Archives for March 2012

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Good and Bad Reasons to Contribute to a Roth IRA

If you read other personal finance blogs, you probably noticed that yesterday was the Roth IRA Movement — a day where many personal finance bloggers got together (at the suggestion of Jeff Rose from Good Financial Cents) to promote the Roth IRA to young investors.

Most of the articles I saw were well-written, and I think it’s great to encourage investors to save via tax-advantaged accounts.

That said, I also ran across a few poorly-reasoned arguments in favor of the Roth as compared to tax-deferred savings vehicles, such as a 401(k) or traditional IRA. (I’m not naming names, because my desire is not to pick on anyone but rather to challenge ideas.)

I thought it might be beneficial to sort through some of the good reasons to contribute to a Roth and some of the poor reasons to contribute to a Roth.

Good Reasons to Contribute to a Roth IRA

In many cases, a Roth IRA is the right choice. For example, Roth IRA contributions are likely preferable to saving via tax-deferred accounts if:

  • You think there’s a meaningful chance that you’ll have to spend the money in the not-so-distant future. (Remember, Roth IRA contributions can be withdrawn free from tax and free from penalty at any time.)
  • You think your marginal tax rate will be higher in retirement than it is now.
  • You think your marginal tax rate will be approximately the same in retirement as it is now, and you want to take advantage of the fact that Roth IRAs do not have required minimum distributions (RMDs).
  • You have no idea how your tax bracket in retirement will compare to your current tax bracket, so you’re “tax diversifying” by using some Roth savings and some tax-deferred savings.
  • You’ve maxed out your 401(k) and you earn too much to be able to make deductible contributions to a traditional IRA.
  • The investment options in your 401(k) are terrible, and you’ve already contributed enough to get the maximum employer match.
(For reference, the above list is not meant to be exhaustive. There are other, less common reasons why you might want to contribute to a Roth. But I think that covers the major ones.)

Not-So-Good Reasons to Contribute to a Roth IRA

There are also, however, some commonly-cited yet unconvincing arguments for contributing to a Roth IRA, including:

  • “Tax-free” is better than “tax-deferred.” It certainly sounds better. But the commutative property of multiplication tells us that paying, for example, a 25% tax now leaves you with the same after-tax amount as paying a 25% tax later. So unless you expect your marginal tax rate to increase between now and retirement, “tax-free” (via a Roth) is no better than “tax-deferred.”
  • You’ll pay less tax with a Roth than with tax-deferred savings. This is usually true, but that’s irrelevant. All that matters is how much you have left after paying the tax. And, as explained above, if the tax rate is the same, it doesn’t matter whether you pay it now or later.
  • Tax rates will increase in the future. If this is true, it is relevant, but it’s not a sufficient reason to prefer Roth contributions to tax-deferred contributions. Even if legislative tax rates go up, your marginal tax rate could be lower in retirement than it is now if your taxable income goes down dramatically when you retire — as is the case for many people.

Regarding the topic of the commutative property of multiplication and how it applies to the Roth vs. traditional decision, I’ll leave you with an allegorical explanation via one of my favorite blogs (the now dormant Bad Money Advice):

“Once upon a time there were two farmers named Joe and Bob who lived in the Kingdom of Ira. The King of Ira said to Joe and Bob that they must pay one fourth part of their grain as a tax. But, being a kind and wise king, he gave them a choice. They could pay a fourth of their seed in the spring or a fourth of their harvest in the fall.

Joe chose to pay a fourth of his seed and so could sow only three fields, but kept all that he reaped. Bob decided to keep all his seed, and planted four fields, but had to give the bounty of one of those fields to the king. Both farmers had three fields worth of grain to feed their families and so lived happily ever after.”

Update: Bogleheads author Taylor Larimore wrote in to mention an additional advantage of the traditional IRA:

In a marginal situation, the Traditional may be better. By investing in a traditional IRA the investor gets a tax deduction.   She may also be able to later convert to a Roth with little or no tax during the period of low/no income after retiring and before the taxable income from Social Security or IRA RMDs begins.  The result is a deductible IRA with tax-free accumulation that is tax-free at withdrawal.

Asset Allocation and Risk Tolerance

The following is an adapted excerpt from the 2012 edition of Investing Made Simple.

When putting together a portfolio, the first thing to decide is your desired asset allocation. That is, how much of your portfolio should be invested in each asset class (e.g., U.S. stocks, international stocks, and bonds)?

Your asset allocation should be determined by your tolerance for risk. In turn, your tolerance for risk is determined by:

  1. The degree of flexibility you have with regard to your financial goals, and
  2. Your personal comfort level with volatility in your portfolio.

Financial Flexibility

Example 1: Jason is a construction worker. He’s 57, and each day he is becoming increasingly aware that his body is unlikely to be able to continue in his line of work for more than two or three more years. Between his Social Security and savings, Jason is pretty sure that his basic expenses will be covered—but only barely. Because Jason can neither delay his retirement nor reduce his expenses, Jason has a low ability to take risk.

Example 2: Debbie is 54. She hopes to retire at 62 with enough savings to provide for $50,000 of annual spending. Debbie likes her work though, so she wouldn’t terribly mind having to work until her late 60s. And $50,000 is just a goal. She knows she could get by just fine with about 70% of that. Because Debbie’s goals are flexible, she has a greater ability to take risk.

Comfort with Volatility

Your risk tolerance is also affected by your comfort level with volatility. One way to estimate this comfort level is to ask yourself, “How far could my portfolio fall before I started losing sleep, feeling stressed, or wanting to sell everything and move to cash?”

When answering this question, be sure to answer both as a percentage and as a dollar value—otherwise you may come to inaccurate conclusions. For example, you may remember that at age 25 you experienced a 40% loss and handled it just fine. But if you’re 45 now, and your portfolio is 10-times the size that it was at age 25, a 40% loss could be an entirely different experience.

When assessing your risk tolerance, it’s generally wise to guess conservatively. If you end up with a portfolio that’s slightly too conservative for your tastes, you’ll only be missing out on a relatively small incremental return.

In contrast, if you end up with a portfolio that’s too aggressive, you might end up panicking during periods of high volatility. Even one instance of getting out of the market after a sharp decline can be more than enough to eliminate the extra return you were hoping to earn from having a stock-heavy allocation.

Stocks vs. Bonds

Once you have an idea of your risk tolerance level, it’s time to move on to the first (and most important) part of the asset allocation decision: your stock/bond allocation.

One rule of thumb that serves as a reasonable starting point for analysis is to consider limiting your stock allocation to the maximum tolerable loss that you determined above, times two. Or, said differently, assume that your stocks can lose 50% of their value at any time.

The most important thing to remember with asset allocation guidelines, however, is that they’re just that: guidelines. For example, with regard to this particular rule of thumb, it’s important to understand that a loss greater than 50% certainly could occur, despite the fact that such declines are historically uncommon. This is especially true if your stock holdings are not well diversified or if your non-stock holdings are high-risk such that they could decline significantly in value at the same time that your stocks do.

U.S. Stocks vs. International Stocks

It’s not terribly surprising to learn that the U.S. stock market isn’t the best performing market in the world every single year. In fact, it’s often not in the top 10.

The difficulty in international investing—as with picking stocks or actively managed mutual funds—is that it’s nearly impossible to know ahead of time which countries are going to have the best market performance over a given time period. The solution? Own each (or at least many) of them.

The primary goal of investing a portion of your portfolio internationally should not be to increase returns, as there is no guarantee that international markets will outperform our own. Rather, the primary goal is to increase the diversification of your portfolio, thereby reducing your risk.

In total, the U.S. stock market makes up roughly half of the value of all of the publicly traded stocks in the world. However, most investment professionals recommend allocating more than 50% of the stock portion of your portfolio to domestic equities. Why? Because investing internationally introduces an additional type of risk into your portfolio: currency risk.

Currency risk is the risk that your return from investing in international stocks will be decreased as a result of the U.S. dollar increasing in value relative to the value of the currencies of the countries in which you have invested.

Simplified Example: A portion of your portfolio is invested in Japanese stocks, and over the next five years it earns an annual return of 8%. However, over that same period, the yen decreases in value relative to the dollar at a rate of 3% per year. Your annual return (as measured in dollars) would only be 5%.

So how much of your portfolio should be invested internationally? There’s a great deal of debate on this issue, with investment professionals recommending that you hold anywhere from 10% to 50% of the stock portion of your portfolio in international stock funds.

The trick is that without knowing how the U.S. market will perform in comparison to markets abroad, there’s simply no way to know what the “best” allocation will be. In my own opinion, allocating anywhere from 20% to 40% of the stock portion of your portfolio to international index funds would be reasonable for most investors.

Rebalancing

No matter how perfectly you craft your portfolio, there’s little doubt that in not too terribly long, your asset allocation will be out of whack. The stock market will have either shot upward, thereby causing your stock allocation to be higher than intended, or it will have experienced a downturn, causing your stock allocation to be lower than intended.

Rebalancing is the act of adjusting your holdings to bring them back in line with your ideal asset allocation. A periodic rebalancing program essentially automates the old adage, “buy low, sell high,” as you’ll be selling the portion of your portfolio that has increased in value so that you can buy more of the portion that has decreased in value.

It’s worth noting that rebalancing can be extremely difficult from a psychological standpoint. It can feel as if you’re selling your “good investments” to put money into your “bad investments.” The key is to remember that just because something has performed well (or poorly) recently doesn’t mean that it will continue to do so in the immediate future.

How often should an investor rebalance? That’s a tricky question. Some people advocate in favor of rebalancing once your portfolio is off balance by a certain amount (such as your stock allocation being either 10% higher or 10% lower than intended). Others argue that rebalancing should be done at regular intervals, regardless of how off-balance your portfolio becomes in the interim.

Unfortunately, the best-performing rebalancing strategy varies from period to period, and it’s no easy task to predict which one will do best over the course of your investing career. Rather than spending a great deal of time and effort thinking about it, my suggestion is simply to pick one method and resolve to stick with it.

Simple Summary

  • Your tolerance for risk should be the primary determinant of your stock/bond allocation. Your risk tolerance is determined by how comfortable you are with investment volatility and how flexible your financial goals are.
  • Generally speaking, it’s better to have an asset allocation that’s too conservative than an asset allocation that’s too aggressive.
  • For the sake of additional diversification, most investment professionals recommend investing somewhere from 20% to 40% of your stock holdings internationally.
  • Rebalancing is the act of adjusting your portfolio to bring it back in line with your ideal asset allocation. Rebalancing helps to automate “buying low” and “selling high.”

Investing Blog Roundup: Thanks for Spreading the Word

Thanks to each of you who told somebody else about the promotion regarding the 2012 edition of Investing Made Simple. In the last 48 hours, an eye-popping 12,000 people have downloaded the free Kindle version.

(As a reminder, today’s the last day to get the Kindle version for free or to pick up a print copy for just $5).

Investing Articles

Other Money-Related Articles

Thanks for reading!

Free Book, Investing Made Simple Updated

This last week, I finished the 2012 update for Investing Made Simple. The changes include:

  • Updated tax information in the chapter regarding IRAs and 401(k) accounts,
  • An updated section about ETFs as compared to index funds,
  • An updated section about target retirement funds, and
  • A reworking of the chapter about asset allocation and risk tolerance.

Get a Free Book

To kick things off and to say thanks to regular readers, I’ve decided to have a brief promotion. Starting now and lasting through this Friday (3/23):

Answers to Questions

I don’t own a Kindle. Can I still read the Kindle edition somehow?

Yes. There’s no need to own a Kindle to read a Kindle book. They can be read using free software on a regular PC or Mac.

I’ve already read the prior edition. Should I buy this one too?

Overall, it’s the same book with the same message, and I’ll also be sharing a couple chapters here on the blog over the next week or so. So there’s probably no need to buy it again. (On the other hand, for a price of zero, there’s little reason not to pick up the Kindle version.)

Can I tell other people about the promotion?

Yes. If you know anyone who might benefit from the book, please don’t hesitate to let them know about it so they can pick up a free Kindle copy or inexpensive print copy.

Why does the Amazon page show the old copyright date?

Because the new edition is published under the same ISBN as the old edition, the copyright date on Amazon’s description page will not be updated. But the edition that is being shipped out is the 2012 edition — I’ve tested it myself with multiple purchases to be sure.

On the off chance that you receive an old edition that Amazon had been saving just for you in a warehouse somewhere, send me an email letting me know what happened, and I’ll have a copy of the new edition sent to you directly from the printing company.

I already have the old edition on my Kindle. How do I update it to the new edition?

Before buying the new one, you’ll have to delete the old edition from your Kindle and from your Kindle account on Amazon. To delete an item from your Kindle account:

  • On Amazon go to the “Your Account” page,
  • Click on “Manage Your Kindle” in the “Digital Content” section, and
  • Click the “actions” drop-down menu for the book in question and choose “delete from library.”

Click here to see the book on Amazon. I hope you find it helpful!

Should Asset Allocation Change Over Time?

This last weekend I read Zvi Bodie and Rachelle Taqqu’s recent book Risk Less and Prosper. One of the central points of the book is that, contrary to conventional wisdom, stocks do not become less risky over time.

We’ve been over this before, but I think the hullabaloo over such statements is mostly due to different people meaning different things when they say the word “risky.” As far as I can tell, most experts actually seem to agree that:

  1. The longer the time period in question, the less likely it is that stocks will lose money relative to their starting value (“stocks become less risky”);
  2. The longer the time period in question, the less predictable the ending value of a stock investment (“stocks become more risky”);
  3. The longer the time period in question, the more likely it is that stocks (and just about everything else, for that matter) will experience a catastrophic loss relative to their starting value due to a genuinely catastrophic economic event (“stocks become more risky”); and
  4. The longer the time period in question, the more likely it is that stocks will outperform safer investments.

The suggestion that young people should have stock-heavy allocations is often based on the idea that stocks become “less risky” over time. Bodie and Taqqu reject this idea, but they still make the case that younger investors can typically afford to have a larger portion of their portfolio invested in stocks than older investors can. Their reasoning is that, while stocks don’t get any less risky with time, investors become less risk tolerant over time.

Economic Risk Tolerance

Bodie and Taqqu argue that young investors can take on more risk because they have a greater degree of financial flexibility. (As you’ll see — next week, hopefully — this is very much in line with my explanation of risk tolerance in the 2012 edition of Investing Made Simple.) This increased flexibility is the result of a few factors, including:

  • The more years you have left in the workforce, the more chance you have of being able to shift to a higher-paying position (or career), should it be necessary to increase your savings rate due to poor investment returns.
  • The younger you are, the greater the impact of cutting your expenses by a given percentage. For example, bumping up your savings rate from 15% to 20% will have a huge impact if you make the change at age 30 but only a minor impact if you make the change just a few years before retirement.
  • It’s much easier to stay in a job than it is to find a new job, so risk tolerance declines significantly immediately upon retirement.

Emotional Risk Tolerance

An investor’s emotional ability to take risk often declines over time as well, due to the simple fact that his/her portfolio is larger than it’s been in the past. For example, a 40% portfolio decline at age 25 might mean losing an amount of money equal to just a few months of wages. At age 55, it’s the equivalent of a few years of wages. Many people become understandably nervous when they see that their portfolio has lost more money in the last 6-12 months than they’ve earned in the last 4-5 years.

How Much Safe Retirement Income Do You Need?

Monday’s post about building a super-safe retirement portfolio drew a few questions about how to take the same idea, but scale it down a bit. For example, one reader asked:

“Could it make sense to do this ‘super safe’ sort of thing with a part of my portfolio, but use regular stock and bond mutual funds for the rest of it? I was fortunate enough to get to choose when I retired, so I think my savings are adequate. But I still like the idea of having some income I don’t need to worry about.”

In short, my answer is an emphatic yes. I think most retirees would do well to use safe sources of income to satisfy their most basic spending needs. Then, once you’ve satisfied your must-have level of income with safe, inflation-adjusted sources, it can (depending on your preferences) make sense to use a higher risk allocation for the rest of your holdings in the (quite reasonable) hope of earning higher returns.

Prioritizing Your Spending

My best suggestion for how to implement this idea is to run through your current budget, consider how it will change in retirement (if you’re not already retired), then ask yourself which budget items you could eliminate or reduce without feeling that your standard of living was disappointingly low.

In other words, rather than simply shooting for one retirement spending goal, try breaking it down at two different levels:

  • “I do not want to have less than $X per year” and
  • “I hope to have $Y per year.”

Then, depending on your risk tolerance, you can pick which of those levels you want to satisfy via safe, inflation-adjusted income sources such as Social Security benefits (remember, delaying Social Security is an excellent way to increase your safe level of income), pension (if any), inflation-adjusted lifetime annuities, and TIPS.

Brief tangent: As you can see here, risk tolerance is about more than just choosing an overall stock/bond allocation. It also plays a role in answering other important questions such as how much of the portfolio to annuitize and when to claim Social Security benefits.

After you have a high enough level of safe income that you no longer need to worry, you can allocate the rest of the portfolio however you wish.

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