Archives for November 2016

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Where is the “Sweet Spot” for Passive Investing?

A reader writes in, asking:

“At what level of money does passive investing make the most sense? Is there a ‘sweet spot’ so to speak in terms of portfolio size or income? How would the strategy have to be adapted to work at different levels?”

Firstly, there’s no sweet spot. Passive investing is a prudent choice across the full spectrum of asset and income levels — as soon as you reach an income/asset level where investing becomes relevant in the first place, that is.

Passive investing makes sense for the new beginner who is just getting started with small amounts, and it makes sense for huge pools of money such as university endowments.

The primary reason why passive investing is a reasonable choice at all levels is that it’s based on a mathematical truism — one that applies regardless of the amount of money in question. Specifically, as long as the average passively managed dollar incurs lower costs than the average actively managed dollar, it is mathematically certain that passively managed dollars will on average outperform actively managed dollars. (If you’re unfamiliar with that concept, I’d encourage you to read William Sharpe’s wonderfully succinct paper “The Arithmetic of Active Management.”)

What Does Change at Higher Income or Asset Levels?

Having said the above, it’s important to note that the implementation of a passive investment philosophy is somewhat different at different income/asset levels.

For example, tax-efficient investing strategies are very different for the person whose entire portfolio consists of a $5,000 Roth IRA than for the person with a seven-figure portfolio, most of which is invested in taxable brokerage accounts. And they’re different still for investors whose portfolio size is such that they have to be concerned with the estate tax (with its 2016 exclusion of $5.45 million, and twice that for married couples). But in each case, it’s perfectly prudent to use a passive portfolio of boring index funds.

In addition, the asset allocation decision is somewhat different at different levels of assets/income. Specifically, when your total assets are low relative to your living expenses, you have less flexibility with your asset allocation. That is, you cannot afford to have a risky allocation if you may need this money in the near future (i.e., if your retirement savings are currently doubling as an emergency fund). But again, a boring passive portfolio is still a good idea.

2017 Tax Brackets, Standard Deduction, Personal Exemption, and Other Updates

Every year, I publish a brief update with the following year’s tax brackets, standard deduction, and so on. This year, there is more uncertainty, as the likelihood of a legislative change happening in early 2017 and actually being effect for 2017 is somewhat higher than normal. Still, what follows is the information as it stands now. If you want additional details, the official IRS announcement can be found here.

The tax brackets for 2017 are as follows:

Single 2017 Tax Brackets

Taxable Income
Tax Bracket:
$0-$9,325 10%
$9,326-$37,950 15%
$37,951-$91,900 25%
$91,901-$191,650 28%
$191,651-$416,700 33%
$416,701-$418,400 35%
$418,401+ 39.6%


Married Filing Jointly 2017 Tax Brackets

Taxable Income
Tax Bracket:
$0-$18,650 10%
$18,651-$75,900 15%
$75,901-$153,100 25%
$153,101-$233,350 28%
$233,351-$416,700 33%
$416,701-$470,700 35%
$470,701+ 39.6%


Head of Household 2017 Tax Brackets

Taxable Income
Tax Bracket:
$0-$13,350 10%
$13,351-$50,800 15%
$50,801-$131,200 25%
$131,201-$212,500 28%
$212,501-$416,700 33%
$416,701-$444,550 35%
$444,551+ 39.6%


Married Filing Separately 2017 Tax Brackets

Taxable Income
Marginal Tax Rate:
$0-$9,325 10%
$9,326-$37,950 15%
$37,951-$76,550 25%
$76,551-$116,675 28%
$116,676-$208,350 33%
$208,351-$235,350 35%
$235,351+ 39.6%


Standard Deduction Amounts

The 2017 standard deduction amounts will be as follows:

  • Single or married filing separately: $6,350
  • Married filing jointly: $12,700
  • Head of household: $9,350

The additional standard deduction for people who have reached age 65 (or who are blind) is $1,250 for married taxpayers or $1,550 for unmarried taxpayers.

Personal Exemption Amount and Phaseout

The personal exemption amount for 2017 is $4,050.

However, the total personal exemptions to which you’re entitled will be phased out (i.e., reduced and eventually eliminated) as your adjusted gross income (i.e., the last line of the first page of your Form 1040) moves through a certain range.

  • For single taxpayers, personal exemptions begin to be phased out at $261,500 and are fully phased out by $384,000.
  • For married taxpayers filing jointly, personal exemptions begin to be phased out at $313,800 and are fully phased out by $436,300.
  • For taxpayers filing as head of household, personal exemptions begin to be phased out at $287,650 and are fully phased out by $410,150.
  • For married taxpayers filing separately, personal exemptions begin to be phased out at $156,900 and are fully phased out by $218,150.

Limitation on Itemized Deductions

As was the case for the last few years, the amount of itemized deductions which you are allowed to claim is reduced by 3% of the amount by which your adjusted gross income exceeds certain threshold amounts. These threshold amounts are the same as the lower threshold amounts listed above for the personal exemption phaseout (e.g., $261,500 for single taxpayers). However:

  1. Your itemized deductions cannot be reduced by more than 80% as a result of this limitation, and
  2. Your itemized deductions for medical expenses, investment interest expense, casualty/theft losses, and gambling losses are not reduced as a result of this limitation.

IRA and 401(k) Contribution Limits

For 2017, the contribution limit to Roth and traditional IRAs is unchanged at $5,500, with an additional catch-up contribution of $1,000 for people age 50 or older.

The contribution limit for 401(k), 403(b), and most 457 plans is unchanged at $18,000, with an additional catch-up contribution of $6,000 for people age 50 or older.

The maximum possible contribution for defined contribution plans (e.g., for a self-employed person with a sufficiently high income contributing to a SEP IRA) is increased to $54,000.

AMT Exemption Amount

After adjusting for inflation, the following are the AMT exemptions for 2017:

  • $54,300 for single taxpayers,
  • $84,500 for married taxpayers filing jointly, and
  • $42,250 for married taxpayers filing separately.

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Financial Lessons from the 2016 Presidential Election

As I mentioned on Friday, I want to share a few investing-related thoughts regarding last week’s presidential election. As always, however, my goal is to keep this nonpolitical.

Models Work Great, Until They Don’t

Nearly all of the experts were saying that a Clinton win was likely, and some were super confident about such an outcome. For instance, the final forecast by The Upshot gave Clinton an 85% chance of winning.

It makes me think of the Long-Term Capital Management blowup of the late 90s or the Lehman Brothers blowup in 2008. (In each case, the people involved created a model for how various types of assets behaved. Then they borrowed lots of money to invest according to their model. Then the models turned out to be flawed, resulting in massive losses.) Modeling complex systems is difficult, and it’s best not to bet heavily that your model is an accurate representation of how the real world works.

Or, in a more common and less risky part of the investment world, it makes me think of the model-based portfolios that I often see advisors create for their clients. You get 3% of your portfolio in Fund A, 6% in Fund B, 15% in Fund C, and so on — because that’s what the model calls for.

Personally, I much prefer to have a very “dumb” portfolio — one that doesn’t rely on any predictions, other than the most basic. Specifically, with our money invested primarily in domestic and international “total stock market” index funds, the only prediction being made is that the publicly traded companies of the world will continue, on average, to earn profits.

Small, Unpredictable Events Can Have Huge Outcomes

Consider what would have happened if the timing of the FBI email announcement and the release of the Access Hollywood video had been switched, such that it was the video that was getting the primary news coverage immediately prior to the election. I wouldn’t be at all surprised if such a scenario would have resulted in a Clinton win.

Point being, a U.S. presidential election is a major macroeconomic event, yet the outcome can be determined by small, unpredictable events. This is a critical part of why it’s so hard to make specific predictions accurately.

Predicting the Market is Hard

On election night, the prices for stock market futures fell considerably. But then on Wednesday the U.S. stock market (as measured by Vanguard’s Total Stock Market Index Fund) actually turned out to rise by a little over 1%.

In other words, it’s as if the market on Tuesday night was saying, “A Trump presidency? Oh no!” But by the very next day had changed its mind to: “Trump presidency? Sounds great!” Over the long term, the market’s performance will ultimately reflect the profits earned by our publicly traded companies. Over the short term, however, it’s nonsense. Trying to predict that nonsense by jumping in and out of the market at just the right times is not wise.

For example, I know of two people who pulled out of the market prior to the election in order to “wait until things calmed down.” But guess what? The election is over, and things haven’t calmed down. Our country is as divided and chaotic as ever. So when do you get back into the market when trying such a stunt?

What to Expect Going Forward?

Several people have emailed to ask what I think we should expect as far as legislative changes. I would say that, with Republicans in control of the White House as well as both chambers of Congress, certain things have become more likely than they would have been under a Clinton administration. For example:

  • Tax rates are more likely to come down,
  • The Affordable Care Act (or critical pieces of it) is more likely to be repealed, and
  • Taxes that specifically affect people with higher incomes and/or net worth (such as the estate tax or the 3.8% tax on net investment income) are more likely to be repealed.

But again, my whole overall point here is that things are less predictable than we like to think they are. There’s absolutely no way to know which (if any) of the above events will occur — much less when they will occur or exactly what the specifics will look like.

The best bet is to use a portfolio that works well in a wide range of scenarios, and to be flexible with your financial planning, when possible.

When Does it Make Sense to Buy a Home Rather than Rent?

A reader writes in, asking:

“Do you have any advice for how to determine when it is better to buy rather than rent? I’ve heard rules of thumb regarding ‘price to rent’ ratios and breakeven points. But I’m trying to move beyond rules of thumb so I can be a little more sure of my decision.”

Looking at price-to-rent ratios can help you to quickly get an idea of locations in which buying is likely to make more sense than renting (or vice versa). But when it comes time to make an official decision, I think the best way to assess the situation is to compare your expected total economic cost of housing over the period in question under each scenario (renting and buying).

To be clear, this is purely a financial analysis. Most people will have significant non-financial preferences in one direction or the other as well, and it would be a mistake to ignore such preferences.

How Much Would It Cost to Rent?

The simpler side of the analysis is renting. For example, if we assume that you will be living in the location in question for 7 years, you would want to tally up the total cost of renting (i.e., rent plus renters insurance) over those 7 years. Be sure to account for the fact that your rent will typically increase over that period.

How Much Would It Cost to Own a Home Over the Period?

On the “buy a home” side, you would again want to tally up all of the monthly/annual costs you would incur over the period. Things like:

  • Mortgage payment,
  • Property taxes,
  • Homeowners insurance,
  • HOA fees if applicable,
  • Estimated maintenance costs (making sure to account for the condition of the home in question), and
  • Any interest/dividends/capital gains that you’re missing out on as a result of having made a downpayment.*

Then you would want to add the one-time costs:

  • At the time of purchase (e.g., mortgage application fees, escrow fees, and other closing costs), and
  • At the time of sale (e.g., realtor commissions and other closing costs).

But then there are two “negative costs” to include as well:

  • Any tax savings you receive as a result of the mortgage interest deduction, and
  • Any equity that you build up in the home as a result of paying down the mortgage and appreciation in home value.

Of course, almost all of these inputs will be estimates. That’s simply the nature of the beast. It is important, however, to try a few different scenarios (e.g., one in which the various estimated costs related to buying turn out to be lower than you’d anticipate, one in which they’re normal-ish, and one in which they’re higher than you’d anticipate) to see how much the overall result would be affected.

Similarly, most people probably aren’t exactly sure how long they’ll be living in the location in question. If that’s the case for you, I’d suggest running the analysis using different lengths of time (e.g., 4 years, 7 years, and 10 years) to see how the math changes.

Looking at the Results

What this analysis will generally show is that the longer you stay in the home, the more likely it is that buying will make sense, for a few reasons:

  1. You’ll often find that the annual costs of owning a home (i.e., the costs excluding the one-time buying/selling costs, but including the negative costs of tax savings and equity buildup) are cheaper than the annual costs of renting. As a result, the longer the period you look at, the better buying will look, as there’s a greater length of time for those savings to overwhelm the one-time costs.
  2. The greater the length of time, the faster the rate at which equity builds up, as a smaller portion of the mortgage payment is dedicated to interest.
  3. Rent increases over time whereas mortgage payments do not (assuming we’re talking about a normal fixed-rate mortgage, that is).

*For people with a background in finance or a related field, rather than including forgone earnings on the downpayment, if you want to be as precise as possible with your analysis, you would actually want to discount all of the costs in this analysis (i.e., calculate their present value in order to account for the fact that dollars today are worth more than dollars in the future).

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