Planning for Unlimited Roth IRA Conversions

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If you have high income, you may know that a Roth IRA is off limits for you. You cannot contribute to it or convert a Traditional IRA to it. Starting in 2010, Roth IRAs will be accessible to everyone. This article can help you decide whether and when to convert your Traditional IRA to a Roth IRA.

Before continuing, note that this article is not intended to provide a full review of IRA tax laws. You are encouraged to consult your CPA before making tax related decisions.

How can you contribute to a Roth IRA? The new law does not remove the income cap on contributing to a Roth IRA, but it does remove the income cap on converting a Traditional IRA to a Roth IRA. This means that every year you can contribute to a Traditional IRA and the next day convert the contribution to a Roth IRA, essentially resulting in a contribution to your Roth IRA.

Here are a few characteristics of IRAs (referenced later as #1 to #5):

Characteristic Traditional IRA Roth IRA Taxable
1 Are investment taxes1 imposed? No, investments are tax free while the money is in the account Yes
2 When is income tax paid? When money is taken out When income is earned
3 Can income tax be paid from outside the account? No Yes N/A
4 How long can money stay in the account? Up to age 70½, then withdraw throughout life For life, then withdraw throughout life of heirs Forever
5 How soon can money be withdrawn from the account? Age 59½; disability; death; up to $10,000 for first home for you, your parents, children or grandchildren; unreimbursed medical expenses above 7.5% of AGI; higher education; medical insurance after getting 12 weeks of unemployment payments due to losing your job; as a result of an IRS levy; or equal payments at least till age 59½ and at least for 5 years, but:
Roth Contributions: Can be withdrawn any time.
Roth Earnings & Rollovers: Cannot be withdrawn for 5 years after the first ever contribution to a Roth IRA.		 Anytime

Maximize IRA Balances: Both IRA types are free of investment taxes for as long as the money is in the account (#1). Therefore, you should maximize contributions of money designated for retirement into IRAs, and minimize withdrawals. Given #5 above, you can maximize Roth IRA contributions regardless of when you may need the money (with limitations on withdrawal of earnings).

Maximize Roth IRA Balances, with several exceptions. The Roth IRA provides the following benefits:

  1. Reduced Taxable Portfolio: When paying income taxes from outside the account, you have more money grow free of investment taxes (#3). If you are at the 33% tax bracket and you convert today using taxable money, you save investment taxes on 33% of the IRA balance. If you are taxed on 4% of your portfolio per year on average, at about 30% combined federal & state tax rate, it equals 1.2% in taxes on 33% of the IRA balance = 0.4% saved per year.
    Put differently, if you take money out of the IRA with your income tax rate at 33%, you are left with $67 on every $100 withdrawn. By paying the tax from outside the IRA earlier on, you increase your balance by 49% (100/67-1), and substantially increase the amount that is free of investment taxes.
  2. Money Growing Longer with the Tax Benefits: You can keep your money in your Roth IRA for your life expectancy beyond age 70½ + the age difference between you and your heirs (#4), typically providing 20-50 extra years free from investment taxes.
  3. Reduce Taxes During Stock Declines: When your IRA balance shrinks during stock market declines, any dollar amount you choose to convert will represent a larger percentage of your IRA balance, allowing you to convert a greater portion of your money at the same tax rate. If your IRA has a diversified long-term stock investment, this is an opportunity to save on taxes.
  4. Convert Less Money at High Tax Rates: As your IRA balance grows, more of the amount that you later withdraw or convert to a Roth IRA gets pushed into higher income tax brackets. If your IRA grows faster than the expansion of tax brackets, converting earlier on can keep more of the converted amount at lower tax brackets.
  5. Shield from Uncertain Future Tax Rates: Given that current tax rates are known while the future is unknown, it is more conservative to pay the taxes in today’s known rates, as opposed to risking being subject to higher future rates. Any risk you can remove may help you better plan for your retirement.
  6. An extra incentive in 2010: Only in 2010, the payment of taxes on converted amounts can be deferred by an average of an additional 1.5 years (½ the tax is paid in tax year 2011, and ½ in 2012). If your portfolio grows on average by 15% per year, the money used to pay the income tax on the conversion can grow by an average of 23.3% over 1.5 years, reducing your effective tax rate by 18.9% (=(1-1/(1+23.3/100))*100). For example, converting in 2010 at the 28% tax bracket, would be equivalent to converting any other year at 22.7% (28*(1-18.9/100)).
Rule of Thumb : You should not convert your Traditional IRAs to Roth IRAs (or contribute to a Roth IRA), if you expect your tax rate to be:

  1. Much lower (typically 10% less or more),
  2. In very few years (typically 5 or less).

Otherwise, you probably should convert, since the growth of the IRA balance can push you into higher tax brackets2, negating the benefit of waiting. In addition, if you have money outside your IRA for paying the income tax, by paying it now, you shield the tax amount from future investment taxes, making the case for conversion soon even stronger.

When in the Year should you Convert to a Roth IRA? It is most beneficial to convert your Traditional IRA to a Roth IRA right in the beginning of the tax year (January 2 nd ), for two reasons:

  1. Your converted money can grow an additional 1.3 years until you pay the taxes on the conversion (4/15 of the following year).
  2. You can undo the conversion (officially named: “recharacterizing”) until your tax filing deadline 4/15 (or 10/15 with an extension). During these 1.3 years, you can choose to undo the conversion if the account declined, and redo it next year at a lower cost.

Convert More than Planned. If you have any doubts regarding the amount to convert, a beneficial strategy could be to convert the full IRA (or at least the most you could possibly expect wanting to convert). Up to 4/15 of the following year, you can undo any part of it, providing you maximum freedom to leave converted as much or as little as makes sense, with the benefit of hindsight. This is especially useful in 2010, given the benefit of extra tax deferral, and while the stock market is so low.

Advanced Planning (not typical). There is one reason to not convert the full account. If you are almost certain you want to convert a lot less than the full account, even if its value jumps substantially, you could convert, say, half of it. In case the account drops in value during the year, you can undo the full conversion, and reconvert the second half right away. Without this tactic, you would have to wait until next year, and at least 30 days from the previous conversion (the latter not being a problem if you convert early in the year), because only one convert-undo cycle is allowed per year.

Disclaimers about the Advice Above.

  1. It is usually smart to use retirement money last, and keep in it investments that grow fast (stocks). If you hold in your IRA slow growing assets, such as bonds or cash, some of the considerations in favor of a conversion are moderated. This case is not addressed in this article, since it is typically not recommended.
  2. If the government decides to abolish the income taxes, replace them with a consumption tax, and leave the Traditional IRAs free and clear of taxes, a Roth IRA would be a much worse choice. It is doubtful that the government will give such a big gift to Traditional IRA owners, but it is a possibility.

Summary

Starting in 2010, all Americans have an opportunity to convert their entire IRA balances to Roth IRA. This article analyzed some of the considerations. While it may be difficult to make the best decision, in most cases it is well worth the effort. If you do not have a professional that can help you with this decision, in most cases a Roth IRA will be your better deal.

1 Investment taxes = Interest, dividends and capital gains

2 When estimating your future tax rate, take into account the investment taxes on your taxable portfolio + IRA amounts you convert or withdraw in that year. For example, a if your portfolio generates 4% taxable income each year, and you expect to have over $20M in such portfolio in a taxable account you are may end up staying at the highest tax bracket for life.

Disclosures Including Backtested Performance Data

What is the True Tax Benefit of the IRA?

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The first thing you are likely to hear about Individual Retirement Arrangements (IRAs) is that they are: “tax deferred” accounts. Some may add that they provide: “compounded growth before being taxed”. This article refutes these claims and analyzes the actual tax benefits of IRAs:

  1. The ability to pay income taxes at a lower rate, if your income tax rate is lower at retirement.
  2. Money is investment-tax free (interest, dividends and capital gains), while in the IRA.

Identifying the actual tax benefits of IRAs is essential to decide between IRAs (called Traditional IRAs) and Roth IRAs. The decision between the two types of IRAs will be the topic of the next article.

What is an IRA?

Let’s start by defining an IRA: Individual Retirement Arrangement is a retirement plan account that provides some tax advantages for retirement savings in the United States. You can open such an account as a brokerage account, letting you invest in a similar way to other brokerage accounts. It has limitations on withdrawals, while providing tax benefits.

A Roth IRA, is an IRA that does not provide a deferral of income-taxes:

  • Any money put into the account is taxed like the rest of your income.
  • Any money taken out of the account is not taxed, like any other regular account.

Other differences between Traditional IRAs and Roth IRAs, as well as benefits specific to Roth IRAs, are left for discussion in the next article.

Potential Benefit: Tax Deferral

When putting money into an IRA, you can typically avoid paying income tax, letting the money grow for many years, until you withdraw the money. Let’s review the benefit of the tax deferral with an example. Note that this example is constructed to isolate the tax-deferral effect, leaving the other IRA benefits for a later discussion.

In this example a 50½ year-old person makes one $5,000 IRA contribution, and starting at age 70½ he starts making Required Minimum Distributions, until he dies at age 90½, and his heirs take out the full balance.

The first two years of withdrawals are detailed with 3 steps: (1) the account value before the withdrawal (reflects the investment growth), (2) the account value split to the amount to withdraw and the amount left, and (3) payment of income taxes on the amount withdrawn.

Later, two more summary lines are provided for 10 and 20 years into the withdrawal phase, followed by a full withdrawal by the heirs.

The Value of Tax Deferred Money
(Ignoring Tax-Free Gains, Income Tax Rate: 30%, Investment Growth: 17%)
Point in Time Traditional IRA Taxable Account
Income earned $5,000 $5,000
After putting into the account $5,000 $3,500 after income tax paid
Annual withdrawals at age 70½ Withdraw Left Withdraw Left
After 20 years of growth – $115,528 – $80,870
Before withdraw 1/27.4 of account $4,278 $111,249 $2,995 $77,874
After withdraw 1/27.4 of account $2,995 after tax $111,249 $2,995 $77,874
After 1 year of growth (age 71½) – $130,161 – $91,113
Before withdraw 1/26.5 of account $4,915 $125,320 $3,440 $87,724
After withdraw 1/26.5 of account $3,440 after tax $125,320 $3,440 $87,724
.        
+9 years (80½), withdraw 1/18.7 $13,356 after tax $337,714 $13,356 $236,400
+10 years (90½), withdraw 1/11.4 $52,673 after tax $782,563 $52,673 $547,794
Heirs withdraw balance $547,794 $0 $547,794 $0

In the example above, we can see that tax deferral is not a benefit of IRA accounts at all. This is apparent by seeing that all numbers under the “Withdraw” columns are equal at all times. No matter how long the money is in the account, what the income tax rate is (as long as it is the same when contributing to the account as when withdrawing from it), what the investment growth rate is, and how you withdraw the money (how often and which amounts), you end up with the exact same amount of money for use during retirement.

How is this possible? It stems from the simple mathematical law: the order of multiplication does not affect the result. Here are both calculations of the value of the accounts if withdrawn after 20 years:

Traditional IRA: $5,000 x 1.1720 x 0.7 = $80,870

Taxable: $5,000 x 0.7 x 1.1720 = $80,870

Note that after putting the money into the account, and up until right before withdrawing the money, the IRA balance is indeed greater. This may be the source of the error of seeing tax deferral as a benefit. This is an error because you cannot use the IRA money without paying income tax on it. So, you are only fooled to believe you have more money, until after paying the income taxes.

How is this information useful? Since income tax deferral provides no benefit in IRA accounts, the deferral of income tax of Traditional IRA vs. no income tax deferral for Roth IRAs is not a reason to prefer Traditional IRAs over Roth IRAs. Only Benefit #1 below provides a reason to prefer Traditional IRAs in some cases (when the benefit exists and outweighs the extra benefits of Roth IRAs, as will be discussed in a future article).

Benefit #1: The Ability to Pay Income Taxes at a Lower Rate

If your income tax rate declines in retirement, the deferral of income taxes does provide a benefit. For example, if your tax rate goes down from 30% to 20%, you get:

Traditional IRA: $5,000 x 1.1720 x 0.8 = $92,422

If we divide this calculation by the original one (30% tax rate), we get:

Benefit = ($5,000 x 1.1720 x 0.8) / ($5,000 x 1.1720 x 0.7) = 0.8 / 0.7 – 1 = 14.3%

The benefit depends only on two numbers: the tax rate when the money is put into the IRA vs. the tax rate when the money is taken out. It doesn’t matter how fast the account grows, and it doesn’t matter if the money is in the IRA for 1 year, 40 years, or any other number of years.

On the other hand, if your income tax rate is higher in retirement, the use of an IRA creates a penalty. For example, if your tax rate goes up from 30% to 40%, you returns decline by: 1 – 0.6 / 0.7 = 14.3%

Note that the exact benefit depends on the tax paid on the full amount, which may include paying parts of the tax at higher brackets. This information is very important when comparing to a Roth IRA.

If you expect your tax rate to be higher in retirement, you can convert your IRA to a Roth IRA, to make sure you pay taxes at today’s lower rate, while keeping the other IRA benefits and more benefits specific to the Roth IRA that will be covered in a future article.

Benefit #2: Investment-Tax Free

Any money put into an IRA, is free of investment taxes (interest, dividends and capital gains), for as long as the money is in the IRA. This provides a clear benefit that increases with the time the money is in the account. For example, say you are invested in a portfolio like Long-Term Component, and assume that the long-term growth is 17%, with 7% taxed each year, at a combined federal rate of 20% (mostly long-term gains and qualified dividends at 15%, and minimally short-term gains and non-qualified dividends), and state rate of about 10%. Your tax cost is 2.1% per year. The example above becomes:

Taxable: $5,000 x 1.1720 x 0.97920 x 0.7 = $52,898

If we divide the original calculation by this calculation one, we get:

Benefit = ($5,000 x 1.1720 x 0.7) / ($5,000 x 1.1720 x 0.98620 x 0.7) = 1 / 0.98620 => 53%

Summary

IRA accounts offer tax deferral of income taxes, which, contrary to common belief, is not a benefit. They do provide two other great benefits:

  1. The Ability to Pay Income Taxes at a Lower Rate: In case your income tax rate goes down by the time you withdraw your money, you get a benefit that depends on (and only on) the tax rate when withdrawing when compared to the tax rate when depositing the money in the first place.
  2. Money is Investment-Tax Free, while in the IRA: This is a substantial benefit that grows with the time the money is in the account, and grows with the investment taxes saved.
Disclosures Including Backtested Performance Data

A Strategy for Avoiding Stock Declines during Recessions

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Can you think of the easiest way to avoid continued stock-market declines, during a recession? This article presents the most common strategy, based on ideas from various investors. It guarantees that you stop your stock losses, and you are likely to feel a big sigh of relief. There is one catch – read on for details.

The strategy has different variants, but the basics are common and are very intuitive:

  1. Follow the economic news. Whenever you hear concerns about the economy start selling your stock portfolio. If it seems like we are getting into a deep recession, sell your whole portfolio, until things look better.
  2. Keep following the economic news. Once the economists become more positive, start buying stocks. When the economic outlook looks really good, make sure you are invested heavily in stocks.

The benefits of this strategy are easy to identify:

  1. Whenever the economy is doing poorly and you hear gloomy news on a daily basis, you get to be outside the stock market. You can smile seeing your accounts retaining their value, while people around you are nervous about their investments.
  2. When everyone is optimistic, you get to have your money in the stock market, enjoying being invested when there is such excitement around.
  3. At all times, you can feel good about your actions. Not only are they intuitive – many people around you are acting the same way, providing a great support network.

There is one big catch: The stock market does not go up and down together with the economy and the sentiment on the news. It tends to precede the economy by 6-12 months. Whatever news you hear is already reflected in stock prices, and only the unknown affects the stock market moving forward. As a result:

  1. When you hear about the economy doing poorly, the stock market is already down substantially. When you learn that we are in a recession, the stock market tends to be past most of its decline. For example the 2008 recession was announced by the National Bureau of Economic Research on December 1, 2008 – close to the stock market bottom.
  2. When there is optimism, the stock market has already experienced a substantial portion of the recovery.
  3. Given the predictive nature of the stock market, bottoms tend to be reached at the moment of greatest pessimism. By selling on pessimism, you are likely to sell low. Optimism and comfort are reached when the stock market is much higher.

The strategy presented virtually guarantees that you sell low and buy high! While it provides great psychological comfort, it comes at a price of giving up some of the greatest run-ups in stock prices in history, and getting substantially reduced long-term returns.

For example:

  1. On December 9, 1974, the cover story of “Time” magazine, “Recession’s Greetings” was very gloomy. A year later, the Dow Jones Industrial Average was up 47.7%, with a new “Time” cover story: “U.S. Shopping Surge”.
  2. On March 10, 2009, there was great pessimism about the world economies as the stock market hit bottom. A couple of months later, the globally diversified portfolio, Long-Term Component, was substantially higher, as there were some initial signs of optimism.

Summary

It is easy to invest in a way that feels good. This article provides the guidelines for that. Unfortunately, doing what feels good bears a large price tag on your investment performance. You have to make a choice between what feels good for you and what is good for you.

Disclosures Including Backtested Performance Data

Asset Allocation during Declines

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When you face a substantial decline in your portfolio, it becomes tempting to keep the money in cash until the recovery begins. The greater the decline, the greater the temptation. Watching the news and reading economic analyses makes it even tougher to stick to your long-term plan. As demonstrated in the previous article, “Can You Avoid Market Declines?” (Hanoch February 2009), finding the bottom of a decline is virtually impossible. The problem is compounded by the difficulty in buying back when the portfolio is lower and the economic atmosphere is worse. Fortunately, if you established a well thought-out plan in advance, you may not need to face this temptation.

During declines, people try to reduce “Market Risk” – the risk of a decline in stock prices. There are two additional risks that should always be considered as well: “Inflation Risk” – the risk of losing purchasing power over time, and “Longevity Risk” – the risk of outliving your money. As you will see below there is a clear tradeoff – reducing market risk increases inflation risk and longevity risk.

The reason for the smaller focus on the other two risks is the eagerness to deal with the current pressing problem, and the need to feel in control. Since the latter two risks are not imminent, people tend to neglect them in favor of market risk.

The best way to deal with market risk is to sell some stocks. If the plan was not designed in advance to prepare for substantial declines, this is an unfortunate necessity during a decline. When done it should be a cold and rational decision that is followed in the long run, especially as stock prices go up. The desire to get back in the market as economic conditions improve is likely to lose you money and increase your inflation and longevity risks. Let’s review these now.

Inflation Risk: During severe declines, governments (both democrat run and republican run, each with their own emphasis) tend to stimulate the economy, and create the risk of inflation in upcoming years. If you hold cash or bonds during this period, you risk losing your purchasing power, since an investment that is free of market risk is almost guaranteed to lose money after taxes and inflation. This means that while maintaining the stock allocation can result in a number of years until recovery, cash or bonds are not likely to ever recover your losses.

Since inflation is the increased prices that companies charge for their products and services, company ownership (stocks) is the best way to protect yourself from inflation risk.

Longevity Risk: By selling stocks during severe declines, you realize the substantial losses, but risk missing out on the gains during the recovery. As a result, you risk outliving your money. If you maintain the lower allocation to stocks in the long run, the loss in purchasing power of your cash and bonds increases the risk of outliving your money.

By keeping your money in stocks, you miss the speculative opportunity to outperform your stock portfolio, but you also ensure that you gain the impressive long-term after-costs returns of stocks.

Conclusion

If your annual withdrawals from your portfolio are conservative (e.g. 2%-5%, depending on the portfolio), and your portfolio is globally diversified, with no individual stock selection or market timing, you may be facing greater inflation and longevity risks than market risk, especially during declines in your portfolio. In such case, you may want to think twice before selling stocks and changing your plan.

Disclosures Including Backtested Performance Data

Can you find Skilled Active Mutual Funds?

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How would you like to choose mutual funds that will outperform benchmarks of the stock market? This is an ongoing pursuit of millions of people. Up until recent decades, people intuitively believed that if you pay professionals to spend hours every day researching stocks, they would outperform a brainless benchmark. It was only a matter of how big the outperformance would be – at least that was what people believed. Since then, multiple studies compared the performance of actively-managed mutual funds with benchmarks, and found out that it is not as trivial as intuitively seemed.

The task: This article reviews an academic study that tried to find out what portion of actively-managed mutual funds outperformed benchmarks due to skill, as opposed to random luck. This can help you decide whether you want to pay someone to try to outperform the benchmarks by picking the right stocks or by timing the market.

The study is by Russ Wermers, a professor of finance at the University of Maryland, Laurent Barras of the Swiss Finance Institute, and Oliver Scaillet of the University of Geneva. It observes returns of actively-managed mutual funds over the 32-year period of 1975 to 2006. It avoids short-term biases by including only funds with at least 60 months of returns, and is free of survivorship bias, by including funds that existed at any time in the period observed.

How do you decide? Given the alternative of passively managed funds that track diversified benchmarks, combined with the fact that globally diversified stock investments recovered from all declines in hundreds of years to achieve handsome long-term averages, you have to make a good case for trying to beat benchmarks, while risking doing worse.

You may choose to use an actively managed mutual fund if the odds of outperforming the benchmark are substantially higher than the odds of underperforming it. A smart speculator would do so given any chance of success over 50%, while a more risk-averse individual may want much higher odds.

The results: Can you guess what the chance for success was based on this study?

During the 32 year period studied, from 1975 to 2006, only 0.6% of funds delivered higher returns than their benchmark through skill (not even counting sales loads).

Feel free to reread the number above – the number is indeed less than 1%.

The decision: Based on these results, choosing actively managed funds seems unlikely to make you excess money while adding the risk of one person making wrong predictions. Neither the conservative investor nor the smart speculator should see any benefit in taking this chance.

Accepting the results of passively managed funds may sound boring, without the excitement of trying to “beat the market”, and plain “average”, but when compared to the dismal results of actively managed funds, it seems like the more sensible approach. It may be average compared to the benchmarks, but outstanding compared to most investors that still use actively managed funds.

What can you control? By narrowing it down to passively managed funds, you can avoid the risks of stock picking and market timing. Instead you can focus on things you can control such as minimizing costs, minimizing taxes and maximizing diversification. By using such criteria for selecting mutual funds you can peel off the speculative layer, turning yourself from a speculator to an investor, with a more direct link to the productive capacity of the world.

Disclosures Including Backtested Performance Data

Sell or Buy?

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You are in the midst of a severe decline, with a combined length and magnitude that tend to occur a few times in a lifetime. People are in panic. According to the news, you expect the decline to continue for a very long time, and everyone you know is rushing to sell whatever is left of their stock investments. Should you sell?

Target Audience: This article limits the discussion to stock market investors, not speculators. Investors use the long-term growth of stocks to provide them with long-lasting income, as follows:

Stock investor: Invests globally in thousands of companies across sectors, with no individual stock selection, and limits annual withdrawals to a small percentage of the portfolio (for QAM’s Long-Term Component – 4% of the peak value of the portfolio).

All QAM clients are investors, since QAM refuses to speculate with their money. Two typical groups of investors are:

  1. Young people that need to build a nest egg for their retirement.
  2. Retirees that need current income throughout their retirement years.

Discussion: Investors had abysmal experiences in trying to time the stock market (the topic of the next article). When dealing with your life’s savings, and when counting on them for your daily livelihood during retirement, you cannot afford to try to guess the turning points of the stock market.

Instead, you can benefit from companies that provide the world population with products and services as cheaply and efficiently as possible. Given that people have not changed their preference for getting these products and services in the most efficient way, the system should keep working, and you should keep enjoying its benefit without speculating on the turning points of the different stages of the business cycle. Now we discuss a few important factors that should keep you strong and relaxed through tough declines.

Government stimulation: After the painful experience of the Great Depression, the U.S. government and many other governments learned that during declines the smartest thing for it to do is stimulate the economy. Note that this principle was adopted by post World War II U.S. governments, regardless of the party in power. It is done in many ways, including reducing interest rates and providing substantial loans and investments that help keep the economy going.

To finance this activity, the government issues bonds that are essentially long-term loans. Given the long-term growth of the economy, the government eventually collects the money to repay its loans. This has proven to work throughout the U.S. history with a track record of no defaults on government loans. This tremendous security, combined with the great fear of the stock market, leads people to buy government bonds en mass right in the depth of stock market declines. As a result, the government is able to raise substantial amounts of money to shore up the economy, at a very low cost (low interest rates on bonds).

The cost of not selling: If you depend on your stock portfolio for current living expenses, it might seem painful to sell at such a decline, and it might seem even scarier to think about the cost of withdrawals if you keep your money invested throughout a prolonged decline.

Let’s analyze the cost for Long-Term Component in an extreme case, substantially worse than anything seen in the past 40 years:

  1. A 5-year decline averaging at 33%.
  2. Annual withdrawals of 4% of the peak value of the portfolio.

The damage:

  • Each dollar withdrawn at a 33% decline costs 50% extra (=100%/(100%-33%)-100%).
  • Therefore, each 4% annual withdrawal costs an extra 4% x 50% = 2%.
  • In total, the 5-year withdrawal costs an extra 5 x 2% = 10%.

This dooms-day scenario costs 10% of your portfolio.

The benefits of not selling:

  1. Given that the economy keeps working in good times and in bad times, declines tend to follow with rapid growth that makes up for the lost time and value of the stock market. Historically, we’ve seen that the longer and deeper the decline, the more impressive the recovery.
  2. You already experienced a lot of the pain. From this point you, most likely, have a lot further to go up than down. For example, if you are at a 30% decline that will bottom at 40%, your current investment:
    1. Will bottom at an additional 14% decline (=100%-(100%-40%)/(100%-30%)), but
    2. Will go up by 43% (=100%/(100%-30%)-100%) by the time it recovers.

Conclusion: Stock investors (as defined above) can support their goals more by buying rather than selling at a deep decline. Since you cannot predict the performance of your portfolio in the next few months, you should stick to your long-term plan and keep the split to stocks vs. bond/cash reserves as stated. Specifically,

  1. If you are working and have extra money to save, you can benefit greatly from investing it.
  2. If you are retired, you can continue with your limited periodic withdrawals, and continue to enjoy your retirement years with great peace of mind.

Summary

If you are a responsible investor in the stock market, whether you have a time horizon of 30 years, or you depend on your investments for current retirement living (at limited withdrawals, depending on your portfolio), you can benefit from the tremendous power of the world economies to support your financial needs. You can leave the emotional swings of stock investing to the speculators. Instead, you can focus on your daily activities with great peace of mind throughout all market conditions.

Disclosures Including Backtested Performance Data

What are the Implications of High Oil Prices?

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It’s been nearly four years since I wrote the article “Could High Oil Prices be Good?” (Hanoch, October 2004) and oil prices went up significantly since then. This article presents the main factors affecting oil prices and the potential implications on your investments.

Causes for higher oil price:

  1. Increase in demand: Given the rapid development of various emerging markets, notably China and India, combined with worldwide population growth, oil demand is growing rapidly, mostly by cars for personal use. This is not likely to be a cyclical factor and the trend may continue for many years.
  2. Limited Supply:
    1. Declining oil reserves: Oil is a limited resource on earth, and as we come closer to depleting it, prices are likely to go up irreversibly.
    2. Tension in oil producing countries: Tension in the Middle-East, strikes and political instability in Venezuela , and growing instability in West Africa increased oil prices. This factor may have a limited time horizon.
  3. Weaker dollar: Since the price of oil is denominated in dollars, the weak dollar made oil artificially more expensive. Given the cyclicality of currencies, next time the dollar strengthens, oil should become cheaper.
  4. Speculators: Oil price is determined in the futures market. The futures market is a wonderful tool that helps big oil consumers (like airline companies) hedge the risk of rising prices and set their upcoming oil cost in advance. It is also a place for speculators to bet on higher oil prices. They bid up the price beyond the demand dictated by actual oil consumers and have created a large premium to the price – like a pyramid scheme. Once the price deviates too far, or government regulation addresses this, the bubble may burst and erase the premium, causing a big decline in the price.
  5. China‘s managed energy prices: Oil price in China is controlled by the government and held artificially low, resulting in higher demand. Refineries lose their incentives to produce, given their rising cost of input compared to the fixed product price. As a result there are already supply shortages in China . This artificial situation is not likely to be sustainable, and controls are likely to be lifted at some point.

The implications on your life:

Because oil demand is expected to increase in the long run and oil reserves are a finite resource, you cannot expect oil prices to decline to low levels in a natural way in the long run. A bursting speculation bubble or a stronger dollar can have a dampening effect on prices for a limited period, but the lasting effects of accelerated demand around the world and depleting reserves should bring prices back up.

Given these factors, the only way to lower the long-term cost of energy is to use renewable energy alternatives to oil. Unfortunately, implementing these renewable alternatives costs money upfront, and as long as oil price is tolerable, only people that are highly concerned with their long-term well being at the price of a current burden are going to accept this high initial cost.

As the price of oil goes up, the financial benefit of renewable alternatives grows. The result is a clear tradeoff between current comfort and future comfort:

  1. Low oil price provides current comfort, making travel, food and many other products cheaper.
  2. High oil price provides future comfort by accelerating the development of renewable alternatives that can ultimately completely free us from dependence on the limited oil supply.

A complete departure from the dependence on oil may take many years, but there are already current activities underway given the current price of oil. Here are a few examples:

  1. Hybrid cars are being sold in big numbers (over 1,000,000 cars so far) and offer real savings in gas consumption and total costs to their owners.
  2. People are reducing their energy consumption by improving the insulation of their homes, buying solar panels and energy-efficient appliances and light bulbs.
  3. The once expensive Canadian and Venezuelan tar sands are now highly competitive with conventional crude oil. These massive reserves are estimated to be approximately equal to the world’s total reserves of conventional crude oil. Note that this is not a renewable source of energy, but is an example of how time can be bought for developing renewable alternatives.

The implications on your investments:

Short-Term: As the price of oil goes up, it has two competing impacts on your stock investments:

  1. It increases the value of the energy sector in your portfolio.
  2. It increases the cost of doing business for other sectors, making them less profitable.

The net effect on your portfolio is slower growth or declines during spurts of oil price appreciation.

Long-Term: As the price of oil goes up, renewable sources of energy are developed and become more competitive with oil and more widely used. It increases the profitability of all companies other than oil related companies, having a positive net effect on your portfolio, with higher growth.

Bottom Line: Stock portfolios are held for long-term growth and income, and as such, they are likely to benefit from the long-term financial benefits of higher oil prices.

Conclusion

If you have the means to withstand the strain of high oil price on your current lifestyle, you can benefit from the potentially nice long-term portfolio growth and improved future lifestyle that high oil prices may bring. The higher the oil prices, the bigger the current pain, but also the sooner the long-term solution will be in place.

Disclosures Including Backtested Performance Data

Are you Optimistic or Pessimistic?

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Do you believe that your diversified stock portfolio will go up or down in the next 12 months? If you answered “down” – you are not alone. Most people are pessimistic after declines. This article presents two main reasons for this belief and a flaw with both reasons.

Reason #1 : It went down recently, and is likely to keep going down . We tend to remember recent events better than older events, and give them greater importance. This is a psychological effect called “Recency”. In the context of investing, we tend to believe that declining stock investments will keep declining. Since stock markets go up in the long run, with fluctuations around their long-term growth, it is impossible that declining markets will keep declining forever.

Even when people understand this contradiction, they think that their stock portfolio will go up, just not anytime soon. They plan to keep money outside the stock market until it starts going up, but fail to find the turning point. One reason is that stock prices fluctuate within long-term up and down trends. By the time they realize that the recent increases are the beginning of a long-term recovery, they miss out on enough of the gains that they underperform a buy-and-hold approach.

Reason #2 : The economy has slowed down and is believed to keep slowing further . This belief is actually irrelevant (whether flawed or not) to the prediction of stock performance. Stock prices reflect the belief about the future value. It declines because there is a majority belief that the economy will slow down in the future. The behavior of the stock market in 12 months reflects the expectation regarding the economy many months later, which is much harder to predict than the near-term future of the economy.

One consistent truth : Since people that try to predict the near-term future tend to underperform their own portfolio, the best thing you can do is focus on a more predictable pattern: the long-term. In the long run, stock markets tend to go up. This was true in the past since people depended on companies to produce their goods, and should keep holding true as long as people will keep depending on companies for their daily consumption of goods and services. Human preference for getting things easily and cheaply is likely to keep the concept of companies going, and as a result: stock prices growing.

Solution : Your best strategy is to be optimistic about your investments at all times. Given the substantial long-term growth of stock markets, you can be even more optimistic during decline periods. There is no guarantee for a quick recovery after declines, but the longer and/or deeper the decline goes, the steeper the recovery is likely to be.

Summary

Psychological biases and misconceptions drive us to be pessimistic about the future of our portfolio right when we have more reasons to be optimistic. Worse, it leads some people to gamble with their own money, trying to time the market. Staying consistent with the stock portion of your investments is not only the smartest plan; it is also the most conservative.

Disclosures Including Backtested Performance Data

How Much Should You Spend Buying a Home?

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[Updated February, 2011]

Conventional wisdom says that owning a home is a smart financial move. It is smart because you can borrow most of its value, leaving most of your money to grow in faster growing investments like stocks, while eliminating rent payments and enjoying the growth of your home value. You get the maximal benefit if you can borrow most of the home value or even all of it.

The catch is that buying a home with a large mortgage introduces substantial financial risks, if not done right. The article “When should you own your Home?” (Hanoch, December 2007) presents a long list of these risks, and a list of rules to help you determine whether you can afford buying a home without taking excessive risk.

This article goes one step further and presents a calculation for the amount of money you should have in disciplined stock investments, so when combined with your income, you can buy your home with limited financial risk.

Assumptions:

  1. You borrow as much as the bank will lend you up to 100% of the home value.
  2. You fulfilled the full list of requirements for holding a mortgage together with stock investments, presented in the article ” Should you Pay Off your Mortgage or Hold Stocks?” (Hanoch, February 2008). Please read carefully the full article, including the strict investment requirements. If you do not follow these principles, you might end up losing your home in the next severe recession.
  3. You invest in Long-Term Component by QAM, or any other portfolio that can sustain 4% annual withdrawals, growing with inflation, without any harm to the long-term growth of the portfolio during periods worse than all recessions in recent decades (including 1973-1974, 2000-2002 & 2008).
  4. The annual homeownership cost is approximately 10% = mortgage interest (8% fixed) + property tax (1%) + repairs (1%). You can adjust this based on your specific case.
  5. You have income to cover expenses other than homeownership costs.

Rules of thumb: Based on these assumptions, we provide rules of thumb for the size of stock investments needed for buying a home. Let’s start by demonstrating the rule for different homes:

Rule of Thumb: Minimum Recommended Stock Investments for Buying a Home With Maximal Borrowing (100% of the home value)
Home Value Needed Investments Calculation Based on Rule
$200,000 $40,000 0.2 x $0.2M = $0.04M X times Home Value
costing $X million
$500,000 $250,000 0.5 x $0.5M = $0.25M
$1,000,000 $1,000,000 1 x $1M = $1M
$2,000,000 $4,000,000 2 x $2M = $4M
$4,000,000 $16,000,000 4 x $4M = $16M
$5,000,000 $20,000,000 4 x $5M = $20M 4 times Home Value

Expensive homes ($4M+) : Before buying a very expensive home, it would be wise to save enough money to cover all homeownership costs + reasonable living expenses, regardless of income from work. Since such an expensive home is typically a luxury rather than a necessity, you wouldn’t want a loss of job or business to put you in serious financial trouble.

To summarize: a rule of thumb for the total assets you should have for expensive homes:

Homes above $4M: Minimum stock investments recommended = 4 times home value

Cheaper homes : The cheaper the home, the more it is reasonable to count on your income from work. Lower home values have lower maintenance costs, and require a lower paying job which is typically easier to find even if your job is lost during a recession.

A rule of thumb for depending on more income (and less stock investments) for lower home values is:

Homes below $4M costing X million: Minimum stock investments recommended = X times home value

Examples : The following table summarizes the maintenance financing of different homes. Given a Home Price, its Maintenance is estimated at 10% of the home price. The Recommended Investment is taken from the formulas above. The investment is assumed to provide 4% in annual income. The last two columns show the maintenance cost that is left to be covered through other sources of income.

Home Price Maintenance (10%) Recommended Investment Investment Income (4%) Other Income (Maintenance – Investment Income)
Amount Pct. of Maintenance
$200,000 $20,000 $40,000 $1,600 $18,400 92%
$500,000 $50,000 $250,000 $10,000 $40,000 80%
$1,000,000 $100,000 $1,000,000 $40,000 $60,000 60%
$2,000,000 $200,000 $4,000,000 $160,000

 $40,000

 20%
$4,000,000 $400,000 $16,000,000 $640,000 -$240,000 < 0%
  1. As you can see, with relatively cheap houses costing $200,000, we can mostly depend on income from work, since many jobs can provide $18,400 to cover homeownership costs.
  2. As we go into more expensive homes of $500,000, $1,000,000 & $2,000,000, we want to be less dependent on income from work (80%, 60% and 20%, respectively).
  3. Once we reach the luxury home of $4,000,000, we would like to have investments that can cover the full maintenance of the home and leave us with $240,000 for other living expenses.

Summary

The article presented quick rules-of-thumb for calculating the price of home you can afford while maintaining high short-term and long-term financial security. This may be a good starting point for a detailed analysis.

Disclosures Including Backtested Performance Data

Should You Pay Off Your Mortgage or Hold Stocks?

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The previous article, “When should you own your Home?” (Hanoch, December 2007) provides guidelines for determining if you can afford owning a home. The next step is to determine the size of mortgage you should take.

After putting a down payment that the lender required, you may be left with extra money. You have to decide whether to use it to pay off some of the mortgage or put it in an alternative investment. This article discusses the option of investing the excess in the stock market.

You may view this option as: (1) paying off the mortgage no faster than the required pace or (2) borrowing to invest – both statements are correct. Whatever your perspective, having a large loan combined with stock investments has led many to lose their homes and declare bankruptcies. This is the result of counting on the stock investment to grow enough to help pay the interest on the loan, while in reality the investment can decline in value for many years. When combined with a loss of job for an extended period, the results can be devastating.

You should be very careful, and review important requirements for considering this idea:

  1. Conservative stock investing: Diversification, No stock picking, No market timing. Most investors (including professional money managers) underperform the S&P 500 (10.5% in the long run), due to concentration in certain stocks or asset classes, stock picking and/or trying to avoid decline periods. In many cases, they underperform their mortgage rates, resulting in high risk combined with negative returns.

    In order to limit the decline periods of your portfolio, you have to diversify it globally, and include large and small stocks. You should avoid trying to predict which stocks will go up or when the portfolio will go up. Stay diversified using passive investments like index funds and hold onto them for the long run. This is true for any stock investor, but an absolute must when you have a mortgage to pay – you should not gamble with borrowed money.

    Note that stock diversification reduces risks without reducing returns. You cannot use bonds or any other low return investment for risk reduction, because it will reduce your overall returns, significantly increasing the risk of underperforming your mortgage rate in the long run.

    To be clear, you should have some money in bonds or money market, to carry you through recessions, but not as part of a long-term investment.

  2. Be prepared for a very bad combination of events: Make sure that you can handle many things going wrong at once, including no less than the following:
    1. Extended loss of your ongoing sources of income: Losing your job or clients from your business for a long period, during a severe recession.
    2. Extended decline of your stock portfolio: A decline of your stock portfolio, longer than all declines in recent decades (for Long-Term Component: nearly 3-years; for the S&P 500: 6 years; with stock picking or market timing: 10 or more years).
    3. Rising interest rates: A significant increase in the interest on your variable-rate mortgage. As mentioned in the previous article, you should be prepared for a prime rate of no less than 8%-9%. Alternatively, stick with fixed rate mortgages.
    4. Real estate recession: A very long real estate recession. Property values have declined for a full 10 years before recovering their peak value, as recently as the 90’s in many places. Be prepared for even longer declines. This means that you will not be able to refinance your loan to get a higher mortgage, lower interest rate, or fix the rate on the loan.
    5. Unexpected costs: A large combination of the following occurring at once: All home expenses not covered by your insurance, like home damage from earthquakes, floods or ongoing repairs like a roof replacement. All deductibles for insurance, including homeowner’s, health, car, etc. Car repairs and replacements. Uncovered medical expenses, including long-term care (or consider long-term care insurance).

    Make sure you can handle the above events occurring at once, as unlikely as it may seem to you. You should be able to handle the events in two ways:

    1. Financially : Make sure you can handle your ongoing living expenses when a combination of the events above occurs.
    2. Emotionally : Make sure you are unshakably confident about your stock investments, so you will never even consider selling your investments at a decline unless you have no other financial choice. If you stick to the conservative investment approach presented above, you have a good reason for being confident.

If the requirements above seem too harsh, you might be getting yourself into trouble. When borrowing to invest you choose to take certain risks in hopes for increased long-term returns. If you are not prepared for everything that can go wrong on the way, you might end up with much lower returns and even face bankruptcy. This would be very unfortunate since you chose to take the risks – you were not forced into the situation.

A Tradeoff . Note that there is a clear tradeoff between paying off a mortgage and continuing to carry it while investing the excess in a stock portfolio. The following table summarizes it:

Option Short-Term Security Long-Term Security
Pay off mortgage Higher Short-Term Security: lower mortgage payments Lower Long-Term Security: forgone growth of stocks beyond interest on mortgage
Invest in stock market Lower Short-Term Security: higher mortgage payments Higher Long-Term Security: extra stock growth minus mortgage interest

Example 1a. John has $4,000,000 in savings and qualifies to purchase a $1,000,000 home with 100% mortgage based on his assets. He is retired, and has only social security income.

He requested that his broker balance his current financial security with future growth, since he is 65 and wants to prepare for the possibility of a long life. His money is invested as follows: 60% in selected high quality Large US stocks and 40% in Bonds.

Low Potential Returns : Since his stock investments are concentrated in Large US stocks, his risk level is very high. This is exaggerated by the stocks being actively selected. The bonds reduce the volatility of his portfolio, but also reduce the long-term returns. He pays high fees for an actively managed portfolio (could be 2%-4% or more). Based on this information, we can expect his long-term returns to be 5%-8% at best. Since this is just about what he would pay on mortgage interest, there is no potential long-term gain on holding a mortgage.

Conclusion : Given the low potential returns, despite his high financial means, he should buy the house with cash (no mortgage).

Example 1b. See example 1a + John realizes that his actively managed, concentrated investments, are too risky for him. He decides to diversify them globally, and eliminate the risks and costs of active stock selection by focusing on index funds. Whenever a severe decline is expected, he can shift some of his investments to more conservative places like the virtually risk-free government bonds.

His long-term portfolio returns are 12%, while he qualifies for a 30 year fixed mortgage at 7%. He also learns that he can conservatively withdraw 4% annually without a real risk to the long-term viability of his investments.

High Potential Returns : Since this long-term return is significantly higher than the interest rate he might pay on a mortgage, he has the potential for significant gains by not paying off his mortgage. Specifically, on a $1,000,000 mortgage, he can make (12% – 7%) x $1,000,000 = $50,000 per year to supplement his social security income.

Low Financial Risk : His $4,000,000 savings can supply him with $160,000 income per year (at a conservative 4% withdrawal rate), enough to cover his full mortgage payments, property taxes, repairs and other living expenses.

High Investment Risk : When stating that he is open to shifting some of his investments to bonds when a decline is expected, he intends to engage in market timing. He would change his investment strategy based on predictions of future returns. When wrong, he would miss out on growth periods, and reach lower lows during declines with higher overall risk.

Conclusion : Despite his excellent financial situation and globally diversified indexed investment, he chose to incur the risk of timing the market. In this case, he should still buy the house with cash.

Example 1c . See example 1b + John understand the risks of any type of market timing. He decides to have a written investment plan and to stick to it at all times. Knowing that he might not be strong enough at times of financial turmoil and severe recessions, he uses the services of an investment advisor that specializes in disciplined investing.

High Potential Returns : See example 1b.

Low Financial Risk : See example 1b.

Low Investment Risk : By holding globally diversified investments during all recessions, and sticking to the plan with a low withdrawal rate, he is likely to recover future severe recessions.

Conclusion : With the combination of high potential returns, low risks and discipline, John should maximize his mortgage loan and enjoy extra potential income of $100,000 per year.

Example 2 . Mary is 45 years old and works as the CEO of a public company. She has a private jet, 3 houses, a large yacht and clothes designed by top designers that are updated regularly to meet with recent trends. She tends to spend her $2,000,000 income (including salary and bonuses).

She is about to buy a $2,000,000 house and is committed to disciplined investing in a globally diversified portfolio, avoiding stock selection or market timing.

High Potential Returns : See example 1b, resulting in $200,000 extra potential growth.

High Financial Risk : Mary has very high fixed costs for maintaining her private jet, 3 homes, yacht and designer clothes. Being a CEO, she can lose her job for many reasons well beyond her control, leaving her with very large fixed expenses and no income or liquid assets to cover them. After liquidating some of her assets, she might be miserable getting used to a much lower standard of living.

Low Investment Risk : See example 1c.

Conclusion : Despite the high potential returns and high income, Mary is already under great financial risk. She should avoid new mortgages, and consider significantly scaling back her spending until she has substantial savings to carry her through severe recessions without being so dependent on her job.

Example 3 . Lisa is a 70 year old retired high school teacher, with pension payments to cover her expenses. She is currently renting, and would like to buy a $200,000 house. She has savings of $400,000 and can qualify for a 100% mortgage at 7% fixed interest. She is a disciplined investor, working with a written plan and committed to a globally diversified portfolio of index funds, held through all market cycles. Given her limited assets, she carries long-term care insurance, and other insurances to protect her from all common risks.

High Potential Returns : See example 1b, resulting in $20,000 extra growth.

Low Financial Risk : Lisa has guaranteed pension payments to cover her expenses. Her $400,000 savings can supply her with $16,000 income per year (at a conservative 4% withdrawal rate), enough to cover her full mortgage payments, property taxes and repairs.

Low Investment Risk : See example 1c.

Conclusion : Lisa has low income and low assets for a retiree. But her expenses and house cost are also low. In fact low enough to allow her to take a 100% mortgage, enjoying an extra long-term growth of $20,000, to increase her financial security over the years and leave a larger inheritance to her children.

Disclaimer about the examples : Note that the examples demonstrate the ideas of this article, and do not represent a full analysis of each of the cases. A full analysis with a clear written plan should precede any of these investments.

Summary

Most people would do best if they paid off their mortgage as quickly as possible, other than maintaining reserves for recessions. This is true for many reasons, including: concentrated investments, risks of active stock selection or market timing, panic during recessions, and most importantly not having enough assets to carry them through severe recessions without a job.

If you are one of the rare people with iron discipline, investing responsibly and with enough assets to carry you through recessions, you can grow your financial security substantially by carrying a large mortgage and investing the proceeds, regardless of your age. When done right, your risk level should be lower than an investor with 60% Large US Stocks, 40% Bonds and no mortgage.

Due to the complexity of this activity, it is recommended to hire an investment advisor that has experience with the task and is very comfortable with it.

Disclosures Including Backtested Performance Data