A Few Miles From Uncertain

Photo by Christopher Wheeler

When did you start investing? 

My first investment was with my first IRA contribution in 1992. The previous year had been a really good one for stocks and most indicators showed an economy on the rebound from the 1990 recession, but jobs were not being created as quickly as in previous recoveries. Stocks were trading near all-time highs, which made me wonder if I should wait for a better time to buy. Adding to the angst, it was an election year, and the jobs issue made what initially looked like would an easy re-election for the incumbent less certain.

The pace of the recovery was so tepid that a relatively unknown governor from Arkansas was gaining momentum with an entire presidential campaign strategy built around the phrase, “It’s the economy, Stupid”. In addition, a straight talking billionaire was attracting attention for memorable quips such as his description of job losses to Mexico causing a "giant sucking sound". All the while, the President couldn't believe that so many people read lips.

Despite all that doubt, the S&P 500® had a respectable return of 7.6% that year. In fact, with dividends reinvested, the fund I invested in is now worth over four times as much as my initial contribution.

Along the way, there were many uncertainties that tested my risk tolerance. Looking back now, it can seem obvious that taking risks and staying the course was the right decision. However, at the time they occurred, the ever present concerns about bubbles, busts, inflation, deflation, terrorism, war, the economy, etc, tested even the most steadfast investors.

Perhaps I owe some of my resolve to growing up just a few miles from Uncertain. Uncertain, Texas, that is. If you're not familiar, check out this recently released Ewan McNicol documentary titled, "Uncertain". It has absolutely nothing to do with investing, but it will give you some insight into living on troubled waters deep behind the Pine Curtain of East Texas.

Today, the worries in the investing world may be different than in 1992 (or not), but the concept of risk and reward is ever present. This week, I share with you the latest Issue Brief from my friends at Dimensional Funds that explores the paradox of uncertainty.

In addition, I’ve included a short video on dealing with uncertainty from DFA’s founder and Executive Chairman, David Booth.

I hope you enjoy the information. Get in touch if you’re feeling, well, uncertain.

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The Uncertainty Paradox

May 2017

"Doubt is not a pleasant condition, but certainty is an absurd one."
—Voltaire

“The market hates uncertainty” has been a common enough saying in recent years, but how logical is it? There are many different aspects to uncertainty, some that can be measured and some that cannot. Uncertainty is an unchangeable condition of existence. As individuals, we can feel more or less uncertain, but that is a distinctly human phenomenon. Rather than ebbing and flowing with investor sentiment, uncertainty is an inherent and ever-present part of investing in markets. Any investment that has an expected return above the prevailing “risk-free rate” (think T-Bills for US investors) involves trading off certainty for a potentially increased return.

Consider this concept through the lens of stock vs. bond investments. Stocks have higher expected returns than bonds largely because there is more uncertainty about the future state of the world for equity investors than bond investors. Bonds, for the most part, have fixed coupon payments and a maturity date at which principal is expected to be repaid. Stocks have neither. Bonds also sit higher in a company’s capital structure. In the event a firm goes bust, bondholders get paid before stockholders. So, do investors avoid stocks in favor of bonds as a result of this increased uncertainty? Quite the contrary, many investors end up allocating capital to stocks due to their higher expected return. In the end, many investors are often willing to make the tradeoff of bearing some increased uncertainty for potentially higher returns.

MANAGING EMOTIONS

While the statement “the market hates uncertainty” may not be totally logical, it doesn’t mean it lacks educational value. Thinking about what the statement is expressing allows us to gain insight into the mindset of individuals. The statement attempts to personify the market by ascribing the very real nervousness and fear felt by some investors when volatility increases. It is recognition of the fact that when markets go up and down, many investors struggle to separate their emotions from their investments. It ultimately tells us that for many an investor, regardless of whether markets are reaching new highs or declining, changes in market prices can be a source of anxiety. During these periods, it may not feel like a good time to invest. Only with the benefit of hindsight do we feel as if we know whether any time period was a good one to be invested. Unfortunately, while the past may be prologue, the future will forever remain uncertain.

STAYING IN YOUR SEAT

In a recent interview, David Booth was asked about what it means to be a long-term investor:

“People often ask the question, ‘How long do I have to wait for an investment strategy to pay off? How long do I have to wait so I’m confident that stocks will have a higher return than money market funds, or have a positive return?’ And my answer is it’s at least one year longer than you’re willing to give. There is no magic number. Risk is always there.”

Part of being able to stay unemotional during periods when it feels like uncertainty has increased is having an appropriate asset allocation that is in line with an investor’s willingness and ability to bear risk. It also helps to remember that, during what feels like good times and bad, one wouldn’t expect to earn a higher return without taking on some form of risk. While a decline in markets may not feel good, having a portfolio you are comfortable with, understanding that uncertainty is part of investing, and sticking to a plan that is agreed upon in advance and reviewed on a regular basis can help keep investors from reacting emotionally. This may ultimately lead to a better investment experience.

Source: Dimensional Fund Advisors LP.

There is no guarantee investment strategies will be successful. Diversification does not eliminate the risk of market loss.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

Planning for Alzheimer's

Have you misplaced your eye glasses recently? Or, have you recognized a face at the grocery store but been unable to recall the person's name?

Forgetting a name or where we put our keys are typical realities for many of us as we get older. For the 5 million Americans currently living with Alzheimer’s Disease, however, routine activities such as driving, cooking, taking medicine, or managing finances can have disastrous consequences if the disease isn’t noticed or addressed in a timely fashion.

A 2016 study published by Dr. Halima Amjad and colleagues, of the Division of Geriatric Medicine and Gerontology at John Hopkins, showed that patients with unrecognized dementia were nearly twice as likely to engage in unsafe activities than those that had been diagnosed. In fact, nearly a third of those studied with undiagnosed dementia were still handling their own finances, compared with only 12% of those that had been diagnosed.

According to the Alzheimer’s Association 2017 Alzheimer’s Disease Facts and Figures, the number of Alzheimer’s cases are projected to as much as triple over the next 30 years. Considering that 1 in 3 seniors die with dementia, it would be bordering on insane to not incorporate planning for cognitive decline in all our financial plans.

Perhaps the most at risk are those that are the most self-sufficient and independent individuals. In other words, those that most doggedly manage their own affairs may ultimately be the most prone to harming themselves. Add in other dynamics such as strong personalities and high levels of intellect that may make a child or spouse reluctant to address concerns, and you may have a recipe for disaster.

Take, for example, the Central Texas rancher client we had at my previous employer. He historically had been a bond and Bank CD buyer and had accumulated a nice nest egg over his 70 or so years. Even though he was assigned to an advisor in our local office, he typically conducted most of his business online or through our central call centers.

Then, one day, he showed up at our office with his wife. They were both confused and had questions about why their account had dropped in value. Upon reviewing the account, we immediately noticed that he had been trading stock options and had lost a significant amount of money.

Through the discussion with both the husband and the wife, it was apparent that they were both impaired in some way and probably not capable of acting in their own best interest. They had a son listed as the beneficiary on their account and when we reached out to him, he was very reluctant to challenge his father’s judgement. We were compelled to close the client’s account and get him out of those high-risk investments he had made, but the damage had been done.

This situation demonstrates one of the most apparent benefits of having a personal relationship with a financial advisor, accountant, or some other professional that knows you and that you interact with periodically. You don’t have to be a CFP®, CPA, JD, or MD to know the warning signs, though. According to alz.org®, the top 10 are:

1. Memory loss that disrupts daily life
2. Challenges in planning or solving problems
3. Difficulty completing familiar tasks at home, at work, or at leisure
4. Confusion with time or place
5. Trouble understanding visual images and spatial relationships
6. New problems with words in speaking or writing
7. Misplacing things and losing the ability to retrace steps
8. Decreased or poor judgement
9. Withdrawal from work or social activities
10. Changes in mood and personality

Have a Conversation Today

Discussing aging and its consequences can be difficult, especially if dementia symptoms have already set in. In a worst case scenario, you may have to go to court to have your loved one declared incompetent. While the conversations are never easy, they are better had sooner than later. Some of the tools and best practices to consider and discuss are:

• Power of Attorney
• Trusts
• Update beneficiaries
• Current will
• Living will
• Health care proxy
• Long-term care insurance
• Secure storage of legal documents, passwords, and trusted advisors

If you would like to discuss your plan, get in touch.

Two HUUUGE Questions About The Biggest Tax Cut In American History

Stock markets rallied this week in anticipation of, and in reaction to, the President’s tax plan. Probably the biggest concern on most people's’ minds has been, "What do I stand to lose?" Meanwhile, policy makers must wrestle with who will  “pay” for tax cut proposals (as much as $7 trillion by some estimates) by closing loopholes. Of course, what may be a loophole to some is considered sacrosanct to others. Even though many important details are still lacking, there do seem to be some answers to the two most common questions I’ve fielded in conversations over the past few weeks.

Will I still get a deduction for making retirement contributions?

Initially, the president’s press secretary, Sean Spicer, was quoted as saying the proposal only included tax deductions for charitable giving and mortgage interest, “that’s it.” Afterwards, he clarified that the plan did NOT include doing away with the deduction for making retirement account contributions. It does make you wonder how close of a decision it was, given the recent report from the Congressional Joint Committee on Taxation showing that about $1.5 trillion in taxes could be raised in the next decade by changing how the upfront tax benefits of those accounts are currently treated.

For now, most retirement account contributions such as your salary deferrals, company matching, profit sharing, etc, are made pre-tax. The growth of the account is then tax deferred until retirement, where the proceeds are taxed upon withdrawal.

One proposal being examined is treating all retirement account contributions in the same manner as Roth IRAs, that is, you would receive no tax break on the front end but you wouldn't pay taxes upon withdrawal either. Believe it or not, arithmetic doesn’t favor paying a certain percentage in taxes sooner versus later.

Consider this simple example. You are in a 25% tax bracket and invest $1,000 for 10 years at 7.2%.

1. Pre-Tax, Tax Deferred:  You put in $1,000, it grew to $2,000, and you owed $500 (25%) in taxes upon withdrawal, leaving you with $1,500.
2. Post-Tax, Tax Free: You put in $750 ($1,000 minus 25% tax), it grew to $1,500, and you owed nothing in taxes, leaving you with $1,500.

Conventional wisdom is that you will be in a lower tax bracket in your golden years, but the more complicated reality is that your tax situation may change by circumstances that can be challenging to control, such as exceeding Social Security taxation levels, having Required Minimum Distributions push you into a higher tax brackets, and/or the potential for higher tax rates in the future driven by the voracious government appetite for spending.

So, yes, your deduction for this year’s retirement contribution appears safe. Even if the upfront tax benefits were to go away, however, it is likely that you would still see significant benefits to continuing your contributions.

Should I wait for capital gains taxes to go down to take a profit?

Depending on your current income tax bracket, long-term capital gains (LTCG) are currently taxed as low as 0% and as high as 23.8%. The White House proposes dropping LTCG rates to a high of 20% by eliminating the 3.8% Medicare surtax that is currently added on to LTCG rates for single taxpayers with adjusted gross income over $200,000 or $250,000 for joint. The House GOP’s, “A Better Way” has proposed reducing the top rate on LTCG even further, to 16.5%.

If you made a $1,000 investment over a year ago that is now worth $2,000, the most you potentially owe in Long Term Capital Gains + Medicare surtax is $238, or about 12% of the overall value of your holding. Even if the GOP’s 16.5% proposed LTCG rate were to become law, your tax burden would only shrink to $165, or to about 8.25% of your holding. Considering that 10%+ stock market corrections occur about once per year, it wouldn’t be surprising (and it may even be likely) that the next dip will cost you more than you would have saved by waiting.

I typically recommend not waiting to liquidate any amount you foresee spending in the next couple of years, regardless of pending tax laws. History suggests that it is likely we will see a swoon or two in that timeframe that could easily exceed any potential tax savings.

Everyone's situation is different, which is why you shouldn’t wait on having a plan in place. Get in touch if yours needs review.