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investing

3 Ways of Dealing Without Recharacterization

Oct 20th, 2010
by jblankenship.
1 comment

deal by D.C.AttyWith the new conversion opportunity made available by the passage of the Small Business Jobs Act of 2010 (see New Opportunities to Roth), there is one factor that is not available that you normally have when doing Roth conversions: recharacterization.

If you recall, the primary reason that you would want to recharacterize is if you converted funds and then, by the time you pay the tax, the holdings that you converted have dropped in value.  So, instead of paying tax on something that is much less in value than previously, for a Roth IRA conversion you can recharacterize the conversion up to October 15 of the following year (see Help Mr. Wizard – I didn’t wanna do a Roth Conversion for more details on recharacterization)

But there are ways to reduce the risk associated with your Deemed Roth Account Conversion (since you are not eligible to recharacterize the conversion).

For one thing, you could use dollar-cost averaging to spread the risk of market fluctuations over several points in time through the year.  Simply split your intended conversion amount into four amounts, and convert one of those amounts each quarter, for example.  This way if the market drops through the year, you’re converting funds at the lower values.

Another option would be to spread the date-specific risk over several years, by converting smaller amounts each year.  This would also reduce the risk of adverse market results, and spread out the tax over several years (if possible).

Yet another choice could be to convert only those assets that have very low volatility, such as bonds.  The probability of a major drop in value is much lower for these assets, so your need for a recharacterization would be far less likely.

There are many other, more complicated ways to reduce your risk against such a situation, but these are a few that are easily implemented.  Hopefully this will help you in your process of converting retirement plan assets to Roth.

Photo by D.C.Atty

The Cost or Benefit of Time Out of the Market

Oct 18th, 2010
by jblankenship.
2 comments

evolution of vans by Spencer C. CurtisI don’t know if you’ve ever heard it before, but there have been studies done with the intent to help folks realize the benefit of remaining invested in the market… with the outcome being if you missed the ten best days of the market’s returns over a particular period of time, your overall results are significantly diminished.

I’ve always been intrigued by the concept of these studies, so I decided to undertake a similar study of my own, using a few different circumstances in order to hopefully reflect what might happen in real life.

The Study

I used S&P 500 data to represent the stock market, and for the sake of better understanding and applicability to the present, I have limited the data used to the time period of January 1990 to present.  In order to better represent what most folks would do in real life, I used monthly results, rather than daily – because I figure that most folks, if they change a position (i.e., sell out of stocks, for example), most likely they would not jump right back into the same position the next day.  I figured 30 days was a little more realistic of a timeline for making changes to your holdings.

Also, I did not include dividends in the analysis, although these can be a significant part of your returns.  It was much simpler to work with the actual returns, rather than try to estimate when dividends might be paid and whether or not you were currently invested at that time.  I figure the results would be very similar, either way.

Lastly, transaction fees and taxes have not been factored in to these calculations.  Depending upon the circumstances these two factors can have a drag on your results – but taxes won’t come into play in an IRA, for example, plus transaction fees may not apply to your case.  In addition, if you’re working with traditional mutual funds, sometimes there are repercussions to changing your position frequently – such as holding periods.  These have also not been factored into the results.

Results

For the long-term benchmark, I assumed that the investor made an investment in January 1990, and left it alone until the end of September, 2010.  If you did this, you would have seen a total return of 230.05% – that’s a simple average of 11.5% per year.  Now we’ll start making some assumptions to change things up a bit.

What happens if we got out of the market for just one month during that twenty year period?  If we did this and happened, just by chance, to miss the month during that period with the best return of all of them, we’d have reduced our overall return to 194.63%. The month was April 2009, if you wondered, and the return was 12.02% for that month.

On the other hand, what if we were extremely lucky and missed the very worst month during the period?  (October 2008, at -20.39%, in case you were wondering.)   That would result in an overall result of 314.59%, or an average annual increase of more than 4%!  But how in the world can you guess that you’ve got the right month?  The very best month and the very worst month in 20 years were only six months apart…

Here’s another option to consider: what if you took two months out of the market during the 20 year period?  If it was the best two months that you missed, you’d drop your overall return to 164.73% (the second-best month during the 20 years was February of 1991).  But if your timing was immaculate and you skipped the two months in the 20 year period with the worst possible returns, you’d boost your results to 367.72% (the second worst month was September 2009).

Lastly, I took the data and calculated what would happen if you had the worst luck of all and missed the 10 best months during the 20 years studied… your result would be a paltry 46.45%, only 2.32% per year.  On the other hand, if you had near-perfect timing and happened to miss out on the ten worst months of the period – you’d have pulled down a total return of 816.90%, a yearly average of 40.85%!!  Clearly it would benefit you to have a crystal ball.

Add In Human Nature…

Since one month is a very short period of time, I took the same data and calculated what would happen if you not only missed the months in question, but then you also delayed an extra month before getting back in the market.  Here are the results under those circumstances:

Missed best month and the month following: 176.92%
Missed best two months and the months following: 142.11%
Missed best ten months and the months following: 25.06%
Missed worst month and the month following: 354.85%
Missed worst two months and the months following: 397.91%
Missed worst ten months and the months following: 943.74%

Clearly, once again, it pays to have had a degree of clairvoyance working in your favor.  But obviously you can’t plan to have this kind of timing – so far I think we’ve learned that staying the course has benefits.  Although it would be pretty cool if you had hindsight working in your favor and could miss all those bad months, the likelihood of hitting it just right is pretty low.

What About Reacting?

So – since we don’t have a crystal ball available to us, what’s the next most obvious way to handle things?  Reacting, of course.  So I took the same data and ran the calculations based upon those same months, only instead of missing the best or worst, you missed only the month following the best or worst months, in reaction to the prior months’ results.  Here’s how that turns out:

Missed the month after the best month: 210.21%
Missed the months after the best two months: 201.86%
Missed the months after the best ten months: 164.90%
Missed the month after the worst month: 262.10%
Missed the months after the worst two months: 251.36%
Missed the months after the worst ten months: 312.20%

This shows us that there may be some benefit to be had by taking the reactionary stance – for the worst ten months example, you’d have improved your overall return by over 80% for the period, more than 4% per year. But how would you know if you were choosing the right 10 months to react to?

The other thing that this shows us is that reacting to a positive result by locking in your returns and standing pat doesn’t help – I suspect that the momentum of the market is working for both cases.  This means that, if the market is on the rise, more often than not, it will continue to rise in the following month, and vice versa.

Practical Application

Since we don’t know for sure what the best and worst months will be in advance, what if we used the prior month’s return against a benchmark result and then reacted by getting out of the market for the following month?

On the upside, once again, locking in your positive results in any month with better than a 4% return (an arbitrary number that I chose), you’d wind up with a result less than half (at 111%) of what you’d have gotten by just buying the market and staying in it for the full period (which was 230%).  There were 32 months in the 20 year period that met this criteria.

The market momentum once again works its magic (at least with the data I used). If you chose to get out of the market on the first day of any month following a downside month (of which there were 97 in the period studied), you would have wound up with an overall result of 355.93%.  This is a good thing!  By putting this easily-understood method into play, your overall results increased by better than 6% per year.

Keep in mind that the study only covered the previous 20 years – a relatively small period of time, with some pretty dramatic results, both positive and negative.  I’m going to do some further study on the historical data and I’ll let you know more about those results after I’ve done that analysis.

Even with that fact in mind, I think this might be a useful tactic to consider putting into place.  I still think that the core of your portfolio should be left in place for the long term – especially with your well-balanced portfolio.  But it could work in your favor to put such a plan into place for a small portion of your portfolio, such as maybe 10-20% of your domestic stock holdings. The critically important fact here is that for this to work you have to stay disciplined and make your moves at the correct times.  Otherwise this won’t work.

And if you don’t want to hassle with this kind of manipulation, it’s still pretty clear that you can definitely do worse than the long-term hold tactic, which is the simple, tried and true way to handle your portfolio.

Photo by Spencer C. Curtis

Household Businesses that are Doing Well During the Recession

Sep 13th, 2010
by Louise Baker.
1 comment

recession by Anders VWhile many small businesses have been suffering as the nation tries to emerge from a struggling economy, certain household-name businesses are doing quite well. From restaurants to retail stores, there are many examples of companies having success during these tough times.

McDonald’s (NYSE: MCD)

McDonald’s has profited quite a bit in this economy. Offering meals well under $10.00 and a number of new menu items, the chain served some 60 million customers each day in 2009, up 2 million per day from the previous year. Earnings per share for calendar year 2009 were up 9% from the previous year. The latest 2010 figures for July 2010 show United States sales growing by 5.7% over the same period in 2009. Sales in Europe rose 5.3% and Asia, the Middle East and Africa had a very impressive growth rate of 10.1%.

Walmart (NYSE: WMT)

The nation’s leading retailer has been able to hold up well during this most recent economic downturn. Long known as the low price leader, Walmart has attracted more customers that used to shop at somewhat more upscale stores. The regular clientele continue to shop at Walmart for hardware, household goods and groceries. Attractive pricing, a wide variety of items and many special deals have made Walmart the preferred choice of millions struggling with the difficult times. People still need to buy all the necessities such as clothes and food and Walmart is amongst the most affordable options out there.

Dollar General (NYSE: DG)

This store has found a niche that does very well in times where people need to make the most of a dollar. Offering most of their merchandise for a single dollar (some items are more), the store is great for things like cleaning supplies, paper plates, toilet paper and all sorts of other household items. People always have a few dollars in their pocket and can fill a bag for $10.00 or less. Shoppers still like to shop in quantity and Dollar General, with its conveniently located stores, has accomodated that need.

Goodwill Stores

Goodwill Industries has experienced a surge in customer traffic and sales. The king of the second hand or thrift stores is a well managed company that sells donated second hand merchandise (and some brand new items) at highly discounted prices. Women love shopping for clothes as they can pick up jeans for $5.00 that would sell new in a Department store for $50.00.

Florida Power & Light (FPL)

Like all regulated utilities, FPL continues to make a profit by providing service at a price determined by government agencies. They have invested well and are able to cut costs in many areas while providing excellent service. Management has taken advantage of technology and has instituted innovative plans to improve productivity which transfers to the bottom line.

Louise Baker is a freelance blogger and journalist who writes for Zen College Life, the directory of higher education, distance learning, and online schools. She most recently wrote about the top online colleges.

Photo by Anders V

No, You Can’t Contribute Stocks to Your IRA

Sep 8th, 2010
by jblankenship.
No comments yet

markets china stocks close by artemuestraSometimes the question comes up – “Hey, I have this taxable stock account with my favorite stock (or mutual fund, or bond, or CD, or what-have-you).  Can I just transfer the stock over to my IRA as an annual contribution?”

In a word, NO.  Contributions to IRAs are only allowed in cash.  In order to accomplish what the contribution you hoped to, you’d have to liquidate the security holding, paying any tax on capital gains, and then use the cash proceeds to make your contribution.

Keep in mind, this doesn’t apply to rollovers – even the indirect “60-day” rollovers.  You can rollover securities holdings from one IRA (or qualified retirement plan) to another IRA in-kind.  If it’s done indirectly (not a trustee-to-trustee transfer), the same securities must be used with the roll-in.

So, for example, if you had an IRA with $50,000 worth of ABC stock, you could distribute the stock (rather than cashing it out) to a taxable account, and then within 60 days contribute the same stock to another IRA.  During that 60-day period, you could do any number of things, such as collect interest or receive a qualified dividend from the stock, which would be taxed at qualified dividend rates.  As long as you complete the transfer of the exact same stock within the 60-day window, there is no tax owed on the transfer.

Let me point out that I don’t recommend this sort of activity, I’m just explaining that it’s possible.

Photo by artemuestra

What Does A Fidelity Target Date (Freedom) Fund Invest In?

Aug 11th, 2010
by jblankenship.
3 comments

Note from Jim:  I’m on vacation this week – hope you enjoy the following post from my friend and colleague, Roger Wohlner, CFP® who writes at the blog Chicago Financial Planner.  Roger operates his Fee-Only financial planning practice out of Arlington Heights, Illinois.

Fidelity is one of the largest providers of 401(k) plans and like many fund company platforms it is common for their plan sponsor clients to offer several or all of Fidelity’s Target Date funds known as the Fidelity Freedom funds. These funds have target dates from 2005 every five years out to 2050 with an even shorter-term Retirement Income fund. The premise behind these and other Target Date funds is that a plan participant will choose a fund with a date close to when he or she might retire, invest their contributions and let the fund manager do the rest. The funds typically lighten up on equity investments as the target date draws nearer, at some point they go to a “glide path” into retirement typically at the target year. This means the fund at that point is geared to the typical life expectancy of someone retiring in that year, the allocation allows the fund shareholder to “glide” into retirement.

There has been much controversy as to whether Target Date funds work as advertised. My purpose in writing this post is not to comment on these issues one way or the other. Rather I want to take a look at how the Fidelity Freedom Funds actually invest shareholder’s money.

The Freedom Funds like many Target Date funds are funds of funds. Each Freedom Fund has its own mutual fund ticker symbol. Unlike many mutual funds which make direct investments into individual stocks or bonds, the Freedom Funds invest in a variety of Fidelity mutual funds. Which funds and the percentage held of each fund will vary by Freedom Fund. I made a list of their underlying holdings using Morningstar’s Advisor Workstation. I then used the Fi360 Toolkit to rate these funds based on their 11 point criteria:

• Fund inception date (at least three years)
• Manager Tenure (min. 2 years)
• Minimum fund size
• 2 measures relating to fund investment style and asset composition
• Expense ratio
• 2 measurements of risk-adjusted return
• Trailing 1,3,5 year returns

All funds are rated relative to other funds in their peer group.

In looking at the 26 Fidelity mutual funds that I found as holdings of the various Freedom Funds I found the following for the ranking period ending 12/31/09:

• Three of the funds received the highest ranking of 0. This means no deficiencies, they passed all criteria.
• An additional four funds earned a score ranging from 1-25 indicating that they passed most of the criteria. This would indicate that these funds rank in the top 25% of all funds in their peer group with enough data to be ranked.
• Four funds had scores ranging from 26-50 indicating that they did not pass in a couple of areas but these funds overall rank in the top half of their respective peer groups based upon the ranking criteria.
• Five of the funds had a ranking in the 51-74 range indicating that they were deficient in several of the criteria and overall place in the lower half of their peers with enough history to be ranked.
• One fund had a score of 87 meaning that it was deficient in most areas and ranked in the bottom 13% of its peers. A ranking in this range indicates that strong consideration should be given to replacing such a fund.
• Nine of the funds did not have enough history to be ranked. These funds are all Fidelity Series funds. This appears to be a new group of funds that Fidelity has designed for use in their Freedom Funds. The funds all have anywhere from a month’s worth of history out to about a year. They would flunk the inception date test for the amount of time the fund has been around. These may ultimately prove to be good funds over time, but as an advisor I am generally loath to invest client money in new, untested funds unless there is a compelling reason to do so.
• Noticeably absent from the underlying funds within the Freedom Funds are any of Fidelity’s low cost core index funds covering areas such as the S&P 500; total domestic stock market; international equities; or their total bond market index fund. These are by and large solid, low cost holdings. Also absent are several top Fidelity funds such as Contra, Low-Priced Stock, and others.

In their defense of the 11 numbered Freedom Funds, 10 earned a score of 0 for the most recent ranking period and the other one earned a top quartile score of 20. Keep in mind; however, these rankings are within the target date peer groups via Morningstar. All of these groupings have a small number of funds and there is not a lot of history in some cases. A really good or really bad quarter or two can skew a target fund’s relative ranking. Additionally the peer groupings have changed and been revamped at least twice in the past several years.

Should you invest in these funds? As a plan participant you need to understand the fund’s investment philosophy, the glide path concept, and the fund’s underlying investments. Remember just because a particular fund has a target date closest to when you might retire, you can go with a closer date fund if you want to be a little less aggressive or a longer-dated fund if you want to be a bit more aggressive.

Plan sponsors it is incumbent upon you to monitor the Target Date funds in your plan as closely as you would review any plan investment choice. In the case of a Fidelity plan you may or may not be limited to the Freedom Funds.

Again I am not saying the Freedom funds are good or bad. Clearly they did well relative to their peers in 2009. Participants and Sponsors need to understand these funds and what they can and cannot offer.

Photo by Paul Keleher

Using Capital Gains and Losses to Help With a Roth Conversion

Jul 21st, 2010
by jblankenship.
1 comment

libr0500Many analyses done with respect to Roth IRA conversions only come out to a positive outcome when the attendant tax on the conversion is paid from non-IRA sources.  For many folks this shoots down the entire prospect, as there is no available cash outside of IRAs and other investments to use to pay the tax on the conversion.  Taking the cash from the IRA in the form of a distribution can result in a 10% penalty, which can kill the whole plan.

One source of funds that you may not have considered is within your non-IRA investment accounts – especially if you have inherent capital gains and losses (even moreso if you have carried-over capital losses that wouldn’t otherwise be utilized readily).

Offsetting Gains With Losses To Produce Cash

Here’s how it works: You sell your “loss” positions, establishing a capital loss for tax purposes.  Then you can sell your “gain” positions in like amounts, giving yourself a tax-free source of cash, since the loss will offset the gain for taxation purposes.

For example – imagine that you have a $100,000 IRA that you’d like to convert.  Running the numbers, you’ve come to realize that the conversion will cost $25,000 to complete.  In addition to the IRA, you also hold some non-IRA money, in the form of two investments.  One of these investments has an inherent loss of $20,000, and the other has an inherent gain of $30,000.

By selling out of the “loss” position completely and selling just enough of the “gain” position to offset the tax loss you’ve realized, you have effectively created a tax-free source of income in the amount of $20,000.  This still leaves $5,000 if you’re planning to convert the entire amount.

After you’ve finished with your conversion activities (and after 30 days has passed so that you don’t run afoul of the wash sale rules), you can re-invest the leftover money in those same investments, keeping your allocation at least similar to what it was before.

At this stage you have three choices, assuming you don’t have an extra $5,000 laying around:

  1. You can choose to only convert a portion of your IRA – the amount that you can generate tax-free money to pay tax upon.  In our example, this would be $80,000.
  2. You can use more of the cash that you freed up from the sales of your non-IRA gain and loss holdings.
  3. You can convert the entire amount and take distribution of the additional $5,000 to pay the extra tax.  Actually you’d need to pull out $5,500 in order to pay the penalty on that amount that you’re distributing.

Of these three, I’d recommend option 2, which is the outcome where you complete the conversion of the entire amount without having to pay additional tax or penalty on the money that you’re using to pay the tax on the conversion.  Yeah, that last sentence belongs in a museum.  Happy converting!

Photo by NOAA Photo Library

Know Thyself

Jul 19th, 2010
by jblankenship.
3 comments

'Pythagoras_Emerging_from_the_Underworld',_oil_on_canvas_painting_by_Salvator_RosaThis ancient two-word phrase, attributed to several Greek luminaries ranging from Socrates to Pythagoras, implores the reader toward introspection.  This introspection can be especially helpful when considering how we feel about our financial future – particularly when we are at extremes of emotion.

The recent stock market activity has given us plenty of opportunities to experience extremes of emotion… but then again, you can pretty much choose any time period and make a similar statement.  There are quite a few studies that have recently brought to the forefront several things that we need to understand about ourselves and how emotion could impact our decision-making process.

Loss Aversion – as investors in general, we feel the impact of a loss approximately twice as much as we experience the good feelings from a gain.  It has further been estimated that as we approach retirement, this ratio increases to a factor of five times more pain for a loss as opposed to the joy we experience for a gain.

This seems to be true no matter whether the loss is realized or simply on paper.  The problem is that, in stock market investing, short term losses and gains are simply normal market activity, and we need to temper our emotions to keep things in perspective.

We Want Control… or Do We? – it would seem to follow the train of thought that, if we are feeling pain in our investing activities that we’d appreciate some guarantees and protection of some sort in our choices of products.  However, guarantees come with a cost – that of giving up control.  And as investors we prefer control (or the perception of control) over guarantees, studies have shown.

On the other hand, other studies tell us that a guaranteed income from an investment is preferred over an assured return on investment over time.  These studies show that, given a choice between an annuity with a monthly income and an investment portfolio structured to provide the same sort of returns over time, if we’re near retirement we choose the annuity seven times out of ten.

This means that we value the concept of income, that of receiving a check every month over the excess costs and lack of control that an annuity represents.  At the same time, we prefer to feel like we’re in control of our investing activities.

Lack of Understanding of the Numbers – when presented with the outcome of financial calculators, many of us consider whatever calculations were done in the background to be tantamount to magic.  For example, the very concept of inflation and its impact on our future finances is a mystery to us – we work best when calculations are discounted to present values.

Even though it’s been decided that it was politically incorrect, one popular baby-boomer who is now age 51 once admitted that math is tough (Barbie, of the doll fame, who actually admitted that “Math class is tough”).  There’s no shame in admitting that fact – for a lot of us, math can be very tough.  And as we get older (some say by age 53) our understanding of mathematical numeracy begins to decline dramatically, making math even tougher.

This can lead to distrust of the very calculations that could help you make good decisions in your financial life.

So What Does All Of This Mean?

Mostly this just means that we’re carrying with us a lot of preconceived notions and emotional preferences that we must take into account as we make financial decisions.  “Know Thyself” means that we should understand how these various notions can paint our perceptions of situations, and if we understand these things, we can recognize when our own limitations are working against us and take actions to consider things in a new, less biased, light.

For example, it’s natural to feel the pain of losses.  But as explained in the article The Lost Decade and What It Means, the activity of investing, especially in the stock markets, is a long-term activity and short-term losses, even over a few years, are temporary in the scheme of things.  Keep this in mind before making any rash investment decisions – you’re likely to regret emotion-driven decisions.

Photo by Wikimedia

Capital Gains and Losses and Your Taxes

Jun 28th, 2010
by jblankenship.
No comments yet

SNGLloyd_656If you own taxable investment accounts, real estate, collectibles, or literally any item that can appreciate or depreciate in value, you’ve likely had to deal with capital gains or losses on your tax return.  (Actually, only if you’ve sold the item.)  But how much do you really know about capital gains and losses?  The IRS has published Tax Tip 2010-35 listing 10 Facts About Capital Gains and Losses – detailing what the IRS deems important about gains and losses and how they could effect your tax situation.  Following below the IRS’ list is some additional detail on treatment of capital gains and losses.

10 Facts About Capital Gains and Losses

  1. Almost everything you own and use for personal purposes, pleasure or investment is a capital asset.
  2. When you sell a capital asset, the difference between the amount you sell it for and your basis – which is usually what you paid for it – is a capital gain or a capital loss.
  3. You must report all capital gains on your income tax return.
  4. You may deduct capital losses only on investment property, not on property held for personal use.
  5. Capital gains and losses are classified as long-term or short term, depending on how long you hold the property before you sell it.  If you hold it more than one year, your capital gain or loss is long-term.  If you hold it one year or less, your capital gain or loss is short-term.
  6. If you have long-term gains in excess of your long-term losses, you have a net capital gain to the extent your net long-term capital gain is more than your net short-term capital loss, if any.
  7. The tax rates that apply to net long-term capital gains are generally lower than the tax rates that apply to other income.  For 2010, the maximum long-term capital gains rate for most people is 15%.  For lower-income individuals, the rate may be 0% on some or all of the net capital gain.  Special types of net capital gain can be taxed at 25% or 28%.
  8. If your capital losses exceed your capital gains, the excess loss can be deducted on your tax return and used to reduce other income, such as wages, up to an annual limit of $3,000, or $1,500 if you are married filing separately.
  9. If your total net capital loss is more than the yearly limit on capital loss deductions, you can carry over the unused part to the next year and treat it as if you incurred it in that year.
  10. Capital gains and losses are reported on Schedule D, Capital Gains and Losses, and then transferred to line 13 of Form 1040.

Calculations

To determine tax treatment, your short-term capital gains (STCG) and short-term capital losses (STCL) are “netted”, and the same is done with your long-term capital gains (LTCG) and long-term capital losses (LTCL), as in the following equations:

STCG – STCL = Net STCG(or L)

LTCG – LTCL = Net LTCG(or L)

If the amount of loss (in either equation) is greater than then amount of gain, you have a net capital loss (either short or long).  Likewise if the amount of gain is greater than the amount of loss, you have a net capital gain.  These amounts are then netted against each other, as follows:

Net Capital Gains = Net STCG(or L) + Net LTCG(or L)

Tax Treatment Situations

If you have only short-term gains and losses, any net gain will be taxed at your ordinary income tax rate – that is, it is added to your other income from wages and the like, taxed just the same as income.  A net loss can be deducted from your income to the extent of the $3,000 annual limit discussed previously.  Any remaining net loss can be carried over to future years and deducted against net capital gains first, and then at the $3,000-per-year rate against your ordinary income until the net loss is exhausted.

Likewise, if you have both short-term and long-term gains and losses and the net short-term gains are greater than any net long-term losses, the remaining difference is taxed and treated as ordinary income.

If you have only long-term gains and losses, any net gain will be taxed at the applicable long-term capital gains rates (typically 0% or 15% through 2012).  Any net loss is treated the same as the net short-term capital loss described above.

If you have net long-term gains and net short-term losses that are less than or equal to the net long-term gains, in the “netting” discussed above, your net long-term gains will be reduced to the extent of your net short-term losses.

If the nettings result in net capital gains for both long-term and short-term, your net short-term gains will again be taxed at your ordinary income tax rate, but the net long-term gains will be taxed at the applicable long-term capital gains rate (typically either 0% or 15% through 2012).

And lastly, if the nettings result in net capital losses for both holding periods, this net loss is (as you might expect) allowed to be deducted from ordinary income at the $3,000-per-year rate.  Any amount of loss that remains is carried over to future years (as described previously).

Photo by Wikimedia

Investment Returns: What Should You Expect?

Jun 21st, 2010
by jblankenship.
1 comment

our lady of expectations by RavagesOne of the things that I always ask clients (in fact it’s on my initial questionnaire that potential clients fill out) is “What is your expected return from your investments?”  It can be pretty insightful to see what people are thinking that they should be able to receive in returns from their investments – I’ve seen everything ranging from 2% up to 25%.

In general, what I see in response to this question is high – much too high to be realistic.  If you look at the stock market over long periods of time, you’ll see that the annualized return over the past 100 years was roughly 9.4% (including reinvested dividends), for example.  What’s important is to understand how market returns are composed, in order to put it all into context.

How Market Returns Are Composed

Stock market returns are made up of several components:  the amount of return that stocks earn above the “risk-free” rate of return of Treasury Bills (known as the equity premium), plus the risk free rate of return, plus the rate of inflation.  This is usually expressed as an equation:

Inflation + Risk-Free Rate + Equity Premium = Equity Return

If you looked at present figures, you’d see that Inflation is presently running around 2.2% (CPI-U, since April 2009).  The Risk-Free Rate is presently something like 0.7%, and the historic Equity Premium is around 4.8%.  Adding all this together we come up with

2.2% + 0.7% + 4.8% = 7.7%

The key to all of this is not exactly what figure we come up with, but to give us an idea of what composes the return figures.  If you happen to receive a return of 7.7%, that would be quite a coincidence indeed – this calculation gives us an expectation to aim for, and that is all.

But understanding that inflation is one of the primary components of this equation, along with the rate of return on Treasury Bills, helps us to understand why low inflation and low interest rates (like we’re experiencing these days) often equates to lower than the historic average in terms of overall stock market returns.

Going back to the last 100 years’ figures, we see that the rate of inflation averaged 3.13% during that period.  If we consider that the risk-free return for the period was roughly 0.9%, we calculate that the Equity Premium for the period was approximately 5.36% as such:

9.41% – 3.13% – 0.9% = 5.36%

This reflects only a 0.56% differential in the Equity Premium between today’s figures and the historic averages.  The past 50 years experienced a higher rate of inflation (4.08%) with approximately the same average return (9.45%) and risk-free rate (0.9%), which suggests that the Equity Premium has been lower during that period, somewhere around 4.47%, which is still significant.

But It’s The Portfolio We’re Talking About…

Keep in mind, we’re not only talking about stock market returns – we’re talking about overall portfolio return expectations.  If we assume that the averaged-out rate of return that we can expect (in terms of premium over inflation and risk-free returns) is reduced by 2-3%, then in today’s marketplace with the 7.7% expected equity return, our blended return should range between 3% to 7.7% across the spectrum.

That may seem anemic, especially in the context of the crazy 15%, 18% or 20% returns we’ve seen in years past – but as we saw, those returns were based on some crazy bubble-based speculations.  The expectation of returns in those periods had no basis in reality… so welcome back to reality.  The point is that you need to be realistic about the returns we expect.  There’s no benefit to you by expecting a 20% return when it’s highly unlikely to be delivered.  Don’t get me wrong, I believe in being optimistic – but not when it can be detrimental to your financial life.

Photo by Ravages

The Lost Decade and What it Means

Jun 15th, 2010
by jblankenship.
1 comment

last decade of 1st century bc by MaulleighBy now you’ve likely heard plenty about the “lost decade” in the stock market:  On January 3, 2000, the S&P 500 index closed the day at 1,455.22, and on May 28, 2010, the index closed at 1,089.41 – for a negative return on the nearly 10 1/2 years… I’m sure you’ve noticed in your investment statements.

But what does this mean?  There are plenty of folks out there (in the mass media) who will tell you that stock market investing is no longer a wise move… why, after all, if you’d had your money in a savings account you’d have done better!  So does this mean it’s time to chuck all of your stock investments and switch everything to bonds?  Of course not.

Remember, it’s long term

No matter who you are as an investor, if you expect to achieve any return above inflation, you have to include equities (stocks) in your portfolio to some extent.  And when developing portfolio allocations, pretty much anyone under age 70 should be considering a time horizon of 30 years or more – and those over age 70 should be thinking similarly, since your chance of living to age 95+ is continuing to increase every year.

What I mean by this long-term view is that you need to stop thinking about stocks in a day-to-day, quarter-to-quarter, year-to-year or even decade-to-decade context, but rather in the context of thirty, forty, fifty and more years.   A college graduate, just starting a new job this year and investing in a sparkly-new 401(k) may likely be continuing to take distributions from that 401(k) in the year 2080, for example.  Even if you’re retiring this year at age 62 – you may still have 30 or more years of investment activity ahead of you.

Think about all that has happened in our history over the past 30, 40, 50, 60, and 70 years – 70 years ago we were still over 18 months away from Pearl Harbor and the US entry into World War II.  We’re talking about a significant amount of history that has occurred – and a likewise significant amount of returns that stocks have provided over that time.

So let’s look at the numbers for the S&P 500 more closely:

Decade
Annualized
Return		 30-year
Annualized
Return		 70-year
Annualized
Return
1870′s 10.90% 8.16% 6.81%
1880′s 8.31% 7.20% 5.80%
1890′s 5.21% 3.59% 6.88%
1900′s 7.63% 7.09% 6.85%
1910′s (1.84%) 5.27% 5.54%
1920′s 16.78% 7.20% 7.53%
1930′s 1.88% 7.12% 7.23%
1940′s 3.36% 8.24% 6.44%
1950′s 16.45% 6.44%
1960′s 5.30% 5.02%
1970′s (1.34%) 8.09%
1980′s 11.48% 7.35%
1990′s 15.14%
2000′s (3.16%)
Average 6.86% 6.73% 6.64%

* These annualized numbers are inflation-adjusted and include re-invested dividends

Notice how the numbers fluctuate pretty wildly among the 10-year periods, but begin to calm down as you look at the longer-term time horizons.  While there is nearly a 20% differential between the best and worst 10-year periods, when you look at the 30-year periods the differential is less than 4.75%, and over the 70-year periods the differential is even less:  only 2% separates the best period from the worst.

So, while you may have an off decade or two in your overall investing experience, in the long term you’re likely to approach the average return, as long as you keep your head and remain vigilant with your investment allocation in good times and bad.

Why A Decade?

The other thing about this “lost decade” business that bothers me is that it’s an arbitrarily-chosen timeframe – why do we only want to measure in terms of an exact decade?  What if we started these periods in March of the years ending with 3?

10-year
Annualized
Return		 30-year
Annualized
Return		 70-year
Annualized
Return
3/1/1873 10.39% 8.49% 6.22%
3/1/1883 6.91% 6.36% 6.19%
3/1/1893 8.14% 4.51% 7.00%
3/1/1903 4.29% 3.37% 6.62%
3/1/1913 1.45% 4.73% 5.84%
3/1/1923 4.40% 7.66% 7.23%
3/1/1933 7.44% 10.38% 8.21%
3/1/1943 10.22% 9.34%
3/1/1953 12.64% 5.45%
3/1/1963 5.43% 5.11%
3/1/1973 (0.89%) 5.38%
3/1/1983 11.05%
3/1/1993 5.82%
3/1/2003 4.59%
Average 6.56% 6.43% 6.76%

* These annualized numbers are inflation-adjusted and include re-invested dividends

As you can see, within reason, these periods averaged out very similar when compared to the exact decades, but the differential between the best and worst decades was much different (this would be referred to as the “deviation” of the returns).  And as we noted in the first table, as the time horizon increases, the deviation reduces to very near the average for that timeframe.

So, don’t get hung up on an arbitrary measure such as this to begin with.  Recent history has a very poor track record for predicting the future (in short term views, especially) – remember how heady the market was after the 1980′s and 1990′s dramatic returns?  No fool would have suggested that you shouldn’t be in stocks at the turn of the millennium – but look at what has happened since then.  Same thing goes for the end of the 1970′s – stocks looked like a terrible place to be, but then along came the bull markets of the 1980′s and 1990′s.

Taking another view – when there’s a downswing in the markets, when you’re in the position of continual investing, you’re actually getting more shares for your money than in the upswing periods.  In the long run this gives you a much better footing than a single lump sum invested at (perhaps) the wrong time.

The Point

The point of all this is that if you have a long-term horizon (and we all do, to some degree) and you hope to earn something more than the level of inflation, stocks are your best bet.  And holding your properly-diversified portfolio of stocks through thick and thin is the best method for investing in the market – lost decade or not.  Because in the long run, stocks are most likely to return their historical long run average – which is much better than any other alternative investment out there.

Photo by Maulleigh
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