Gil Hanoch

A Hidden Benefit of Roth IRAs

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Quiz!

When can you withdraw Roth IRA contributions without penalties?

  1. When your Required Minimum Distributions (RMD) start: age 72 or older
  2. Age 59½
  3. 5 years after the contribution
  4. 5 years after opening the Roth IRA
  5. Immediately
  6. Never

A Hidden Benefit of Roth IRAs

There are plenty of articles that talk about tax benefits of Roth IRAs. But, there is a benefit that can shine if used correctly:

  1. You can withdraw the contributions (as opposed to earnings) right away without penalties!
  2. You can also withdraw amounts that were converted to Roth IRA penalty-free, 5 years after each converted amount.

How can you use this benefit?

  1. As soon as you start earning income (whether you are 25 or 10 years old), put the maximum allowed into a Roth IRA, unless you are certain to spend it soon. If you don’t have enough low-volatility reserves outside the Roth IRA, keep building them inside the Roth IRA.
  2. If your income is too high, you can contribute to a Traditional IRA and immediately convert to Roth IRA, regardless of your income (nicknamed Backdoor Roth).
  3. If you have enough reserves (in taxable accounts + Roth IRAs), maximize your employer retirement contributions (e.g. 401k or 403b), putting the employee contributions into Roth (e.g. Roth 401k), if possible.
  4. The point above applies also if you are self-employed – you can maximize contributions to a Solo-401k, adding large employer contributions.
  5. Whenever you switch jobs, you can rollover your 401k or 403b to a [Roth] IRA, and convert the IRA to Roth IRA. For large balances, you can spread the conversion over multiple years, emphasizing years with low taxable income, to lower the effective income tax rate. Once in Roth IRA, it becomes available for withdrawal penalty free after 5 years.
  6. Count your Roth IRA contributions (not earnings) immediately & conversions (after 5 years) as part of your cash reserves, by calculating a sustainable withdrawal rate from them (typically 3%-4% for stock portfolios). For example, if you contributed a total of $100,000, you can count $3,000 or $4,000 of it as part of your cash reserves.
  7. There are a number of ways to access your Roth IRA earnings, without penalties. They are covered in many articles, but I will point out an important one: substantially equal periodic payments. It requires a commitment to withdrawals for 5 years, and at least until age 59½, so wait to use it after depleting all other sources (all money outside retirement accounts + all principal contributions to the Roth IRA). The nice thing is that it creates lifelong income, similar to the manufactured approach I described for the Roth IRA contribution right above.

Quiz Answer:

When can you withdraw Roth IRA contributions without penalties?

  1. When your Required Minimum Distributions (RMD) start: age 72 or older
  2. Age 59½
  3. 5 years after the contribution
  4. 5 years after opening the Roth IRA
  5. Immediately [The Correct Answer]
  6. Never

Explanation: You can withdraw Roth IRA contributions (not the earnings on them) without penalties right after making the contribution, with no delay, regardless of your age. See this month’s article for how to use this to your benefit.

Disclosures Including Backtested Performance Data

A Strategy to Increase your Investment Growth without Sacrificing Security

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Quiz!

What are the benefits of high investments in a diversified stock portfolio relative to withdrawals? (Multiple answers may be correct)

  1. They help get freedom from work.
  2. They add to your cash reserves, dollar for dollar.
  3. You can count a small portion of them as part of your cash reserves.
  4. They provide a potential snowball of accelerated increase in your wealth.

A Strategy to Increase your Investment Growth without Sacrificing Security

In a perfect world, you would allocate all of your money to high growth investments, to maximize the speed of building wealth. The issue is that growth comes with volatility, and you may need your money during a big decline for your investments. Examples for needs are a loss of job, a downturn for your business, buying a house, and the biggest of all – retirement. Common solutions involve a money market account, bonds and other low-volatility investments, that come with lower growth.

Is there a better solution? It turns out that there is another solution that lessens the compromises – a low withdrawal rate from a diversified stock portfolio. A diversified stock portfolio with a low withdrawal rate of 3%-4% may grow faster than cash or bonds when subject to the same withdrawal rate.

How do you get there?

  1. Build stable reserves to survive tough situations that are out of your control.
  2. Beyond that, invest in a diversified stock portfolio.
  3. Using a likely sustainable withdrawal from the stock portfolio (typically 3%-4%), reduce your reserves by that amount, moving it into the stock portfolio. You can check periodically (e.g. quarterly), and move the money whenever your investments grow relative to your spending (through any combination of new savings and investment growth).

This strategy creates a positive snowball: The more you have in stock investments, the more you can shift from the reserves to them. This accelerates the growth of your money, which allows to move more from your reserves to stocks.

Depending on how early you start, and how flexible you are with your spending, you may be able to reach 100% allocation to stocks before retirement, allowing you to sustain it for life. This can result in some combination of:

  1. Growing security (the fixed dollar withdrawal becomes a decreasing percent from a larger pot).
  2. Higher available spending (keeping the same withdrawal rate = a higher dollar amount, as the portfolio grows).

What is the catch? There are several catches:

  1. You have to stay perfectly disciplined with your strategy. It is tempting to sell low or put new savings elsewhere, when the news is grim. This can revert the entire long-term benefit.
  2. The plan is designed to allow selling a likely sustained portion (e.g. 3%-4% per year) for spending needs. This is fine as long as the needs have nothing to do with the investment performance. You may be tempted to sell low, to invest elsewhere. This is not a spending need, and if you are tempted to do that at low points, you are better off seeking a different plan in the first place.
  3. You may underestimate the needed reserves, or simply be surprised by something unplanned. As long as it comes at a normal point for the stock portfolio, there is no problem. But, it can hurt you during deep declines. Try to be realistic.

Quiz Answer:

What are the benefits of high investments in a diversified stock portfolio relative to withdrawals? (Multiple answers may be correct)

  1. They help get freedom from work. [Correct Answer]
  2. They add to your cash reserves, dollar for dollar.
  3. You can count a small portion of them as part of your cash reserves. [Correct Answer]
  4. They provide a potential snowball of accelerated increase in your wealth. [Correct Answer]

Explanation:

  1. They can cover your expenses while not working. If they are big enough, the investment growth/income can support long periods without work.
  2. Investments can be volatile, so you cannot assume that the full amount will be available for you at any point.
  3. You can count a likely sustainable withdrawal rate (typically 3%-4%) as part of your reserves, since that amount is likely to be there for you even during deep declines. Read this month’s article to learn more.
  4. Investments tend to grow by some percent on average. As the investments grow, a fixed percentage of larger pots becomes a large amount.
Disclosures Including Backtested Performance Data

Do I Invest in Bitcoin?

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Quiz!

What asset is bitcoin most similar to, and why?

  1. Dollars
  2. Bonds
  3. Gold
  4. Stocks
  5. Real estate

Do I Invest in Bitcoin?

Bitcoin was invented in 2009 as a digital currency, and exhibited phenomenal growth so far, raising the question: what growth can we expect moving forward? While it is easy to extrapolate recent growth into the future, it is not always correct. History is full of such examples. Below is an analysis of bitcoin as an investment.

Potential intrinsic long-term growth:

  1. Ongoing value creation: bitcoin doesn’t offer any product or service (unlike companies), or a place to live in (unlike real estate). It is tough to identify value creation in the long run.
  1. Ongoing value destruction: bitcoin cannot lose value through a sharp increase in supply, so not expected to lose value to inflation, unlike the dollar.

Conclusion: There is a potential for 0% very long-term growth beyond inflation.

Today’s pricing: 0% growth beyond inflation assumes that bitcoin is priced correctly today. While there are no useful measures to give it any specific value greater than $0 (it doesn’t produce anything), there is some useful information:

  1. Bitcoin is a software product, and its returns have been correlated with tech stocks (but more volatile). If this correlation sustains, we may be able to draw potential information about bitcoin’s pricing (valuations) using tech stocks.
  1. Bitcoin existed only during the current up-cycle of US tech stocks (since 2009, 15 years). This makes it risky to assume that its past returns will continue. US tech stocks have become extremely overpriced. They have extreme prices relative to intrinsic values (Price/Book). The S&P 500 developed an unusual concentration in tech stocks, as it did before prior crashes. Mid-last month, it reached record overpricing beyond the extreme of year 2000 (potentially, an all-time historic record overpricing). While tech stocks (as presented by the Nasdaq) declined by 78% after that peak, the excess volatility of bitcoin could imply a greater decline.

The future: One of the biggest stated appeals of bitcoin is the ability to avoid losing value to the high inflation created by governments, similar to the stated benefit of gold. Both aim to achieve this benefit through their limited supply (with a hard cap on the supply for bitcoin). This commonality allows us to put the benefit to the test of a very long history of gold.

  1. Recessions: History had more severe recessions under the gold standard, including The Great Depression. With inability to print more money easily, the Federal Reserve (the “Fed”) could not stimulate the economy. In contrast, without the gold standard, the Fed and government were able to stimulate the economy during recessions. As an extreme example, it helped prevent the 2008 recession from turning into a depression. Central bankers and economists are largely unanimous against the idea of returning to a gold standard. If bitcoin becomes too prevalent, the government could set regulations to make bitcoin uncompetitive, or even illegal (as China & Saudi Arabia did).
  1. Spreading recessions: The gold standard linked countries through fixed exchange rates. If a country struggled, people wanted to stop holding its currency. This would lead to a depleting stock of gold for the country. To prevent that, the country raised its interest rate, to make its currency more appealing to hold. Higher interest rates led to reduced economic activity, magnifying the country’s economic struggles.

More topics:

  1. Environmental Impact: Bitcoin mining uses an enormous amount of energy (over 100 terawatt hours last year). While it seeks to use energy at times of low demand, it is a true waste when compared to storage in batteries for later use. Until the world operates on 100% abundant renewable energy (we are far from that), bitcoin has a negative environmental impact.
  1. Limited supply is not a benefit: Bitcoin is designed to have limited supply. This does not imply any rate of growth, if it does not come along with an appeal. For example, if I can find a small rock of an uncommon shape or size, it won’t likely have much value, no matter how rare it is.

Summary: I don’t see bitcoin as an appealing investment in terms of expected returns (inflation + 0%) or risk-adjusted returns (extreme volatility, with very low expected returns). It doesn’t have theoretical reasoning as an investment – it doesn’t generate anything. It also doesn’t have a history of a full cycle, so past returns are still between irrelevant and offering a hint at a potential sharp reversal.

There are plenty of productive investments that generate value beyond inflation, including companies (stocks) & real estate. Their viability is rooted in basic human needs: the desire to get things done cheaply and efficiently (e.g. buying a car from a company instead of building it at home), and the need to have a place to live in (real estate). Of these assets, there are plenty that are priced very reasonably (including value & international stocks).

To answer the question of the title, I do not invest any of my money in bitcoin.

Quiz Answer:

What asset is bitcoin most similar to, and why?

  1. Dollars
  2. Bonds
  3. Gold [The Correct Answer]
  4. Stocks
  5. Real estate

Explanation:

  • Both bitcoin and gold are used as an inflation hedge – the ability to store money without seeing it decline with inflation.
  • Both don’t generate anything on an ongoing basis (though gold has intrinsic value, such as for jewelry, and bitcoin doesn’t).
Disclosures Including Backtested Performance Data

My Personal Experience with the Recency Bias

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Quiz!

Which diversified investment looks more appealing?

  1. 15% average growth per year over the past 10 years, up from a long-term average of 10% per year.
  2. 5% average growth per year over the past 10 years, down from a long-term average of 10% per year.

Say that after 2 extra years, the faster growing investment continued performing better than 10% per year. Which would you choose now?

  1. The first one.
  2. The second one.

My Personal Experience with the Recency Bias

What is the Recency Bias? It is making decisions based on recent events, with the expectation that they will continue.

How can the Recency Bias hurt investors? Most investments are cyclical, while the recency bias assumes no cycles. Common harm is buying high after unusual gains or selling low after unusual declines. When done repeatedly, it can lead to long-term underperformance of a simple buy-and-hold strategy.

Are there less obvious cases of Recency Bias hurting investors? Yes. Many investors are disciplined enough to hold onto their investments at low points, but they may wait for gains before investing new money. Missing a 1% or 2% gain is nearly harmless. But some investors wait for more and more evidence. Once they see (and miss) 20% or 30% gains, some wait to buy at a dip, and some wait for more evidence of gains. Only after seeing 50% to 100% gains, some feel that the gains are here to stay, and invest after missing out on huge gains. The damage is far worse than simply missing gains, leading to a negative snowball. The delayed investment hurts their personal returns, they think that their investments are worse than reality, so they stay less committed to them, hurting their returns even further, cycle after cycle.

Did I ever experience the Recency Bias? Yes & no. When trying to think about the likely returns of an investment in the next 10 years, I know that it’s likely to be different than the past 10 years, given studies of investment cycles and valuation measures. But, in anomalous times, where a cycle gets stretched longer than usual, I am tempted to temper my expectations for the next leg of the cycle. I recognize that real life works the opposite – the longer we have an anomaly, the stronger the reversal tends to be. Examples of my recency bias:

  1. When looking at the raw data, it is rational to expect the S&P 500 to lose value over the next 10 years. But the recency bias leads me to believe it may get low positive returns.
  2. When looking at the raw data, it is rational to expect non-US Value (low Price/Book) stocks to enjoy unusually high returns over the next 10 years. But I catch myself sometimes expecting only average returns.

How damaging can the Recency Bias be? The examples I gave right above are not too harmful. They don’t lead me to make decisions that are opposite of rational, so I can live with them. The harm comes from an expectation opposite of rational, that leads to decisions that are very likely to fail. Here are examples:

  1. Expecting the S&P 500 to average more than 10% per year in the next 10 years, or even 6% or 8%.
  2. Expecting low interest rates in the next few years.
  3. Expecting AI-focused companies that reached extreme valuations to significantly outperform the rest of the market in the next 10 years.

How do I avoid big harm by the Recency Bias? I base my expectations based on a combination of:

  1. Full cycle, long-term behavior.
  2. Logic.
  3. Valuations (e.g. Price/Book) today relative to typical in the past.

Quiz Answer:

Which diversified investment looks more appealing?

  1. 15% average growth per year over the past 10 years, up from a long-term average of 10% per year.
  2. 5% average growth per year over the past 10 years, down from a long-term average of 10% per year. [The Correct Answer]

Explanation: High growth diversified investments tend to be cyclical, with reversals being more common than not after 10 years.

Say that after 2 extra years, the faster growing investment continued performing better than 10% per year. Which would you choose now?

  1. The first one.
  2. The second one. [The Correct Answer]

Explanation: When above/below trend continues beyond 10 years, reversals continue to be the more common case, with greater odds and magnitude.

Read this month’s article to find out what leads people to pick the other option for both questions.

Disclosures Including Backtested Performance Data

7 Rules for Success With Illiquidity

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Quiz!

Which are ways to deal with illiquidity?

  1. Illiquidity is not an issue, as long as the portfolio is diversified and designed for high growth.
  2. Design a portfolio that can generate income that grows beyond inflation, using the liquid money.
  3. Keep liquid cash for ongoing expenses.
  4. Find a few good deals to generate liquid growth.
  5. Count on income from the illiquid money using conservative assumptions.
  6. Ignore the illiquid assets when thinking about available money, until they are turned to liquid.
  7. Hold bonds, to have money aside with low volatility.

7 Rules for Success With Illiquidity

If a big portion of your net worth is illiquid, you may face unique challenges. The challenges apply whether you have $10M, $100M or $1B. People with substantial assets faced these challenges, creating stress and financial risks. Here are a couple of examples of challenges:

  1. Cash drag: you may keep a large amount in cash or bonds, ready for ongoing expenses, or available for a future investment. This creates a drag on the returns, which can be significant depending on the amount. The problem gets magnified when you depend on the liquid allocation for ongoing expenses – it may not grow enough to cover expenses until a liquidity event.
  1. Illiquidity risk: in certain situations, you may face a risk of bankruptcy. For example, say your expenses are $1M per year, and you have $1M in liquid investments along with a company worth $500M. You are in the process of selling the company. Large sales typically take time, and buyers back down more frequently than you may expect. If the sale drags for a year, and at the last minute the buyer backs down, you are left with no money to pay the bills which could lead to bankruptcy.

Here are 7 solutions:

  1. Establish lines of credit (LOCs) or loans that are readily available for temporary cash needs, especially when waiting for an upcoming liquidity event. The first target is LOCs backed by the illiquid assets, when possible, but it could be any asset or business you own. Be very careful of this solution – if used incorrectly or abused (used for long-term spending), it can lead to catastrophes.
  1. Aim for a low withdrawal rate from your liquid investments. Calculate your typical annual expenses, deduct any conservative income you can get from your illiquid assets under tough circumstances, and divide by your liquid investments. A withdrawal rate of 3%-4% can put you in a strong position depending on the allocation of your liquid investments. At higher rates, your risk level goes up.
  1. Don’t count on money from the sale of illiquid investments until the money is in the bank. People get nervous with large purchases, and far too many deals fall through.
  1. When selling a company to a private company, in exchange for shares of the buyer, don’t count on the money until an exit (cash sale or IPO) of the buying company.
  1. Allocate your liquid money to investments that are designed to provide income that can grow with inflation. While cash & many bonds improve stability, they can lose money to inflation.
  1. Prepare for difficulty with liquidating your illiquid investments. Allocate your liquid money for high enough growth for as long as you may wait for liquidity.
  1. Subject to the points above, keep your liquid investments diversified, so you are not dependent on a small collection of companies to help pay for your living expenses.

Illiquidity involves risk, and the solutions above are ideas to help with this risk, to create a successful outcome. They require very careful planning, with serious pitfalls to watch out for. Many liquid investments that grow beyond inflation are volatile and require discipline to stick with through the ups and downs of a cycle. Lines of credit and loans can easily be abused, shifting them from protectors to tools for hurting liquidity.

Quiz Answer:

Which are ways to deal with illiquidity?

  1. Illiquidity is not an issue, as long as the portfolio is diversified and designed for high growth.
  2. Design a portfolio that can generate income that grows beyond inflation, using the liquid money. [Correct Answer]
  3. Keep liquid cash for ongoing expenses.
  4. Find a few good deals to generate liquid growth.
  5. Count on income from the illiquid money using conservative assumptions. [Correct Answer]
  6. Ignore the illiquid assets when thinking about available money, until they are turned to liquid. [Correct Answer]
  7. Hold bonds, to have money aside with low volatility.

Explanations:

  1. No matter how fast your illiquid portfolio grows, if you don’t have enough liquid money to cover your expenses, you can go bankrupt, even if you are a billionaire.
  2. Inflation is a risk that applies even to very wealthy people. Having liquid (accessible) income that grows beyond inflation helps.
  3. Liquid cash is great for a while, but it loses money to inflation, and doesn’t generate growth for long-lasting income.
  4. Liquid growth is great. The issue with this answer is the phrase “a few”, implying a concentrated portfolio that may lead to irreversible declines in case of bad luck.
  5. While illiquid investments may not be accessible easily, some generate income. You can count on the income you expect to get even under tough scenarios to stay conservative.
  6. Very wealthy people got into trouble counting on illiquid money in the process of selling a large asset, just to see the sale fall through. Don’t count on it, until the money is in the bank.
  7. Depending on your overall picture, bonds may be helpful and even necessary. But, similar to cash, they are not strong at generating income that grows with inflation and may give diminishing security for longer lasting needs.
Disclosures Including Backtested Performance Data

The Latte of Investing

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Quiz!

Are you likely to make money on waiting to invest until conditions become better than today?

1. Yes, the negative news can lead to continued declines. Waiting allows you to buy lower.

2. No, as conditions improve, stocks tend to go up.

The Latte of Investing

You may have heard how a daily $5 café latte can add up to significant money over time. Many people see it as a small daily cost that makes no difference in the big scheme. They ignore the fact that it is recurring, leading to a much bigger total. While different people value the store-bought latte to different degrees, it demonstrates how some people may overspend on small recurring items.

There is an analogy in investing. Many people get nervous about investing after declines (that involve negative news), and delay investing until things calm down. They feel that whatever gains they may miss on the small amount is dwarfed by the gains they will enjoy with the big remaining portfolio. While the logic may sound convincing at first, when repeated, the small, missed gains can add up to very big money.

What can you do? Operate consistently: invest money as soon as it is saved.

What if it’s tough to do? Recognize that if you are uncomfortable investing at the current low level, you are likely to be even less comfortable investing at an even lower level. You are very likely to wait until the news is better than today, leading to buying higher, and missing gains. Past experience of investors supports this theory – investors tend to significantly underperform the investments they use.

Initially, it may be tough to be consistent. Once you form a habit, you may enjoy the automatic action, without a need to debate often.

Quiz Answer:

Are you likely to make money on waiting to invest until conditions become better than today?

1. Yes, the negative news can lead to continued declines. Waiting allows you to buy lower.

2. No, as conditions improve, stocks tend to go up. [The Correct Answer]

Disclosures Including Backtested Performance Data

What Moves Interest Rates?

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Quiz!

What are reasons for the Fed to lower interest rates? (There may be multiple correct answers.)

  1. A decline in Inflation.
  2. A mild recession in the US.
  3. Core PCE Inflation reaches the 2% goal.
  4. A slight increase in unemployment.
  5. A severe recession in the US.
  6. Very high unemployment.

What Moves Interest Rates?

For a long time, some experts predicted a decline in interest rates. How could they be so wrong for so long? What really drives the Fed’s decisions?

Topic

Expectation

Reality

What are normal interest rates?

Very low, after 0% for years

Closer to the current 5.5%

What inflation is needed?

Declining inflation

An absolute level of 2%

What is the target inflation?

Higher than 2%, maybe 3%

2%

How does inflation change?

Linearly

The decline typically slows down as it approaches 2%

How are employment & inflation balanced?

Employment isn’t a big factor.

As long as inflation isn’t very high, we deserve low interest rates.

With unemployment so low, the main goal is to lower inflation

What are the Fed’s biases?

They want low interest rates

They don’t want to repeat the 1970’s where prematurely lowered rates let inflation spike again

What is good?

Low interest rates

Maximum employment with 2% inflation

Explanations: It seems that some people are driven by wishful thinking more than reality. Investors used the extremely low interest rates of the 2010s to justify extreme large US stock valuations, and they are eager to see interest rates go down. They hope to see very low interest rates as both the norm and the target. The Fed thinks very differently. They have two goals in mind (based on their job description): maximum employment and 2% inflation. With the employment goal in place, their focus is on getting inflation down. They saw inflation spike out of control in the 1970’s, and they are trying to avoid a repeat. The Fed said clearly that they will go as far as needed to reach their inflation goal.

What should we expect? Inflation is still nearly double its target: 3.5% vs. 2%. With inflation declines typically slowing down as we head towards the target 2%, we may have a long period with high interest rates. It is reasonable to expect the Fed to space out the rate increases further and further apart, as long as inflation keeps moderating. It may keep the interest rates the same for an extended period until inflation gets close to its target 2%.

Are there other scenarios? Yes. If the economy slows down and unemployment surges, the Fed will go back to a balancing act between employment and inflation, and could lower interest rates for a while. In that case, stock prices could do the opposite of mainstream expectations – they may decline. This could be most pronounced for stocks with the highest valuations (as measured by Price/Book).

Should we welcome lower interest rates? At first thought, lower interest rates are compelling, making it easier to fuel growth with cheap borrowing for companies & individuals. When considering the drivers of the Fed’s actions, lower interest rates without much lower inflation may be bad news – reflecting a response to a recession.

What can you do? You can structure your investments to benefit from high interest rates, and welcome the reality. Value stocks (with low price/book) tend to do unusually well with sustained high interest rates (not every month and not guaranteed). Note that your ideal investment allocation depends on your overall risk profile and goals.

Quiz Answer:

What are reasons for the Fed to lower interest rates? (There may be multiple correct answers.)

  1. A decline in Inflation.
  2. A mild recession in the US.
  3. Core PCE Inflation reaches the 2% goal. [Correct Answer]
  4. A slight increase in unemployment.
  5. A severe recession in the US. [Correct Answer]
  6. Very high unemployment. [Correct Answer]

Explanations:

  1. The Fed seeks 2% inflation, not just a decline in inflation. Declines can moderate interest rate increases and space them out more, but less likely to lead to a reversal long before approaching the target 2%.
  2. The Fed said repeatedly that it will accept a mild recession if needed to control inflation.
  3. When Core PCE Inflation reaches its 2% goal, interest rates don’t need to stay elevated and would likely move down.
  4. Slightly higher unemployment would still be low historically, and wouldn’t justify lower interest rates without much lower inflation.
  5. A severe recession would likely lead to lower interest rates, though not guaranteed if inflation spikes very high.
  6. Very high unemployment would likely lead to lower interest rates, especially if inflation isn’t very high.
Disclosures Including Backtested Performance Data

Building Credit for Kids under 18

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Quiz!

At what age can a person in the US get a credit card?

  1. 0
  2. 16
  3. 18
  4. 21

Building Credit for Kids under 18

If you have kids under age 18, there are steps you can take to introduce them to the world of credit:

Build credit: You can add them as authorized users on your credit card(s). I tested this on Chase Freedom Unlimited. This can start building up their credit history, without them ever using the card. By the time they are 18, they should have a credit history.

Access to credit: In their teen years, you can have a separate credit card in one of the parents’ names, add your child as an authorized user and let them and only them use it. This goes around the age limit of 18+ for getting a credit card. There are multiple benefits:

  1. Enabling them to pay anywhere that requires a credit card for payment.
  2. Your child experiences the power & risk of using a credit card under your supervision. By the time they are adults, they have a chance to form healthy habits, and learn some pitfalls of credit cards.
  3. You can see 100% of their credit card transactions separately from yours, allowing for a full learning experience, while identifying clearly all of their transactions.

Remember that you do this at your own risk – whatever they feel like doing with your credit card, you are on the hook.

Quiz Answer:

At what age can a person in the US get a credit card?

  1. 0
  2. 16
  3. 18 [Correct Answer]
  4. 21

Explanation: The official age is 18, but this month’s article presents a way to get access at a lower age.

Disclosures Including Backtested Performance Data

What are Some Pitfalls of Bonds Today, and When will they Subside?

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Quiz!

Which of the following statements are true? (There may be multiple answers.)

  1. Short-term bonds are attractive today, given their high interest payments.
  2. Short-term bonds are appealing whenever there is a large upcoming expense.
  3. Short-term bonds enjoy low volatility.
  4. Long-term bonds are attractive today, given their high interest payments.
  5. Long -term bonds are appealing whenever there is a large upcoming expense.
  6. Long-term bonds enjoy low volatility.

What are Some Pitfalls of Bonds Today, and When will they Subside?

Bonds offer much higher interest payments these days compared to 2 years ago. They are appealing for various uses. They are especially useful if you prefer/need to moderate the volatility of stocks. When deciding on a bond allocation, it is worth paying attention to the following pitfalls:

  1. Short-term bonds: After inflation and taxes, it is tough to get substantial income, and often the net real income is negative. For example, a bond paying 4%, to a person with 25% income tax rate, nets 3% income. With inflation of 4%, this leads to a -1% return. Tax-free municipal bonds address the tax penalty, but at a price of lower income, that also faces the inflation headwind. It is not a reason to avoid using them, but important to be aware of the issues when deciding on the allocation.
  1. Long-term bonds: Long-term bonds sometimes (not always) enjoy higher income but face an additional problem: the risk of rising interest rates. Historically, once inflation reached a 9% level, as happened last year, it took a median of 10 years to go back to normal.  So, without any bad luck, the bond becomes a risky investment for extended periods. The price of a 20-year bond paying 4% per year changes by 13% for every 1% change in interest rate. Compounding the declines for a 4% rate increase causes about a 40% decline. If you hold the bond to maturity you avoid the interest rate risk, but still have inflation risk. In addition, there are more compelling investments for long-term holding periods.

When would the risk of long-term bonds go down. Once Core PCE inflation (the measure that the Fed tracks) gets closer to 2%, the Fed may feel confident enough that it completed addressing the high inflation, and will more likely stop raising interest rates. While there are many factors affecting interest rate decisions, this is a prominent risk factor for bondholders.

Note that this article only pointed out a couple of risks of bonds today and is far from a comprehensive review of bonds. There are many types of bonds that are appropriate for different uses at different times.

Quiz Answer:

Which of the following statements are true? (There may be multiple answers.)

  1. Short-term bonds are attractive today, given their high interest payments.
  2. Short-term bonds are appealing whenever there is a large upcoming expense.
  3. Short-term bonds enjoy low volatility. [Correct Answer]
  4. Long-term bonds are attractive today, given their high interest payments.
  5. Long-term bonds are appealing whenever there is a large upcoming expense.
  6. Long-term bonds enjoy low volatility.

Explanations:

  1. While high interest payments are more appealing than low interest payments, you need interest payments materially above inflation to give appealing after-tax growth or income. Other investments can do this job better.
  2. Not knowing anything else, this statement is true: short-term bonds are appealing when there is a large upcoming expense. There is an important exception to this statement: when the total withdrawal rate (including the unusual expense) is low enough, it is possible to enjoy the benefit of stocks while supporting the unusual expense, as long as the investor is perfectly disciplined. Some large expenses can be broken down to a series of smaller expenses, alleviating the need for bonds. Examples are student loans and mortgages.
  3. Correct: Short-term bonds indeed enjoy low volatility.
  4. Long-term bonds seem attractive today, given their high interest payments, but they can decline in the face of rising interest rates.
  5. Long-term bonds are not appealing for large upcoming expenses. They can decline significantly in the face of rising interest rates, as seen in 2022.
  6. Long-term bonds fluctuate a lot more than short-term bonds with changes in interest rates. They have lower volatility than stocks, but not always low volatility.
Disclosures Including Backtested Performance Data

Dispelling a Myth: Stock Valuations are Always Lower with Higher Interest Rates

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Quiz!

Are Extended-Term Component (ET) valuations lower or higher when interest rates are higher?

  1. Lower
  2. Higher

Dispelling a Myth: Stock Valuations are Always Lower with Higher Interest Rates

When interest rates are higher, there are 2 implications for stock valuations (Price/Book):

  1. Negative: Future earnings get discounted more, justifying lower stock valuations – what people expect. This effect is smaller for value stocks that are valued more based on near-term earnings.
  2. Positive: The reason for higher interest rates tends to be higher inflation, which represents higher prices charged by companies. Higher income to the companies justifies higher valuations.

Extended-Term Component (ET), a portfolio that emphasizes deep value stocks, is impacted more by the positive effect. The chart below shows a positive relationship between the Fed Rate and valuations (P/B) for ET, since 1999. With today’s rates at 5.25%, the range of valuations is raised, making current valuations (P/B = 0.87) close to the low end of the range (of: 0.73 to 2.08). If history repeats itself, it could point to more upside potential.

Adding to the good prospects, the Fed’s preferred measure of inflation is holding steady for a 5th month, with a slight increase last month to 4.7%. This is more than double the Fed’s target of 2%, adding pressure on the Fed to keep raising rates. With headline inflation peaking at 9.1% last year, and historically interest rates rising above peak inflation, it is possible for interest rates to peak above 9.1%, which is about 4% higher than today. If interest rates peak higher than today, valuations may also peak higher, adding to the positive forces.

Notes: Future ranges can be different, and there is no guarantee that future interest rates will be higher. Small note: the 6% rate column (the last one) is impacted by limited data.

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Quiz Answer:

Are Extended-Term Component (ET) valuations lower or higher when interest rates are higher?

  1. Lower
  2. Higher [Correct Answer]

Explanation: See chart and explanation in this month’s article.

Disclosures Including Backtested Performance Data