One of the more challenging financial planning concerns that often comes up is the concentration risk of too much money in a specific stock that has a very low tax basis. Investors are often torn between the risk of holding too much in any one company, and the potentially large tax bill that can come from realizing a large capital gain.
Sometimes this is a result of working for a company that has offered you stock grants or options as part of your compensation and has subsequently done very well. Sometimes it is simply the result of getting very lucky and buying a stock that had some exceptional gains. Either way, the this can present a tax dilemma. Since it’s generally not advisable to have more than 5% of your liquid net worth in any one company, its important to explore your opportunities to mitigate this risk.
Tax Loss Harvesting
Tax loss harvesting is a long-term approach of selling one holding for another in order to capture a tax loss on a position that has declined, or a dividend lot that was reinvested at a higher price in order to replace it with an investment that is similar, but not identical. As an example, selling an S&P 500 index fund at a loss in order to buy a Russell 1000 index fund. Doing this over time can capture losses that can be used to offset gains and slowly peel back a concentrated position without disturbing the integrity of the risk profile and allocation of your other holdings. Unfortunately, this will typically take a long time to generate enough losses to significantly reduce a large highly concentrated position with a big unrealized capital gain.
The use of options can be applied in order to hedge out the downside of a concentrated position while you slowly reduce it over the course of many years. Strategies known as options collars can be implemented in which an investor purchases out of the money put options, while simultaneously selling out of the money call options can limit the downside and the upside at once. It is possible to do this at times with a relatively low cost. However, options trading is something that requires a high degree of expertise and understanding of the risks involved in order to execute a proper hedge. In some cases, if the position is large enough, there are investment firms that can create a specific structured product which can be tailored to a specific investor in order to help offload that responsibility when the investor doesn’t have the knowledge to hedge the portfolio themselves.
An exchange fund (not to be confused with an exchange traded fund), also sometimes known as a swap fund is a product offered to investors by large financial institutions that is essentially a partnership that invests in a diversified portfolio of stocks that track to a benchmark, not unlike a typical mutual fund. However, they are designed to be funded with a stock holding that you transfer to the fund along with your lower cost basis, and in exchange you receive a proportionate amount of the same value of this diversified fund with the same cost basis. While you still have the same problem of an unrealized capital gain, you no longer have the risk of a concentrated position.
This strategy comes with its disadvantages. One is that you often have to maintain the fund for as long as 7 years, so you don’t have the same degree of liquidity. However, if you were going to keep the stock holding, or otherwise invest it in something more diversified, it becomes an insignificant difference. Another issue is that you have internal expenses to buy the equivalent of an index fund that are more typical of a managed mutual fund. The cost to buy an S&P 500 index fund might ordinarily be 0.03%, while the cost of an exchange fund might run 0.80%-1.00% annually in internal expenses.
Additionally, these funds often pay you only the price return of the underlying index, and not the dividend income, so you sacrifice some of the upside for the immediate diversity. Such funds require that you deposit a large position, often $500,000-$1,000,000 in value. It is also typically necessary that it’s a holding that is widely held and fairly liquid. Exchange funds would most often not offer this to a new issue, or a thinly traded company.
Overall, these are a few common strategies available to reduce concentration risk in cases where taxes are a consideration and a significant liability. It’s important to examine these situations from the perspective of your longer-term financial plans, and the risk reward of holding a concentrated position. Oftentimes investors feel emotionally attached to a company because they made a lot of money with the stock, or they worked there. Emotions and investing are an unhealthy combination. It’s important to try and be objective as you possibly can.
Other times investors who worked for a company feel a sense of confidence because they feel they have a better understanding of how the company is doing from the inside. Unfortunately, sometimes this is an unfounded overconfidence. Lehman Brothers was a more than 180-year old investment bank, and one of the most powerful institutions in the world, and they imploded in a couple of weeks. One can never be sure, and the safety and protection of a diverse portfolio compared to any one company cannot be overstated.
Tax considerations are an important part of the portfolio management process. However, it’s also important not to let the tax tail wag the investment dog too much. Some of the strategies referenced can be a reasonable middle ground to addressing the tax concerns of a large gain in a heavily concentrated position.
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Not long into the 2008 financial crisis, the Federal Reserve among other policy responses dropped short-term interest rates to zero. After nearly a decade of anemic economic growth, we finally started to see enough economic activity that the Fed began increasing rates. Unfortunately, as we all know the government lockdowns caused a severe contraction to GDP and forced the Fed to reduce rates back to zero yet again. All of this has resulted once again in limited savings options for the average American.
A savings account is never a great long-term investment option. However, it’s imperative that all investors maintain some degree of short-term liquidity for emergencies. In general, it’s a good idea to have at least six months to one year of an emergency fund so you don’t have to liquidate a longer-term investment option at an inopportune time.
Money Markets & Savings Account
Historically money markets offer savings rates that have been higher yields than a typical savings account at a national bank. Unfortunately, in the current environment most money markets offer nominal interest rates not much better than a typical savings account. One option that offers some improvement can be found in the online banking space. The lack of “brick and mortar” costs associated with online banks will often lead to interest rates that are more competitive than a larger national bank found on every corner in the nation. Traditional savings and money market accounts are useful when it comes to fulfilling the need for an account that will require day to day liquidity. It’s also important to understand that not all money markets are FDIC insured. Since a money market is technically a mutual fund, it is possible for the fund to “break the buck” and pay back less than $1 per share. While this is very rare, it did happen in 2008.
Certificates of Deposit
CD’s are still a viable option as a short-term savings vehicle. While the rates may not always seem that much more attractive than a typical savings/money market, they may still make sense. If you likely have no need to spend down cash other than an unforeseen emergency, then a CD may still make sense. Even if you need to lock in a CD for 3-5 years, typically the only penalty you would incur should you need to break it would be the loss of the interest that you would have earned. There is generally no risk to your principal as long as you stay within FDIC limits.
Short Term Bond Funds
An ultra-short term bond fund comprised of very-high credit quality is not a savings account. However, they typically come with very nominal downside risk for the investor who doesn’t have any known short-term needs. It’s important to pay close attention to credit quality, as a short-term bond fund in an extreme market downturn can see noticeable short-term losses. While these declines are unlikely to look anything like the declines seen in equity markets, they can be impactful. At the height of the market panic in late March of 2020 it was not uncommon to see a 5%-10% decline in short-term funds that took greater credit risk. One clear indicator is the yield of a fund. If the yield is noticeably greater, then more than likely its worth looking closer at the credit rating of the issuers the fund is buying. In contrast, most short-term funds of very high-quality debt actually appreciated as the markets plummeted in March of 2020.
Many of us have had the local bank teller notice a large cash position and encouraged us to speak to the local investment professional at the bank. One such option they will propose is what is known as a Single Premium Deferred Annuity (SPDA). The SPDA is an insurance contract that functions much like a CD with no fluctuations to your investment principal. They are not insured by the FDIC, but rather backed by the insurance company, and sometimes further backed by the state insurance commissioner’s office up to certain limits.
The advantage of the SPDA is that they sometimes offer rates that are a little better than a CD, and the interest is tax deferred. Once they mature, the contracts usually have a floor interest rate that you can continue to collect without exchanging into a new annuity. At times those interest floors have been attractive compared to current market rates.
The disadvantages are they don’t typically permit you to break the contract penalty free. What you can often do is withdraw a percentage of the contract, sometimes 10% per year without penalty. There is also a penalty on withdrawals made before age 59 ½, so it’s not a suitable option for those younger in age.
Credit Risk Caution
One area to be very cautious is in the floating rate space. Floating rate notes are extremely short-term corporate debt that is only available to institutional buyers. However, a number of mutual fund companies offer floating rate funds that buy such paper and offer more attractive yields. A quick look at a chart of most floating rate funds will show price changes that are typically between 2%-3% principal fluctuation during positive or negative market changes. During the 2008 financial crisis when the credit markets came to a near total freeze, these floating rate funds saw average declines of -27%. This is an area that is often mistakenly looked at as a short-term cash position. We would caution against such an approach. Floating rate securities can be an attractive investment at times, but any vehicle that offers substantive credit risk is not an ideal savings alternative.
When it comes to an emergency fund, it’s important to remember that the goal is stability at the best interest rate available with a reasonable amount of liquidity, and not to become too frustrated with the low returns currently available. Emergencies often happen during periods of great market volatility. What you don’t want is to find yourself in a position of having to sell a quality asset at a depressed price, therefore eliminating your ability to benefit from an eventual price rebound. Maintaining a proper emergency fund should actually provide you with more comfort in your ability to take greater risk with your other investment accounts with the knowledge that the short-term risk has already been addressed.
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Value stocks vs Growth stocks, which is the better investment? The debate between value investing as opposed to growth investing is an ongoing one. Which is better depends on from which point in time you ask the question. It’s first important to understand what the difference between the two investment categories are.
A value company is one that generally trades lower than its underlying fundamentals suggest that it should be trading at compared to the market or its sector. They often have higher dividend yields, and trade at attractive (lower) price to earnings ratios (P/E).
Growth stocks are companies that have an expectation that they will grow faster than the average rate of growth for the market. They typically demonstrate characteristics such as sales and earnings growth that is outpacing the rest of the market or their sector. They will normally trade at an elevated price to earnings ratio, and generally pay either no dividend income, or have a nominal dividend income compared to the overall market or sector.
Different market cycles have favored value or growth at different times. Since about 2008, coming out of the financial crisis, growth stocks have been favored over value in most years. Investors have favored these more expensive companies.
An example of a value stock in todays market would be a company like Johnson & Johnson (JNJ), which pays more than a 2.5% dividend, but is not expected to have the same rate of growth as a company like Alphabet (GOOG); aka Google, which pays no dividend and is considered a growth stock.
Using the ten-year period ending on June 30th 2020, the ten year return for the S&P 500 Growth Index was 16.36%. During the same period, the return for the S&P 500 Value Index was 10.69%.
However, this cycle is not perpetual. Over the last 40 years, when the gap between the more expensive growth stocks and the more conservative value companies tends to widen, the cycle typically reverses. After the great tech bubble implosion that began in March of 1999, the cycle reversed and from 2001-2003 value stocks outperformed.
During the 25-year period between 1990-2015, value stocks were favored. The returns were as follows:
The S&P 500 Growth Index returned 8.72%
The S&P 500 Value Index returned 9.58%
On an annual basis, value outperformed growth 69% of the time over that same 25-year period, providing for less overall volatility. This data was similar across large cap, mid cap and small cap indices as well.
Trying to determine when the cycle reverses is essentially a form of market timing. However, it’s not much of a secret that the recent breakout from the bottom of the market in March of 2020 has been led by a relatively small group of growth stocks that have substantive weighting in the S&P 500. This may mean that it is time for value companies to catch up. Perhaps it means that the cycle will continue even longer. One can never be certain.
If we look at recent pricing on a price to book value ratio, the difference is significant. During the period ending June 30th 2020, the differences are as follows:
The S&P 500 traded at 3.5 times its book value.
The S&P 500 Growth Index traded at 7.4 times its book value.
As we can see, growth stocks have already had quite a move upward by comparison.
A look at the chart above provided by Fidelity Investments, which cites data from the University of Chicago’s Booth School of Business illustrates how over the longer term, stocks priced cheaply tend to have better long run performance. The same chart illustrates how this has not been the recent trend over the last decade. More specifically, since 2014 the disparity has been rather pronounced. In this illustration, stocks are broken down by the most expensive quintile, and the least expensive quintile as measured by both price to earnings and price to book ratios.
Looking purely at return is never the sole answer either. Investments should be looked at on a risk adjusted basis. In simpler terms, how much more risk is needed to increase overall returns. Generally speaking, it is fair to say that value companies tend to introduce less volatility into a portfolio than their growth counterparts. This has been the case through most market downturns. We saw this play out during the market correction at the end of 2018.
However, the recession and market decline induced by the coronavirus threw many of the historical norms out the window. Society became extremely dependent on the use of remote technology as citizens were on lockdown, favoring the services offered by the technology sector, which makes up a very big part of the large cap growth space.
Time will tell as to whether or not we are about to see a reversal back into value driven companies in the short term. We generally favor a slight bias in most portfolios toward value companies as a method to reduce volatility and enhance longer term returns over short term volatility. This is especially important for retirees, or those closing in on retirement, as they often depend on some form of income from their portfolios. However, the overall core holdings are a blend of both value and growth across all market caps. Any attempt to time value vs growth on an absolute basis can result in missing a significant market move.
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When questioning your rate of return, the answer seems like a simple one to a simple question. However, like most financial matters, the answer is never as simple as it seems. There are actually various ways in which the rate of return of an investment is measured.
One such method is what is called the Time Weighted Return (TWR). This is a method most commonly used by mutual funds when quoting the performance of the fund. This method measures the performance of a specific investment over a specific period of time. This is used by investment companies because the manager of a mutual fund has no control over when investors will choose to withdraw or add money to their investment fund. Depending on when your personal transactions occurred, you may see a different return than what is quoted by the investment company.
Another method is the Internal Rate of Return (IRR). This method is designed to take into account the impact of cash flows either in or out of the investment fund(s). This is a better representation of your actual experience based on when you added or subtracted funds. This is also sometimes called a Money Weighted Return (MWR).
Which method should be used?
That depends on what you wish to measure. If your goal was to evaluate how well you or your advisor selected a set of investment vehicles relative to other options, you would likely use the TWR method. The reason is that short term market volatility may have a significant impact on short term results. If two separate investors allocated dollars in the precise same percentages to the same exact investments, but one began in January of 2020, and the other in April of 2020, the results are vastly different by August of 2020. Due to the fact that financial markets saw a steep selloff in the midst of the Coronavirus lockdowns, the outcome for the exact same strategy is wildly different in such a short duration of time. One investor may look foolish, while the other may appear to be a genius, yet they did the exact same thing just a few months apart. Neither is true, as the difference is little more than luck over such a short duration of time.
If you were trying to measure the performance of your 401k plan as you were saving for retirement via your bi-weekly contributions, you may have been recommended a growth-oriented asset allocation. It’s not uncommon for someone to be told that their asset allocation has had a rate of growth of 8%-9% over the last 10 years. However, when they look at their actual return, it may be closer to 7%. This is a function of the IRR/MWR.
If you think about this in simple terms, the stock market is up 75% of the time. This means that 3/4ths of the time you are paying more for the same investments every two weeks. If done over a forty-year career, you paid quite a bit more in year forty than in year number one. The same would be true even over a ten-year time frame. That means your personal return over all those years of saving will most certainly be lower than the actual return of those investments over that same time frame. This is not a reason to avoid investing, but it rather demonstrates the importance of starting early. The younger you are when you begin to save, the less total assets you need to save to achieve the same result.
In such an example, if you wanted to see how well you did in in your 401k terms of investment selection, you’d use the TWR. If you wanted to see your actual result in order to track your personal progress towards your retirement goals, you’d use the IRR/MWR. The same is true in the example of an investor withdrawing funds to supplement an income stream. The periodic cash flows withdrawn will inevitably alter their rate of return over time.
Neither of these methods is good or bad. Instead it’s just important to understand which question is being asked, which isn’t always clear, in order to answer the question with the best possible answer.
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The concept of asset allocation was made famous by the economist and Nobel laureate Harry Markowitz and his introduction to Modern Portfolio Theory (MPT). The principle idea behind MPT in simple terms is the notion that an investor can maximize their returns within a given level of risk with the use of multiple asset classes. Under this premise, an investment is not evaluated on its own, but rather how it affects the overall portfolio when added to the other investments. One of the key variables is not just the historical performance of an investment, but how it correlates to the other investments in the portfolio. In lay terms, does the new added investment move in the same direction at the same time as the other components. Correlation is a mathematical measurement of how assets move. A correlation of 1.00 are two assets that move in perfect tandem. A correlation of 0.00 means when one asset increases, the other does nothing. A correlation of -1.00 are to assets that move precisely the opposite.
The lower the correlation, the less frequently the two assets move in tandem. A lower correlation is important, because as one investment does well, it offers the opportunity to do some profit taking, and add to another investment which is temporarily out of favor, also known as rebalancing. If an investor can maintain a lower correlation, they can produce more stability in their portfolio. This becomes extremely important when drawing an income stream from a portfolio.
One of the challenges in building a portfolio is that historical norms are not necessarily reflected in the shorter-term data. A quick look at the longer-term comparison of various areas of the market show that small cap and mid cap stocks outperform larger cap companies.
During the period of 1926-1983 the average returns were as follow:
Small Caps returned 17.05% with a Standard Deviation of 32.35%
Large Caps returned 11.26% with a Standard Deviation of 20.62%
Yet, from 1972-2019 the returns were less pronounced in favor of small caps:
Small Caps returned 15% with a Standard Deviation of 20.90%
Large Caps returned 13.2% with a Standard Deviation of 17.30%
The recent 10-year and 5-year returns through March 31st 2020 show the following:
Small Caps returned 8.02% over 10 years and 0.45% over 5 years.
Large Caps returned 10.44% over 10 years and 6.65% over 5 years
What can be seen in the recent data is US Large cap equities have produced higher returns with less volatility in recent years. This is especially true for the 5-10 year data, which ends in March of 2020, a period that was much more harsh for Small cap equities as the effects of the government lockdown took effect.
Yet, what we know is that current trends are not always indicative of the future. Other asset classes such as foreign equities have also underperformed US markets for some time. We have also seen the correlation between US and foreign equities rise. Over the last 10 years, the S&P 500 has maintained a high correlation with the MSCI EAFE index of about 0.85. While it’s reasonable to expect that with a much more global economy that is quite interconnected as compared to even 50 years ago, correlations will remain high. That does not necessarily mean that US market will consistently continue to outperform. They may or may not continue that trend.
We see from other asset classes like Real Estate Investment Trusts (REIT’s) that the correlations to the S&P 500 remain moderate. During the recent period of 1999-2019 the correlation between the S&P 500 index and REITs was about 0.65, while REITs returned 9.90% per year, making it an excellent diversifier.
One of the best diversifiers of risk remains investment grade bonds. During the last ten years, which has seen record low interest rates, the Barclays Aggregate Bond Index has returned 3.77% for the period ending March 31st 2020. However, the correlation between the investment grade bond market and the S&P 500 index has been a negative correlation of -0.22.
With each corresponding asset class, there is a trade-off of risk versus return. However, the data stills suggests that a diversified approach of incorporating all of these assets into one integrated portfolio will produce the least amount of volatility. Just as it is not prudent to attempt to guess when to get in or out of markets, it is also not wise to assume that you will know which are of the market will lead over the next decade. It may be time for Emerging Market equities to lead, or perhaps Developed International markets. If all of the recent new money creation leads to inflation, then Commodities would likely be a leader. Many believe that Small Cap equities are primed to lead over the next several years. Then there is always the endless debate of Value versus Growth companies. Asset classes are very much cyclical. Sometimes the cycle will last a few years. Sometimes for a decade or more. Since there is no plausible way to be certain, the principles of Modern Portfolio Theory still apply to any sound financial plan.
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