Archives for December 2013

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How Interest Rates Affect Stock and Bond Prices

A reader writes in, asking:

“I’m aware that bond prices and bond interest rates have a high correlation with prices typically going down when rates go up. What happens to stock prices if rates go up? Is that something I should be afraid of?”

To back up a step, bond prices and bond yields aren’t just closely correlated. They’re directly mathematically connected. A bond’s current yield is calculated by dividing the interest it pays by its current price. If the price goes up, the yield, by definition, goes down. If the price goes down, the yield goes up. No exceptions. (Think of two opposite sides of a seesaw.)*

This is a crucial point, so please forgive me for belaboring it: Saying that bond rates went up is simply another way of saying that bond prices went down.

Interest Rates and Stock Prices

The connection between interest rates and stock prices, however, is not nearly as reliable.

If interest rates go up, all else being equal, stock prices will go down — because some investors will choose to move their money from stocks to bonds, given that bond yields have become more attractive than they used to be. (And this reduced demand for stocks will cause stock prices to decline.) And conversely, if interest rates go down, all else being equal, stock prices will go up — because some investors will choose to sell their (now lower-yielding) bonds in order to move to stocks.

The catch, of course, is this “all else being equal” business. In the real world, there are thousands of other variables, and they’re always moving around.

So, for instance, if interest rates go up, how stock prices will actually react depends on why interest rates went up. That is, what changed in our economy to cause lenders to raise their rates? And how does that change affect our expectations for corporate earnings? If the change has a positive effect on corporate earnings expectations, stock prices could very well go up in spite of interest rates going up. Conversely, if the change has a negative effect on corporate earnings expectations, stock prices will go down, and they’ll go down by more than the amount that would be predicted solely by the change in interest rates.

*Update: Boglehead Taylor Larimore astutely points out that there is in fact an exception: cases in which the actual terms of the bond change (i.e., bankruptcy). If a bond is discharged in bankruptcy, its price and yield would both fall at the same time (to zero). As long as the terms of the bond do not change, however, the inverse relationship between price and yield cannot be violated.

Can I Do a Partial 401(k) Rollover?

A reader writes in, asking:

“After quitting my job, is it possible to do a rollover with just part of my 401k? I would like to be able to move some money to an IRA but keep some of it in the 401k.”

Yes, from a tax standpoint, you are allowed to roll over a portion of your 401(k) while keeping the rest of it in place.

I say “from a tax standpoint,” because there’s also the administrative standpoint to consider: Not all 401(k) plans are set up to allow partial rollovers. (Your plan administrator will be able to tell you whether your plan allows them.)

A partial rollover can be helpful if, for instance, your 401(k) has one investment option that is both excellent and not available to retail investors, but the rest of the investment options are miserable. In such cases, it can make sense to keep just enough money in the account to hold as much of that one investment as you want to hold, while rolling everything else out of the account to an IRA.

Partial rollovers can also be helpful if you retire between ages 55 and 59.5. In these cases, due to a separation from service in or after the year in which you turn age 55, you would have penalty-free access to the 401(k) money, but because you’re not yet age 59.5, you might not have penalty-free access to traditional IRA money. As a result, you may want to roll over part of the 401(k) — in order to be able to invest it however you want — while leaving enough money in the 401(k) to satisfy living expenses until you reach age 59.5.

Partial rollovers are also one way to take advantage of the “net unrealized appreciation” rules if you have appreciated employer stock in your 401(k). That is, you roll everything except the appreciated employer stock into an IRA, and, in the same year, you do an in-kind distribution of the employer stock to a taxable account, thereby allowing the appreciation to be taxed (when you sell the stock) at long-term capital gains tax rates rather than ordinary income tax rates. (Your basis in the employer stock will still be taxed at ordinary income tax rates when you take it out of the 401(k). And if you’re under age 59.5, it’s possible that the basis will be subject to the 10% penalty as well.)

Strategic Bequest Planning

A reader writes in, asking:

“It has become clear that barring a market catastrophe, our portfolio will probably outlast us. We’re nowhere near the point where estate tax would be a concern, but I’ve been thinking about how to maximize the value we leave to our children.

Rather than splitting our Roth and traditional IRAs equally between our children, what do you think about leaving our Roth IRA entirely to our child who is in a higher tax bracket and leaving most of the traditional IRA to our child who is in a lower tax bracket. We would set it up so they each receive the same net amount after taxes, and this way they both get more, after taxes, than they would if we split it equally.”

If the goal is to maximize the total after-tax value of the assets you leave to your heirs, it can make sense to:

  1. Leave a greater portion of your tax-deferred assets to the heir(s) with the lowest marginal tax rate, while
  2. Leaving more Roth assets and assets that would that would qualify for a step-up in basis (e.g., appreciated stocks in a taxable brokerage account) to the higher-tax-rate heir(s).

Still, there are two potential hangups.

First, there’s simply no way to ensure that each of your heirs actually receives the same after-tax amount. Most likely, your children will be taking distributions from the inherited retirement accounts over a period of multiple years, and your children’s respective marginal tax rates will surely change over the course of those years as their income changes and as legislatively-determined tax brackets change. In addition, unless all of the accounts have the same exact asset allocation, the different accounts will perform differently prior to your death, resulting in imbalances between the amounts received by each heir.

Second, if your heirs don’t understand why you split the accounts unevenly, it could cause ill will between them (or toward you) after your death. Assuming that’s a situation you’d like to prevent, it will be critical to get the kids on board with this idea ahead of time, to make sure they understand why you’re doing it (i.e., to maximize the after-tax value to be split among them) and to make sure they agree it’s a good idea, even though it means that they will not receive identical amounts.

Why Do Risk-Adjusted Returns Matter?

A reader writes in, asking:

“Why do academics always talk about risk adjusted returns? I get that risk matters and you shouldn’t have a riskier portfolio than you can manage. But if I compare two strategies over a period, I’m better off at the end if I used the strategy with the higher return, not the one with the higher risk adjusted return. So why is risk adjusted return relevant?”

The usefulness of the risk-adjusted return concept is that we can use it to evaluate a proposed strategy to determine whether it has historically been a better way to increase returns (or reduce risk) than simply adjusting any of several other well known variables (e.g., stock vs. bond allocation, duration of bond holdings, credit quality of bond holdings, etc.).

For example, imagine that you currently have a 50% stock, 50% bond portfolio that uses simple “total market” index funds for both the stock and bond portions. But then you meet with a financial advisor who suggests that you would be better off if you got rid of your total market stock funds and switched to a portfolio of individual stocks, picked according to a specific set of criteria. And this advisor shows you historical data demonstrating that his hand-picked stock portfolio has had higher returns over the last several years than your total market stock funds.

Obviously, one problem here is the critically dubious implication that the past is a good predictor of the future. But let’s set that aside for the moment to focus on another problem: A portfolio comprised of a handful of individual stocks will generally have far more risk than a broadly diversified total market stock portfolio.

In other words, the advisor isn’t making an apples-to-apples comparison, and he has not demonstrated that his strategy is actually an improvement over a total market strategy. What needs to be demonstrated is whether the 50% bond, 50% hand-picked-stock portfolio the advisor is proposing has had greater returns than an index fund portfolio with the same level of risk.

For example, you might find that the advisor’s 50/50 strategy with handpicked stocks has historically had a risk profile comparable to a 70/30 stock/bond portfolio using total market funds but that its historical annualized return is closer to that of a 60/40 portfolio using total market funds. If that’s the case, then the advisor has clearly not added any value. All he has done is bump up the risk and return in an inefficient way. A 70/30 total market portfolio would have had higher returns with the same level of risk as what the advisor is proposing, and a 60/40 total market portfolio would have had the same level of returns, with less risk than what the advisor is proposing.

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