Day: September 3, 2018

Are you prepared for a 55% drop?

09/03/2018 1 Comment Richard Thripp Big-Picture FI

Stocks will eventually crash. The key is to be financially and psychologically prepared to stay invested even when your 401(k) gets chopped in half, your job disappears, and your mortgage goes underwater.

Investing in the whole stock market is a great way to build wealth over the long run. But, just how long is “the long run”? As I am writing this on September 3, 2018, the U.S. stock market hit new all-time highs last week, after a bull market that has lasted, by some accounts, nearly 10 years. Today’s young investors may have no memory of the 2008 financial crisis, where the market declined by about 55%, from its peak on October 9, 2007 to the lowest point on March 9, 2009. For the unlucky who invested at the peak, it took about five years just to get back to even.

Although in the Great Depression, stocks declined by 90% and took 25 years to get back to even, it does not seem a depression of this magnitude will be repeated. However, something less severe than the Great Depression but as bad or worse as the 2008 financial crisis could occur. There is no way to time the market or figure out when it will occur, which is why sound financial advice looks at when you will need to spend your assets and decides the proportion of your assets that should be in stocks—diversified across the whole U.S. or global market.

I am a firm believer in the hypothesis that the duration of your time in the stock market is most important. When comparing investment gains over many years to those over shorter periods, the longer periods show greater gains. However, I have often wrote here that “the long run” is about 15 years or more. In fact, there is a recent example when stocks produced no real returns in a period longer than this: 1966 to 1982. Of course, if you stayed invested since 1966 you have seen tremendous real gains, but for investors then, the pain was profound because interest rates were high; you could earn 7% or even higher per year with 10-year Treasury bonds. As of this writing, the rate is only about 2.9%, which merely keeps pace with inflation.

If you believe the duration of investment is key, then if you receive a windfall, this means you should invest a lump sum proportionate to your asset allocation percentage into the whole stock market, despite the fact that we are historic market highs. At the same time, it is essential to be emotionally, financially, and logistically prepared for a 55% drop in stock valuations.

It is easy to look back on the 2008 financial crisis and ask why people sold their stocks rather than buying more and more. However, many Americans faced a triple whammy of losing their high-paying careers, having their mortgage payment go up and home value plummet, and taking a 40% or larger haircut on their 401(k)s and other investments (if any). Then, many cashed out their investments at fire-sale prices, just to delay foreclosure on their homes. Additionally, no one knew then that the recovery would happen so quickly and powerfully.

Being prepared for a 55% drop means having low overhead, such as a smaller home and older car. It means having a six- or even 12-month emergency fund to cover your living expenses, and enough money in low-risk accounts or investments. At all times, what you want to avoid is being emotionally swayed or financially compelled to liquidate your stocks during a temporary market crash.

Before Adjusting Capital Gains for Inflation, Try Interest on Savings Accounts

09/03/2018 No Comments Richard Thripp Activism

Recently, a proposal has been discussed by U.S. Treasury Secretary Mnuchin and President Trump of adjusting capital gains for inflation when it comes to taxation of those gains. This has rightly been criticized as a tax break for the rich, but what has not been widely discussed is the hypocrisy and inequity of not including savings accounts, certificates of deposits (CDs), Treasury bills and bonds, and corporate bonds, which yield “interest” instead of “capital gains,” in the inflation-adjustment proposal.

Although there are no legal restrictions preventing most Americans from investing in stocks (equities), about half do not. Reasons include more pressing financial concerns, fear of loss, and a lack of understanding of how stocks work. Therefore, adjusting capital gains for inflation will mainly be helpful to wealthier Americans.

Capital gains already have numerous tax advantages over earned income, such as:

  • No 15.3% payroll taxes (7.65% employee and 7.65% employer share)
  • If older than one year (long-term), the tax rate is much lower or even 0%
  • Long-term tax rate tops out much lower (20% instead of 37%) for high earners
  • You can choose when to incur capital gains taxes (when to sell)
  • Capital gains tend to be received by high-earners, who gain the most from these advantages because they are in high tax brackets

Presently, interest on savings accounts, CDs, T-bills/bonds, and corporate bonds is taxed at the same rate as earned income and short-term capital gains. Except certain corporate bonds, these types of investments do not yield any capital gains, but rather yield interest only. Thus, none of the above benefits of capitals gains apply. Americans, especially those with lower incomes and net worths, are more likely to put their money in savings accounts, CDs, and Treasury securities rather than stocks. Therefore, they miss out not only on the capital appreciation power of stocks, which is much greater than low-risk assets over the long term; they also miss out on preferential tax treatment that already exists. To add an inflation adjustment on top of this is ridiculous.

Some may quip that stocks do pay something similar to interest, in the form of dividends, which are taxed like earned income and short-term capital gains. This is false; for most “buy and hold” investors in index funds and many individual stocks, the vast majority of dividends are treated as “qualified” dividends which are treated not like interest, but as long-term capital gains. Again, investors in stocks get preferential treatment.

Each year, banks, the U.S. Treasury, and other firms must issue Form 1099-INT to report how much interest income you received in the prior tax year on savings accounts, CDs, T-bills/bonds, et cetera. However, we should not forget that savings accounts typically pay low interest rates—sometimes as little as 0.03% annual percentage yield (APY), with the best accounts paying no more than about 2.0% APY. If we were to adjust savings interest for inflation, which is around 2.4% presently (or 2.9% including food and energy), this would be a loss rather than income! If we adjust capital gains for inflation, shouldn’t we adjust interest too?

Logisitcal challenges aside, if we were to go a step further, offering an above-the-line deduction (like we do with student loan interest) for lost purchasing power on Americans’ savings, capital gains would still be far too advantaged.

Due to the unfairness of how interest is treated, with no consideration of inflation, some have dubbed saving money a suckers’ game. Although a majority of Americans do not understand this, investing, on the other hand, is a winners’ game. The prudent step would be for the government to begin adjusting interest income for inflation but not capital gains. Even then, investors would still be receiving highly preferential treatment as compared with savers.

The above article is also posted on Thripp.com.