Enlightened Financial Planning

Don’t Fear the Correction      July 28th, 2014

At of the end of June, the Standard & Poors 500 index has completed 32 full months without a correction of 10% or more.  We are living in a remarkably long bull market; the average time span without a full-blown correction is just 18 months.  Since the last correction in September of 2011, the S&P 500 has gained 75%, threatening the remarkable 100% advance that began in March of 2003 and lasted until the market peaked in October of 2007.

 Today, as the S&P moves near the 2,000 level, as the small cap Russell 2000 and the Nasdaq index both reach record highs, it may be a good time to prepare for that inevitable correction down the road.  It may take the market down 10% or, worse, reach the technical definition of a full market correction, which is a downward move of 20% or more.

 Prepare how?  First, it helps to recognize that every market has pullbacks, and that these are a normal part of stock market behavior.  Since the Great Recession lows in March 2009, the S&P index has experienced nine different corrections, ranging in magnitude from 6% to more than 21%. 

Second, it helps to recognize that these pullbacks are almost totally unpredictable.  Knowing there will be a pullback doesn’t tell us when or help us maximize returns.  If we take money out of the market today, on the certainty that a pullback is coming, we are just as likely to miss another year or two of upward movements as we are of sidestepping an immediate downturn.  Nor do we know how long the downturn will last.  Add in trading costs and taxes, and the decision to guess when to step out of the market, and back in gain, is not likely to add value in the long run.

 Third, recognize now that the next unpredictable correction will look blindingly obvious in hindsight.  It will seem like everybody but you knew in advance what was coming and when.  In reality, what you’ll be hearing is reporters quoting the same few people over and over again, people who confidently predicted that a downturn was nigh and turned out to be right.  Look a bit more deeply than the reporters do, and you’ll find that this small number of people had been predicting that the end was nigh over and over and over again for years.

 Finally, realize that inaction is actually taking strong and unusual action.  People who simply kept their money in stocks during each of the market downturns ended up seeing the indices reach new highs once the correction had run its course.  Strong long-term investors benefit from the incremental daily, weekly, monthly efforts of millions of workers who come into the offices, factories and warehouses and build the value of their companies. 

 People will change their opinions about what stocks are worth, but in general, over time, the value of most companies will rise to the extent that those workers add value during their workdays.  When people lose faith in that value, as they will when the next correction hits, it will put stocks on sale and give the rest of us an opportunity to buy in at lower prices–if we have the courage to separate ourselves from the herd.


By Bob Veres, publisher of Inside Information - the premier publication of financial industry trends and information for leading practitioners in the financial planning profession



Evidence for Time Diversification      July 2nd, 2014

One area where many professional advisors disagree with academics is whether stock investments tend to become less risky as you go out in time.  Advisors say that the longer you hold stocks, the more the ups and downs tend to cancel each other out, so you end up with a smaller band of outcomes than you get in any one, two or five year period.  Academics beg to disagree. They have argued that, just as it is possible to flip a coin and get 20 consecutive “heads” or “tails,” so too can an unlucky investor get a 20-year sequence of returns that crams together a series of difficult years into one unending parade of losses, something like 1917 (-18.62%), 2000 (-9.1%), 1907 (-24.21%), 2008 (-37.22%), 1876 (-14.15%), 1941 (-9.09%), 1974 (-26.95%), 1946 (-12.05%), 2002 (-22.27%), 1931(-44.20%), 1940 (-8.91%), 1884 (-12.32%), 1920 (-13.95%), 1973 (-15.03%), 1903 (-17.09%), 1966 (-10.36%), 1930 (-22.72%), 2001 (-11.98%), 1893 (-18.79%), and 1957 (-9.30%).

Based purely on U.S. data, the professional advisors seem to be getting the better of the debate, as you can see in the accompanying chart, which shows rolling returns from 1973 through mid-2009.  As you can see, the outcomes in any one year have been frighteningly hard to predict, ranging anywhere from a 60% gain to a 40% loss. But if you hold that stock portfolio for three years, the best and worst are less dramatic than the best and worst returns over one year, and the returns are flattening out gradually over 10, 15 and 20 years. No 20-year time period in this study showed a negative annual rate of return.

But this is a fairly limited data set. What happens if you look at other countries and extend this research over longer time periods? This is exactly what David Blanchett at Morningstar, Michael Finke at Texas Tech University and Wade Pfau at the American College did in a new paper, as yet unpublished, which you can find here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2320828.

The authors examined real (inflation-adjusted) historical return patterns for stocks, bonds and cash in 20 industrialized countries, each over a 113-year time period. The sample size thus represents 2,260 return years, and the authors parsed the data by individual time periods and a variety of rolling time periods, which certainly expands the sample size beyond 87 years of U.S. market behavior.

What did they find? Looking at investors with different propensities for risk, they found that in general, people experienced less risk holding more stocks over longer time periods. The only exceptions were short periods of time for investors in Italy and Australia. The effect of time-dampened returns was particularly robust in the United Kingdom, Japan, Denmark, Austria, New Zealand, South Africa and the U.S.

Overall, the authors found that a timid investor with a long-term time horizon should increase his/her equity allocation by about 2.7% for each year of that time horizon, from whatever the optimal allocation would have been for one year. The adventurous investor with low risk aversion should raise equity allocation by 1.3% a year. If that sounds backwards, consider that the timid investor started out with a much lower stock allocation than the dare-devil investor–what the authors call the “intercept” of the Y axis where the slope begins.

Does that mean that returns in the future are guaranteed to follow this pattern? Of course not. But there seems to be some mechanism that brings security prices back to some kind of “normal” long-term return. It could be explained by the fact that investors tend to be more risk-averse when valuations (represented by the P/E ratios) are most attractive (when stocks, in other words, are on sale, but investors are smarting from recent market losses), and most tolerant of risk during the later stages of bull markets (when people are sitting on significant gains). In other words, market sentiment seems to view the future opportunity backwards.

Is it possible that stocks are not really fairly priced at all times, but instead are constantly fluctuating above and below some hard-to-discern “true” or “intrinsic” value, which is rising far more steadily below the waves? That underlying growth would represent the long-term geometric investment return, more or less–or, at least, it might have a relationship with it that is not well-explored. The old saw that stocks eventually return to their real values, that the market, long-term, is a weighing machine, might be valid after all.

By Bob Veres, publisher of Inside Information – the premier publication of financial industry trends and information for leading practitioners in the financial planning profession.





The Value of Education      June 12th, 2014

Now that college graduation exercises are upon us, you are no doubt hearing reports that young people matriculating from this or that prestigious alma mater are having trouble finding jobs. The easy conclusion seems to be that a college degree doesn’t matter very much anymore in the new economy. But that, of course, is a short-term view; younger people have fewer job-related skills than people who have been employed for a few years, so they generally have trouble getting that first job no matter what their education level.

You can see this in the first chart below; older workers, who have presumably more experience in the workplace, tend to have lower unemployment rates than their younger competition. A recession like 2008-2009 simply reinforced a long-term pattern; it made the jobs situation worse for everybody. Today’s difficult job market continues to allow employers to put a premium on experience.

Longer-term, however, a college degree does seem to confer huge advantages for getting employment. Consider recent jobless statistics, broken down by education level:

Jobless rate for persons who have not earned a high school degree: 11.6%

Jobless rate for high school graduates with no college training: 7.4%

Jobless rate for persons with some college training or an associate degree: 6.4%

Jobless rate for persons who have earned a bachelor’s degree or higher: 3.9%

Longer-term, as you can see from the second chart below, people who are educated at every level tend to be less likely to be unemployed than those with lower educational attainment. The better-educated also tend to earn higher incomes over their lifetimes–the most recent statistics compiled by the Pew Research Center suggests that the average high school graduate with no further education will earn about $770,000 over a 40-year worklife, compared with $1.4 million for a worker with a bachelor’s degree.

Parents reading this article, and graduates who are paying off enormous student loans, are no doubt wondering whether Pew was able to factor in the upfront costs of getting the college degree, plus the opportunity cost of four years (or more) spent on campus rather than in the workforce. Even when these considerable costs are factored in, the net gain for a student who graduated from an in-state four-year public university is about $550,000 over a person’s worklife. The third chart shows the various disparities in yearly earnings at different ages; you can see that at age 25, the differences are not huge, but over time, college education begins to create significant income separation.

Bottom line? Ignore the gloomy reports of college graduates having trouble finding work. This has always been a problem, admittedly made worse by today’s weak job market, but not an indictment of the value of a college education. Education, as George Washington Carver once remarked, is still the golden key that unlocks the doors of opportunity.

By Bob Veres, publisher of Inside Information -the premier publication of financial industry trends and information for leading practitioners in the financial planning profession.


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Simpler College Funding      May 29th, 2014

Many Americans make contributions to Section 529 plans to help their children or (more often) their grandchildren pay for their college education.  The average balance in these plans today is a record $17,174 according to The College Savings Plans Network, and the total dollars is close to $200 billion.

 Chances are you already know about these “IRAs for college,” where the earnings can grow tax-free, and the money can be withdrawn tax-free so long as it is used for federally-approved college costs.  Each person can contribute up to $14,000 a year without triggering gift taxes, and through a special provision, you can make five years worth of contributions, moving money out of your estate into the hands of children.

 Surprisingly, not everybody thinks this is the best way to save for college.  For one thing, money in a 529 plan can count up to 5.54% of a child’s college savings in the financial aid worksheets used by most colleges and universities, which directly diminishes the potential for financial aid.  More importantly, state 529 plans tend to offer limited investment choices, and the benefits of tax-free compounding are somewhat blunted by the fact that the assets should probably be invested conservatively since they’ll typically be needed before long by the student who is entering school.  If you’re heavily invested in stocks and a 2008 hurricane blows through the investment markets, you risk leaving the college-age child with a tuition shortfall.

 Is there an alternative?  Section 2503(e) of the Internal Revenue Code provides that gifts that are made to an education provider, on behalf of kids, grandkids or any beneficiary, don’t count as taxable gifts.  So instead of putting the money into a 529 plan, you could pay the child or grandchild’s tuition directly.  No gift taxes required, no limited investment options, no money counted against the child’s need for financial assistance by the university’s endowment fund.

 As your children or grandchildren will (hopefully) learn in their philosophy or business classes, there are times when simpler is better.

Global Tax Rates      May 22nd, 2014

Tax day has arrived in the U.S., along with the usual complaints about the complexity and financial burden that federal and state taxes (and FICA) impose on our lives. But have you ever wondered how U.S. taxes compare with what citizens in other countries have to pay?

Recently, the accounting firm PricewaterhouseCooper calculated the tax burden, for tax year 2013, for people living in 19 of the G20 nations. (The 20th member is the European Union, which has a variety of tax regimes.) The report looked first at people who are in the upper-income levels–a person with a salary equivalent of $400,000, with a home mortgage of $1.2 million. After all income tax rates and Social Security (or equivalent) contributions have been taken out, what percentage of her income would this person have left over?

The people we should have the most sympathy for on our annual tax day live in Italy, where this person would get to keep $202,360 of that $400,000 income–or 50.59%. A comparable person living in India would keep 54.9%, while someone living in the United Kingdom would keep 57.28%.

Here’s the full list. Notice that the U.S. is about in the middle of the pack:

19. Italy – 50.59%

18. India – 54.90%

17. United Kingdom – 57.28%

16. France – 58.10%

15. Canada – 58.13%

14. Japan – 58.68%

13. Australia – 59.30%

12. United States – 60.45%

11. Germany – 60.61%

10. South Africa – 61.78%

9. China – 62.05%

8. Argentina – 64.02%

7. Turkey – 64.64%

6. South Korea – 65.75%

5. Indonesia – 69.78%

4. Mexico – 70.60%

3. Brazil – 73.32%

2. Russia – 87%

1. Saudi Arabia – 96.86%

Before you conclude that the U.S. is below average on this list, you should know that PricewaterhouseCoopers applied New York state (13.3%) and New York city (maximum 3.9%) taxes on the American calculation. If it had used Texas or Florida state tax rates instead, the U.S. would easily have ranked somewhere in the top ten.

And this list is somewhat skewed because so many European countries are left off it, because they are lumped into the EU. It also doesn’t include Canada, which imposes a 29% top federal tax rate on its citizens, and then tacks on a maximum 25.75% rate at the province level.

PricewaterhouseCoopers did include many of the EU countries when it calculated the tax burdens on people with average incomes, and here the list looks somewhat different. The accounting firm assumed that a hypothetical married couple, with two children, earned the average income in each nation, and then calculated the overall tax rate the family would have to pay.

Denmark – 34.8%

Austria – 31.9%

Belgium – 31.8%

Finland – 29.4%

Netherlands – 28.7%

Greece – 26.7%

United Kingdom – 24.9%

Germany – 21.3%

United States – 10.4%

South Korea – 10.2%

Slovak Republic – 10%

Mexico – 9.5%

Chile – 7%

Czech Republic – 5.6%

(China, Russia, South Korea, Indonesia and Brazil would assess 0% taxes on this hypothetical family)

Does this mean that the U.S. tax system is fair? Or equitable? It depends on your perspective. Tax rates in the U.S. have been as high as 94% on all income over $200,000 (1944-45), and as low as 28% (1988-1990), with the bulk of years coming in between 40% and 70%. Meanwhile, some countries assess more taxes from corporations than from their citizens, while some have it the other way around. And some nations are evolving. At the beginning of World War II, individuals and families paid 38% of the total federal tax burden, and corporations picked up the other 62%. Today, thanks to aggressive lobbying, corporations have turned that around and then some. Individuals and families pay 82% of today’s total federal income tax haul, and corporations pay 18%.

We should also remember that high taxes don’t necessarily correlate with economic misery or poverty. Consistently, Belgium, which had the highest tax burden on average wage-earners (and imposes a top 50% rate on upper-income citizens) also consistently scores as one of the happiest countries in the world.