When I meet somebody new and they hear what I do for a living, if they ask any questions those questions are almost always about tax or investing.

I’d estimate that 90% or more of the discussion on the Bogleheads forum is about investing and tax planning. Ditto for most personal finance discussions I see elsewhere online.

When it comes to financial planning, people really want to talk about investing and tax planning. And I understand why. Thinking that you’ll be able to increase your investment returns or save on taxes feels good.

But investing and tax planning are, respectively, the second-lowest and lowest priority in the realm of financial planning. In an ideal scenario, digging heavily into those topics should come last, after everything else is in order.

Insurance, estate planning, and cash flow planning come first. (I would encourage anybody to read the Basic Financial Planning Checklist I created a few years ago.)

When working with a new financial planning client, it’s common that they’ll show up with a slice-and-dice asset allocation that presumably a great deal of thought went into — but they have no idea how much they’re spending per year.

Or they can deliver a whole thesis off the top of their head about modern portfolio theory, the efficient market hypothesis, and multi-factor models — but they are woefully underinsured with respect to life or disability coverage.

Or they’ve spent an enormous amount of time researching Roth conversion planning — but they don’t have a will or other basic estate planning documents in place.

Every once in a while, somebody shows up with a portfolio of just target date funds — but they know how much they spend each year, they have all of the necessary types of insurance coverage, they have their estate plan already in place and recently updated. That’s the person who gets the gold star. From the financial planner’s perspective, it’s a huge sigh of relief when you see that person.

Hiring a financial planner to ask whether you should have a small-cap/value tilt to your portfolio is like setting an appointment with your primary care physician, so that you can ask her whether she thinks you should switch your standard Saturday morning breakfast from scrambled eggs with spinach to an omelette with tomato and mushrooms. There are a hundred other health questions that should come first. And if you truly have all of those other questions answered and squared away already, then the answer to this question is, “Either is just fine. You’re all set. Go happily live your life.”

In finance, the risk from owning stocks is divided into two categories:

1. Diversifiable risk is the risk of a specific stock earning poor returns.
2. Undiversifiable risk (also known as systematic risk) is the risk that the stock market as a whole earns poor returns.

The reason for the name “diversifiable risk” is that, if you own enough companies, then diversifiable risk is mostly eliminated. You’re no longer exposed to any significant risk resulting from the failure of one particular company.

In short, “diversifiable risk” = “risk that can be eliminated via diversification.”

On the other hand, no matter how many companies you own (except for “zero,” that is), you’re exposed to the possibility that the entire stock market will have poor returns over any given period. Undiversifiable risk cannot be eliminated via diversification, hence the name.

Why the Distinction Matters

If you’ve done much reading about investing, you know that greater risk leads to greater expected return.

The reasoning is that, when an investment’s returns are volatile, it becomes less desirable to investors relative to investments with more predictable returns.  This lower demand results in a lower market price for the investment, thereby resulting in a greater expected return.

Here’s the catch that many investors miss: it is only nondiversifiable risk that is rewarded with greater expected returns.

Why? Because if risk can be eliminated through something as simple as diversification, it’s not all that undesirable. As a result, it neither decreases demand nor increases expected return.

Or said yet another way, the average dollar invested in stocks by definition will earn the average return of the overall stock market (before costs). If one stock earns better-than-market returns it’s only because another stock earns worse-than-market returns. Individual stocks, collectively, have the same return as the overall stock market. But individual stocks have much more risk than the overall stock market.

The only time it would make sense to buy an individual stock is if you understand that, yes, individual stocks in general have a worse risk/reward profile than a “total stock market” fund, but you have reason to think that this particular stock will have above average returns.

But Picking Stocks is Hard(er Than You’d Think)

For two reasons, successfully picking those winning stocks is harder than most people think.

First reason: at any given time, the price of a stock already reflects the market’s consensus expectations about the company’s future earnings.

For example, if the market expects a particular tech company to have rapid earnings growth going forward, then that company’s shares will be expensive relative to companies with lower expected future earnings (i.e., it will have a higher price-to-earnings ratio). One would say that the market’s expectations about this company’s earnings growth are “priced in” — that is, they’re already built into the price.

This means that buying shares of this stock will only provide you with above-average returns if the company’s earnings grow faster than expected. If the company’s earnings grow quickly, but no more quickly than the market expected them to, the stock’s performance will not be any better than the performance of the rest of the market (and will probably be worse).

In other words, it’s not good enough to be able to identify “this company will be very profitable in the next several years” or “this company will have dramatically growing profits in the next several years.” A stock’s performance is not determined by whether the underlying company performs well or poorly. Rather, it is determined by whether the underlying company does better or worse than the market expected it to do. There is, therefore, little to be gained from picking individual stocks unless you know something that the rest of the market doesn’t — something that isn’t already “priced in.”

And “the market” does not primarily consist of people like your coworker Jimmy of dubious financial savvy. The vast majority of dollars moving around in the market are being moved by very intelligent people, who do this as their full-time job, and who generally have better and faster access to relevant information than you do. You must know something that those people do not.

Second reason: most stocks don’t have good returns. The best-performing 4% percent of stocks explain the entire equity risk premium since 1926, as other stocks collectively earned no more than Treasury bills. And more than half of stocks delivered negative lifetime returns. In other words, you could pick 5 stocks, 10 stocks, 15 stocks, and still completely miss owning any of the future superstar stocks. You might find, after a few decades, that your individual stocks were in the vast majority of stocks that earned very mediocre returns over time.

As far as I’m concerned, if I’m going to own stocks:

1. I don’t want any diversifiable (uncompensated) risk in my portfolio,
2. I want to be sure that I’ll own whichever stocks happen to be the future superstars, and
3. I don’t want to put myself in a position where I have to outsmart the market.

So I just use boring “total stock market” index funds/ETFs.

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.

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.

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?)

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.