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Risk and Return Are Interchangeable

Today I want to talk about one of the investing lessons that took me the longest to learn and really internalize. And, when talking with clients and corresponding with blog readers, it’s clear that this topic is one of the biggest gaps in many people’s investment knowledge.

Anybody who has been studying investing for any period of time is aware of the relationship between risk and return: safer investments tend to offer lower returns. Cash typically earns lower returns than bonds. Bonds typically earn lower returns than stocks. Safer bonds typically earn lower returns than riskier bonds. And so on.

Similarly, it’s not hard to grasp the idea that we would always like our portfolios to provide the greatest amount of return possible for a given level of risk. Why not, right?

But the full ramifications of that idea — that we want the greatest amount of return for a given level of risk — are deeper than most novice investors really understand.

It means that an increase in return is not, in itself, a good thing. And it means that a reduction in risk is not, in itself, a good thing. In each case, we have to ask: “in exchange for what?”

That is, outside of the extremes (i.e., portfolios that are already 100% stock or 100% cash), we already have an easy way to adjust the risk/return level of the portfolio: adjust the allocation between stocks/bonds/cash. Doing so is free and extremely easy. So if somebody points out some way to increase the return of your portfolio, the first thing you must ask is whether the strategy being proposed is any better than simply adjusting the stock allocation upward. And if somebody points out some way to reduce the risk of your portfolio, you must ask whether the strategy being proposed is any better than simply adjusting the stock allocation downward.

That’s the hurdle that must be met: “is this better than simply adjusting my stock/bond/cash allocation?” And you must always keep this in mind, otherwise you’ll be sold a bunch of nonsense over the years.

But here’s the part that took me an especially long time to internalize: a reduction in risk without a corresponding reduction in return is effectively the same thing as an increase in return. If you can find a way to keep the return the same and reduce your risk, then you could slightly nudge the stock/bond allocation of the portfolio upward in order to bring your risk back to what it was before, while now having a higher level of return.

Similarly, if you can find a way to increase return without increasing risk, that’s effectively the same thing as a reduction in risk — because you could nudge the stock/bond allocation of the portfolio slightly safer, in order to bring the expected return back to what it was before, but now with lower risk.

Risk and return are interchangeable.

And that’s the holy grail that the investment industry is always seeking: an unusually high level of return for any given level of risk, whether that’s better-than-cash returns for a cash-like level of risk, better-than-bonds returns for a bond-like level of risk, or better-than-stocks returns for a stock-like level of risk. Any of the above means you have achieved some magic.

Of course, reliably achieving such magic is nearly impossible. And when somebody tells you that such magic can be achieved, it’s prudent to be very skeptical.

Asset Location Fundamentals (Which Investments to Own in Which Account)

A reader writes in, asking:

“Would you please direct me to where I can find your advice on asset location? In particular, is a Roth, Traditional IRA, or taxable account the best place to hold an International Equity ETF?”

Asset location (as opposed to asset allocation) is the question of which investments should go in which accounts. For example, if your portfolio includes Roth accounts, tax-deferred accounts, and taxable accounts — and you want your portfolio to include US stocks, international stocks, and bonds — which thing should go in which account?

To back up a step, in most cases, a taxable account is not the best place to hold any investment intended for retirement (other than muni bonds). That is, almost everything is better in a retirement account than in taxable. So if all of a person’s retirement investments can be held in retirement accounts, they usually should be.

When there must be a taxable part of the portfolio (e.g., because the amount you saved/invested per year exceeded the annual retirement account contribution limits), it becomes a question of determining which parts of your desired asset allocation are most tax-efficient. Or said differently, “out of my desired asset allocation, which parts are the least-bad to own in taxable?”

Asset Location: Stocks vs. Bonds

Stocks are usually more tax-efficient than bonds (i.e., they’re less bad to have in taxable than bonds are, usually). That’s because dividends and long-term capital gains are usually taxed at lower tax rates than bond interest. However, the tax efficiency of stocks relative to bonds depends not only on tax rates but also on yields (i.e., how much income each pays). As an extreme example, a bond paying 0% interest would be quite tax efficient, as it would generate no annual tax cost at all.

Municipal (“muni”) bonds are an exception to the above, because the interest they pay is completely exempt from federal income tax. And in many cases, muni bonds issued within a given state will be exempt from state income tax within that state as well. That’s why fund companies often offer state-specific muni bond funds.

Muni bonds should never be held in a retirement account. Though whether you should own muni bonds at all (rather than taxable bonds) depends on the difference in yields between muni and taxable bonds as well as your tax rate. (Essentially, when looking at a muni bond fund, you want to calculate the equivalent taxable yield. Then determine whether taxable bond funds with a similar level of risk have yields that are higher or lower than that.)

Asset Location Among Stocks (and Stock Funds)

Stocks with lower dividend yields are more tax-efficient than stocks with higher dividend yields (because again, the less income something pays, the more tax-efficient it is). So if your stock holdings are split between “growth” and “value,” growth is generally the better of the two to hold in taxable.

REITs are a particularly undesirable holding in taxable, because they pay high dividend yields and those dividends are taxed at a higher rate than qualified dividends.

Holding international stocks in taxable allows you to take advantage of the foreign tax credit.

Asset Location Among Bonds (and Bond Funds)

As noted above, muni bonds may be the best choice for somebody who has to hold bonds in a taxable account.

Among taxable bonds, Treasury bonds are exempt from state income tax, which makes them somewhat more tax-efficient if you live in a state with income tax.

Also, the safer a bond is, the lower its yield will be, and therefore the more tax-efficient it will be. Therefore:

  • Bonds with higher credit ratings will generally be more tax-efficient than bonds with lower credit ratings.
  • Bonds with shorter duration will generally be more tax-efficient than bonds with longer duration.

So, taken together, the above points indicate that short-term Treasury bonds tend to be quite tax-efficient, relative to a lot of other taxable bonds.

Other Asset Location Notes

When you own a mutual fund in a taxable account, each year you have to pay tax on your share of the capital gains that the fund realized whenever it sold anything over the course of the year. As a result, the more frequently a fund sells its holdings, the more capital gains you’ll have to pay tax on each year. Point being, funds with low portfolio turnover are more tax-efficient than funds with high portfolio turnover. In addition, the higher the rate of turnover, the greater the percentage of the gains that will be short-term rather than long-term. And that’s bad, because short-term capital gains are taxed at higher tax rates than long-term capital gains.

Index funds, therefore, tend to be more tax-efficient than actively managed funds. (Index funds — especially “total market” funds — have low turnover, because the investment strategy of the fund is just to buy and hold everything in the index rather than regularly buying and selling different stocks/bonds based on the fund manager’s predictions.)

“All in one” funds such as target-date funds tend to be tax-inefficient, for a few reasons:

  • Their bond holdings tend to be tax-inefficient. They’re often a “total bond market” fund or something similar. Most people who need to own bonds in taxable would be better off with either muni bonds or by focusing on tax-efficient taxable bonds (such as short-term Treasury bonds).
  • Even if the underlying funds have very low portfolio turnover, the outer layer (i.e., the fund that owns the underlying funds) creates an additional level of turnover as the fund rebalances between the underlying holdings. And that creates a tax cost. If the fund-of-funds ever decides to do a wholesale switch from one underlying fund to another, it can create a major tax cost to shareholders.
  • They reduce the opportunities for tax-loss harvesting. When the portfolio is split up among US stocks, international stocks, and bonds (or split up at an even more granular level), there can be tax-loss harvesting opportunities created when any one of those components goes down in value. With an all-in-one fund, collectively the whole thing has to go down in value (rather than just one part going down in value) to create a tax-loss harvesting opportunity.

Asset Location: Roth vs. Tax-Deferred

On the topic of which assets should go in Roth and which should go in tax-deferred, the general principle is that the assets with the highest expected returns should go in Roth accounts. This is because Roth accounts have no RMDs during the original owner’s lifetime, so if you have the choice of allowing one account or the other to grow most quickly, it’s best to have the Roth account growing most quickly.

One noteworthy exception would be cases in which a Roth IRA (or a portion thereof) is actually intended for near-term spending (e.g., because of the ability to take contributions back out of the account tax-free and penalty-free, you’re planning to use it in the near term for a home down payment). In such cases, volatile holdings would not make sense for the account.

Financial Planning at an Early Stage: Is It Just Guessing?

A reader writes in, asking:

“I’m 26, single, with a good job. I have been saving 10% of each paycheck since I started working. I’m starting to read more about investing, and I’m using calculators online but one thing I can’t wrap my head around is isn’t all of this just a wild guess? Like, I’m supposed to input a return and an age when I’ll retire. But…I don’t know? And when people talk about Roth and Traditional accounts, they always talk about tax rates. I’m not even sure what my tax rate is this year, but somehow I’m supposed to know what it will be when I’m 70??”

You are absolutely right.

You don’t know what investment returns you’ll get. You don’t know how much you’ll earn each year through your career. You may not, right now, even be able to predict what career you’ll be in 10 years from now — much less the specific position and income. We don’t now what’s going to happen with Social Security. We don’t know what’s going to happen with tax law. You, likely, don’t know if you’re going to get married or what that person’s career will be like. Or how many kids you’ll have, if any.

So, if you’re trying to do projections out to age 65 to see how much you’ll be able to spend based on your current plan, yes, it’s just a wild guess.

But that’s okay!

As you get closer and closer to retirement age, more of those things will become known. You don’t need to know them right now.

Right now, early in your career, the focus of financial planning is mostly about building good habits.

Make a habit of periodically checking that you have proper insurance: health, disability, auto, and renters (or homeowners if/when then becomes applicable). If anybody else is dependent on you financially, you should have life insurance as well.

Get in the habit of tracking your spending so that you know how much you’re spending and on what. For many people, when they do that for the first time, they find that they’re spending a lot on some things that really aren’t that important to them. Whenever you find that to be the case, you have identified an easy area for improvement.

Build an emergency fund of safe, accessible assets. At least a few months of living expenses. Gradually, seek to build that up to 6 months of living expenses. (The primary purpose of an emergency fund isn’t for an unexpected spending need, though those do arise. The primary purpose is to make sure you don’t have an absolute disaster if you lose your job unexpectedly and it takes a while to find a new one.)

You’re already saving a significant part of your income each year, which is great. Admittedly, there’s no way to know how much is “enough” this early. We can make some reasonable guesses (see Wade Pfau’s “Safe Savings Rate” research, for example), but it’s still a guess. The critical thing at this stage is that you have started a habit of saving. Whenever your income goes up, save more.

Get in the habit of investing those savings (other than your emergency fund), in a low-cost and diversified way. Most often this means a single target-date fund or a simple portfolio of 2-3 index funds/ETFs.

And get in the habit of investing in that same simple portfolio, every paycheck, regardless of what the market has done recently. A market downturn isn’t a problem for you — it’s a bargain-buying opportunity.

With regard to accounts, if your employer offers a matching contribution to a 401(k)/403(b), make sure that you’re contributing enough to get the maximum match. And, if you can, contribute to a Roth IRA, rather than just saving in a taxable brokerage account.

It’s true that you can’t predict the future 30, 40, 50 years from now. But that’s OK. There are still a lot of things you can do right now that will improve your future, even if there’s no way to know precisely how that future will look.

(For further related reading, see A Basic Financial Planning Checklist or What is Comprehensive Financial Planning?)

Does This Count as Market Timing?

A reader writes in, asking:

“I am new to really paying attention to investing. Most sources seem to agree that market timing is a bad idea. But then I also have read a lot about buying I Bonds or TIPS because they have high interest rates right now. Why isn’t that market timing? Does market timing only involve stocks?”

“Does _____ count as market timing?” is one of the most common types of investing questions I’ve received over the years writing this blog. The answer, in my opinion, is that it doesn’t matter whether or not an investment strategy “counts as market timing.” All that matters is whether or not it’s a good idea.

Some people will apply the market timing label to any strategy that has anything to do with interest rates or market valuations, thereby declaring all such strategies taboo, despite the fact that there’s a huge variation as to:

  1. The level of risk involved and
  2. The probability of success.

To illustrate what I mean, let’s take a look at a few example strategies, any of which could be described as market timing, depending on who you ask.

Strategy 1: Moving Between Cash and Stocks Everyday

Bob has determined that he cannot afford very much risk, but he still needs high returns to meet his goals. So he decides to move his entire portfolio between 100% cash and 100% stocks from day to day in an attempt to catch the best days in the market and miss the worst ones.

Bob’s strategy relies entirely on predicting what the stock market will do over very short periods, which is pretty much impossible. And if Bob fails, he could experience losses that he cannot afford. This type of market timing is clearly not a good idea.

Strategy 2: Shifting Your Bond Maturities

At a time when interest rates are far below their historical averages, Steve shifts his bond allocation from intermediate-term bonds to short-term bonds. Steve’s thought process is that interest rates are likely to come back up in the near future, and he doesn’t want to experience the larger loss in value that would occur with bonds with longer duration. He plans to wait for rates to come back up, then switch back to intermediate-term bonds.

Steve’s strategy is essentially a guess that interest rates will soon go up. Predicting where interest rates will go in the near future is about as hard as predicting where the stock market will go in the near future. (So this is not, for example, a strategy that I would be interested in using myself.) But a key difference between this strategy and Bob’s strategy above is that if Steve is wrong (and interest rates do not rise any time soon), it’s probably not a disaster for Steve. He just misses out on the slightly-higher returns that he could have gotten by holding longer-term bonds.

Strategy 3: Moving from Stocks to Bonds (Permanently)

Laura is planning to retire in the near future. At the time Laura is making the decision, the last couple of years in the stock market have been good and TIPS yields are high. Laura decides to shift a significant portion of her portfolio out of stocks and into a TIPS ladder.

Laura’s strategy is based on recent market performance and current interest rates, but it doesn’t rely on any prediction at all. It’s simply a decision that current rates are good enough to carry her through retirement with very little risk.

The Point of “Don’t Try to Time the Market”

Because of the taboo we’ve placed on anything that could be described as market timing, investors are sometimes afraid to use all the available information when making their decisions. I do not think this is a good thing.

The point of the “don’t try to time the market” message is simply that new investors need to learn that it’s impossible to predict a) where the stock market is going next or b) where interest rates (and therefore bond prices) are going next.

But it can be OK to make financial decisions based on current interest rates or market values, as long as you don’t have to successfully predict where the stock market or interest rates are going next in order for the decision to make sense.

How to Invest with a Looming Recession

A reader writes in, asking:

“I had a question that might work well for an upcoming blog post. Deutsche Bank recently forecasted an upcoming recession, and I was curious what your suggestion would be regarding how to invest a bonus with a potentially looming recession.”

It’s important to make a distinction between the stock market and recessions. For a few reasons, a recession happening over a particular period does not necessarily mean that the stock market would perform poorly over that period.

Firstly, the stock market is concerned with how much profit businesses earn. Recessions are determined by changes in production. (Specifically, a recession is usually defined as a decline in GDP over two consecutive quarters.) Production and profitability are linked, but production changing by a certain percentage definitely doesn’t mean that profitability will change in the same direction by the same percentage.

Second, GDP is concerned with a broader group of entities. The stock market is the market for publicly-traded corporations. So by definition it’s only concerned with publicly-traded corporations. In contrast, GDP includes production by privately-held businesses as well as by government entities.

Finally, the most important distinction, for our purposes, is that the price of a stock is essentially a prediction. It’s a function of how much the market collectively expects that company to earn. (Specifically, it’s the present value of the expected future cash flows from that company.)

So if the market has recently decided that publicly-traded corporations are, collectively, about to become less profitable (which could well be the case in a recession), that doesn’t mean that the market is probably about to go down. It means the market has probably just gone down. (And indeed, it has. As of this writing, the stock market is down about 14% year-to-date.)

In finance-speak, we say that the probability of a recession has already been “priced in” (i.e., it’s already reflected in the current price of stocks).

To reiterate this important point: the current prices of stocks are, themselves, predictions. So to make a prediction about what the stock market will do next is to make a prediction about a prediction. (i.e., will people’s predictions about corporate profitability become worse or better in the near future?).

And that’s really darned hard. Stock prices generally already account for all of the information that you or I are likely to know.

So How Should We Invest?

Moving in and out of stocks (or in and out of certain sub-categories of stocks) usually doesn’t make sense, because of how hard this guessing game is. That’s why it usually makes sense to just pick an asset allocation and stick with it, rather than trying to adjust your allocation based on events in the news.

Conversely, it definitely can make sense to change your asset allocation when your life circumstances change. For example, for a young person who sells a business for a very large sum, the allocation that might now make sense could be very different than the allocation that made sense a few months ago.

It’s possible that such a concept would apply with a bonus, if the bonus is a life-changing amount of money. But most of the time that’s not the case. Most of the time a bonus doesn’t constitute a major change in life circumstances and therefore does not require a change to the overall portfolio asset allocation.

Changes to the fixed-income side of a portfolio can make sense though, as economic circumstances change. That’s because current interest rates do give us some actionable information. That is, the interest rate on a given fixed-income investment is a decent predictor of its rate of return (and it’s obviously a very good predictor, if you plan to hold to maturity). So shifting between fixed-income options as the available interest rates change is not crazy.

For example, for years Allan Roth has written about using CDs rather than individual bonds or bond funds when CDs offer an interest rate that is as good (or sometimes even better), with less risk than bonds. Similarly, many people have been buying I-Bonds lately, because of how their yields compare to most other fixed-income options.

So, how should we invest if a recession is looming? About the same way we invest the rest of the time. It doesn’t usually make sense to make portfolio changes based on economic news, though changes within the fixed-income part of the portfolio can make sense, as the fixed-income option with the highest interest rate for a given level of risk can change over time.

A Basic Financial Planning Checklist

A realization that has only very slowly occurred to me, over 15 years in the world of financial planning, is that the most common financial planning mistake that I see people make is not so much a particular bad decision, but rather completely ignoring certain parts of financial planning.

In many cases, that shows up in the form of focusing too much on the investing part of the picture, while having some other critical financial planning need that is going unaddressed.

And that’s not terribly surprising. Investing involves thinking about upside — how your assets will grow (and how they could grow, if you make a high-risk bet and get lucky). That can be fun.

In contrast, many critical financial planning tasks involve thinking about downside. (What if you become disabled or die earlier than anticipated?) That’s less fun.

In addition, a lot of critical financial planning tasks look suspiciously like work.

What follows is just a brief checklist of financial planning topics, all of which should probably be addressed before spending much time thinking about exactly what is the correct allocation to international bonds or whether index funds are preferable to ETFs.

Insurance planning:

  • Do you have health insurance? (And if it’s open enrollment season, have you checked to see whether there’s a different plan that might be a better fit for your household?)
  • If anybody is financially dependent upon you, do you have sufficient life insurance? (Alternatively, have you canceled any coverage that is no longer necessary?)
  • If you are still working, do you have sufficient disability insurance? (And does the policy check all the necessary boxes? For instance, is it “own occupation” if such is important in your case?)
  • Do you have sufficient homeowners/renters insurance?
  • Do you have sufficient liability coverage on your auto policy?
  • Do you have an umbrella policy?

Cash flow planning:

  • Do you know how much you spend each month (or over the course of a year)?
  • Do you have a sufficient emergency fund? (Of note: a retirement portfolio can often serve as an emergency fund, once it is of sufficient size.)
  • Are you saving enough each month to meet your goals? (Or if retired, are you confident that the amount you are spending per year is sustainable?)

Estate planning:

  • Have you checked the beneficiaries (including contingent beneficiaries) of your retirement accounts and life insurance policies recently?
  • Do you have a will in place?
  • Do you have a durable power of attorney for finances?
  • Do you have a healthcare power of attorney?
  • When was the last time the above documents were updated?
  • Have you considered whether a trust of any sort would help you to achieve any postmortem goals for your assets?

Tax planning:

  • Are you confident that you are contributing to (or withdrawing from) the right types of accounts each year? (For example, should you be making Roth contributions instead of tax-deferred contributions?)
  • Have you considered whether Roth conversions would be useful now or in the near-term future? (Most often, this is helpful during years of retirement prior to RMDs and prior to Social Security.)
  • Do you know whether you are in or near the phaseout ranges (or other thresholds) for any tax credits or other significant tax provisions?

Basic investment planning:

  • Is your portfolio reasonably diversified, as opposed to having a large portion allocated to one stock (e.g., an employer or former employer)?
  • Is the basic allocation (i.e., the stock/fixed-income allocation) roughly appropriate for your risk tolerance?
  • Are you using funds with reasonably low expense ratios?

Basic retirement planning:

  • Do you have a plan for when you intend to retire? (And have you thought through the potential ramifications of being forced into retirement somewhat earlier than the intended date, due to illness, job loss, etc.?)
  • If nearing age 62 (or 60 if you’re a widow/widower), do you have a plan for when you will claim Social Security benefits?

In my opinion, most people should just be using a very simple portfolio (e.g., a basic three-fund portfolio or even a simple all-in-one fund if the portfolio is entirely in retirement accounts) until they’ve taken care of the above items. Using a basic portfolio frees up time and mental energy to focus on other things that matter quite a bit more.

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 particularly advanced asset allocation questions. In nearly all cases, it’s perfectly fine to stick with the three-fund portfolio (or, again, a low-cost all-in-one fund if your portfolio does not include taxable accounts).

To be clear, the above list is not absolutely-super-duper-all-inclusive. For some people there will be additional points in one category or another that should be addressed. Also, the order of priority will vary from one person to another. 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.

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