Should Investors Sell After a "Correction"?

Weston Wellington, Down to the Wire
Vice President, Dimensional Fund Advisors

Stock prices in markets around the world fluctuated dramatically for the week ended August 27. On Monday, August 24, the Dow Jones Industrial Average fell 1,089 points—a larger loss than the “Flash Crash” in May 2010—before rallying to close down 588. Prices fell further on Tuesday before recovering sharply on Wednesday, Thursday, and Friday. Although the S&P 500 and Dow Jones Industrial Average rose 0.9% and 1.1%, respectively, for the week, many investors found the dramatic day-to-day fluctuations unsettling.

Based on closing prices, the S&P 500 Index declined 12.35% from its record high of 2130.82 on May 21 through August 24. Financial professionals generally describe any decline of 10% or more from a previous peak as a “correction,” although it is unclear what investors should do with this information. Should they seek to protect themselves from further declines by selling, or should they consider it an opportunity to purchase stocks at more favorable prices?

Based on S&P 500 data, stock prices have declined 10% or more on 28 occasions between January 1926 and June 2015. Obviously, every decline of 20% or 30% or 40% began with a decline of 10%. As a result, some investors believe that avoiding large losses can be accomplished easily by eliminating equity exposure entirely once the 10% threshold has been breached.

Market timing is a seductive strategy. If we could sell stocks prior to a substantial decline and hold cash instead, our long-run returns could be exponentially higher. But successful market timing is a two-step process: determining when to sell stocks and when to buy them back. Avoiding short-term losses runs the risk of avoiding even larger long-term gains. Regardless of whether stock prices have advanced 10% or declined 10% from a previous level, they always reflect (1) the collective assessment of the future by millions of market participants and (2) the expectation that equities in both the US and markets around the world have positive expected returns.

Exhibit 1 below shows that US stocks have typically delivered above-average returns over one, three, and five years following consecutive negative return days resulting in a 10% or more decline. Results from non-US markets are similar.

Contrary to the beliefs of some investors, dramatic changes in security prices are not a sign that the financial system is broken but rather what we would expect to see if markets are working properly. The world is an uncertain place. The role of securities markets is to reflect new developments— both positive and negative—in security prices as quickly as possible. Investors who accept dramatic price fluctuations as a characteristic of liquid markets may have a distinct advantage over those who are easily frightened or confused by day-to-day events and are more likely to achieve long-run investing success.

REFERENCES

“Wild Ride Leaves Investors Grasping,” Wall Street Journal, August 25, 2015.

“Investors Scramble as Stocks Swing,” Wall Street Journal, August 25, 2015.

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Dimensional Fund Advisors LP ("Dimensional") is an investment advisor registered with the Securities and Exchange Commission. 

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This content is provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services. 

Contrary to the beliefs of some investors, dramatic changes in security prices are not a sign that the financial system is broken but rather what we would expect to see if markets are working properly. The world is an uncertain place. The role of securities markets is to reflect new developments— both positive and negative—in security prices as quickly as possible. Investors who accept dramatic price fluctuations as a characteristic of liquid markets may have a distinct advantage over those who are easily frightened or confused by day-to-day events and are more likely to achieve long-run investing success.

Tax Tales and 6 Tips for Not Getting Bit

Photo by philhearing 

One of the most overused idioms in the investment world is “Don’t let the tax tail wag the investment dog.” Tired as the expression may be, its persistence is grounded in the great lengths people go to avoid paying taxes. Maybe a different take should be how to make the inevitable tax bite as gentle as possible.

I have always been amazed by the impact of taxes on individual investor’s decision making. Many times, the results are negative. One such example was a 45 year old single dad that had seen his options in his company stock, a software company, quintuple in 1999. He suddenly found himself with enough money to send his three kids to college, pay off his mortgage, and even retire if he wanted. The only problem was that he didn’t want to sell at that time and pay taxes on his gains.

I was helping him with his planning in early 2000, and he agreed that he should cash in some of his profits to diversify but he wanted to wait until early 2001 so he could delay the tax hit. The stock dropped about 75% before the New Year rolled around, and ultimately 99% from its high by the time he was ready to sell. Not only did he avoid paying all those taxes, last I heard he is still working to pay off those mortgages and student loans to this day.

The investment industry is keenly aware of people’s aversion to being bitten by the tax dog. All you have to do is see the $35.6 billion in variable annuity sales in the second quarter of this year.[1] If you’re not familiar with variable annuities that is likely because you haven’t encountered an annuity salesperson, as virtually all of these products are sold versus bought. In other words, you went shopping for a mutual fund and walked out with an annuity. The pitch sounds great, grow your money tax-deferred like your retirement account with no limit to your contributions.

The catch? Most investors will never come out ahead versus investing in low-turnover stock index funds.[2] If you wonder why they are sold in such great numbers, all you need to do is follow the commissions paid to the salespeople who market them. If you want to see a salesperson squirm, have them show you what they stand to make if you buy their annuity versus an ETF or index fund that invest similarly to the underlying funds being recommended.

Fortunately, just as fear of taxes can provide negative influences on your decision making, so too can they provide incentives to make the right choices. Here are my six tips for putting a leash on Uncle Sam.

1.       Maximize your work retirement accounts. This isn’t the most innovative recommendation, but I consistently see folks not taking full advantage of their retirement accounts. One recent example was a self-employed client that had a SEP IRA but that instead could use a Self Employed 401k to take advantage of catch up provisions after age 50 (an extra $6,000 in 2015).

For 2015, the maximum contribution for a 401(k), 403(b), or governmental 457(b) is $18,000; $24,000 if you are > age 50, or maybe more in some circumstances. Every dollar invested is pre-tax or grows tax-free if you have a Roth option. If your plan offers a match, not only are you getting the benefit of pre-tax investments, but you’re getting free money (subject to your companies vesting rules).

2.       Contribute to an IRA, even if it’s not deductible. Most folks I talk to think that contributing to a non-deductible IRA isn’t worth the hassle. In 2015, you can put up to $5,500 per person ($6,500 if you’re > age 50) into these accounts to grow tax-deferred without the costs associated with variable annuities. If you qualify for the tax-deduction or a tax-free Roth IRA contribution or conversion, even better.

3.       Pay down debt. With rates on savings well under 1%, the volatility in stock markets, and the lack of liquidity in real estate or private equity, paying off that credit card, automobile loan, or even your mortgage can be an attractive "investment". The savings are like a tax free guaranteed return equal to the interest rate you are paying.

If you’re thinking that giving up the mortgage interest tax deduction is unattractive, think of it like this. Where else would you pay $1 to “save” .40 cents?  A tax deduction for a necessary expense is nice, but it doesn’t make much sense to spend more to save less. If you can’t afford to pay off a mortgage, consider refinancing to a shorter duration loan while interest rates are at all-time lows. 

4.       Choose a high-deductible health care plan (HDHP) paired with a Health Savings Account (HSA). You may take on more out-of-pocket health care costs potentially, but you will typically see lower insurance premiums as one of the benefits. Best of all, for 2015 you can put up to $6,650 ($7,650 if you’re > age 55) into an HSA not only pre-tax, but pre-FICA if it is part of your employer’s cafeteria plan. If you don’t spend it all during the year, it continues to grow tax-free for your future medical out of pocket medical expenses.

5.       Use a 529 College Saving Plan for college savings. These are offered through state sponsored plans, some of which may provide a state income tax break. The biggest benefit, however, is that the growth of the investments is tax free if used for the beneficiary’s qualified higher education expenses paid —tuition, fees, books, supplies, equipment, and room and board. There are fees on these plans, but several are very low cost. A good place to research the different choices and learn more is www.savingforcollege.com.

6.       Harvest some losses. If you have taxable investments that are worth less than you bought them for, selling them can result in losses that can be used to offset gains on others. If you don’t have gains to offset, you can also deduct up to $3,000 per year “above the line” on your tax return. There are potential limitations, such as the “wash sale rule” to be aware of, so you are probably best off to discuss with your tax advisor before implementing this strategy.

 If you are still worried about taxes, you can always take one other piece of advice from Texas A&M football coach Kevin Sumlin, “If you’re scared of that, get a dog.”[3]

[1] http://myirionline.org/docs/default-source/news-releases/iri-issues-second-quarter-2015-annuity-sales-report-%28pdf%29.pdf?sfvrsn=0

[2] http://www.forbes.com/sites/feeonlyplanner/2012/07/02/9-reasons-you-need-to-avoid-variable-annuities/

[3] http://www.dallasnews.com/sports/college-sports/texas-aggies/20120618-texas-am-s-kevin-sumlin-says-aggie-fans-eager-for-sec-road-games-will-have-a-different-answer-for-me-next-year.ece

Hey Ladies, Want to Dance?

Retirement Three-Step

Photo by  istolethetv

“Let’s go boot scooting,” said one of my best friends as we discussed what we were going to do one Friday night back in college.

“Why?” I asked.

“Because ladies LOVE to dance!” he shot back as he stood up and pretended to do a two-step with an imaginary partner.

This particular friend was a good dancer and he always seemed to have success in meeting the opposite sex. Not only did we go dancing that night, but I signed up for lessons shortly thereafter, as did several of my other buddies.

This came to mind as I read a recent survey by the Transamerica Center for Retirement Studies and the Aegon Center for Longevity and Retirement. In this study, there were several data points that caught my eye.

·         81% of US homemakers are women

·         67% of homemakers are not prepared for retirement

·         89% lack a written retirement plan

It seems, as much as you ladies like dancing, you defer your retirement planning to your partner more often than not. With up to 50% of marriages ending prior to death and longevity statistics suggesting that women will outlive men by an average of almost five years, it is likely that most of you will find yourselves dancing alone at some point before the lights come on. Retirement planning may not be as much fun as a jitterbug, but it is too important not to learn even if you prefer to follow your partner for now.

So what can be done? Here are three steps (pun intended), and none of them require much more effort than an occasional night on the dance floor.

Don’t be a girl interrupted. If you are in a relationship that your partner earns most of the money and has the benefits, it’s important that you understand what those benefits are in case your life is interrupted. How many months of expenses are in your emergency fund, how much disability and life insurance you have, and beneficiary designations on retirement accounts and insurance policies are the first areas to focus on.

Learn as you go. Just as a couple of lessons can make one more willing to get out there and dance, it holds true for finances as well. One relatively easy step to take is to open a Spousal IRA (up to $6500 in 2015), which offers the same benefits as an account in the name of the working partner.

Take control of the entire process, from budgeting to fund the account, where you will open it, and what you will invest in. You will be in a much better state of mind to learn the inevitable lessons than after an unexpected separation or worse.

Diagram your steps. Insist on having a written financial plan. At a minimum, the plan should include a balance sheet detailing your assets and liabilities, a list of your goals, and where you stand in relation to accomplishing your objectives. For example, if junior is going to college in 3 years, estimate how much you need versus what you have earmarked for those costs.

Plans are not set in stone. They are just our best guesses and estimates given the information available today. At least once a year, you should sit down and review the plan and make any necessary revisions.

Let’s go ladies, it’s your lead!