Congrats you’re a new parent or homeowner! Here’s a cheat sheet on estate planning
By Daniel Harris, RIA, Sunday August 14, 2016
The first rule of estate planning is insurance. Insurance covers things that you could not afford to happen like the death of a breadwinner or the loss of a breadwinner’s ability to work and bring in income. We all count on our incomes to sustain our families and so you need to protect it against the two biggest risks: death and disability.
How much term insurance to buy
Over the years I’ve developed a simple formula to calculate how much term insurance you need.
Cost of Living (after tax) – spouse’s income – 1/25th the value of your investment portfolio
Example Jane Doe: $65,000 (cost of living) - $100,000 (John Doe’s income) - $4,000 (1/25th of a $100,000 investment portfolio) = -$39,000
No life insurance needed on Jane Doe, you are covered.
Example John Doe: $65,000 (cost of living) - $0 (Jane Doe, stay at home mom) - $4,000 (1/25th of a $100,000 investment portfolio) = +$61,000
Jane needs to buy a policy on John that will pay her $61,000 the year that he passes and will pay her $61,000 plus 3% for inflation the years after.
Example on a 5-year policy (take each year and multiply by 1.03 to account for inflation):
Year 1: $61,000
Year 2: $62,830
Year 3: $64,715
Year 4: $66,656
Year 5: $68,656
Total: Jane needs a $323,857 policy
To get the cost of a policy go to https://www.term4sale.com or if you are pretty healthy you can go straight to Ohio National, which is always the cheapest, if you are healthy https://www.ohionational.com/public/calculator/termcalc.html
As for agents I like Chris Abrams, http://abramsinc.com he can sell you term for most companies except for Ohio National. For Ohio National you’ll have to go through their website to get an agent (who won’t be as good as Chris Abrams) but Ohio National policies are a little bit cheaper which might offset the hassle for you.
How much disability insurance to buy:
Cost of Living (after tax) – spouse’s income – 1/25th the value of your investment portfolio – the disability insurance coverage you have at work (after tax)
Most disability insurance from work is taxed and to use this formula take into account how much it covers you after the taxes are taken out. Most disability policies at work only pay 2 to 3 years of coverage. Google “modified own occupation” to see what I mean.
There are three disability insurers in California: Guardian, Principal, Standard and MetLife (MetLife is leaving the disability market).
For women your best bet is Principal: https://www.principal.com/individuals/insure/income-protection-disability-insurance/disability-income-protection
For men you best bet is Standard:
In my view, MetLife’s policy is seriously defective due to its limitation and Guardian’s in greatly overpriced for what they cover (and underwriting is a major pain with Guardian). You can buy both of these policies through Chris Abrams, who I recommend http://abramsinc.com [Chris doesn’t give me anything for my recommendation I just think he is a good and efficient agent]
Disability policies are complicated, I recommend talking to our firm in advance of buying one (we’re impartial), as there are some unique features that aren’t easy to understand if you’ve never owned a disability policy.
The estate planning flow chart
Now that you’ve covered your bases on insurance let’s look at estate planning. I’m going to do an asset based approach starting with your most valuable assets.
In estate planning there are only three goals 1) move assets to people you want to have them 2) avoid unnecessary probate commissions 3) avoid unnecessary taxes
Why have a living trust for property outside of California?
A living trust sweeps the property into California jurisdiction meaning you deal with it in California courts. If you don’t do this, you’ll have to go through probate in whatever state the property located in even though it will be a pain to make court appearances there.
What is a Transfer on Death Deed and why is it better than a living trust for California real estate?
A Transfer on Death Deed is simple and free. It takes no effect when the first spouse dies (assuming you own your home as community property or joint tenants with rights of survivorship which takes precedent over a TOD deed). The TOD does take effect when the second spouse dies. Assume you had two children and gave your house 50/50 to them. They simply go down to county recorder’s office with your death certificate and the county transfers the deed to them. It’s super easy.
The limitations are 1) you have to give equally to all beneficiaries on the transfer on death deed 2) you have to record it at the county so it’s a small amount of work upfront. Doing these 30 minutes of work should save a typical homeowner about $12,000 in probate fees (the typical cost of probating a house in San Diego)
Why not a living trust instead? Living trusts seem like they do the same thing at first but you really need a lawyer to implement the changes for you, dissolve the trust ect. When you set it up you may have used one of those $20 a month legal insurance programs but when you dissolve it you’ll probably be paying $350 an hour for help (because you’re no longer covered by the insurance program when you aren’t working). So the living trust, in the long run, is substantially more expensive because you can’t do it yourself.
The American Bar Association has written extensively about TOD deeds and how to use them, which you can read about here: http://www.americanbar.org/newsletter/publications/gp_solo_magazine_home/gp_solo_magazine_index/realestate_transferondeath.html
Why should I check my beneficiary designations on financial assets?
Beneficiary designations trump probate proceedings (and your will) and like a transfer on death deed the assets with a transfer on death or beneficiary designation are swept right out of your estate and not subject to any probate fees.
What does it matter if my other assets are worth less than $150,000?
If you have less than $150,000 in assets that have already been swept out of probate by your Transfer on Death Deed, Beneficiary Designations, or living trust (anything titled in the living trust will be exempt from probate) you go through the simplified probate procedure (CA Probate Code Section 13151). Essentially this involves filing a form with the court saying I’m this person’s legal heir and therefore I should deserve their jewelry and couch which they never titled in the name of their living trust.
Even people with living trusts go through this form of probate because you always forget to put some assets in the living trust. This is why you have a statutory will http://www.calbar.ca.gov/portals/0/documents/publications/Will-Form.pdf, which is free or have an attorney draft you a customized “pour over will” which is what you’d use if the standard options don’t work for you. I’ll talk about probate attorneys I like in the next post.
Property passed this way is done through “affidavit” or a form with the court and usually costs $50-$100 per major piece of property and takes 40 days to transfer the property as opposed to the 2 years it takes to transfer property through regular probate.
Who is subject to estate taxes?
All of these procedures (living trusts, beneficiary designations, transfer on death deeds) on their own do nothing to save you on estate taxes. The good news is almost no one pays estate taxes currently. About 19,000 people pass away in San Diego County each year and less than 190 pay any estate taxes. If you are one of the richest 190 go talk to Jim Siegel. If you aren’t you don’t have to think about or worry about estate taxes.
One last thing…
Just to be clear, I’m not your lawyer, insurance agent or financial advisor and I don’t know the particulars of your situation. I think it’s good to get the perspective of someone who has no financial interest in these fields about how they work and how to use them effectively from a customer’s perspective. However, this article is written from the position of a layman, not a lawyer, and you should just use it as something to think about and research on your own. While I may be unbiased and have no financial interest in your probate strategy, I’m not writing from the perspective of a lawyer.
I wouldn’t recommend acting on these recommendations unless you’ve done your own research and concluded that they are the right moves for you. If you are unsure you can seek out legal counsel to guide you. In the next article I’m going to talk about probate attorneys I really like and why I like them. They can walk you through the pros and cons of the options and can help check your work which can give you peace of mind that you did it right.
Are you in an abusive relationship with your bank? You should consider a credit union and a high yield online only savings account.
By Daniel Harris, RIA, Saturday August 13, 2016
I’m going to tell this story through my history with my big national bank. One that I have been a customer of for almost 20 years now, but have almost no relationship with them today (I only keep the account minimum there and don’t really use the account).
In 1996 my big national bank took a chance on me and treated so nice that I intended to be a customer for life (even if their rates weren’t always the best).
When I was 16 and only had a few thousand dollars a big national bank took a chance on me and gave me a free student savings and checking account with really low minimums (like $100 or something like that). My parents had to cosign but I still thought it was cool I could have my own bank account.
It made me feel like a real adult! I loved doing business with them and the tellers were always so pleasant and nice to me even though I was a kid and didn’t have any money.
The first ten years were great and I remained a happy customer until 2006 when I finished grad school and they started to be increasingly annoying cross sellers of products
Now part of this may have to do with the fact that I left my “nice” central valley town and my “nice” college campus where students were the tellers and now I was in San Diego. The other part of it may be that I got a job and so now I looked like a better banking customer.
It started gradually at first. Every second or third time I went in there they would try to push a product like a CD or higher yielding account. I wasn’t mad at them; we all have to make a living. I always politely declined but I started to find the increasing frequency of the pitches annoying.
By 2007 and 2008 they were full on aggressive pitchers of crappy products
A few years into the workforce the bankers got a lot more aggressive. Every time I went in they pitched a CD or a high yield account and when I said no thanks they seriously would not shut up (asking me question like “why not” constantly). All I wanted was to deposit my check and get on with my day and I started to dread dealing with the tellers. At this point they were starting to really frustrate me. They got to use my money for cheap and if I said no they should drop it – not act like a used car salesman who isn’t going to eat tonight if I don’t buy your crappy product.
Then three experiences caused me to fall out of love with my big national bank
In the subsequent few years three things happened that really pissed me off. I’m a pretty even keeled guy and loyal customer so it’s actually super hard to upset me. But I do expect things to work because that is why I’m using your business.
The first thing that happened when I was signing up for a credit card is one of the bankers literally insulted me (while I was buying a product which is mind blowing). I couldn’t help but think how far my big national bank was in 2006 from the nice friendly place they were in 1996. At the brokerage firm I was at you’d get fired on the spot if you ever insulted a customer (who insults their customer??). The people they were hiring seemed to have been found under a rock somewhere, which is a far cry from how awesome they were in the 1990’s.
The second thing that happened was I got a credit card from them, which never ever worked. I’ve had credit cards from other companies before and after but I’ve literally never had a credit card that gets rejected everywhere I used it. I called the help line on the back of the credit card, went in to see the personal banker three different times and no one could fix it. I probably sunk 15 hours of my life into getting this fixed. Worse yet, no one seemed to care. The bank swore the credit card was working despite me telling them otherwise. Then one day I got an impersonal letter in the mail saying my credit card was being cancelled due to non-use. WTF.
The third thing happened two years ago right before my wife and I got married. I was pissed about the credit card thing and the constant high pressure up sales tactics when I’m just trying to deposit a check (it felt like depositing a check at a used car dealership to me) so I had moved most of my money away from the bank to a brokerage firm with better service. My wife had a pretty decent chunk of change there though.
We tried to create a joint checking account (we each had individual accounts already) and link some of our accounts and not others. In legal terms, this is a called not commingling your assets to maintain some separate property assets. So they title the accounts and guess what – they comingled our money against our specific instructions! Worse yet they couldn’t figure out how to fix the problem. We finally just said screw it; we won’t have a joint account because it was beyond the ability of the bank to set up something basic like this. This isn’t rocket science – it’s bank accounts – but it was beyond their ability to handle at the time.
When we fired our big national bank the 24-year-old banker was shocked. He asked me who got our business and asked if it was Chase (it wasn’t).
What is funny is that if you asked me in 1996, if I would ever leave my big national bank the answer would have been a resounding no. They gave me an account when not everyone would and I was naturally loyal to them. But we all have a job to do and messing up the basic job of banking, combined with giving my products that didn’t work, combined with insulting me, combined with giving me the high pressure sales tactic to buy their crappy 0.20% “high yield” savings account finally got them fired. I’m probably more patient than other people.
So in 2014 for the first time since 1996 – we really looked at the banking sector with fresh eyes, asked around, read yelp, and decided for the first time in our lives to join a credit union…
It was one of the best decisions we’ve ever made.
Credit unions today are like the banks of the 1990’s. In a credit union:
Everyone is friendly and helpful and they don’t try to cross sell you to death every time you make a deposit
The account is free as long as you get online statements and it links up well with other investment tools including online banks, brokerages, venmo ect.
They have safe deposit boxes, issue loans, have credit cards and everything you find at your big national bank
They are happy to have your business and they treat you like family
You can link it to a high yield savings account from another bank and sweep money in and out in order to earn higher interest on your savings in a seamless process
The most critical thing is how they treat you. I call big national banks financial wife beaters – they give someone a crap sandwich and them tell them how lucky they are to be eating crap. Is it good? Would you like seconds? Just for you, we have an extra special 0.02% interest savings account, you just need to deposit $100k and do direct deposit and make three brokerage trades every day.
Wife beaters survive by convincing otherwise good people that they aren’t worth anything and they should accept a crappy deal. We didn’t realize how bad of a deal we were getting until we looked at the alternatives. You should look at the alternatives :)
But guess what…everyone’s banking is identical to everyone else’s banking. An online bank’s checks clear just as well and do a credit union’s. The safe is just as secure at a credit union as anywhere else. Things work just as smoothly at online banks (often more smoothly) than they do at the big national banking behemoths.
Finally, a credit union will give you higher rates on your checking (or no minimums) and lower interest on your loans. They will buy your car for you, they will give you financial seminars for free, they’ll always be helpful and they actually seem happy to have your business.
So basically, I’m now a huge fan of credit unions. Even though I’ve only been with them for two years I think they are phenomenal. If your bank is being the slightest bit annoying stop by and check out your local credit union. They are some much better!
By the way here is the link for local credit unions in San Diego. https://www.nerdwallet.com/rates/savings-account?bank_type=CU&deposit_minimum=999&page=1&sort_key=apy&sort_order=desc&zip_code=92122
I can’t encourage you enough to check them out…
Two common investment myths to watch out for: 1) diversification is a free lunch and 2) static asset allocations won’t occasionally make you the turkey in the middle of a turkey shoot
By Daniel Harris, RIA, Friday August 12, 2016
I went to Vegas with some friends who were regular gamblers. I’ll never forget one of the gamblers telling me about their strategy of hot and cold slot machines and how to ensure you win. These machines are electronic and run on random number generators but it just showed me how much people will believe in whatever they want to believe.
I find that one of the hardest things about being an investor is separating myth from facts. I spend a ton of time each year doing that as I rigorously test the academic knowledge and practical advice that pours into the investment world each year.
We have two myths that are pervasive right now. The first is about risk free diversification and the second is about static asset allocations. Let me show you why these are myths and not facts.
Is diversification risk free?
I define “risk” as you not meeting your financial goals whether it be because you: 1) lose your money on investments 2) don’t make enough money on your investments or 3) lose your money in a noninvestment related catastrophe. I really think this characterizes how people actually use their money and what risk is to them in real life.
The important thing to understand about diversification is that it almost always decreases the productivity (investment return) of your money. You often have to work 20-30% harder or save up 2x-5x as much to make up for excessively diversifying your investments. It’s like running the 100 meters with an open parachute on your back, into the wind.
What is excessive diversification? It depends on you and your personal goals, but most diversification I see comes from people’s hedging because they just aren’t sure what to do. This uncertainty is so costly in lost efficiency that they could keep a paid ten person entourage and one reasonable investment advisor charging them fees each and every year and they’d still be better off with all that overhead than allocating assets themselves in such a really hedged way.
This is a very costly strategy because their good options are starved of resources while their bad options are given a relative abundance of resources. The costs usually are in the several hundred thousand dollar range in lost efficiency if not in the millions, from what I’ve seen.
In contrast, precise diversification, tailored as closely as possible to your actual needs is the way to go, in my view. Think of it like insurance – you buy what you need based off what types of losses you feel you can handle and not a penny more. Unlike in insurance, most losses in investments, as a basket, are just temporary so long as you don’t sell out at the bottom.
Are Static Asset Allocations Better?
A static asset allocation says that I’m going to own 70% stocks and 30% bonds no matter what the price of those assets are and no matter how my goals evolve over time.
For military history buffs, static asset allocations suffer from what I call the Battle of the Somme Syndrome. This is where used old tactics against new weapons and managed to suffer 1 million casualties in 5 months (57,000 casualties on the first day alone).
Whether it be real estate, tech stocks, conglomerates, oil companies, government bonds, Japanese stocks, emerging markets stocks – you have to recognize when you are seeing unprecedented change and not blindly apply precedent to those historically unique situations. More money is lost in not recognizing a Battle of the Somme than has ever been lost through excessive fees, fraud, or any other complaint I’ve ever heard about the financial industry. Cyclical after cyclical investors get brutalized by Battle of the Somme type situations.
The problem with a static allocation is the same thing that went wrong in the Battle of the Somme. If the situation changes you have to have your approach or you end up like a guy in no man’s land between two trenches facing down a machine gun. You are totally exposed and that isn’t something I want to see happen to you.
As investors, if we are not very conscious of what is going on around us we can very easily get exposed like this and be on the wrong side of a giant turkey shoot.
The either/or fallacy
Some people may argue that if you don’t think diversification is a free lunch and you don’t believe in asset allocations that you pick when you are young and you implement regardless of market conditions then you must be a “market timer” or an “active manager” or some other thing that sounds derogatory. Don’t fall for it. The world isn’t black and white like that.
Investing is incredibly profitable but it is also full or peril for investors who chose to be comatose while they do it. I sort of view it like the guy in the into the wilderness movie – without the starving part. If you make a mistake you can really hurt yourself and you have to be highly careful to not fall into these traps. I wouldn’t lie to you about this – this stuff is really hard. However, it is no more challenging and a lot more lucrative than other forms of investing when you do it right.
That respect for the inherent dangers (and benefits of investing) will, in my view, keep you from having as bad of losses or from stunting the growth of your investments too much. I find investing to be one of the most technically challenging fields I’ve ever worked in, in part, because the rules are constantly changing as people’s behavior adopts to the positive and negative feedback they get from the investment markets.
With that said if you are willing to invest in yourself by giving your time or money to learn this stuff or be educated in it, and you have a fairly normal temperament, I think you can knock the lights out with your investments. They can be so much more productive than a lot of people ever dream so it’s worth your time to really invest in yourself and optimize this part of your life.
Should you buy a second home or rent out your old home that you don’t live in anymore?
By Daniel Harris, RIA, Sunday August 7, 2016
Many of us know people who own two homes – sometimes intentionally and sometimes by circumstance. Does it make sense to do so? If you are considering buying one is it a financially sound thing to do?
Your primary home really shouldn’t be thought of as an investment. The reason is that there is usually no capital appreciation when you account for inflation, maintenance and property taxes. Also, if it were an investment you would rent it to someone else and produce passive income but rather you live in it yourself and so it produces no income. That’s normal, but it’s also why a home isn’t usually considered an investment.
The second home is a quagmire that people often find themselves in by accident. Many times it was someone’s starter home or they moved and they just kept it. Their reasoning is that it is cash flow positive and pays the mortgage so why not keep it? There is a considerable degree of nostalgia and good memories from an old home even though when you rent it out you don’t have the right to use it anymore.
Most people recognize that a second home is a hard way to make money. Here are the reasons why:
1) Most people have to use property managers who charge 8-9% of gross rent for a normal annual rental or 20-30% of gross rent for vacation rentals.
2) The down payment and the part of the mortgage you personally paid for stays tied up in the property and there is a big opportunity cost in losing the use of that money.
3) There is no economy of scale in maintenance or property management because you just have one unit. In real estate the more units you have per property manager the higher the return. So a one-unit real estate investment is often the lowest returning type of real estate asset (often earning little more than a treasury bond over it’s lifetime).
Nonetheless, there are some benefits to a second home.
1) As long as you never sell the home or keep on doing 1031 exchanges every five years or so you may be able to spend the income in produces without paying any taxes. A 1031 exchange allows you to buy a similar but more valuable property without having to pay capital gains tax.
People use 1031 exchanges to reset the depreciation clock to 100%, which allows them to shield their rental income from taxes. If you ever sell the property don’t buy a new one you have to pay all that money back at 25% Federal “recapture” rates, which are 5% above the long-term capital gains rate. So it only works if you never recapture the depreciation. Interestingly, the evidence suggests most professional investors do frequent 1031 exchanges and have very little accrued depreciation in their property (often 6 years or less of depreciation).
A 1031 exchange is explained in plain English here: https://en.wikipedia.org/wiki/Internal_Revenue_Code_section_1031
And also by the IRS here:
2) If you don’t mind leverage you can control a lot of property without a lot of money. However, most professional real estate investors don’t do this. Most try to keep their borrowing to 40-70% of the real estate’s asset value. In every recession people lose their shirts by over borrowing in real estate and you need to be able to have reasonable debt levels that you can pay even if there is some vacancy.
So what is the take away on second homes?
1) In general second homes often make subpar investments, which is why most millionaires shun them. They cost more to manage and rent then almost any other asset. And of course, if you want more real estate in your portfolio you can always buy a real estate investment trust which gives the best properties in town and no one is going to call you up at 2 am when their toilet is overflowing. Avoiding that 2am call is worth something to a lot of people.
2) However, if you don’t mind the 2am call about the overflowing toilet I’d encourage you to have high (REIT like) standards. In today’s environment that means that your real estate portfolio should produce an 8.6% profit pretax or 4.3% after tax. That’s what you can earn from a REIT currently.
3) Try to keep your debt levels low at 40-70% over time. If you have low debt levels in a good market it means that you can have dry powder to buy into a bad market when prices will be suppressed.
4) If this is an investment, consider using the 1031 exchange frequently. When you’ve owned a property for five to ten years you should consider a 1031 exchange for a better property. This resets the tax clock to 100% and allows you to collect the income tax free. Of course this is a rough rule of thumb and not an exact science. But don’t buy unless you expect 10% (price not rent) appreciation in the next 5 years.
5) If you are looking at a second home as a vacation home know that many millionaires don’t own second homes but rent their vacation properties. The reason is that unless you use them all the time, they are usually cheaper to rent than to own. However, if you would use it for at least once a month for decades on end it may be cheaper to buy. Owning a vacation home is best when it is nearby and you can use it all the time, otherwise the research suggests it is much better to rent.
If you have any questions about real estate feel free to get in touch with me. These are of course my opinions, and you should do your own research and make your own decisions about what makes sense for you.
Second Quarter in the Markets
By Daniel Harris, RIA, Friday July 15, 2016
Without garnering much fanfare, 2016 has unquestionably been the year of the commodity and the emerging markets. While US stocks have had a respectable 6.96% gain this year, precious metal stocks are up 88%, Brazilian stocks are up 56% and oil & natural gas stocks are up 16%. A diversified U.S. stock index fund is way behind other investors who invested in emerging markets and commodities.
As you can see, 2016 has been all about inflationary assets (commodities, emerging market stocks, real estate etc.) Part of this isn’t surprising. Some of these assets are overvalued and unlikely to hold their gains and some of them are undervalued and likely to create even more gains for investors. For the overvalued assets it could take ten years to get back to their current prices and for the undervalued ones, they could easily double or triple in the next decade.
The economy is doing great with home prices going up, inflation staying down and the leading economic indicators signaling continued growth of this economic expansion. Personal savings rates were up significantly through March but have been falling since then – which may be a sign that people are feeling better about the recent performance of their portfolios.
Home prices are up by about 5% nationally this year and now within 3% of their June 2006 high when you adjust for inflation. On the one hand this a good thing because it represents a lot of people’s biggest asset and it makes people feel richer.
Inflation continues to be well beneath the historical average of 2.9%. Inflation in the last year has been about 1.05% as measured by the consumer price index. Consumer prices fell through the holiday to February but have been on an upswing since them having gone up at an annualized pace of 3.74% since February.
Leading Economic Indicators are still positive
The leading economic indicators, a test of things that predict future economic growth are still positive having grown by about 1.4% at their last measurement. In general, it’s rare to see recessions until the leading economic indicators show a growth rate of less than 1%. So this period of economic growth looks like it will last for at least one more quarter and perhaps much longer.
Increased Savings Rates
People are saving more and are currently saving about 5.3% of their income. This is down from about 6% in March but is still a much higher rate than is typical for investors in the last three to four years.
Tax & Legal Update
There are only two major changes on the tax and legal front in the second quarter. First, the Department of Labor passed the Fiduciary Rule for 401(k) plans which means that participants can’t be forced into binding arbitration in their 401(k)’s and employers are more liable for breach of fiduciary duty due to not pursuing low fee providers for their retirement plans.
This will likely be a boon for the lawyers: http://www.bloomberg.com/news/articles/2016-07-08/your-401-k-fees-are-attracting-more-attention-from-lawyers
Plan Sponsors and fiduciaries have to be very careful about the DOL’s new regulations in this area because as I understand it a fiduciary is personally responsible under ERISA and the corporate shield is generally not thought to protect you. This may have a chilling effect on employers offering 401(k) plans but since the owners and managers are often the biggest beneficiaries of these tax shielding structures they have the most to gain by keeping fees low and making sure their investment options are good. If your plan was set up many years ago and you haven’t looked at your investment options, you might be at risk for personal liability for not having reasonable fees on your plan. You may want to get it looked at by an independent source like your accountant or our firm to give you an idea of whether your fees are reasonable compared to comparable plans.
The second change is that the 529A, which is a tax advantaged instrument where you can put up to $100k in over time to pay for a child’s special needs (in lieu of a special needs trust) has been expanded to allow you to use any state’s plan as opposed to only your own state’s plan. The benefit of the 529A is that it is a lot less costly to administer than a special needs trust. The disadvantage is that Medicare can recover money from a 529A after the death of an owner, which in general it cannot do against a properly set up special needs trust.
As always, if you’d like to discuss how these changes impact your personal situation you know where to find me.
The Evolution of Indexing
By Daniel Harris, RIA Tuesday July 12, 2016
There is a funny saying in investing which basically says that when there is a good idea – the innovators will see it first and take advantage of it reaping most of the gains for themselves.
Next come the imitators, quick to realize someone else is making a good profit on something they will surely copy. They’ll make less money than the innovators because the best opportunities are picked over but they’ll still make some money.
Then come the people who don't really understand the idea but heard other people made money doing it so they want to do it themselves. Whether it be tech stocks in the 1990's, real estate in the mid 2000's, commodities and emerging markets in the mid 2000's this is a trend we see over and over again as financial advisors.
My concern is that I'm starting to see people adopt indexing without understanding it well. I hear things like passive management is better (indexing is passive to the fund company but not to the investor because you have to chose an index - an active decision), expenses eat up your whole portfolio (this is true only of in class comparisons of two portfolios that own the exact same assets, but not true generally as you'll see below), turnover in portfolios is a big deal (similar to expenses this is true for in class comparisons but not true generally).
These arguments remind me of what I heard in the late 1990's about tech stocks ("it's a new economy and stocks are set for permanently higher valuations", or "stocks have never had a losing decade in the US") about real estate in the mid 2000's ("I'm going to retire on my home equity", "home prices only go up" or "home prices can never fall more than 20%"), and about emerging markets and commodities in the mid to late 2000's ("emerging markets are growing faster so their stocks will be worth more" or "the world isn't creating any more oil so prices will only go up"). Do you remember these arguments from times past? I don't mean to be mean, but at the time I heard these arguments I was really suspicious of them, just as I am of the arguments from the latest adopters of indexing.
People who I know who were indexers ten years ago were true innovators, those who jumped on board later were perhaps imitators, and I have true concerns about the latest converts to the movement.
What does the academic research say about indexing?
It's well established in the academic research that amongst assets with an identical investment manadate (in class comparisons), say large capitalization US growth stocks, the best performing funds over a ten year period will be those with 1) the lowest expenses 2) the right type of companies (small or large) and 3) the lowest turnover.
But it's important to note that these distinctions are all "in class" and not between all investment classes. If you compared different types of assets expenses ratios and turnover would be poor predictors of outcomes. Other factors would be much more predictive including asset classes and features of those asset classes at the time of investment.
But don't take my word for it - let's look objectively at the low price funds at Vanguard and the best performing funds at Vanguard and see how they match up over a ten year period. If expense ratios are a panacea, we'd expect the 14 funds listed first to be the first fourteen funds in the second list. In truth, only 20% of Vanguard's inexpensive funds made the list of their top performing funds. 80% of the top performers were expensive funds by Vanguard's standards. The very cheapest funds the S&P 500 fund and the TSM fund didn't make the list of top performers. Here is the data below:
Vanguard's cheapest funds in annual expense ratio (14 funds all under 0.08% in annual expenses)
1) Vanguard 500 Index (S&P 500) Admiral Shares (VFIAX): 0.05%
2) Vanguard Total Stock Market Index Admiral Shares (VTSAX): 0.05%
3) Vanguard Total Bond Market Index Admiral Shares (VBTLX): 0.06%
4) Vanguard Short Term Inflation Protected Securities Index Admiral Shares (VTAPX): 0.08%
5) Vanguard Balanced Index Admiral Shares (VBIAX): 0.08%
6) Vanguard Growth Index Admiral Shares (VIGAX): 0.08%
7) Vanguard Large Cap Index Admiral Shares (VLCAX): 0.08%
8) Vanguard Value Index Admiral Shares (VVIAX): 0.08%
9) Vanguard Mid Cap Growth Index Admiral Shares (VMGMX): 0.08%
10) Vanguard Mid Cap Index Admiral Shares (VIMAX): 0.08%
11) Vanguard Mid Cap Value Index Admiral Shares (VMVAX): 0.08%
12) Vanguard Small Cap Growth Index Admiral Shares (VSGAX): 0.08%
13) Vanguard Small Cap Index Admiral Shares (VSMAX): 0.08%
14) Vanguard Small Cap Value Index Admiral Shares (VSIAX): 0.08%
Average expense ratio of the 14 least expensive funds at Vanguard: 0.07% per year
Vanguard's 10 Year Top performings Funds have an average expense ratio of 0.26% (low price funds (ER < 0.09%) listed in bold, high priced funds not in bold)
1) Vanguard Health Care Fund (VGHCX): 11.71% return (0.36% expense ratio)
2) Vanguard Dividend Growth Fund (VDIGX): 9.08% return (0.33% expense ratio)
3) Vanguard PRIMECAP Admiral Shares (VPMAX): 8.99% return (0.34% expense ratio)
4) Vanguard Capital Opportunity Admiral Shares (VHCAX): 8.88% return (0.38% expense ratio)
5) Vanguard PRIMECAP Core (VPCCX): 8.85% return (0.47% expense ratio)
6) Vanguard Growth Index Admiral Shares (VIGAX): 8.67% return (0.08% expense ratio)
7) Vanguard Long Term Treasury (VUSTX): 8.54% return (0.20% expense ratio)
8) Vanguard Long Term Investment Grade (VWESX): 8.4% return (0.21% expense ratio)
9) Vanguard Long Term Bond Index (VBLTX): 8.38% return (0.16% expense ratio)
10) Vanguard Equity Income (VEIPX): 8.11% return (0.26% expense ratio)
11) Vanguard Tax Managed Small Cap Admiral Shares (VTMSX): 7.89% return (0.11% expense ratio)
12) Vanguard Mid Cap Index Admiral Shares (VIMAX): 7.80% (0.08% expense ratio)
13) Vanguard US Growth (VWUSX): 7.76% return (0.47% expense ratio)
14) Vanguard Mid Cap Growth ((VMGRX): 7.75% return (0.43% expense ratio)
15) Vanguard Small Cap Index Admiral Shares (VSMAX): 7.75% return (0.08% expense ratio)
Average expense ratio of Vanguard's 15 best performing funds (net of fees) in the last decade: 0.26% per year
Percent of top performing funds that were not the lowest cost index funds: 80%
Percent of top performing funds that were the lowest cost index funds: 20%
If expense ratios are so predictive why did Vanguard's high priced funds do better than Vanguard's low priced funds? What gives?
The lesson I hope you take away from this is that saving on fees is no panacea if you compare across asset classes (as you should). No one disputes, John Bogle's innovative argument that within an asset class the low price leader will win. This means if you want to own the S&P 500 you'll be better off using Vanguard's fund at 0.05% as opposed to State Street's Fund at 0.09% per year. That 0.04% per year difference will accrue to you every year - giving you more money over time.
But Bogle never uses between asset class arguments, because the evidence doesn't support his claims that low price is always better. I suspect he doesn't do it because he's an honest guy and he knows that characteristics of the underlying assets have a bigger impact than expense ratios over both short and long period of times. The Vanguard revolution is limited to within asset class comparisons and so it's impact is much smaller than people assume. In other words, a 0.08% fund of a low productivity asset class is not expected to do better than a 0.42% fee fund in a high productivity asset class. This is true over 5 years, 10 years, 15 years, 25 years, or even 50 years.
Even with the benefit of indexing at the fund level, the investor is still stuck with the unenviable decision to decide which asset classes to invest in. If the underlying asset characteristics are unfavorable (as the S&P 500 was in 2006) it doesn't matter that the fund expense ratio was cheap - you end up far worse off investing in it than you may be from investing in more expensive asset classes. This is a warning to investors to first check the characteristics of the asset and then the expense ratio of the fund, and not the other way around. I fear far too few new indexers are going through all the proper steps before investing and I'm concerned that similar to investors in tech stocks in the 1990's, real estate in the 2000's and emerging markets and commodities in the mid 2000's - these investors are likely to get burned because they are not paying enough attention to the context in which they are investing.
What is the take away?
My advice is not to assume indexing solves all your problems - and make sure to be very aware of your environment when you do it. Specifically, I would recommend focusing on four questions:
1) If I buy this asset can I realistically expect to sell it to another investor for a profit above the price I paid for it even in less than favorable market conditions?
2) Is this index the one the offers me the best risk and return profile given my needs and the current market conditions?
3) How long do I intend to own this index and is this the optimal index for that holding period?
4) If the market turns against me and my index falls out of favor with other investors, how long will I have to wait, based on historical experience, for me to get back to even in inflation adjusted dollars?
If you approach indexing through this lens, I'm confident that your investing decisions can be more disciplined and that you will be less likely to fall into the trap that a new investment approach can solve all your problems. For people who have been around a little bit like me, I know investment flavors of the week come and go (indexing is not a flavor of the week but considering expense ratios only is). It may be old fashioned, but being a fundamentally sound investor means that you buy things that you can likely sell to others at a profit and you reduce your risk by paying a price that is reasonable considering what you are getting.
WSJ Reports: US Ten Year Treasury Bonds are more expensive than at any point since 1790
By Daniel Harris, RIA, Friday July 8, 2016
The Wall Street Journal had a great article out this week detailing how the US Treasury yields are at their lowest level since the birth of the republic. You can read the article here: http://www.wsj.com/articles/treasury-yields-hit-historic-lows-amid-brexit-fallout-1467414740
This is what I call a Robertson Stevens moment. For those of you alive for the tech crash in the late 1990’s there was an investment bank named Robertson Stephens. Robertson Stephens was a San Francisco based investment bank that was involved in the IPO craze and did 74 tech IPO’s worth about $5.5 billion in 1999. By 2002 they were out of business.
I’ll always remember them because my sister was at Stanford at the same time as this craze and they gave the econ majors in the late 1990’s a bunch of shirts that ironically said “no thanks old economy – we’ll take it from here.” The hubris I saw in the tech bubble is the same thing we see today in the bond market – and many people are ignoring it to their likely financial detriment.
My sister had that shirt for years and it always served as a reminder to me to step back and look at what is actually happening around you instead of assuming that it all makes sense. Ask yourself this question: does it really make sense that this is happening? When something stops making sense you usually are going to make money from it or lose money from it and it’s important to realize which of those two things are going to happen to you.
The current in vogue theory in academic circles is something the capital asset pricing model. It’s been the predominant way to look at government bonds since the 1980’s. The concept assumes that under no circumstances can a treasury bond ever be expected to lose money. In fact, they have a special word for it – it’s called a “risk free” asset.
You shouldn’t buy into this theory just because an economist came up with it – it’s been shown to be empirically false. Nonetheless, it’s still sort of a prevailing view in the same way that houses were viewed as a “safe investment” in the mid 2000’s even though an empirical analysis would show the buyers couldn’t really make the payments once the teaser rates went away.
The concept is based somewhat in reality just in the same way the Robertson Stephens business model wasn’t based off pure fairy dust. The internet was a big thing and it did change the world and make it more productive. What it didn’t do was eliminate a fundamental rule of business that you have to make a profit for the owner to win – and the absence of those profits caused Robertson Stephens and many of their former IPO companies to collapse and leave the owners with nothing.
The same was true with mortgages in the mid 2000’s. Historically home prices did not fall more than 20% and so they assumed it couldn’t happen. Of course, the reason why it never happened is because historically you had tight underwriting standards, verified people’s income, made them put 20% down and that made the asset class stable. In an environment of liar loans, no underwriting standards, no money down and teaser rates that dominated the early 2000 real estate market it was obvious why the asset didn’t perform the same.
I believe we are in the third iteration of this in the last two decades. We’re are having a Robertson Stephens moment where we want to believe in the government because we want to believe in an authority that can demystify a seemingly complicated system. But perhaps we aren’t listening to the right authority.
The government bond market has historically been secure because taxes are a sure thing (and they still are), government generally kept their borrowing levels down except during war and interest rates tended to be slightly higher than the long term rate of inflation. However, with insufficient protection against inflation due to low interest rates and high bond prices you could end up losing money on your treasuries. Moreover, many central banks have negative interest rates so it’s a guarantee that you’ll lose money on those bonds unless there is really high deflation.
The worst part of this situation is that governments themselves are one of the biggest owners of treasury bonds and since they are leveraged 77 to 1 it only takes a 1.29% decline in the value of their holdings (which can be caused by inflation) for the central banks to be insolvent. The presumption the treasuries are risk free has to be right or else the central banks can collapse – because they’ve built their risk profiles on this very assumption.
Like technology and housing before it – our financial system is built around our assumptions of risk. If we assume treasury bonds can’t lose money, then we will take all kinds of risks in owning them. If we assume they can lose money, we will be cautious and not use too much leverage.
The lowest bond rates in our history (also the highest bond prices because the yields and bond prices are inversely related) is a big deal. For retirees this will have big consequences but it could also hurt banks and governments as well. As an investor, it forces us to reconsider what we consider to be safe assets and invest accordingly.
If you want to know how this applies to your personal situation you know where to find me.
Why invest in growth assets anyways?
By Daniel Harris, RIA, Saturday June 25, 2016
The biggest risk in investing is not that your portfolio will fall in value, it’s that you’ll run out of money. If you’ve ever spent time with people in their 80’s or 90’s you’ll find that some of them actually have run out of money and have to live pretty spartan lives to get by on social security and the modest amount of income their annuity of small portfolio throws off.
The best defense to this surprisingly common problem is investing in growth assets. Many growth assets compound at 5% higher per year than defensive assets and 7% above the long-term rate of inflation.
Below is an example of what you would have investing in defensive assets and what you would have investing in growth assets. The example assumes $100k is invested and no additional money is ever added. The number on the left is what you would have investing in defensive assets and growing the money at 2% above inflation and the number on the right is what you would have investing in growth assets at 7% above the rate of inflation. The important thing to note is that even if a growth asset loses 80-90% of it’s value it would still be worth more than the defensive over a long period of time.
5 Years: $110,408/$140,255
10 years: $121,899/$196,715
15 Years: $134,586/$275,903
20 Years: $148,594/$386,968
25 Years: $164,060/$542,743
30 Years: $181,136/$761,225
35 Years: $199,988/$1,067,658
40 Years: $220,804/$1,497,445
45 Years: $243,785/$2,110,245
50 Years: $269,158/$2,945,702
55 Years: $297,17/$4,131,500
60 Years: $328,103/$5,794,642
65 Years: $362,252/$8,127,286
70 Years: $399,955/$11,398,939
75 Years: $441,584/$15,987,601
80 Years: $487,543/$22,423,438
Now most of us won’t live to invest for 80 years, but because you can stretch IRAs and other instruments it’s not unreasonable for our portfolio to last our children’s lifetime. If we don’t need it they can use it and, if we do need it, growth assets help ensure that we won’t run out of money. So it is a win-win situation to have a growth mindset for long-term investments.
To simplify things, the compound rate of growth in your portfolio is the most important thing provided that you’ve structured your portfolio in a way that you have adequate cash and diversification for your short term financial needs.
Investing in growth assets is not easy. The reason is that there is a lot of competition for these assets and you usually have to be aware and move quickly to obtain them at good prices. There are two things you can do to increase your odds. The first is you can identify what makes a growth asset and constantly find them for your portfolio. This is not a set it and forget it strategy -- it takes substantial work because markets are always evolving. The second thing you can do is you can just find someone who already knows the answer and for a fee that equals a small portion of the extra gains you’ll likely obtain they can just do it for you. But in either case, it’s very important to focus on growth assets because even if they suffered a catastrophic loss at some point – you’ll usually have more money investing in growth assets as opposed to defensive assets over time.
Should you be worried about the Brexit?
By Daniel Harris, RIA, Friday June 24, 2016
The other day a client asked me whether we should be hedging around our positions due to the Brexit. The short answer is no – the Brexit is unlikely to have any long-term impacts on your portfolio and here is why. When you break down how stock markets work you’ll see why I say that with such confidence.
The first reason is customer behavior is historically very sticky and macroeconomic trends have a surprisingly small impact on where customers spend their dollars. Stock markets are made up of individual companies and, generally speaking, if those companies do well the stock market as a whole does well over long periods of time.
Take a look at some of the major companies on the British stock exchange: BP, Unilever (the makers of Dove and Tresemee shampoo, Ben and Jerry’s Ice Cream, Lipton Ice Tea and Vaseline), HSBC, GlaxoSmithKline (which makes Advair to treat Asthma, Avodart to treat erectile dysfunction, Flovent to treat Crohn’s disease and ulcerative colitis, Augmentin to treat bacterial infections, Lovaza to reduce triglycerides in your bloodstream and reduce heart attacks, and Lamictal to reduce seizures for people with epilepsy).
If you have Epilepsy or Crohn’s disease are you really going to want to switch your medication and deal with the side effects to save a few dollars? How can you be sure that the other brand’s price won’t increase at some point in the future too? Are you really going to stop using Dove Shampoo or eating Ben and Jerry’s Ice Cream if it went from $7.00 to $7.70? When is the last time you switched shampoos? Do most of us even know what we usually pay for shampoo or other small items?
These companies have brand loyalty and while there is a price where consumers will change their preferences (they’ll buy smaller cars if gas goes from $2.50 to $5.50 a gallon) it usually has to be a pretty massive price increase and has to last for at least a year before you see any meaningful change in consumer behavior.
The Brexit actually reduces the price of most British goods to many customers around the world. The pound has weakened against the dollar and the Euro making British products cheap compared to U.S. products or European products on the basis of the currency. A weak pound is good for Britain’s export market because it makes their products more price competitive.
But what about a trade war?
While there are 27 countries in the EU only 10 are in the top 30 economies in the world. There are lots of economic stragglers in the EU including: Cyprus, Greece, Romania, Bulgaria, Poland, Slovakia, Hungary, Estonia, Latvia, Lithuania and Malta. Many of the countries in the EU needed a bailout to avoid collapsing a few years ago including Ireland, Portugal, Greece, Spain and Cyprus – they are far from strong. Most EU countries have small economies with insufficient leverage to win a trade war even when working together.
There are three very important economies in the EU: Germany (#4 in the world), France (#6 in the world), and Italy (#8 in the world) and they would be capable of starting a trade war – but how would that benefit them? Moreover, the pro-European leaders of these countries have suffered drops in popularity including Angela Merkel of Germany whose popularity dropped to a four year low earlier this year according to the Telegraph, Francois Holland of France whose popularity rating is at 14% according to the Independent. It isn’t clear whether the EU will stick together and some of it’s biggest proponents are far from popular in their home countries. At the very least, starting a fight with the fifth largest economy in the world, Great Britain, doesn’t seem like it would benefit any of the EU countries.
The EU model itself is very flawed and similar to America’s first shot at forming a government amongst the former colonies – the Articles of Confederation. It is a lose connection of states with a common currency and freedom of trade and movement but no true Federal state. You know this because the immigration enforcement in Greece or Italy is a lot weaker than what you see in Britain or France. These weak forms of Federal governments can be difficult to manage and suffer from the fact that some voters may see themselves as more “British” than “European” which causes them to leave. By contrast in a true Federal state like the United States, most of us primarily identify as “Americans” as opposed to “Californians”
I don’t think you can make a bet that a trade war is more likely than more countries partially or completely leaving the EU. The EU leaders will have their hands full keeping members in given the weak political popularity of many of their supporters at home and the stubborn economic stagnation and political unrest. The economic and political environment in Europe makes it hard for the leaders to have the economic cooperation that would be necessary to wage a trade war on Britain. With Britain out, the EU now lacks a common trade union with 4 of the world’s 5 largest economies and it’s not clear who is worse off as a result – Britain or the EU.
Finally, if you’ve ever travelled to Europe you’ll know that the EU is not the only game in town. The have a separate economic union called the Schengen which has a different set of countries in it than those who are in the EU. Britain is not currently in the Schengen, but they could be if they wanted to.
In the long run, these types of surprising political events happen but despite all the news coverage they generate they usually have very few long-term impacts on your portfolio. The stocks markets have survived wars, depressions, famines, floods, political unrest and even nuclear attacks. In short, stocks have been very resilient.
The reason why markets tend to be resilient is because if the BP gas station is near your house you’ll usually keep on going there. If you like Ben and Jerry’s you’ll usually keep buying it. You already pay more to eat Ben and Jerry’s than you do to buy Safeway brand ice cream. You must like it enough to do that. As a result, you usually continue to buy your Ben and Jerry’s, or BP gas, or GlaxoSmithKline drugs – and this resilience in your preferences is the reason that the companies tend to be resilient too. Most political movements don’t usually impact companies substantially over the long term.
In business it’s the customer preference that matters and if the price of your Cherry Garcia ice cream went up substantially you are just as likely to fire your politician as you are to switch brands, in my view. As a result, companies tend to thrive over long periods of time as long as they’re good at taking care of their customer and giving their customer what they want.