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Why Stock Prices Are Still Volatile in an Efficient Market

A reader writes in, asking:

“Last month Facebook’s price fell because the new European privacy law hurt their advertising revenue. I always see the ‘experts’ saying that we shouldn’t invest in individual stocks because an ‘efficient market’ makes it impossible to pick winners and losers. But the idea that every stock is perfectly priced all the time seems wrong on its face. I can tell you right now that if the U.S. passes a similar privacy law, Facebook’s share price will fall again.”

The idea of an efficient stock market isn’t that the stock market can predict the future. Nobody knows what is ultimately going to happen (either with Facebook or with any other company/industry/country).

That is, the market price for a stock doesn’t mean that this is where the price will stay; it’s simply the consensus best estimate, given the information that is currently available.

By way of analogy, imagine that I’m hosting a raffle, in which the winner gets $100. I’m going to sell exactly 100 tickets to the raffle. How much is each ticket worth?

Each ticket is worth $1, because each ticket has a 1% chance of winning $100. (That is, $100 prize x 1% probability of being the winning ticket = $1 value.)

Of course, the reality is that, of the 100 tickets, 99 of them will turn out to be completely worthless, and one lucky ticket will turn out to be worth $100. But we don’t know in advance which ticket will be the lucky one, so until the raffle actually happens, each ticket is worth $1. (In probability/finance jargon, we say that each ticket has an “expected value” of $1.)

The point of the efficient market concept isn’t that an efficient market would successfully predict which raffle ticket will be the winning ticket. Rather, the point is that an efficient market would successfully price each ticket at $1 prior to the raffle.

With regard to Facebook, there’s a possibility that new regulation will come along that impedes the company’s profitability, in which case the stock will be worth significantly less than it’s worth right now. Or, maybe no such event will occur, and the company’s stock price will rise back to what it was before all the hullaballoo.

But because we don’t yet know what’s going to happen, an “in the middle” price is the current consensus price, even though everybody knows it will ultimately turn out to be wrong (i.e., even though everybody knows the value of the company will ultimately turn out to be more or less than the current market value — just like everybody knows that none of the raffle tickets will ultimately be worth $1).

Investing in Your Earning Potential

A reader writes in, asking:

“Does it ever make sense to slow down the rate at which I’m saving for retirement, or even put it on hold completely, in order to direct money toward expenditures that could increase my income? I suspect that putting money toward additional education in my field would have a good payoff. But I also know that saving and investing is particularly powerful when I’m young. How would one actually go about doing such an analysis?”

To the first question: yes.

Investing in your own earnings potential is often a very good idea (e.g., by getting a particular certification, license, or degree in your line of work, or by putting money into a business that you’re starting), even if it means putting off saving for retirement for a brief period. This is especially true for people early in their career, because the increased earnings will be in effect for many years.

I did this myself, a little over 10 years ago. There was a period of almost two years (around age 23-24) when my wife and I saved nothing for retirement, because we were putting money into my publishing business. The business was growing, and it seemed likely that additional funding would pay off — and it has. The resulting increase in our income has significantly exceeded the return that we would have achieved via additional 401(k) savings. (Plus, now I get to do work that I find much more enjoyable than what I was doing before.)

How to Calculate a Projected Return

If you want to actually make a comparison of rates of return, you first need to come up with a year-by-year estimate of the cost and the payoff from the investment you’re considering. In some cases you may be able to find good statistics on the topic (e.g., how much more, on average, do people in your field with a particular certification earn than people without that certification?).

Then you can use the IRR function in Excel to calculate the rate of return from the projected cash flows. The tutorial in the previous link explains how to use it, but it’s pretty straightforward. You type the projected cash flows in a column of cells, with the cash outflows (i.e., the money you expect to spend) as negative values and the cash inflows as positive values.  Then, in another cell, you use the “IRR” function, selecting the range of cells that includes your projected cash flows (e.g., “=IRR(A1:A17)”).

Then you can compare the calculated return from your projection to the return you would expect from additional investment in your portfolio. (Important note: in each case, you want to adjust the cash flows to account for taxes. For example if you expect an additional $10,000 per year of income, and you have a 25% combined state/local marginal tax rate, you’d enter $7,500 as the expected cash inflow in each cell.)

It varies quite a bit from one case to another, but it’s not at all rare for the rate of return from career-related expenditures to greatly exceed the rate of return you could expect from regular stock/bond investing.

How Risky Is It?

It is important, however, to recognize that comparing a projected rate of return from career-related spending to the rate of return you would expect from additional retirement savings isn’t an apples-to-apples comparison, as the risk level may be quite different.

For instance, if you’re a 23-year-old accountant, getting your CPA certification is very likely to substantially improve your earnings over the course of your career. Frankly, this is probably less risky than putting money into a stock index fund.

Conversely, investing a lot of money into an entrepreneurial endeavor can be super high-risk. You’re essentially buying a single stock (i.e., an undiversified investment), and it’s a riskier stock than your typical publicly traded company. (See, for instance, this cautionary tale I recently encountered of a man whose failed restaurant endeavor cost him his house.)

But, in summary, yes, investments in your own earnings potential are worth considering, even if they would require you to put saving for retirement on pause for a brief period. And this is especially true if:

  1. You are early in your career, and
  2. The hoped-for increase in earnings is very likely to actually occur (i.e., it is not especially speculative).

Worrying about Market Declines and High Valuations

A reader writes in, asking:

“The stock market’s tumble over the last week combined with the fact that stock valuations are still so high makes me wonder about the appropriate way to respond. Time to take some money off the table? I suspect I know what you’ll say, but I’m interested to hear anyway.”

The total U.S. stock market (as measured by the Vanguard Total Stock Market Index Fund, VTSMX) fell by less than 10% last week. If that made you super nervous, that’s a good indication that your stock allocation is too high. A 10% decline should not be a big deal — especially when it comes after a 9-year bull market during which the value of U.S. stocks rose by roughly 400%.

If a decline of less than 10% makes you nervous at all, imagine how you’ll feel about a 30%, 40%, or 50% decline. The goal of asset allocation is to craft a portfolio with which you’d be able “sit tight” (or possibly even rebalance into stocks) during a full-blown bear market.

Making Use of Market Valuations

It’s true that the stock market is still highly valued relative to historical norms. (This should not be a surprise, given the huge returns over the last 9 years.)

But how useful is that information for the purpose of predicting returns going forward?

The following chart shows the correlation between the S&P 500’s valuation (as measured by PE10) and its inflation-adjusted returns for periods of various lengths from 1926-2017. As you would expect, the correlation is always negative, which means that the higher the market’s valuation at any time, the lower we should expect returns to be going forward.

Valuations and Returns

But the correlation between PE10 and ensuing short-term returns has been pretty weak. For instance, the correlation coefficient between PE10 and 1-year returns is just -0.22. The correlation is quite a bit stronger if we look at 10-year real returns (-0.63 correlation) or 20-year real returns (-0.75 correlation).

In other words, valuation levels are not very good at predicting short-term market returns. They are much better at predicting longer-term returns.

But even if we have good reason to suspect poor returns over the next, say, 10 years, a 10-year period of poor returns could come in a lot of forms. The market could be roughly stagnant, with inflation taking a toll. Alternatively, we might see another 7 years of gangbuster returns, followed by a super bad bear market for 3 years. Or we might see a 2-year bear market, followed by 4 years of good returns, then another 4-year bear market. And so on. (Or, the next 10 years could be a period for which valuation isn’t even predictive in the first place! A negative 63% correlation is still far from perfect.)

Point being, we never know what’s about to happen in the near term. So valuations aren’t very useful for trying to “dodge” a bear market, so to speak.

But because they do have decent predictive power over the long-term, valuations are useful for questions such as, “how much should I be saving per year?” And, “how much can I afford to spend per year in retirement?”

And with today’s high valuations, we should expect pretty modest returns — suggesting that high savings rates (for those in their accumulation years) and low spending rates (for those in their retirement years) are probably prudent. This was true a year ago, and it’s still true today.

Financial Planning Priorities

A reader writes in, asking:

“I am getting my financial house in order for the first time. I have no debt and a good income, but have not paid much attention to investing until now. A friend directed me to your blog and to the bogleheads website, but I am finding it all to be overwhelming. Do you have any suggestions for which topics to read about/focus on first?”

The Bogleheads forum is filled with investing enthusiasts. As such, there are several advanced topics that get a lot of discussion there, which most people can safely ignore. For example:

  • Should you use international bonds?
  • Should you use “smart beta” funds?
  • Should you tilt toward small/value/momentum/profitability?
  • Should you include corporate bonds in the portfolio? A TIPS fund?
  • Should the bonds be short-term, intermediate-term, or long-term?
  • How often should you rebalance to your target allocation?

When getting started, most people should ignore all of the above topics and simply start with a “three fund portfolio,” or possibly even a low-cost “all-in-one fund” (e.g., a Vanguard Target Retirement fund).

In fact, most people should never spend any time thinking about the above topics, because:

  1. There’s a limited amount of time that they’re willing to devote to financial planning, and
  2. There are other financial planning topics that are much more important.

For example, all of the following financial planning to-do items are more important than the asset allocation questions listed above.*

  • Basic insurance planning (i.e., making sure you have appropriate health insurance, life insurance if anybody is dependent on you for income, disability insurance unless you’re retired, etc.)
  • Budgeting (i.e., selecting a spending/saving rate that’s appropriate relative to your income/assets)
  • Basic portfolio allocation (i.e., stock/bond allocation, as well as making sure there isn’t too much in one single stock)
  • Basic estate planning
  • Basic tax planning
  • Social Security planning (if near retirement)
  • Minimizing portfolio costs (i.e., making sure to use funds with low expense ratios)

It’s only after taking care of all of these items that it would make any sense to think about things like whether or not your portfolio should include “smart beta” mutual funds. And even for people who have taken care of these other financial planning to-do items, there’s still no need to spend time thinking about all of those advanced asset allocation questions. In nearly all cases, it’s perfectly fine to stick with that simple “three fund portfolio” — or even the single all-in-one fund in some cases.

*I’ve attempted to order this list roughly from highest to lowest priority. The exact order of priority will vary from one person to another though. For example, if you’re unmarried and have no kids, estate planning would be a lower priority than it would be for somebody with children. And estate planning would be an especially high priority for a married couple who each have children from a prior marriage.

What Does an Investment Portfolio Need?

I recently encountered a conversation about the characteristics of a good portfolio. The person speaking (whom I didn’t know) had a long list, but it got me thinking about what I would include on such a list.

I came up with only three things. (That is, only three characteristics that make a portfolio strictly better than a portfolio that does not have those characteristics.)

  1. Diversification,
  2. Low costs (including tax costs, if applicable), and
  3. An appropriate overall level of risk.

With regard to diversification, the most critical thing is diversification among individual holdings (unless we’re talking about FDIC-insured CDs or Treasury bonds, for which diversification isn’t needed). Point being: Don’t set yourself up for financial catastrophe if a single company goes out of business. Also helpful, but less important, is diversification among asset classes — have some stocks and some fixed-income.

With regard to costs, the lower you can get the better. But it’s important to think in dollars rather than proportions. For instance, the difference between an expense ratio of 0.8% and an expense ratio of 0.2% is much greater than the difference between 0.2% and 0.05%, even though in each case the less expensive option is 1/4 as costly as the more expensive option. On a number of occasions I’ve heard from people considering changing fund companies in order to shave just a few hundredths of a percent off their average expense ratio. It would be rare for such a change to be worth the hassle for anything other than a very large portfolio.

When it comes to choosing an appropriate level of risk, it’s important to know that this is a very rough thing. Your risk tolerance isn’t something that can be measured precisely. In addition, your risk tolerance will change over time. (And the riskiness of different combinations of investments changes over time too!) Finding something that feels “approximately right” for you is as good as you’re ever going to get here.

The reason I’m such a big fan of index funds (and/or ETFs) is that, in most cases, it’s easier to achieve each of the three goals above by using index funds. Index funds are typically very well diversified, with very low costs. And it’s easy to achieve any particular level of risk with index funds. But the above goals certainly can be achieved with actively managed funds. Vanguard, for instance, has a long list of actively managed funds with super low costs.

For many investors — myself included — “simplicity” would also be on the list of characteristics that improve a portfolio. And simplicity is also aided by the use of index funds or ETFs. But I’ve left it off the list because some people truly do not care about it. They’re perfectly happy to manage portfolios with 10 different funds across several different accounts. And there’s nothing wrong with that.

When Are Variable Annuities Useful?

This is the final article in a three-part series about variable annuities. The first article discussed how variable annuities work. And the second article discussed how variable annuities are taxed.

To recap, a variable annuity is essentially one or more mutual funds (or other similar investment options) wrapped in an insurance policy. The insurance aspect of the product creates some unique characteristics:

  • A death benefit,
  • The ability to “annuitize” the policy (i.e., convert it into a guaranteed stream of income),
  • Various optional riders that provide other insurance characteristics, and
  • Unique tax treatment.

Death Benefit

As a reminder, the death benefit is the fundamental insurance aspect of a basic variable annuity. The most common death benefit says that if you die while holding the policy and the account value at that time is less than your net contributions, your beneficiary will receive an amount equal to your net contributions rather than the (lower) account value.

The problem here is that this is such a strange sort of insurance. It doesn’t protect you against loss. Nor does it protect your loved ones in the event of your death as life insurance would. Instead, it only protects if both of those events occur at the same time (i.e., you die and at the time of your death the account value is less than your net contributions to the policy). And even then the insurance only provides enough money to “top them off” (i.e., bring the amount they receive back up to the net contribution), whereas a simple term life policy could provide a much larger death benefit per dollar of premium.

Another key point is that the death benefit is most likely to pay off in the first few years you own the policy, because at least in theory after several years the account value will have gone up. So you can eventually (sometimes quickly) reach a point where it becomes clear that the death benefit will have no value at all, and yet you’re stuck paying for the death benefit (via the “mortality and expense risk fee”) every year for the rest of the time you hold the policy.

It’s not that the death benefit doesn’t have any value. The problem is that there’s nobody who needs exactly this sort of insurance. It’s not an especially good fit for anybody.

A general financial planning guideline is that it doesn’t make sense to buy insurance that you do not need. And the death benefit on a variable annuity is insurance that most people do not need.

Ability to Annuitize

The second insurance aspect of a variable annuity is the option to annuitize the policy (i.e., convert it from a somewhat-liquid asset into a guaranteed stream of income). But that’s not necessarily valuable in itself, because with any other liquid asset you always have the option to sell it and simply buy an immediate annuity with the proceeds.

In other words, the ability to annuitize a deferred variable annuity only ends up being helpful if it helps you avoid a meaningful tax cost on that exchange or if the variable annuity has a meaningfully higher payout than what would be offered on the market for immediate annuities.

Optional Annuity Riders

A variable annuity could be a useful part of a financial plan when a particular rider provides a high value to you relative to its cost. The trouble here is that the value of a rider is usually super difficult to determine.

The insurance company has a team of actuaries, financial analysts, and attorneys working together to create the product in such a way that they believe it will be profitable for them. The consumer, on the other hand, doesn’t have nearly the same level of information or analytical ability.

And when a financial services company has a significant information advantage over the client (that is, when the client can’t really tell whether they’re getting a very good deal, a very bad deal, or somewhere in the middle), it is not usually the financial services company that gets the short end of the stick. This doesn’t mean that you should never purchase a variable annuity, nor does it mean that you should never purchase a rider on a variable annuity. It does, however, mean that you should be very skeptical about whether or not you’re getting good value for your money.

Tax Planning Uses

As we discussed last week, the circumstances in which a variable annuity’s tax treatment would be most beneficial would be something like this:

  • You have a high marginal tax rate,
  • You want to invest in an asset that a) has a high expected return (as measured in nominal dollars rather than inflation-adjusted dollars) and b) does not receive very favorable tax treatment (e.g., high-yield bonds or REITs),
  • You do not have room for that asset in your retirement accounts,
  • You expect to hold the asset for a long time (such that the tax-deferral has many years to create significant value), and
  • You expect to deplete the asset during your lifetime rather than leaving it to your heirs (otherwise you’d want a taxable account so they could receive a step-up in cost basis).

This is uncommon, but it’s not unheard of. Also, this situation would be significantly more common if interest rates were higher because the annual tax cost of holding regular “total market” bond funds in a taxable account would be greater than it is at the moment.

The most common financial planning use of variable annuities is simply as a replacement for worse (i.e., more expensive) variable annuities that a person has already purchased. As we discussed last week, if you liquidate a variable annuity, there can be undesirable tax consequences. If, however, you exchange that variable annuity (via a “1035 exchange“) for another variable annuity (or a qualified long-term care contract) then you do not have to pay any tax on the transaction.

As a result, for people who have purchased very expensive variable annuities, it is often advantageous to exchange them for variable annuities with lower ongoing costs (e.g., the Vanguard Variable Annuity or the Monument Advisor variable annuity from Jefferson National/Nationwide). A key point, however, is that a 1035 exchange only gets around adverse tax consequences. It does not get you out of paying surrender charges.

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