Inflation Investment Ideas

Posted On July 15, 2022 By Admin In Portfolio Management /

Inflation continues to shock the Global economy and has become a major concern when we discuss investment ideas. This week’s data showed the Consumer Price Index up 9.1% over last year, and the Producer Price Index is up over 11%. These are numbers not seen since 1981.

Today, I’m going to share some thoughts on inflation and get into how we want to respond to this situation. But first, here is an inside look at the government response to inflation.

Federal Reserve Hitting the Brakes

Last week, I attended a breakfast meeting for the Arkansas CFA Society at the Federal Reserve office in Little Rock. Our guest speaker was James Bullard, president of the St. Louis Federal Reserve Bank and voting member of the Open Market Committee which sets interest rates.

Bullard said that we were at a profound regime switching moment today, and that this is not just a blip in inflation but a “stunning amount of inflation”. He stated that the Fed would move aggressively to reduce inflation and that they were committed to their inflation target of 2%. He thinks the Fed will continue to raise rates until policy rates are greater than the inflation rate and may need to hold those high rates for years to come to bring inflation down.

Bullard felt that the current inflation levels are not simply a temporary supply shock from the Ukraine War. Output is actually up. In March 2020, the Fed responded very quickly to support an economy crashing from COVID-19 shutdowns. 60 days later, markets recovered and housing boomed. He wishes that they had reduced their asset purchases sooner. Instead, the Fed is only now ceasing to buy bonds and is allowing their holdings to run-off as they mature. The global stimulus response was correct, but has overheated.

He was less concerned about the possibility of a recession. Bullard said that recessions are difficult to predict and that the Fed is going to focus on getting inflation under control first. Inflation remains a global problem, but the US Federal Reserve will lead the way on fighting inflation, as the European Central Bank has other issues making them slower to respond.

Inflation, Rising Rates, Recession

It’s important to understand that even if inflation remains elevated for a couple of years, the impact of inflation may only be part of the story. Our investment ideas cannot simply assume high inflation as the only factor. We have to also consider the likelihood of rising interest rates and a recession. We’d love it if the Federal Reserve can orchestrate a soft landing as they apply brakes to this runaway economy. But they have not been very good at soft landings in the past.

The Fed policies are starting to work. Since the June inflation numbers, we’ve already seen the price of oil down by 20%. Mortgage applications are down and we should start to see housing inventories normalize and home prices stop their double digit increases. Interest rates have doubled compared to last year – 5.5% versus 2.75% for a 30-year mortgage – and this will impact how much home buyers can afford to pay. The Bloomberg Commodity Index was at 130 on June 16th and is now at 113, a drop of 13% in one month.

It is hard to imagine additional inflation shocks or surprises at this point. Despite the headlines, markets already know we have inflation. Inflation remains high, but may have peaked and should be starting to come down. The question is what is next? How will the markets respond to the Fed actions? Here are five thoughts about where to go from here.

Five Inflation Investment Ideas

Rising Rates. Bond investors beware. The Fed is going to continue to raise interest rates for an extended period. Keep your duration short on bonds. Consider floating rate bonds, if you don’t have any. Stay high quality – rising rates may cause defaults in weaker credits.
I-Bonds. These are inflation linked US savings bonds. They’ve been in the news this year, but I’ve been writing about them since 2016. Limited to $10,000 in purchases a year. These could do great for a couple of years.
Recession and Stocks. We might already be in a recession today, but won’t know it until later economic data shows a negative GDP for two quarters. Please resist the temptation to try to time the stock market. Recessions are a lagging indicator; stocks are a leading indicator and stocks will bounce back sooner. If you try to get out of stocks, it will be very difficult to get back in successfully. Instead, focus on diversification, with Value and Quality stocks. Avoid the high-flying growth names, we are already seeing those stocks get pummelled.
Roth Conversions. We are in a Bear Market, with the S&P 500 Index down 20%. This could be a good time to look at Roth Conversions, if you believe as I do that stocks will come back at some point in the future. An index fund that used to be $50,000 is now trading for $40,000. Do the Roth Conversion, pay taxes on the $40,000 and then it will grow tax-free from here. This works best if you anticipate being in a similar tax bracket in retirement as today.
Cash is Trash. Inflation is reducing your purchasing power. Thankfully, rising interest rates means we can now earn some money on Bonds and CDs. We can build laddered bond portfolios from 1-5 years with yields of 3-5%. And we have CDs at 3% as short as 13 months. Those are a lot better than earning 0% on cash. If you don’t need 100% liquidity, short-term bonds, CDs, and T-Bills are back.

Perseverance and Planning

I believe in long-term investing. Times like these will challenge investors to have the perseverance to stay the course. Rising rates and a possible recession in the months ahead may pose additional losses to our investment portfolios. If I thought we could successfully avoid the losses and step away from the market, I’d do that in a heartbeat. But all the evidence I have seen on market timing suggest it is unlikely to add any value, and would probably make things worse. We will stay invested, continue to rebalance, tax loss harvest, and carefully consider our options and best course of action.

With higher inflation, the cost of living in retirement increases, and so we have to aim for equity-like returns to make plans work. For our clients who are in retirement or close to retirement, we typically have a bucket with 5-years of expenses set aside in short-term bonds. And that bucket is still there and we won’t need to touch their equities for five years. In many cases, we have bonds which will mature in 2023, 2024, etc. in place to fund your spending or RMD needs. So, I am happy we have the bucket strategy in place, it is working as we had planned.

We have shared some inflation investment ideas, but I think the risks to investors may be greater from the Fed. Rising rates and recession are likely in the cards as they look to slow the economy. In spite of the headlines, this will undoubtedly be different than 1981, so I’m not sure we have an exact road map of what will happen. But, I will be your guide to continue to monitor, evaluate, and recommend what steps we want to take with our investments.

We Bought An Airbnb

Posted On April 4, 2022 By Scott Stratton, CFP(R), CFA In Financial Planning /

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

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

We Went Into Debt

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

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

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

Debt, Inflation, and Government Spending

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

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

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

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

Thoughts on Real Estate Investing

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

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

Bonds in 2022

Posted On December 12, 2021 By Admin In Portfolio Management /

Resuming last week’s Investment Themes, today we consider Bonds in 2022. It is a challenging environment for bond investors. We are coming off record low yields and the yield on the 10-year Treasury is still only 1.5%. At the same time, yields are starting to move up. And since prices move inversely to yields, the US Aggregate Bond index ETF (AGG) is actually down 1.74% year to date. Even including the yield, you’ve lost money in bonds this year. With stocks having a great year in 2021, it is frustrating to see bonds dragging down the returns of a diversified portfolio.

Inflation Hurts Bonds

Inflation is picking up in the US and globally. Supply chain issues, strong demand for goods, and rising labor costs are increasing prices. The Federal Reserve this week said they would be removing the word “transitory” from their description of inflation. And now that it appears that Jay Powell will remain the Chair, it is believed that the Fed will focus on lowering inflation in 2022. They will reduce their bond buying program which has suppressed interest rates. And they are expected to gradually start increasing the Fed Funds rate in 2022.

It is difficult to make accurate predictions about interest rates, but the consensus is that rates will continue to rise in 2022. So, on the one hand, bonds have very little yield to offer. And on the other hand, you will lose money if interest rates continue to climb. Then, to add insult to injury, most bonds are not maintaining your purchasing power with inflation at 6%.

Bond Themes for 2022

There aren’t a lot of great options for bond investors today. But here are the bond investment themes we believe will benefit your portfolio for the year ahead. This is how we are positioning portfolios

We will be increasing our allocation to Floating Rate bonds (“Bank Loans”). These are bonds with adjustable interest rates. As rates rise, the interest charged goes up. These are a good Satellite for rising rate environments.
Within core bonds, we want to reduce duration to shorter term bonds. This can reduce interest rate risk.
We continue to hold Preferred Stocks for their yield. While their prices will come under pressure if rates rise, they offer a continuous cash flow.
Ladder 5-year fixed annuities. I have been beating this drum for years. Still, multi-year guaranteed annuities (MYGA) have higher yields than CDs, Treasuries, or A-rated corporate and municipal bonds. If you don’t need the liquidity, MYGAs offer a guaranteed yield and principal.
I previously suggested I-Series Savings Bonds rather than TIPS. These are linked to inflation and presently are paying 7.12%. Purchases are limited to $10,000 a year per person, and unfortunately cannot be held in a brokerage account or an IRA. Read my recent article for more details. I personally bought $10,000 of I-Bonds this week.

Purpose of Bonds

Even with a negative environment for bonds, they still have a role in most portfolios. Unless you have the risk capacity to be 100% in stocks, bonds offer crucial diversification. When we have a portfolio with 60% stocks and 40% bonds, we have an opportunity to rebalance. When stocks are down, like in March of 2020, we can use bonds to buy more stocks while they are on sale. And of course, a portfolio with 40% in bonds has much less volatility than one which has 100% stocks.

Yields may eventually go back up to more normal levels. While it would be nice to have higher yields, the process of yields going up will be painful for bond investors. Our themes are trying to reduce this “interest rate risk”. We hope to reset to higher rates in the future, while reducing a potential loss in bond prices in 2022.

Inflation Investments

Posted On September 10, 2021 By Scott Stratton, CFP(R), CFA In Financial Planning, Portfolio Management /

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.

Inflation and Real Estate

Posted On March 26, 2021 By Scott Stratton, CFP(R), CFA In Financial Planning /

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:

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.
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.

Creating Retirement Income

Posted On November 5, 2020 By Scott Stratton, CFP(R), CFA In Retirement Planning /

Today, we are starting a five-part series to look at creating retirement income. There are various different approaches you can take when it is time to retire and shift from accumulation to taking withdrawals from your 401(k), IRA, or other investment accounts. It is important to know the Pros and Cons of different approaches and to understand, especially, how they are designed to weather market volatility.

In upcoming posts, we will evaluate SPIAs, the 4% rule, a Guardrails Approach, and 5-Year Buckets. Before you retire, I want to discuss these with you and set up an income plan that is going to make the most sense for you. Today, let’s start with defining the challenges of creating retirement income.

Sequence of Returns Risk

During accumulation, market volatility is not such a bad thing. If you are contributing regularly to a 401(k) and the market has a temporary Bear Market, it is okay. All that matters is your long-term average return. If you invest over 30-40 years, you have historically averaged a return of 8-10 percent in the market. Through Dollar Cost Averaging, you know that you are buying shares of your funds at a more attractive price during a drop.

Unfortunately, market volatility is a big problem when you are retired and taking money out of a portfolio. You calculated your needs and planned to take a fixed amount of money out of your portfolio. If the market averages 8% returns, can you withdraw 8%? That should work, right?

Let’s look at an example. You have a $1 million portfolio, you want to take $80,000 a year in withdrawals. Imagine you retired in 2000, having reached your goal of having $1 million! Here’s what your first three years of retirement might have looked like, with $80,000 annual withdrawals:

Start at $1,000,000, 9% market loss = $830,000 ending value
Year 2: start at $830,000, 12% market loss = $650,400 ending value
Year 3: start at $650,400, 22% market loss = $427,312 ending value

This would blow up your portfolio and now, your $80,000 withdrawal would be almost 20% of your remaining funds. This is Sequence of Returns Risk: the order of returns matters when you are taking income. If you had retired 10 years before these three bad years, you might have been okay, because your portfolio would have grown for a number of years.

Because a retiree does not know the short-term performance of the stock market, we have to take much smaller withdrawals than the historical averages. It’s not just the long-term average which matters. Losses early in your retirement can wreck your income plan.

Longevity Risk

The next big risk for retirement income is longevity. We don’t know how long to plan for. Some people will have a short retirement of less than 10 years. Others will retire at 60 and live for another 40 years. If we take out too much, too early, we risk running out of funds at the worst possible time. There is tremendous poverty in Americans over the age of 80. They didn’t have enough assets and ran out of money. Then they end up having to spend down all their assets to qualify for Medicaid. It’s not a pretty picture.

And for you macho men who intend to die with your boots on – Great. You may wipe out all your money with your final expenses and leave your spouse impoverished. She will probably outlive you by 5-10 years. That’s why 80% of the residents in nursing homes are women. You need to plan better – not for you, but for her.

We plan for a retirement of 30 years for couples. There’s a good chance that one or both of you will live for 25-30 years if you are retiring by age 65. There are different approaches to dealing with longevity risk, and we will be talking about this more in the upcoming articles.

Inflation Risk

Longevity brings up a related problem, Inflation Risk. At 3% inflation, your cost of living will double in 24 years. If you need $50,000 a year now, you might need $100,000 later, to maintain the same standard of living.

A good retirement income plan will address inflation, as this is a reality. Luckily, we have not had much inflation in recent decades, so retirees have not been feeling much pressure. In fact, most of my clients who start a monthly withdrawal plan, have not increased their payments even after 5 or 10 years. They get used to their budget and make it work. Retirement spending often follows a “smile” pattern. It starts high at the beginning of retirement, as you finally have time for the travel and hobbies you’ve always wanted. Spending typically slows in your later seventies and into your eighties, but increases towards the end of retirement with increased health care and assistance costs.

When we talk about a 4% Real Rate, that means that you would start at 4% but then increase it every year for inflation. A first year withdrawal of $40,000 would step up to $41,200 in year two, with 3% inflation. After 30 years (at 3% inflation), your withdrawal rate would be over $94,000. So, when we talk about a 4% withdrawal rate, realize that it is not as conservative as it sounds. Even at a low 3% inflation rate, that works out to $1,903,016 in withdrawals over 30 years. It’s a lot more than if you just were thinking $40,000 times 30 years ($1.2 million).

Periods with high inflation require starting with a lower withdrawal rate. Periods with low inflation enable retirees to take a higher initial withdrawal amount. Since we don’t know future inflation, most safe withdrawal approaches are built based on the worst historical case.

Invest for Total Return

There is one thing which all of our retirement income approaches agree upon: Invest for Total Return, not Income. This is counter-intuitive for many retirees. They want to find high yielding bonds, stocks, and funds. Then, they can generate withdrawal income and avoid selling shares.

It sounds like it would be a rational approach. If you want a 5% withdrawal rate, just buy stocks, bonds, and funds that have a 5% or higher dividend yield. Unfortunately, this often doesn’t work as planned or hoped!

Over the years, I’ve invested in everything high yield: dividend stocks, preferred stocks, high yield bonds, Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), Closed End Funds, etc. They can have a small place in a portfolio, but they are no magic bullet.

Problems with Income Investing

Value Trap. Some stocks have high yields because they have no growth. Then if they cut their dividends, shares plummet. Buy the highest dividend payouts and your overall return is often less than the yield and the share price goes no where. (Ask me about the AT&T shares I’ve held since 2009 and are down 14%.)
Default risk. Many high yield investments are from highly levered companies with substantial risk of bankruptcy. Having 5% upside and 100% downside on a high yield bond or preferred stock is a lousy scenario. When you do have the occasional loss, it will be greater than many years of your income.
Poor diversification. High yield investments are not equally present in all sectors of the economy. Often, an income portfolio ends up looking like a bunch of the worst banks, energy companies, and odd-ball entities. These are often very low quality investments.

Instead of getting the steady paycheck you wanted, an income portfolio often does poorly. When your income portfolio is down in a year when the S&P is up 10-20%, believe me, you will be ready to throw in the towel on this approach. Save yourself this agony and invest for total return. Total return means you want capital gains (price appreciation) and income.

For investors in retirement accounts, there is no tax difference between taking a distribution from dividends versus selling your shares. So, stop thinking that you need to only take income from your portfolio. What you want is to have a diversified portfolio and a good long-term rate of return. Then, just make sure you are able to weather market volatility along the way.

Ahead in the Series

Each of the retirement income approaches we will discuss have their own Pros and Cons. We will address each through looking at how they address the risks facing retirees: Sequence of Returns Risk, Longevity Risk, and Inflation Risk. And I’ll have recommendations for which may make the most sense for you. In the next four posts, I’ll be explaining SPIAs, the 4% Rule, a Guardrail Approach, and 5-Year Buckets.

Even if you aren’t near retirement, I think it’s vitally important to understand creating retirement income. Retirement income establishes your finish line and therefore your savings goals. If you are planning on a 4% withdrawal rate, you need $1 million for every $40,000 a year in retirement spending. Looking at your monthly budget, you can calculate how much you will need in your nest egg. Then we can have a concrete plan for how much to invest and how we will get there. Thanks for reading!

Introducing our Ultra Equity Portfolio

Posted On December 21, 2017 By Scott Stratton, CFP(R), CFA In Portfolio Management /

We are launching a new portfolio model for 2018, Ultra Equity, a 100% stock allocation. Previously, our most aggressive allocation was 85% stocks and 15% bonds. This type of approach clearly is not for everyone, but if you want the highest possible long-term return and can ignore short-term volatility, Ultra Equity might make sense for you.

Bond yields remain very low today, and bond investors face rising risks, including interest rate risk, that rising interest rates depress bond prices, and purchasing power risk, that inflation eats up all your yield. While defaults have been quite low in recent years, as interest rates rise, it will be increasingly difficult for distressed companies, municipalities, and countries to meet their obligations. The level of debt globally has swelled enormously with the cheap access to capital since 2009, and yet the bond market is acting if all this debt hasn’t changed risks at all.

While the Federal Reserve raised the Fed Funds rate again this week, income investors have been disappointed that there are not more attractive opportunities in bonds today. Unfortunately, the rising rates have not benefited all types of fixed income vehicles equally. On the short end, yes, yields are up. We can now access short-term investment grade bonds with yields of around 1.5% to 2%.

However, the yields on longer bonds have barely moved. The 10-Year Treasury is at 2.35% and the 30-Year remains shockingly low at 2.71%. As a result, we have a “flattening” of the yield curve where short-term rates have increased, but long-term rates are virtually unchanged.

I expect this trend to continue in 2018: rising short-term rates and a flattening yield curve, which means there will continue to be a dearth of opportunities for yield-seeking investors. As a point of reference, the historical rate of return for intermediate bonds was 7.25%, but today, you can’t find anything at even half of that rate. We are always thinking about how we can position portfolio allocations to aim for the best possible return with the least amount of risk and the maximum amount of diversification. But at this point, bonds offer little potential for high returns. Instead, we have to think of bonds as risk mitigators, that the primary purpose of our bonds is to offset the risk we have with our equity holdings.

I’ve been reluctant to roll out a 100% equity allocation with the stock market at an all-time high in the US, because it risks falling into the behavioral trap of becoming too enamored with stocks during a bull market, and ignoring stocks’ volatility and potential for losses. For investors with a horizon of more than 10 or 20 years, there is little possibility that a bond allocation will increase your rate of return. If you are comfortable with ignoring volatility, I think some younger investors may want to invest 100% in equities.

Consider this: the expected return on intermediate bonds is only 3.5% over the next 10 or so years. If you have a 60/40 portfolio and earn 3.5% on your bonds, you will need to make at least 11% on your stocks to reach an overall return of 8%. Many investors are coming to the conclusion that to achieve their goals, the optimal allocation to bonds may be zero.

If you are making regular contributions to an equity allocation, you also have the opportunity to dollar cost average, and buy more shares at a lower price, if the market does drop at some point. And while dollar cost averaging does not guarantee you will not experience losses, it is nevertheless an effective way to accumulate equity assets and possibly benefit from any volatility that does occur.

Our Ultra Equity portfolio will differ from our other portfolio models in that we are not looking to reduce risk or to achieve the best “risk-adjusted” returns. Instead, we will invest tactically in areas where we believe there is the greatest potential for strong long-term rates of return. We will always be diversified, investing in ETFs and mutual funds with hundreds or thousands of different securities, but will have no requirement to hold any specific category of investments.

We cannot know how a portfolio like this will fare over the near term, and there will undoubtedly be times when the stock market is down, sometimes even down significantly. If your attitude is that those drops represent opportunity, rather than adversity, then you should ask us more about Ultra Equity to see if it might be right for you.

The Safest Way to Beat Inflation

Posted On March 21, 2016 By Admin In Portfolio Management /

With interest rates so low today, investors wonder where they can keep their money safe both in terms of their principal and purchasing power. We recently discussed Fixed Annuities as one substitute for CDs or bonds, with the conclusion that Annuities are best for investors over 59 1/2 who don’t need liquidity for at least five years. For others, one often overlooked option is Inflation-linked Savings bonds, officially known as Series I Bonds.

What To Do With Your CD Money

Posted On February 1, 2016 By Admin In Portfolio Management / 1 Comment

If you’ve had CDs mature over the past several years, you’ve faced the unfortunate reality of having to choose between reinvesting into a new CD that pays a miniscule rate, or moving your money into riskier assets and giving up your guaranteed rate of return and safety. Although you can earn a higher coupon with corporate bonds than CDs, those investments are volatile and definitely not guaranteed. I understand the desire for many investors to keep a portion of their money invested very conservatively in ultra-safe choices. So, I checked Bankrate.com this week for current CD rates on a 5-year Jumbo CD and here is what is offered by the largest banks in our area:

Bank of America 0.15%
JPMorgan Chase 0.25%
Wells Fargo 0.35%
Citibank 0.50%
BBVA Compass 0.50%

While there are higher rates available from some local and internet banks, it is surprising how many investors automatically renew and do not search for a better return. Others have parked their CD money in short-term products or cash, hoping that the Fed’s intention of raising rates in 2016 will soon bring the return of higher CD rates.

Unfortunately, it’s not a given that the economic conditions will be strong enough for the Fed to continue to raise rates in 2016 as planned. This week, the 10-year Treasury yield dropped below 2%, which is not strong endorsement of the likelihood of CD rates having a major rebound in 2016.

This is the new normal of low interest rates and slow growth. While rates could be nominally higher in 12 months, it seems very unlikely that we will see 4% or 5% yields on CDs anytime in the immediate future. Waiting out in cash is a sure-fire way to not keep up with inflation and lose purchasing power.

What do I suggest? You can keep your money safe – and earn a guaranteed rate of return – with a Fixed Annuity. I only recommend Fixed Annuities with a multi-year guaranteed rate. Like a CD, these have a fixed interest rate and set term. At the end of the term, you can take your investment and walk away.

Today, we can purchase a 5-year annuity with a rate of 2.9% to 3.1%, depending on your needs. I know that’s not a huge return, but it’s better than CDs, savings accounts, Treasury bonds, or any other guaranteed investment that I have found. Since an annuity is illiquid, I suggest investors set up a five year ladder, where each year 20% (one-fifth) of their money matures. When each annuity matures, you can keep out whatever money you need, and then reinvest the remainder into a new 5-year annuity.

The beauty of a laddered approach is that it gives you access to some of your money each year and it will allow your portfolio to reset to new interest rates gradually as annuities mature and are reinvested at hopefully higher rates. In the mean time, we can earn a better return to keep up with inflation and keep your principal guaranteed.

Issued by insurance companies, Annuities have a number of differences from CDs. Here are the main points to know:

Annuities typically have steep penalties if you withdraw your money early. It’s important to always have other sources of cash reserves for emergencies. Consider an annuity as illiquid, and only invest long-term holdings.
If you take money out of an annuity before age 59 1/2, there is a 10% premature distribution penalty, just like a retirement account. A 5-year annuity may be best for someone 55 or older.
Money in annuity grows tax-deferred until withdrawn. If you rollover one annuity to another, the money remains tax-deferred. Most annuities will allow you to withdraw earnings without penalty and take Required Minimum Distributions (RMDs) from IRAs. Always confirm these features on an annuity before purchase.
While CDs are insured by the FDIC, annuities are guaranteed at the state level. In Texas, every annuity company pays into the Texas Guaranty Association, which protects investors up to $250,000. If you have more than this amount to invest, I would spread it to multiple issuers, to stay under the limit with each company.

If you have CDs maturing and would like to learn more about Fixed Annuities, please contact me for more information.

Are Your Retirement Expectations Realistic?

Posted On December 8, 2014 By Admin In Retirement Planning /

While many individuals have very realistic ideas about retirement, I find that some people may be significantly overestimating their preparedness for funding their financial needs. Here are three specific mistakes which can hurt your chance of success in retirement, and a realistic solution for each issue.

Mistake #1: Thinking you can live on a small fraction of your pre-retirement income.
Occasionally, I’ll meet someone who is currently making $100,000, but who thinks that they will need to spend only $40,000 a year in retirement to maintain their current lifestyle. On a closer look, they’re saving about $15,000 today so they are really living on about $85,000 a year. This is a key problem with creating a retirement budget: when we add up projected expenditures, it is very easy to underestimate how much we need because we often forget about unplanned bills like home and auto repairs, or medical expenses. And don’t forget about taxes! Taxes do not go away in retirement, either.

Realistic Solution: Even though some expenses will be lower in retirement, most retirees find that they need 75-90% of their pre-retirement income to maintain the same lifestyle.

Mistake #2: Taking too high of a withdrawal rate.
20 years ago, William Bengen published a paper that concluded that 4%, adjusted for inflation, was a safe withdrawal rate for a retiree. While this topic has been one of the most discussed and researched areas in retirement planning, most financial planners today remain in agreement that 4%, or very close to 4%, is the safe withdrawal rate. However, many individuals who have a million dollar portfolio think that they might be able to take out $60,000, $70,000, or more a year, especially when the market is performing well.

There are two important reasons why it’s prudent to use a more conservative 4% rate. The first is market volatility. The market is unpredictable, so we have to create a withdrawal strategy which will not excessively deplete the portfolio in the event that we have large drop, or worse, a several year bear market at the beginning of a 30-year retirement. The second reason is inflation. We need to have growth in the portfolio to allow for the increased cost of living, including the likelihood of increased medical costs. At just 3% inflation, $40,000 in expenses will double to $80,000 in 24 years. And with today’s increased longevity, many couples who retire in their early 60’s will need to plan for 30 years or more of inflation in retirement.

Realistic Solution: At a 4% withdrawal rate, your retirement finish line requires having a portfolio of 25 times the amount you will need to withdraw in the first year.

Mistake #3: Assuming that you will keep working.
Some people plan to keep working into their 70’s or don’t want to retire at all. They love their work and can’t imagine that there would ever be a day when they are not going to be working. They plan to “die with their boots on”, which in their eyes, makes retirement planning irrelevant.

Unfortunately, there are a number of problems with this line of thinking. The Employee Benefits Research Institute 2014 Retirement Confidence Survey found a significant gap between when people planned to retire and when they actually did retire. Only 9% of workers surveyed plan to retire before age 60, but 35% actually retired before this age. 18% planned to retire between 60 and 64, versus 32% who actually retired in that age range. The study cites three primary reasons why so many people retire earlier than planned: health or disability, layoff or company closure, and having to care for a spouse or other family member. The study also notes that one in 10 workers plan to never retire. Even if you’re willing to keep working, the statistics are clear: most people end up retiring earlier than planned.

For a healthy 65-year old couple, there is a good chance that at least one of you will live into your 90’s. If you still think you don’t need a retirement plan because you will keep working, do it for your spouse, who might have 25-plus years in retirement if something were to happen to you. Don’t make your plan’s success dependent on your being able to keep working in your 70’s and 80’s.

Realistic Solution: Make it a goal to be financially independent by your early 60’s; then you can work because you want to and not because you have to.

A comprehensive financial plan addresses these concerns and establishes a realistic framework for funding your retirement. And whether you’re 30 or 60, it is never too early, or too late, to make sure you are on track for financial independence.