Rising Interest Rates and the Bond Market: What is the Risk?

By lwmdemo4,

As many investors have started to take note, interest rates have begun to rise.   The Federal Reserve Board (Fed) has signaled at least three interest rate hikes for the calendar year 2018.    As the additional concerns of rising inflation begins to mount in the eyes of many forecasters, it is entirely possible that the Fed will act even more aggressively in raising their target rate.

Differing economic conditions can pose challenges to various different asset classes, as well as investment vehicles within a given asset class.  A rising interest rate environment is generally perceived to be a poor environment for fixed income investments.  This tends to be true in a broad sense, although not exclusively true in all areas of fixed income.   Certain types of fixed income investments tend to do well in a rising interest rate environment.  One such example would be High Yield bonds, which tend to benefit from expanding credit.

In a more broad sense, rising interest rates are a challenge for bonds.  The simple reason is that existing bonds are priced based on a number of metrics such as credit quality, maturity, callable features and the coupon of the bond.  The coupon is the stated interest rate the bond pays when it was issued.  If you purchased a bond paying 3%, and new bond offerings of a similar profile are offering 5%, this makes the bond you hold less attractive and will devalue that bond in the eyes of the current marketplace should you wish to sell it prior to maturity.   Even if you have no intent on selling a bond prior to maturity you may suffer from some “statement shock” when you notice the reduction in value.

The fixed income markets in general have benefited from a period of primarily declining interest rates since the middle of 1981.  Since then, according to Ibbotson Associates the SBBI U.S. Government Treasury Index has averaged better than an 8% annual return.   Much of this performance was frontloaded in the early 1980’s as rates began to decline from unusually high levels in which the intermediate treasury was yielding in excess of 16%.   As an example the 7-10 year Treasury index managed to post only an average return of 1.53% for the 5 year period ending in December of 2017, as rates have remained at historic lows for a decade.

More importantly, the concerns relating to fixed income markets is often centered on how will fixed income investments fare should we see a sustained environment of rising rates.   Much of this is likely dependent on numerous factors such as the timing and pace of Fed policy.    After all, much of the Fed’s policies such as the multiple rounds of Quantitative Easing and its rapid expansion of the Central Bank’s balance sheet are unprecedented.  So it remains to be seen how successful the unwinding of such policy positions will be.

However, there is some historical data to reference regarding fixed income and prolonged rising rate environments.   During the period between 1941 until the peak of interest rates in 1981, there was a longer term trend of fairly consistently rising rates bringing the yield on the intermediate U.S. Treasury from about 0.51% to a peak of 16.4%.   During this period in time the intermediate Treasury market still posted average returns of about 3.3%.    So while the returns over this 40 year period where less than half of that the next 37 years posted for the Treasury market, it was still a net positive performance.   During this period of rising rates there were some negative years.   Yet, negative for fixed income tends to be far less impactful than its equity market counterparts.  According to the NYU Stern School of Business, the single worst year for the 10 year US Treasury bond was in 1969 in which the total return inclusive of dividends was a decline of -5.01%.    Interestingly, the worst years posted for the 10 year treasury were actually during the great bull market in bonds over the last 37 years, which were 1999  which was a decline of -8.25% and 2009 which was an -11.12% decline.  During both of those years the stock market countered this downturn in fixed income with the S&P 500 stock index which was positive by 20.89% & 25.94% respectively.

So while to a certain extent we are in some uncharted territory as pertains to Fed policy, there is a reasonably good track record of rising rates and the impact on the bond market.  Yet, it is still important to distinguish between the historical impact of rising rates on Treasury securities versus other areas in the fixed income markets.  Treasury bills have historically been representative of a risk-free rate of return.  It is fair to say that there is no true risk-free asset when one accounts for other forms of risk, such as inflation.  It is fair to say that treasuries do not pose a default risk.   Unfortunately, this is not true of all fixed income investments.  Corporate debt can in fact default, and even municipalities can go bankrupt altering their repayment of debt obligations.   It should be noted that municipal bankruptcies historically have been an extremely rare event.  

An investor should understand the relationship between changes in rates and their bond portfolio in total.  Each bond has what is known as Duration Risk.  Duration is a complex calculation involving present value, yield, coupon, final maturity and call features of a bond.  This can be measured by examining an individual bond or the average across a portfolio of bonds, or bond funds to assess an average duration.   The simplest way to understand duration is that for each 1% change in interest rates, the price of the bond or bond portfolio should approximately move inversely by the percentage amount of its duration.

As an example, if a bond portfolio had an average duration of 4.5, then a 1% increase in interest rates would indicate a theoretical decline of 4.5%.   The opposite is true in a declining interest rate environment.   Understanding this risk is paramount in building a fixed income portfolio.

It is also imperative to understand that when building a truly diversified investment plan, fixed income is not measured exclusively by your short or long term forecast of the bond market.  It must also be measured in relation to other asset classes you own.  While bonds can and do have negative years, those years are not nearly as poor as the volatility and single year declines associated with stocks.   Due to the fact that stocks and bonds do not always move in tandem, bonds serve the purpose of diversification, a consistent income stream, and the dampening of volatility during periods when stocks can contribute significant amounts of volatility and downward pressure on an investment portfolio.  This becomes particularly important as it pertains to those investors who are either retired or approaching retirement and in need of generating a consistent cash-flow from their investments.

While the forecasts made by many of a challenging investment environment for fixed income may in fact come to fruition, it is difficult for any investor truly interested in a diversified approach to eliminate an entire asset class.   Often times, even in a challenging environment for any asset class there may be many areas of opportunity within in the bond market.  Perhaps that will be in international markets or varying degrees of credit risk.  No matter what the outcome, it is likely that bonds still serve an important role for the majority of investors to some degree.

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When Should You Collect Social Security Benefits?

By lwmdemo4,

Among the most consistent questions my colleagues and I have received as financial planners from investors relates to the timing of when they should take their Social Security (SS) benefits.  Social Security is a relatively complex system with many rules that pertain to various circumstances.  Let me first emphasize that there are no absolute answers, and each individual’s situation should be assessed on its own merits.  Unless of course you can tell me precisely when you will die, in which case I can provide you with a far more precise answer.

I would venture to guess that the majority of articles and publications on this topic will suggest that you wait as long as possible to collect.   I will attempt to defy what may be the conventional wisdom, because in my experience the conventional wisdom is often wrong.   Let me first say, none of this is based on the known actuarial problems facing the SS trust fund, which begins to run a shortfall projected around the year 2033.  The SS trust fund is made up of intragovernmental debt (US Treasuries).  The funding sources for SS have been merged with the general taxes collected for many decades.  Since the United States operates as a fiat currency, “running out of money” is essentially impossible.   I say this not to minimize the challenges that such entitlement programs face, as they can have many other substantial economic consequences on the nation beyond the scope of this article.  However, the fear of the government “running out of money” should play no role in determining when you should collect your benefit.

SS benefits allow under normal circumstances that you can collect your benefits prior to your full retirement age (FRA) as early as age 62, or past your full retirement age as late as age 70.  Full retirement can be differing ages as defined by SS depending on when you were born.  Each year you delay the benefit, it increases by 8% using a simple interest calculation rather than a compounding calculation.

The first thing to understand is that SS is actuarially designed so that when you reach your statistical average life expectancy you will have received the same exact total amount of dollars regardless of whether you began at age 62, age 70, or anytime in between.  Each day you live past your average life expectancy, the total amount of dollars received is greater for someone who delayed collecting their benefits versus someone who collected earlier.   Additionally, the term “average” life expectancy is quite misleading.   In financial planning we also study “longevity” planning, which is different than the average.   The average can be misleading because averages are impacted by unfortunate events such as infant mortality or a teenager killed in a car accident.  When we look at longevity, a couple that actually reaches age 65 has better than 75% chance that at least one of them will reach age 92 years old.   So, if you live long enough to qualify it would seem statistically highly probable that you will surpass the average, and therefore you are better off delaying your benefit.   While it may seem that way, here is why it may not.

The majority of examples that illustrate when an individual should opt for their SS benefits will look in isolation at the SS benefit, and often not enough at the details surrounding an individual or couples overall financial picture.  This approach will most often encourage you to wait as long as possible.   Let’s first look at the most common example, which is a married couple.   Many people are unaware that unlike a traditional retirement plan, SS does not offer a traditional survivor benefit.   This means that if Spouse A is earning $2,600 at full retirement, and Spouse B is earning $1,800 at full retirement, upon the death of either of the spouses, the survivor will receive the higher of the two benefits and lose the lower benefit permanently.

Let’s imagine a common example.  Client A is born in 1955 and their full retirement benefit at age 66 and 2 months.  The annual benefits offered are as follows:

Reduced benefits at age 62:                $25,181

Full retirement benefits at age 66:    $33, 933

Delayed benefits at age 70:                 $44,792

For the sake of these illustrations we are going to discount the annual inflation increases on the SS payments because they would be applied at the same rate linked to the consumer price index regardless of what age you opted to begin collecting your benefit.

Client A’s benefit of $25,181 between the age of 62 until 70 is an aggregate income of $201,448 over the 8 year period.   If client A does not receive this annual benefit because they waited until age 70, then we might presume that they needed to spend down the $201,448 from another source such as a 401k, IRA, savings or another investment account in order to meet their income needs.   So how much is the time value of money on the $201,448 spent down to replace the SS benefit that was not collected because Client A waited until age 70 for the enhanced benefit?

Let’s be conservative.

If the same $201,448 remained invested earning an average return of 5% (which is well below historical long term market averages), that would compound into $297,630.    It is widely accepted based on countless financial planning studies that a properly balanced investment portfolio can sustain a 4% withdrawal strategy for 30 years increasing with inflation without depleting assets to zero.  If you were to wait until age 70 to begin withdrawals, a 4% withdraw should be more than sustainable and quite reasonable.  Even a 5% withdrawal at age 70 is highly plausible.  In the interest of remaining conservative in the assumptions used, we will use the 4% withdrawal approach.

The pool of investment dollars has compounded to an additional $297,630 because Client A did not need to draw on these assets due to the early SS benefit supplementing their income, how much is this worth as an income?  Using a 4% withdrawal strategy annually from $297,630 beginning at age 70, you have an annual income in year one of $11,905.   This figure is still smaller than the difference between your age 70 benefit and the age 62 benefit ($44,792-$25,181=$19,611).  That is a difference of $7,706 annually.   So why would it be better to realize the lower income?

Let’s remember that you don’t receive more in total benefits by waiting until you reach your average life expectancy, (currently approximately 81 for women and 76 for men).  What happens if Client A did not live to their statistical average and were to pass away at age 70?  Remember that the survivor benefit to the spouse is the higher of the two benefits, but they lose the smaller benefit.   In such a case the surviving spouse would lose not only the smaller income (which is at least 50% of the larger income), but the benefit of inheriting the $297,630 that was never realized because the assets were spent down rather than saved and grown via an investment portfolio during the 8 year period while waiting to collect the higher benefits.  The result of the combined loss in many cases can be dramatically impactful, if not financially catastrophic on many surviving spouses.

It is sometimes argued and entirely possible to insure this risk by buying a term life insurance policy on the amount of the lost savings.  However, term insurance typically ends at age 80.  In the event the insured died at age 81, the surviving spouse never receives the death benefit, nor do they have the accumulated additional dollars saved by collecting earlier.  Additionally, they lost the cost of the life insurance premiums they paid for 18 years, which negates some of the benefit of having just barely passed the breakeven point at their average life expectancy.    This strategy also presumes the individual is in fact insurable, which is not always the case depending on their past medical history.

What if Client A waits to collect at age 70 and both spouses live to the ripe old age of 95?  

With the average life expectancy for a man being approximately age 76, that is an extra 19 years with an additional $7,706 per year past the breakeven point.  That is a total of an additional $146,414 ins SS income.

So while Client A may have collected a total of an additional $146,414 in total benefits by delaying benefits, we cannot ignore the investment capital that was spent down between ages 62-70, which we established earlier was equal to $297,630 with a 5% return for 8 years.   While this capital using the 4% withdrawal strategy is presumed to be generating less income, it does not necessarily mean it will be spent to zero.

In fact, according to research done by Michael Kitces, if you spend at a rate of 4% per year over a 30 year period in a balanced portfolio (defined as 60% stocks & 40% bonds), statistically 2/3rds of the time you’ll have more than 2 times the amount of assets at the end of a 30 year period.

More than ½ the time the value will nearly double.

More than 1/3rd of the time the retiree ends up with 5 times the amount of principal they started with at the end of 30 years.

90% of the time retirees finish with more than their starting principal at the end of 30 years.

That is equal to between $595,260 $892,890 at the end of retirement.  So while Client A may have collected an additional $146,414 from their delayed SS benefit, they likely lost somewhere between $595,260 -$892,890 due to 38 years of missed compounding.

From a legacy perspective, Client A’s estate is greatly enhanced by collecting early.  While an estate is more of a benefit to Client A’s heirs, either way the bills were paid to support their lifestyle during retirement, and their total net worth is higher at the end of their life.

Many of the above assumption are very conservative growth estimates.  However, it is still worth noting that in order for this to work, Client A must stick to an investment plan in a disciplined manner.  While many retirees certainly do just that, others have a tendency to panic during periods of market volatility which then undermines the above assumptions.

There are other variables worth considering such as taxes.  If the funding source for the theoretical investment capital is a retirement account subject to income taxes on withdrawals, this must be compared with SS income which has some additional tax benefits.  SS income is exempt from State income tax, and at least 15% of the benefit is exempt from Federal income taxes.    While that is a slightly greater benefit for SS, it is not enough to offset the benefit of collecting early in many circumstances.

What if you had no need for your Social Security Income at all?

If you and your spouse have no need for the SS income or the assets you have saved to generate a cash flow because perhaps you have a large pension benefit that more than pays for your lifestyle, then that SS income possibly becomes discretionary investment capital.

Assuming you live to age 95 and the income was invested annually compounded at 5%.

Collecting $25,181 at age 62 would compound at age 95 to $2,116,895

Collecting $44,792 at age 70 would compound at age 95 to $2,244,685

In this example, if you never needed the funds and invested them at the same rate of return, and lived to age 95, it paid to wait.   However, you would need to live until at least age 82 to have benefited from waiting.   Once again, if either you or your spouse pass away prior to that, the lack of a survivor benefit on the lower income is a substantial difference.

As we referenced earlier, there are no absolutes, and circumstances do exist in which it certainly does not pay to collect early.  In the event that you are still working, you want to delay benefits until at least your full retirement age in order to avoid penalties that would negate a substantial portion of the income, if not all of it.

If you and your spouse are in a position where you have not saved an adequate amount of money to support your lifestyle and you are likely to run out of money no matter what you do, it likely pays to delay the benefit as long as possible since you will not have investment capital to produce any compounded growth.   If you are essentially running out of liquid assets anyway, you are likely spending all of the SS benefit every month, and no wealth is accumulated no matter what happens.  Therefore, the larger lifetime payment makes sense.   If you died well before your average life expectancy, you never reached your breakeven point.  But either way there is no legacy of assets left to heirs.

Each situation must be examined independently in order to make an educated decision.  However, it is wise to be cautious of software programs, or any form of advice that measures only the metrics of the SS benefits formula without accounting for all the other moving parts that make up your personal financial profile.

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How To Handle Your Pension Options

By lwmdemo4,

Over the years, one common choice individuals are faced with is how to receive their pension benefit when it is offered to them at retirement. There are more numerous options routinely available, such as a single life payment, joint life payment or even more common in recent years, the lump sum option. Let’s first start by pointing out that for individuals who are employees of a government agency, a lump sum option is typically not a choice you will be offered.

The lump sum option has become more common for those in the private sector that have worked for large multinational corporations, and even some mid-sized businesses. This is largely due to the longer than expected life expectancies we are facing, as well as other demographic changes that can impact the actuarial projections of a pension fund. It is very difficult to predict in a pension fund what these legacy costs will be due to a variety of reasons. Companies may have a smaller number of employees in the future contributing to the fund. They may have slower than expected business cycles that force layoffs and reduce staff. As a result, there is and will continue to be more of a push towards defined contribution plans (401k/profit sharing) in the future. The largest challenge is the substantial increase in life expectancies since many of these pension funds were initiated many decades ago.


Let’s first address the lump sum option. In many of the cases, the lump sum option is the more prudent choice. Pension funds are using the same actuarial data to make projections about life expectancy to determine their liabilities as an insurance company that sells an immediate fixed annuity. An immediate fixed annuity bought privately has the same characteristics to the individual as a private pension benefit once the receipt of income begins. The distribution rate is typically very similar. However, in some cases the entirety of the pension benefit offered as an income is not needed at the moment the individual retires.

Let’s imagine a 65 year old retiree who is being offered $60,000 per year, or a lump sum of $1,000,000. What if the retiree after examining their financial needs, determines they only need about $40,000 per year based on their current lifestyle and other income sources? The individual could simply opt to take the entire $1,000,000, roll it to an IRA on a non-taxable basis, and then choose to buy an immediate fixed annuity by shopping the best payment with multiple insurance carriers. Except, in order to achieve the desired income, they would likely only have to utilize approximately $670,000 at a 6% distribution rate, which would generate an income in the range of $40,000 annually. This would then permit the investor to keep the additional $330,000 in their IRA on a tax deferred basis to keep growing until the income was needed in the future, or to be left to their heirs as beneficiaries. The key is ultimately the flexibility. Please note that these income assumptions are close to current norms, but are not specific to any one insurer or annuity offering.


Solvency is also a key issue. If you are a participant of a private sector pension fund, the only real guarantee you have if a pension fund is taken into receivership is through the Pension Benefit Guarantee Corporation (PBGC). However, PBGC only secures a portion of these pension funds under a formula that is rather complex, and can greatly limit the benefit of someone that would have been entitled to a sizeable pension. Pension funds can and do go bankrupt. It happens more often than most workers realize, and some are substantially underfunded. On the contrary, your 401k, while subject to the same market risk on investments that the pension fund is also subject to, remains 100% yours once you have become vested. At a maximum that is likely to be six years of service with your employer. The difference is a pension fund is a liability of the corporation, whereas a personal account is a segregated asset, and not a liability of your employer, therefore not subject to the claims of their creditors.

The next common sense question is “What happens if I annuitize money from a pension lump sum and then the insurance company goes under?” This is an important consideration, and requires some homework to be done. In many states, there is a state guarantee fund on benefits issued to the purchaser of an insurance product in the event of a default. As an example, New York State has the Life Insurance Company Guaranty Corporation of New York, which currently guarantees benefits of 100% up to $500,000.00 per individual.

So in the event of pension replacement, or any form of an insurance product, it may be prudent to limit the purchase to no more than $500,000 in the State of N.Y. If necessary, you can purchase more than one product from multiple insurance carriers to coordinate benefits. In the case of annuity payments there will typically be more than one company offering a similar payment option. Since insurance is regulated at the state level, you would need to inquire with your insurance commissioner’s office as to what guarantees, if any, exist. It should also be noted that many licensed insurance agents do not mention this backup fund, as they are prohibited from utilizing it as a sales incentive. The responsibility to inquire about any state guarantees rests upon the consumer.

Furthermore, with a pension fund from an employer there may be an option for a survivor benefit to the spouse at a reduced rate. However, many pension funds offer no continuing benefit to children or other non-spousal beneficiaries. So in the event that you choose to retire after 30 years of service with a joint survivor benefit, and then you and your spouse pass away relatively young, there may be nothing left to your heirs. The amount that you either contributed to the pension fund, or that which was contributed on your behalf for your service, simply becomes a forfeiture reallocation. This basically means the pension fund keeps your money, and it reduces the burden of liability they must pay to other families in the future. Should you opt to privately annuitize money in an immediate fixed annuity, insurers virtually always offer multiple guarantee options, such as a 20 year period certain guarantee. Such an option insures that someone of your choosing will receive a benefit equal to the amount of money funded, and it will not be lost.


What about cases in which someone is not offered a lump sum, but only a joint survivor benefit, or what is sometimes called a
pop-up option? This is rather common among civil service employees. These should be examined closely, as there is usually more than one formula available. While there are no universal answers that apply to all, a survivor benefit of some type often makes the most sense for couples.

In many cases, an insurance agent will show you an illustration of how you can purchase life insurance on the pension recipient at a cost that is less than the amount of reduced income one might realize by taking the joint benefit. The challenge in such a scenario is that it often requires a substantial amount of insurance to replace the loss of a pension. This usually requires term insurance to be issued on an individual that will receive a large pension benefit, because it is the least expensive. While term coverage makes excellent sense for a young couple, it can be risky for couples closing in on retirement benefits. If you are 65 (assuming you are insurable), a term policy will typically not cover you past age 80. So what happens if the pension recipient dies at age 81, and the survivor has neither the life insurance, nor the pension, and lives to age 95? The alternative is to utilize permanent life insurance such as whole life, universal life, or variable life policy. However, that will greatly drive up the cost of the annual premiums, often making it a poor choice, and possibly unaffordable.


When examining the cost of insuring the individual benefit versus the joint survivor options being proposed, you should try and think of the reduced annual benefit as the insurance premium. When examining it from that perspective, you are essentially purchasing the equivalent of a level term insurance policy that has no term limit. It will last your life expectancy.

As an example: If the $60,000 pension is reduced to $54,000 in order to capture the joint benefit for a spouse, the reduction should be compared to the cost of a term policy. The amount needed to replace a $60,000 fixed annual income for a 65 year old is approximately $1,000,000 (6% annual distribution rate). The cost to purchase a $1,000,000 term insurance policy for 10-15 years may possibility be less than $6,000 annually, if the individual receives favorable underwriting due to excellent health. However, at the end of the 15 years, the survivor is left with no benefit guarantee, and possibly a number of years remaining in retirement. By taking, the survivor benefit, the $6,000 annual difference becomes the equivalent of a lifetime of level term insurance.

It is always important to note that each situation is unique, and there is no “one size fits all” in financial planning. Determining how to handle ones pension options is one of the larger financial decisions a person will make in their lifetime. In many cases, utilizing a lump sum strategy instead of an employer’s annual payment, and annuitizing all or part of the benefit as a pension replacement makes the most sense. Keep in mind that not all annuity products are the same. Many are loaded with expensive and unnecessary “bells and whistles” like features. It is advisable to seek a second opinion from an independent financial professional on what options make the most sense, rather than simply take the word of a commissioned sales agent. It can be prudent to discuss these issues with your tax advisor and/or a fee-only financial professional that does not sell insurance products for some unbiased advice.

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Tax Loss Harvesting – How To Limit Your Tax Liability

By lwmdemo4,

There are few things people dislike more than having to pay taxes. Investors are no different in that regard, and perhaps even more so as it pertains to capital gains taxes. When an individual goes to work, they know at the end of their work day that they will typically be paid based on specific formula of hourly wages or salary. Investors often commit dollars to a specific opportunity with no guarantee of any return whatsoever. In fact, the risk of a loss of some type is almost always a threat. As a result, any opportunity to enhance the probability of success is paramount. Tax efficiency is a key component of a well thought out investment plan. Tax Loss Harvesting is one of the most important aspects of a tax efficient investment plan.

Capital gains taxes are levied at an investor’s ordinary income tax rate should they hold an investment for less than one year. In the event that an investment is held for more than one year, capital gain rates can be levied at as much as 20%, as well as additional capital gain taxes levied at the state level. Furthermore, another 3.8% tax on net investment income (which includes capital gains) may be assessed on individuals with an adjusted gross income over $125,000 ($250,000 for joint filers) due to legislation initiated with the Affordable Care Act.

When an investor loses money on a capital investment, they may report the loss on their income tax return as an adjustment against their ordinary income (wages/salary). Presuming they have no capital gains in the year of the tax filing, they are permitted to utilize only $3,000.00, and carry the remaining amount forward into future tax years using $3,000.00 annually. So if you bought a stock or lost money on an investment property, it wouldn’t matter if the loss is in excess of $100,000.00. The total loss would take more than 33 years to realize!

However, the IRS does permit the use of an entire capital loss to be used on a dollar for dollar offset against a capital gain in a given tax year. So, the same $100,000.00 loss can be used to wipe out a $100,000.00 gain in a single year, netting a zero tax liability.

When it comes to the active management of an investment portfolio, this is where things begin to get creative.

The IRS has a rule known as a wash sale rule.

The rules effectively state that a wash sale occurs when you sell or trade securities at a loss and within 30 days before or after the sale you:

Buy substantially identical securities, or

Acquire substantially identical securities in a fully taxable trade, or

Acquire a contract or option to buy substantially identical securities.

If you were to buy a stock, and then subsequently sell the stock for a loss, and then repurchase it within the restricted time frame referenced above, the loss will be disqualified. The reason is the IRS does not want investors to sell investments and immediately buy them back the same day in order to capture a loss against something they still really own all the while. New and more advanced technologies now require brokerage firms to track cost basis in great detail which is transferred with an investor’s account from firm to firm, and then report gains and losses to the IRS on the form 1099

The term “substantially identical securities” would clearly mean that you can’t sell stock in IBM, and then re-buy IBM within the window of restriction. It would also prohibit the purchase of options in which IBM was the underlying security. Furthermore, should an investor sell a Vanguard S&P 500 index fund, then immediately purchase a Fidelity S&P 500 index fund, the same would be true, as the underlying investments pertain to exactly the same investment components in the same proportion. Now let’s imagine that you purchased an investment in an S&P 500 Index ETF, and the market subsequently declined. In order to capture the loss, you opted to purchase a position with the sale of the proceeds into an ETF that tracks the Russell 1000 index. In this case, your loss is in fact permitted. The reason is while you are purchasing another index which is highly correlated with a great deal of overlap in underlying holdings, they are not precisely the same.


What about traditional Mutual Funds?

Actively managed mutual funds offer a similar benefit. In the sale of one mutual fund in order to buy another mutual fund that has a manager with a similar strategy and core holdings, the loss is permitted. In both of these examples the positions are substantially similar and highly correlated, but not substantially identical.


Why does this matter so much?

A key part of a sound long term investment plan is to actively rebalance a portfolio during the year back to an appropriate level of risk. In a year in which stocks have done well and bonds have done poorly, you should be trimming some of the profits from your stock market exposure, and adding those profits into your bond market exposure. In years where the opposite has happened, you do the inverse. This process of rebalancing forces a portfolio to constantly sell high and buy low. However, when done in a non-retirement account (IRA/401k) that is not tax sheltered, this can begin to present tax problems.

When utilizing proper Tax Loss Harvesting techniques, the tax liability can be mitigated if not eliminated. Imagine that you had a poor year in the stock market, and wanted to sell some of your bond holdings in order to put more money into your stock holdings. What if the new money was supposed to go into the S&P 500 ETF, which has now declined by $10,000.00 since the original purchase? You can simply sell the entire position, capture the tax loss, and use the proceeds plus the new money from the sale of the bond holdings to purchase the Russell 1000 ETF. In doing so, you have rebalanced your portfolio back to the originally desired asset allocation. Simultaneously, you have captured a tax loss that can be utilized against the sale of the bond holdings where you took the profit and realized a capital gain, allowing one to cancel the other, possibly resulting in a ZERO tax liability, or even a deduction.

This technique becomes increasingly important for investors that buy actively managed mutual funds outside of a tax sheltered retirement account. Actively managed funds often payout capital gain distributions to shareholders of a fund following a positive, or in some cases negative year in relation to the trading that took place. This is essentially a payout of a cash distribution in a specific amount of dollars, while then simultaneously reducing the value of the funds price equal to the amount of the distribution. In some cases a new investor may have bought a fund close to the end of the year, having never participated in the prior gain. Yet, they will still be affected by a distribution the fund pays to existing shareholders. Such a situation is the worst of all scenarios, as it is can essentially be a tax liability without ever having realized the gain. Not many investors wish to pay tax on someone else’s gain.

Bond Funds

Bond Funds present a particularly interesting opportunity, because they derive most of their return from the dividend/interest income they produce. While they have no stated maturity date, the underlying bonds held in the fund do. Imagine an investor who buys a bond fund in their portfolio for diversification, but does not need the income at this point in time. So as a result, they opt to re-invest all their monthly dividend income.

Let’s look at an example using the average cost per share methodology for tax purposes.

An account set for reinvestment of dividends and interest, buys Mutual Fund XYZ which pays $40 a month of interest. In this example also assume an initial purchase of $10,000 and no change to the net asset value of the investment at the end of the period:

Date: Purchases: Cumulative Cost Basis:
January $10,000 $10,000
February $40 $10,040
March $40 $10,080
April $40 $10,120
May $40 $10,160
June $40 $10,200
July $40 $10,240
August $40 $10,280
September $40 $10,320
October $40 $10,360
November $40 $10,400
December $40 $10,440
January $40 $10,480

In this example, your initial $10,000 investment would now be worth $10,480 which is a 4.80% gain. Now, let’s say in this example, due to market fluctuation of Bond Fund XYZ, at the end of the year it was only worth $10,200. This would reflect as a loss of -2.67% (due to the cost basis being $10,480 minus a current value of $10,200), when in reality it is an actual gain of +2.0% ($10,000 now worth $10,200).

Let’s assume that rather than reinvesting the interest payment each month, you had the interest payment go into your money market account. The cost basis would stay at the original $10,000, you would have collected $480 dollars of interest, and you could still recognize a taxable loss if the mutual fund was sold at a price of less than $10,000.

The reason this is a loss with the IRS in the case of the reinvested dividends, is the dividends you received which drive the return of the investment were not obligated to be reinvested. However, because you did reinvest them, you altered your cost basis every month. In many cases, what is a loss on paper may actually be a gain. Now, using a similar strategy as referenced earlier, you can sell XYZ bond fund # 1, and buy ABC bond fund # 2, which are very similar, and captures a loss even when there is really a positive net return.

The use of harvesting losses can offset a capital gain whether realized in the year it was captured, or a future capital gain. There is no disadvantage to harvesting losses, because they can be carried forward for future years without expiration. This should be done at every opportunity that will not trigger excessive trading fees.

In a real life example, in late 2007 we dealt with a client who invested $1,000,000.00 just before the market began to decline precipitating the financial crisis. Through proper tax loss harvesting, the client was able to harvest more than $300,000.00 in tax loss carry forwards. By late 2010, the client had a portfolio that had more than fully recovered back his original value if $1,000,000.00, plus some nominal small gains. The following year, he was able to sell a rental property that he and his wife had for many years been attempting to sell, which generated a taxable gain of $250,000.00. As a result of the proper active ongoing approach to tax loss harvesting, and a disciplined commitment to long term investing, the client realized a tax liability of ZERO, while maintaining their investment allocation for longer term growth.

In the words of Robert Kiyosaki, “It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.”

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Market Valuations

By lwmdemo4,

Market valuation metrics are important in setting expectations for returns and for providing us a guide for where we have been. Valuation metrics attempt to quantify (basically assign a number we can use for comparisons) how over or under valued a market might be. Let’s start by discussing these points:

  1. The stock market is considered a leading indicator.
  2. An overvalued market can become more overvalued.
  3. An overvalued market can grow its way to fair value.
  4. An overvalue market can have a correction.

We will then discuss our current market valuation metrics.


Stock Market is Leading Indicator

The stock market is one of the better leading indicators for the economy. According to Conference-board.org

The ten components of The Conference Board Leading Economic Index® for the U.S. include:

  1. Average weekly hours, manufacturing
  2. Average weekly initial claims for unemployment insurance
  3. Manufacturers’ new orders, consumer goods and materials
  4. ISM® Index of New Orders
  5. Manufacturers’ new orders, nondefense capital goods excluding aircraft orders
  6. Building permits, new private housing units
  7. Stock prices, 500 common stocks
  8. Leading Credit Index™
  9. Interest rate spread, 10-year Treasury bonds less federal funds
  10. Average consumer expectations for business conditions

As you can see, the stock prices for 500 common stocks provide us more information about the economy. Therefore, there are times the stock market is overvalued and that is an indicator the economy may accelerate (and justify the higher valuation).


Stock Market Can Become More Overvalued

Just because the stock market is slightly overvalued does not meant that it cannot become more overvalued. Further, if an investor says the market is overvalued and goes to cash, the market can continue to go up. If the market continues to go up, it would not be unusual for the underlying fundamentals to improve. When the “overvalued” market corrects, it may not drop down to the value the investor went to cash at because the fundamental underlying improved from that moment in time.

It’s difficult to explain but let’s say the price of a stock is 20 and earnings are 1. That is a 20 P/E. Let’s say a 15 P/E is fairly valued so the price should in theory should be 15. An investor then “sells high” because he thinks it should only be worth $15 because a 15 P/E is the fair value. The price doubles to 40 and the earnings go to 1.75. The stock has become even more overvalued at a 26 P/E. The investor stays in cash due to the stock becoming even more overvalued. Now let’s say the stock corrects and price drops to $25 and the earnings stay at 1.75. The investor see value in the P/E being 14.29 and buys the stock again. So he sold at an overvalued 20 P/E and bought it back at a 14.29 P/E, he had to make money correct? Not exactly, he sold at $20 and bought it back at $25. He is $5 worse off.

The moral of the story, you can lose money by “selling” an overvalued market and waiting for it to become a “better deal”.


An Overvalue Market Can Grow Its Way to Fairly Value

We will again use the P/E ratio and let’s remember the stock market is a leading indicator. If we have an overvalued market, prices can grow less than earning and end up fairly valued. Let’s take the stock in the previous example. If we buy it for $20 when the earning are $1 dollar, we have a 20 P/E. If the price goes to $25 and earnings grow at a faster rate to 1.75, we now have a fairly value stock with a 14.29 P/E.


An Overvalued Market Can Have a Correction

This last point is the one everyone fears and why they might sell when they think the market is overvalued. The perfect example is the dot com bubble. Valuations were at historically rich values and the market corrected by dropping prices. The danger with this reason is that it’s very difficult to know when it will predict a correction in price.


Is the Market Overvalued Now?

There is a great guide that JP Morgan provides called the guide to the markets. They provide an excellent valuation slide.

S&P 500 Valuation Measures

(Source JP Morgan’s Guide to the Markets Slide 5)

We have a variety of valuation metrics based on the S&P 500. The third column is “Std Dev.”. We
expect the value to be between 1 and -1, 66% of the time.


Metrics Signaling Over-Valued

P/E – This measure is simply the price of the S&P500 divided by the projected earnings. Currently, this measure says the market is slightly overvalued as a 0.5

CAPE – This measure is the cyclically adjusted P/E or Shiller’s P/E. This measure takes the average of the past 10 years of earnings. Currently, it also indicates the market may be slightly overvalued at 0.5

P/CF – Price to Cash Flow metric is the price divided by the cash flow of the company. The metric is currently at 0.9 which signifies an overvalued market


Fair Value

P/B – The price of the stock dividend by the “book value” or the value of the stock held on the
accounting books of the company based on historical accounting data. Currently, its standard deviation
is 0.0 indicating Fair Value.


Metrics Indicating Undervalued

Dividend Yield – This measure is the dividend of the stock divided by the price. At a -.02, the dividend
yield is indicating a slightly undervalued market.

EY Spread – This measure takes the earnings yield of stocks minus the yield on Baa corporate bonds.
The current standard deviation of -0.7 indicated an undervalued market.


The Take Away

So we reviewed how even an overvalued market can become fairly valued a variety of ways and we also reviewed what our current metrics are telling us about the S&P500. The next question is, “Is the market fairly valued”? With the current metrics, you can make an argument for overvalued, fairly valued, and undervalued. My opinion? I do not feel the current metrics are strong enough to form a strong enough opinion worth acting on. Given the wealth of information out there and how implementing what might sound like a great strategy on what you read in Baron’s magazine or hear don CNBC, its important to partner up with an expert like Brian Cohen at Landmark Wealth Management LLC.


About The Author

Stephen Reh CFA, MBA, CFP® is a financial planner in Southern California. Steve founded www.investwithsteve.com and Reh Wealth Advisors LLC in 2010 to provide fee only asset management and financial planning.

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