. They’ve got two kids and want to make sure their kids can go to college some day, too.

  1. $500 a month into a Roth IRA. The annual contribution limit is $6,000, which is $500 a month. At an 8% hypothetical return, you would have $745,179 in this Roth IRA after 30 years. And that would be available tax-free! If you had this same amount in a 401(k) and had to pay 22% income tax, you’d be facing a $163,939 tax bill. That’s the amazing tax savings of a Roth IRA.
  2. $450 into 529 College Savings Plans. Put in $225 a month for each kid for college. Like a Roth IRA, a 529 Plan offers tax-free growth, provided the money is used on qualified higher education expenses. At an 8% hypothetical return, you would accumulate $41,162 for your 8-year old to go to college in 10 years. And you’d have $77,858 in 15 years for your 3-year old. (What if one kid doesn’t go to college? Switch the beneficiary to the other child. 529 Details here.)
  3. $50 a month into a 20-year term life insurance policy. For most young families, some life insurance is important and I believe term life is a great solution. For a 38-year old male, we can get a $1 million Term policy for as low as $42 a month if they are in excellent health. Contact me for details.

With their $1,000 a month, this family is on their way to potentially having:

  • $745,000 in tax-free money for retirement in 30 years
  • $119,000 towards their kids’ college
  • A $1 million life insurance policy if something should happen to Dad

Double Income No Kids

  1. $500 a month to two Roth IRAs. Don’t need a 529 Plan or life insurance? You can both do Roth IRAs at $500 a month each. Roth eligibility rules are based on joint income, so if one spouse can contribute, both can. After 30 years at our hypothetical 8%, you’d have almost $1.5 million in two Roth IRAs. That’s the incredible power of compound interest! (Make too much for a Roth IRA? Consider the Backdoor Roth Contribution.)

Self-Employed

  1. $500 a month into a Traditional IRA. Get a tax-deduction for this contribution. However, if you or your spouse are eligible for a retirement plan at work, income limits apply.
  2. $500 into a SEP-IRA. This is also tax-deductible for self-employed individuals. You can do both a SEP and a Traditional or Roth IRA. Since the SEP has much higher contribution limits than a Traditional IRA, why not just put the $1,000 a month into the SEP? The SEP may reduce your QBI Deduction for the Self-Employed.

Invest $1,000 a Month

There are lots of smart ways to invest $1,000 a month. We can help you sort through your options and get started. The Roth IRA offers tax-free growth, whereas the Traditional IRA or SEP-IRA offers an upfront tax deduction. For many parents, you may want to invest some of your $1,000 a month in a 529 College Savings Plan. Term Life Insurance could be a piece of the pie, too.

Another option would be to contribute to a Health Savings Account, or HSA. For 2021, you can contribute up to $300 a month ($3,600 a year) into your HSA, if eligible. This is a tax-deductible contribution and can be withdrawn tax-free for qualified medical expenses in the future. If you have family coverage, the HSA contribution limit doubles to $7,200 a year ($600 a month).

Most people don’t feel like they have an “extra” $1,000 every month. That’s okay. You can start with less, even just $50 a month. Most importantly, just get started. Then, you can gradually increase your monthly contributions over time. Once you get to $1,000 a month, you can go up from there! The more you save and invest, the faster you can reach your financial goals.

COVID Relief Bill

COVID Relief Bill Passes

A new bi-partisan COVID Relief bill passed Congress this week and will impact almost every American in a positive way. This stimulus legislation creates additional income and tax benefits to offset the economic damage of Coronavirus. The $900 Billion bill includes another stimulus payment to most Americans, an extension of unemployment benefits, and seven tax breaks. As of this morning, President Trump has not yet signed the bill.

$600 Stimulus Payment

The CARES Act provided many families with stimulus checks this summer. Those checks were for up to $1,200 per person and $500 per child. There will be a second stimulus check now, for $600 per person. Parents will receive an additional $600 for each dependent child they have under 17. Adult dependents are not eligible for a check.

Like the first round of checks, eligibility is based on your income. Single tax payers making under $75,000 are eligible for the full amount. Married tax payers need to make under $150,000. There is a phaseout for income above these thresholds.

Payments will be distributed via direct deposit, if your bank information is on file with the IRS. If not, like before, you will be mailed a pre-paid debit card. This payment will not be counted as taxable income. Payments should start in a week and are expected to be delivered much faster than the two months it took this summer.

These $600 payments are again based on your 2019 income, but will be considered an advanced tax credit on your 2020 income. What if your 2019 income was above $75,000, but your 2020 income was below? If you qualify on your 2020 income, the IRS will provide the $600 credit on your tax return in April. If they send you the $600 based on your 2019 income and your 2020 income is higher, you do not have to repay the tax credit. This is a slightly different process than the first round of checks, and will benefit people whose income fell in 2020.

Unemployment Benefits

The CARES Act provided $600 a week in Federal Unemployment Benefits, on top of State Unemployment Benefits. This amount was set to run out on December 26. The new COVID Relief Bill provides an 11-week extension with a $300/week Federal payment. Now, unemployed workers will have access to up to 50 weeks of benefits, through March 14. Unfortunately, because of how late the legislation was passed, states may be unable to process the new money in time. So, there may be a gap of a few weeks before benefits resume.

Seven Other Tax Benefits

  1. Child Tax Credit and Earned Income Tax Credit. Under the new legislation, tax payers can choose between using their 2019 or 2020 income to select whichever provides the larger tax credit.
  2. Payroll Tax Deferral. For companies who offered a deferral in payroll taxes in Q4, the repayment of those amounts was extended from April to December 31, 2021.
  3. Charitable Donations. The CARES Act allows for a $300 above-the-line deduction for a 2020 cash charitable contribution. (Typically, you have to itemize to claim charitable deductions.) The new act extends this to 2021 and doubles the amount to $600 for married couples.
  4. Flexible Spending Accounts (FSAs). Usually, any unused amount in an FSA would expire at the end of the year. The stimulus package will allow you to rollover your unused 2020 FSA into 2021 and your 2021 FSA into 2022.
  5. Medical Expense Deduction. In the past, medical expenses had to exceed 10% of adjusted gross income to be deductible. Going forward, the threshold will be 7.5% of AGI. This will help people with very large medical bills.
  6. Student Loans. Under the CARES Act, an employer could repay up to $5,250 of your student loans and this would not be counted as taxable income for 2020. This benefit will be extended through 2025.
  7. Lifetime Learning Credit (LLC). The LLC was increased and the deduction for qualified tuition and related expenses was cancelled. This will simplify taxes for most people, rather than having to choose one.

Read more: Tax Strategies Under Biden

Summary

The new COVID Relief Bill will benefit almost everyone and will certainly help the economy continue its recovery. For many Americans, the stimulus payments and continued unemployment benefits will be a vital lifeline. Certainly 2020 has taught all of us the importance of the financial planning. Having an emergency fund, living below your means, and sticking with your investment strategy have all been incredibly helpful in 2020.

Read more: 10 Questions to Ask a Financial Advisor

If you are thinking there’s room for improvement in your finances for 2021, it might be time for us to meet. Regardless of what the government or the economy does in 2021, your choices will be the most important factor in determining your long-term success. We will inevitably have ups and downs. The question is: When we fall, are we an egg, an apple, or a rubber ball? Do we break, bruise, or bounce back? Planning creates resilience.

Questions to Ask a Financial Advisor

Questions To Ask A Financial Advisor

I recently saw an article on 10 Questions to Ask a Financial Advisor, as a way to interview prospective advisors. The article is on point, and I hope that future clients will ask me these questions. Doing so will enable them to understand my process and recognize the value I can provide. Let me save you the time by providing my answers here.

1. Are you a Fiduciary?

Yes, I am a Fiduciary. I am legally required to place client interests ahead of my own. I am an independent Registered Investment Advisor and not tied to any single company or product. My only goal is to do the best I can to help every client.

2. How do you get paid?

On portfolios above $250,000, I charge an asset fee of 1% a year. This is charged at the beginning of each quarter, at 0.25%. On portfolios below $250,000, I charge a flat $200 a month. My clients know exactly how much they pay me and have the right to leave at any time if they are unsatisfied. By charging an annual fee on the value of your portfolio, our incentives are aligned. If your account goes up, I get paid a bit more. And if your account goes down, I make less. I think this is mutually beneficial and creates accountability. My goal is to have a long-term relationship with each client.

Read more: The Price of Financial Advice

3. What are my all-in costs?

Aside from the fee described above, I do not charge any other fees, planning charges, or receive investment commissions. The core of our portfolios are low-cost funds from companies like Vanguard, iShares, and SPDRs. We build portfolio models in-house, so you will never be charged an outside management fee or “wrap” fee. Some other firms will charge you $2,000 for an initial plan, followed by a 1 to 1.5% management fee, and then outsource your portfolio to someone else who will ding you another 1% to manage your investments! Our focus is on keeping your investment costs low.

4. What are your qualifications?

I hold the Certified Financial Planner (CFP) and Chartered Financial Analyst (CFA) designations. I received a Certificate in Financial Planning from Boston University. Since 2004, I have been a full-time financial advisor. Before that, I taught at several colleges and approach my practice as an educator. My academic background includes a Bachelors degree from Oberlin College, and a Masters degree and Doctorate in music from the University of Rochester.

You should also look up an advisor on the SEC’s Investment Advisor Public Disclosure website to check if they have any disciplinary record, bankruptcies, or legal settlements. I do not.

5. How will our relationship work?

Planning comes first. A financial plan can help you see your goals clearly and develop concrete steps to achieve them. Investment policy is the product of financial planning so it has to be second. I work with a small group of families so I can do my best work and provide a high level of service. Financial planning is a long-term process, not a once and done event.

We begin with an in-depth Discovery Meeting to learn both the quantitative details about your financial situation as well as the qualitative goals, needs, and preferences you have for your money and your life. We will gather statements, tax returns, and other documents to analyze. All clients will complete a Finametrica Risk Profile and we will go over the results together. Based on your objectives, we use a modular planning process to address the areas which are most important and relevant to your situation.

In the first year, we have a lot of work to do in establishing your plan. Starting in year two, we will meet twice a year for monitoring and ongoing planning. I encourage clients to reach out to me whenever they have questions about financial topics or if their situation changes.

6. What’s your investment philosophy?

Investors are best served by a passive, long-term investment strategy. Our role is to manage a diversified, target asset allocation for buy and hold investors. We create and manage a series of Portfolio Models to meet the differing needs and risk preferences of our clients.

Within each Portfolio Model, we employ a Core + Satellite investment strategy. Core holdings are low-cost Exchange Traded Funds, in primary categories such as US Large Cap Stocks, US Small Cap Stocks, International Developed Equities, Investment Grade Bonds, and Cash. Satellite holdings are more tactical and may vary from year to year depending on their relative value and attractiveness. Satellite positions may include ETFs, mutual funds, or alternative investments, such as Emerging Markets, Real Estate, Commodities, Preferred Stocks, Convertible Bonds, Floating Rate Income, or other categories or strategies.

We do not believe that we can add value through market timing, picking individual stocks, sector rotation, or speculative strategies. We see little evidence that such strategies are beneficial for investors, especially when we consider the additional risks associated with them.

7. What asset allocation will you use?

Our models include the target allocations below, to be determined by your situation. Each model typically has 10-15 Exchange Traded Funds or Mutual Funds and is diversified across thousands of securities.  

  • Ultra-Equity: 100% Equity / 0% Fixed Income
  • Aggressive: 85% Equity / 15% Fixed Income
  • Growth: 70% Equity / 30% Fixed Income
  • Moderate: 60% Equity / 40% Fixed Income
  • Balanced: 50% Equity / 50% Fixed Income
  • Conservative: 35% Equity / 65% Fixed Income

8. What investment benchmarks do you use?

We use two benchmarks: for stocks, the MSCI World Index Total Return, and for fixed income, the Barclays US Aggregate Bond Index.

Read more: How a Benchmark Can Reduce Home Bias

9. Who is your custodian?

TD Ameritrade Institutional will hold your accounts. They have been acquired by Charles Schwab, and the two firms are in the process of combining over the next 18-36 months. I am very comfortable with both firms and their long-standing commitment to working with Independent advisors and their clients.

10. What tax hit do I face if I invest with you?

We will look at your individual situation and carefully consider taxes in our transfers, trades, and investment strategy. Working with high-net worth families, we aim for tax‐efficiency through the implementation of asset location, low‐turnover funds, tax loss harvesting, and tax‐favorable investment vehicles. We rebalance portfolios typically once a year, to avoid creating short-term capital gains.

Read More: 9 Ways to Manage Capital Gains

Have other questions for me? Drop me a note! I’m happy to chat.

How to Save More Money

How to Save More Money

Growing your net worth is the product of saving and investing. Sometimes, we assume this means we have to slash our spending to be able to save more. Sure, you want to have awareness and planning regarding your spending. But it’s not much fun to give up coffee or never take a vacation. There has to be a balance between sensible spending and your saving goals.

Luckily, there is another way to increase your savings rate: earn more. Especially for younger investors, as your income grows you will find that you can easily save more. This may take a number of years. But, as your career takes off, your income may increase at a double digit rate during your twenties and thirties.

So, don’t despair if you cannot save as much as you would like today! Focus on growing your career and increasing your income. Saving will get easier.

Hold Your Spending Steady

As you get promotions and raises, avoid the temptation to keep up with the Joneses. You will see friends and classmates who are buying fancy cars and huge houses. Good for them! But what you might not see is how much debt they have, how little they save, or their net worth. You won’t know how stressed they are about their finances. They may be two paychecks away from being broke.

Hopefully, your current lifestyle is enjoyable and you find happiness in your relationships and the things you do. Getting more expensive things is not likely to create lasting satisfaction. The temporary, but fleeting, pleasure from consumption is known as The Hedonic Treadmill. If your priority is becoming financially independent, using a raise or bonus to save more is a better choice than spending it.

Put Your Savings On Autopilot

As your income grows, save your raises. Establish recurring deposits to your retirement plans and other accounts, and increase them annually. If take this step when you receive a raise, you will not miss the extra money. Skip increasing your monthly savings, and you probably aren’t going to have extra money leftover at the end of the year. If it’s in your checking account, you will spend it!

For couples, a joint income is a tremendous opportunity. If you can live off of one salary and save the second salary, you will grow your wealth at an amazing rate. In some cases, this could literally be saving one of your paychecks. Or, it may make more sense to participate in both of your 401(k) plans, and save the equivalent of one salary.

Multiple Sources of Income

Given the economic fallout from Coronavirus, many people aren’t getting a raise this year. A lot of us are seeing that our 2020 income will be lower than 2019. Hopefully, this will be temporary, but there are lessons to be learned. It is a risk to have all your eggs in one basket with one job. If you lose that job, you’re really in trouble.

As an entrepreneur, I have always had multiple sources of income. My financial planning business is diversified across a number of clients. I also sell insurance. I make music in a couple of orchestras and teach a few lessons on the side. Some of it is small, but having multiple sources of income gives me flexibility and safety.

Have you considered finding a side hustle, second income, part-time business, or online gig? Find something you enjoy and make it into a business. Find something people need and provide that service. You never know where that part-time work might take you. Maybe someday it will allow you to retire early or be your own boss! In the mean time, use your additional income to save more and build up your investment portfolio. Don’t give up your time just for the sake of buying more things.

How and Where to Save More

How much should you save? If you are saving 15% of your income, you’re doing way better than most people in America. Start at a young age, and a 15% savings rate will likely put you in a very comfortable position by retirement age. For those who are more ambitious, or just impatient like me, aim to save more than 15%. You could be putting $19,500 into your 401(k) each year ($26,000 if over age 50).

And you might be eligible for an IRA, too, depending on your income. Or, consider a taxable account, Health Savings Account (HSA), or 529 College Savings Plan. There are lots of places you could be saving! Put your savings on autopilot with recurring deposits to your retirement plans and other accounts. If take this step when you receive a raise, you will not miss the extra money, but you will be growing your wealth faster.

Do you need a reason to save more? The sooner you save, the faster you can achieve financial freedom. Even if you enjoy your work, it’s great to have the means to not have to worry about your job.

You can save more by spending less. That’s true, but you can only eliminate an expense once. Most people will have some tolerance for cutting costs, but austerity is no fun. Focus on increasing your income, hold your expenses steady, and increase your monthly savings. Put your energy into building your career, and aim for a high income. Couples have a great ability to save, if they can aim to live off one income. Look for creating a second or third income stream. A lot of the wealthy people I know have an entrepreneurial mindset. They have multiple income streams.

As your earnings grow, you will be able to save more and invest more. Most of my newsletters deal with investing, tax, or planning questions. But those benefits only accrue after you’ve done the first step of saving that money. It’s not how much you make that matters, but how much you keep!

Financial Strategies for Low Rates

Financial Strategies for Low Rates

Opportunities for a Low Yield World, Part 3

Today’s low rates are challenging for investors and may require changes not just to your investment portfolio, but also your overall financial strategies. In Part 1 of this series, we looked at the potential of rising defaults in high yield bonds and why it’s problematic to buy high yield bonds. Then in Part 2, we looked at four concrete ways to increase your yield today without radically changing your risk profile.

For Part 3, we looking at the broader ramifications of low interest rates on financial planning. My goal is always to explain and educate, but most importantly, to offer tangible solutions. Even in a crisis, there are opportunities.

But before we get into specific financial planning strategies, let’s consider two important points. First, low interest rates penalize savers. But low rates help borrowers. So, this is a great time to be a borrower, especially if you can lock in a low rate for 15, 20, or 30 years. Hopefully the current crisis will be short-lived, but borrowing at these low rates could be beneficial for decades to come.

Second, we should consider inflation. Bonds may be earning only 1%, but if inflation is zero, you would still have a real return of 1%. Your purchasing power is growing by 1%. Now, if bonds were yielding 6% and inflation was 5%, your real return would be the same, just 1%. While real returns are indeed quite low today, inflation is also below the historic average. So, your real returns aren’t as bad as they might appear.

Now, here are nine specific financial strategies to use today’s low rates to improve your situation.

Borrow for Appreciation

1) Refinance Mortgage. This is a great time to refinance your mortgage and lock in a low rate. Try to avoid lengthening the term of your loan and instead use low rates to pay off your mortgage sooner. If you can save 1% or more and plan to be in your home for several years, it will probably make sense to refi. I would be careful, however, of using low rates to buy the most expensive home possible. A home is largely an expense, rather than a great investment. Even better: use low rates to buy new investment properties. If you can borrow money to buy a business, investment property, or other appreciating asset, money is the cheapest it has ever been. Think long-term today!

2) Pay down debt. As long as you have a good emergency fund and a stable job, how much additional cash do you need? If you have student loans, a mortgage, car loans, or especially credit card debt, maybe it makes more sense to pay down your high-interest debt. Especially, debt that is not tied to an appreciating asset. Paying down 5% loans with cash earning 0% will save you interest costs.

Portfolio Adjustments

3) Reallocate away from bonds. With the 10-Year Treasury yielding under 1%, a lot of investment grade bonds and funds are going to have piddling returns over the next decade. Unless you really need to be defensive (maybe you are 5 years from retirement), having 40-50% earning 1% will likely be a drag on your portfolio. I have no idea what the stock market will do over the next 12-24 months. But, I do believe that a 90% equity allocation will probably outperform a 50% equity allocation over the next 30 years. Not everyone should take on more risk, but young people should invest for growth. The historical returns of a 60/40 portfolio are pretty much out the window with today’s low rates.

4) Alternative assets start to look more attractive when bonds are yielding 1%. Perhaps a 50% equity/30% alternative/20% bond portfolio could provide more return with less risk than a 60% equity/40% bond portfolio.

Retirement under Low Rates

5) Delay Social Security for 8% gains. When you delay your Social Security starting date, you can increase your monthly benefit by 8% a year (from age 66 to 70). Where else can you get a guaranteed 8% return today? No where. It may be better to spend down your bonds earning 1% from 62 or 66 until age 70 for the increase in SS benefits. The lower the rate of return from your portfolio, the more valuable the 8% Social Security increase becomes.

6) Take a pension, not a lump sum. If you have a pension from your employer, should you take the monthly payments or a lump sum? The answer will depend, in part, on your rate of return if you invest the lump sum option. Pension benefits have stayed up, but interest rates have moved down, which means that the pension is on the hook for very expensive benefits now. Companies are sweating this. But for a participant, it is tougher today to assume that you can do better by taking the lump sum. If your goal is lifetime income for you and your spouse, let’s run the numbers before making this decision. (We will also want to consider the credit quality of your Pension, its funded status, and your health and longevity profile.)

7) Immediate annuity. You can try to fund your retirement with bond income, but that’s more difficult with low interest rates. Immediate annuity payouts have not declined as much. So today, they are relatively attractive compared to bonds and eliminate the risk of outliving your money. With bonds, you have only two options under low rates: decrease the payout to yourself or start eating into your principal.

Estate Planning for Wealth Transfer

8) Trust Planning and intra-family loans. The Applicable Federal Rate and the 7520 rate are the lowest they have ever been. These low rates create opportunities for advanced financial strategies in estates and trusts. Intra-family loans: if you want to loan money to children or grandchildren for a mortgage, to buy your business, or to buy life insurance on your life, the interest rate required by the IRS is presently only 1.15%, for loans over 9 years.

9) Grantor Retained Annuity Trust. This is an irrevocable trust, which will shift assets outside of your lifetime gift and estate exemption. As the grantor, you receive income from the GRAT, and the remainder goes to your heirs (outside of your estate). The GRAT assumes the current 7520 rate of 0.80%, which is a low hurdle to beat. If your GRAT can do better than 0.80%, the heirs benefit.

Why do this Estate Planning now? The 2020 Estate Tax exemption of $11.58 million is set to sunset and revert to $5.49 million in 2026. If you are above these amounts, now is a great time to plan ahead. Placing assets into a GRAT now would remove their future growth from your estate. So, if you have assets which you think are undervalued today or which you expect will have significant growth going forward, removing them from your estate today could save tremendous future estate taxes for your heirs.

Low interest rates are problematic for savers and for bond holders, but also an opportunity for different financial strategies. Would some of these nine strategies enable you to benefit from low interest rates? I’m here to help you uncover ideas you haven’t considered, examine if they might be useful for you, and implement them effectively. Let’s take a look at your liabilities, your portfolio, your retirement income, and your estate goals and create a comprehensive plan for you.

The High Yield Trap

The High Yield Trap

Opportunities for a Low Yield World PART 1

Everyone wants their investments to make more money, but we have to be careful to avoid the High Yield Trap. Since the Coronavirus Crash, central banks have been lowering interest rates to near zero. Last year, I was buying CDs at 2-3%. This week, I’m looking at the same CDs with yields of 0.1% to 0.2%. To which, my client innocently asks: What can we buy that will make more than a couple of percent with low risk?

Nothing, today. The five-year Treasury Bond currently yields 0.22%. That’s unacceptable for most investors, and it will push them out of safe fixed income, like Treasuries, CDs, and high quality municipal and corporate bonds. The yields are just too darn low.

Where will they go in pursuit of higher yields? Oh, there are plenty of bonds and bond funds with higher yields today. Credit quality has been plunging, as rating agencies are trying to keep up with downgrading firms that are being devastated by the shutdown or low commodity prices. In fact, through June 16, $88 Billion in BBB-rated bonds were downgraded to Junk Bond status this year. Each downgrade causes selling, which lowers the price of the bond, and the yield goes up (at least for new buyers).

Why It’s Called Junk

Before you get too excited, there are reasons to be concerned about buying lower grade bonds. In an average year, 2% of BB bonds and 4% of single-B rated bonds will default. That’s why high yield bonds are called junk bonds.

When those companies file for bankruptcy, the bond holders won’t be getting paid back their full principal. They will have to wait for a bankruptcy court to approve a restructuring plan or to dissolve the company. According to Moody’s, the median recovery is only 24 cents on the dollar when a bond defaults.

And while a 2-4% default rate might not sound too bad, that’s in an average year. In a crisis, that might rise to 8-10% defaults. In 2009, global high yield bonds had a 13% default rate in that year alone. These are historical rates, and it could be worse than that in the future. Additionally, the possibility of default increases as a company gets downgraded. If your BB-rated bond gets cut to CCC-rated, the chance of default is now a lot higher than 2%. And the price will probably go down, which creates a difficult choice. Do you sell for a loss or hold on hoping that the company can pay off your bond?

Here in Dallas, we are seeing a lot of companies go bankrupt, pushed over the edge by the Coronavirus. Big names like J.C. Penney, Neiman Marcus, Pier One, Chuck E. Cheese, Bar Louie, and others have filed for bankruptcy in 2020. Most of these companies were issuers of high yield bonds and had a lot of debt. When they got into trouble, they could not keep up with their debt payments and had to fold. Expect more retailers, oil companies, and restaurants to go under before the end of 2020. Bond holders in those companies could lose a lot. (In all fairness, stock holders will do even worse. There is usually zero recovery for stock holders in bankruptcy.)

Funds versus Individual Bonds

If you are investing in a high yield bond fund, you may own hundreds or thousands of bonds. The fund may have a 7 percent yield, but don’t get too excited. A high yield fund is not a CD. You are not guaranteed to get your principal back. It’s likely (even more likely in the current crisis), that your return will get dinged by 2-4% in defaults and losses due to credit downgrades.

If you own individual high yield bonds, it can be even more precarious. Either the bond defaults or it doesn’t. Having the potential for an 75% loss, while earning an average 5-7% annual yield, is dangerous game. Everything is fine until you have a default. A single loss can wipe out years of interest payments. That’s why I generally don’t want to buy individual high yield bonds for my clients.

The quoted yield of 5-7% for high yield bonds does not reflect that some of those bonds will default. If you consider a 2-4% default rate, your net return might be more like 3-5%. That’s the High Yield Trap. Your actual returns often fall short of the quoted yield.

High Yield bonds are issued by companies. Stocks are companies. If companies do poorly – really poorly – both the stocks and bonds can get walloped at the same time. That’s the opposite of diversification. We want bonds to hold up well when our stocks are doing poorly. In finance jargon, we would say that there is a high correlation between high yield bonds and stocks. We want a low correlation.

Instead of High Yield?

What I would suggest, if suitable for an investor, would be a 5-year fixed annuity at 3% today. That would give you a guaranteed rate of return and a guaranteed return of your principal. That’s not super exciting, but it’s what investors need from fixed income: stability and dependable income. Don’t buy bonds for speculation. And above all else, Bonds should avoid the possibility of massive losses.

Be wary of the High Yield Trap. The yields appear attractive in today’s super low interest rate environment. But let’s be careful and not take unnecessary high risks. All bonds are not created equal. When you reach for yield, you are taking on more risk. Defaults have the potential to drag down your performance in a fund. In individual bonds, they could almost wipe out your original investment.

High Yield bonds are not inherently bad. If you bought at the bottom in 2009, they recovered very well. But I am very concerned that today’s yields are actually not high enough to compensate for the potential risk of defaults. We’ve already started to see corporate bankruptcies in 2020 and it’s possible we will have above average defaults in the near future. Until we have a real fire sale in high yield bonds, I’d rather stay away.

We will discuss ways of improving your yield next week. Yes, it’s a low interest rate world, but there are ways we can incrementally improve your portfolio while maintaining good credit quality. We will also discuss financial planning strategies for low rates in an upcoming post. If you’d like a free evaluation of your portfolio, to better understand your risks, please send me a message for an online meeting.