Generally, the amount of time you are invested in the stock market determines your returns, with higher probabilities of positive and larger returns if you are invested longer. This distinguishes investing from gambling. However, you cannot have rewards without risk, and it is entirely possible to lose money in a quarter, year, or even a whole decade.

In 2018, we saw what many define as a “bear” market; the S&P 500 index, which contains stocks of 500 of the largest U.S. companies, reached an all-time high on September 21, 2018 (intraday high), but fell 20.06% from this peak by close of trading on December 24, 2018. Although it went up a bit in the last week of 2018, it was still down 6.2% for the year.

Market declines invite counterfactual thinking—thinking what could have been if you had timed the market correctly, selling at the peak and buying at the lowest point. But, timing the market transforms investing into gambling; no one can consistently beat a “buy and hold” approach. If you try to time the market, the odds are against you; your returns are more likely to be lower than if you had bought and held.

Even Warren Buffett cannot time the market correctly; he had long been saying stocks are over-priced and had been holding much of Berkshire Hathaway’s assets in cash, but plowed much of this cash into Apple, banks, and other stocks in 2018 Q3. However, he would have saved billions by waiting until December 2018. Similarly, corporate stock buybacks have been enormous in recent years, and in hindsight, most were poorly timed.

It is not comforting to look to gains in prior years as recompense for 2018’s losses. Even if you invested in 2009, you still lost money this year, despite tremendous gains in prior years. Many more of us who invested over the past couple years saw our accounts in the red this quarter, erasing all gains and even part of our principal—if we could go back and put the money in a savings account or even under a mattress, we would be doing better now.

To survive a bear market, holding for the long term is critical. Preparations should start in the good times, far before panic strikes. When you invest, you should kiss your money goodbye for at least a decade or preferably even longer; if you’ll need it sooner, it’s too risky to put in equities. The Bogleheads, followers of Vanguard’s founder, Jack Bogle, call this principle “never bear too much or too little risk.”

To ensure you will hold, not sell, in a bear market, you must have at least the following: (a) education, (b) mental preparation, and (c) free cash flow. Without mental preparation, even if you have financial education and funds available to cover your expenses without selling equities, you might still sell in a panic. Without free cash flow, you might be compelled to sell to cover your debts or loss of income. Without education, you might have all your money in one stock (a horrible risk), BitCoin, or with a financial “advisor” who is plundering your portfolio with fees.

Free cash flow can be generated by selling the conservative parts of your portfolio during a market downturn. Depending on how conservative these parts of your portfolio are, they might experience no erosion of principal at all—savings accounts, certificates of deposit, and Treasury bills/bonds come to mind. The idea of asset allocation is to maintain a certain percentage of your portfolio in equities; to stay at this percentage, you would automatically buy more stocks when the market is down (“rebalancing”), because equities have declined as a proportion of your portfolio.

When is timing the market appropriate? Some would say never, but the insidious form of market timing really is jumping in and out of the market instead of holding. Assuming that you are not bearing too much (or too little) risk, timing the market can be appropriate on the way in, if it would cause you to invest earlier, or on the way out, if it would cause you to divest later. Although there is a whole industry built around timing stock purchases based on variables such as price–earnings ratios and geopolitical happenings, these are not much better than astrology. Generally, the longer you are invested in an index fund of the whole stock market, the higher your returns. Therefore, the only good forms of market timing are the ones that cause you to be invested for a longer duration.

The S&P 500, which is about 80% of the U.S. stock market by valuation, returns an average of about 10% each year. Adjusting for inflation, the average real returns are around 7–8%. However, if you were to take a portfolio of 100% Vanguard Total Stock Market Index Fund and withdraw 10% of the balance each year, you could easily run into sequence-of-returns risk (or for short, sequence risk). You could get lucky and have many years of good returns at the start, but you could head toward a complete capital wipeout with a few years like 2018 (or worse, 2008) in the first decade of your experiment. Market timing, via refraining from divesting stocks during market downturns, is an essential tool for retirees, including members of the FIRE community (financial independence, retire early), to mitigate sequence risk. Because this approach to market timing involves holding (not selling) and extending the duration of doing so, it is beneficial or at least benign, rather than malignant.

Ten percent is nice, but neither spectacular nor guaranteed. A savings account can now yield you over 2% per year, guaranteed. With stocks, you might earn 10% in 2019, earn 25%, or even lose 40%. Although credit card companies lose money when people default, overall they are wildly profitable because they collect returns on debts that approach 30% per year. Before you invest, you should pay your credit card debts. Even mortgages and student loans with interest rates around 5% per year might be paid first before investing in stocks; this is a guaranteed return, while stocks may lose value. Of course, if your employer matches 50% or 100% of 401(k) contributions you should do this up to the cap before paying more than the minimum payments on your credit cards, but this is a rare example. Usually, money does not grow on trees.

Take solace. In an index fund of the whole U.S. or global stock market, your investment will not go to zero, and it will eventually come back up. On the other hand, if you have the bulk of your investments in your company’s stock, you could certainly lose everything. Even an entire market sector could get wiped out (e.g., fossil fuels). You can’t have rewards without risk, but you can have risk without rewards. An “investment” can be both risky and more likely than not to be a loser (e.g., lottery tickets). It is your responsibility to learn and know the difference, implement this knowledge, and follow through, especially in a bear market.

Continued from Part 1, here are several more terms and my definitions for them.

Financial Freedom: For Americans, at a bare minimum this should mean one can “come up with $2,000 in 30 days,” a question that Peter Tufano found only half of Americans can answer yes to. A baseline of six months’ living expenses (an “emergency fund”) is more appropriate. This gives you the freedom of not living paycheck to paycheck or being compelled to work at a bad job.

Financial Independence: I look at financial independence as a term of art meaning you have enough savings/investments to live off of in perpetuity with no earned income and no sustained drawdown of real principal. Typically, financial planners and writers say you should have about 25 times your annual expenses to do this, which is $1 million if you spend $40,000 per year. This is pretty much the same as a financial endowment at the institutional/organizational level, but instead at the personal level.

There are 329 million people in the United States (November 2018) and U.S. households and nonprofit organizations hold an aggregate net worth of $107 trillion (2018 Q2), which is about $325,000 per person if evenly distributed, or about $425,000 if only distributed among adults—enough for $17,000 per year if income at a 4% withdrawal rate.

FIRE: FIRE stands for financial independence, retire early, a grammatically convoluted acronym that indicates achieving financial independence and then exercising the option to cease having earned income (“retirement”). Of course, one can be financially independent while continuing to work, and many who “FIRE” themselves end up continuing to work on a part-time basis.

Earned Income and Unearned Income: I would just use the Internal Revenue Service (IRS) definition for these. Earned income comes from work or pre-retirement long-term disability benefits, while unearned income includes bank account interest, dividends, and capital gains (e.g., from stocks).

Securities, Stocks, and Bonds: A security is an umbrella term that encompasses equities and debts, also known as stocks and bonds. Buying “stocks” actually means buying shares of a corporation’s stock, which confers ownership and possibly shareholder voting rights. If investing in an index-tracking mutual fund or exchange-traded fund (ETF), voting rights are conferred to your custodian rather than to you (e.g., Vanguard, Fidelity, BlackRock, etc.). Corporate bonds, another type of security, represent an obligation by a corporation to repay with interest, but confer no ownership rights. Stocks are generally more profitable than bonds, but if a corporation files for bankruptcy protection, bondholders get paid first. Many argue that U.S. Treasury bonds are the best type of debt to buy, because they are backed by the full faith and credit of the U.S. government, and that the reduction in risk compared to corporate and municipal bonds outweighs the lower yield. Municipal bonds may be useful to those with higher income who are subjected to state and/or local income taxes, due to their tax-advantaged status.

Emergency Fund: An emergency fund is money that is liquid, accessible, and protected from loss of principal. This is money that you have set aside for emergencies. Because the emergency fund could be needed at any time, it usually should not be invested in stocks because stocks can experience substantial short-term declines. See “The How and Why of Emergency Funds” for more information. If you have credit cards available, most emergencies can be paid for by credit card and then repaid by the statement payment due date, without interest, as long as you have been paying the full statement balance in full each and every month (otherwise, interest begins accruing from the date of the charge). Therefore, you can use an online bank for your emergency fund with limited or no ATM/cash access and pay back the credit card using the bank account.

Inflation and Nominal and Real Value of U.S. Dollars: “Nominal” just means numbers, so when we talk about nominal returns, this means we are not adjusting for inflation. Although the Austrian school of economic thought defines inflation as an expansion of money available (e.g., the monetary supply and quantitative easing programs of the Federal Reserve), this definition is unusual and not in common use. The predominant definition/measure of inflation is based on market prices of consumer goods, represented by the U.S. Bureau of Labor Statistics’s Consumer Price Index (CPI). Nowadays, the Federal Reserve aims to achieve 2.0% inflation per year, which means prices of consumer goods should increase by 2% each year. As of November 2018, many online savings accounts are paying an annual percentage yield (APY) of 2.0%. If inflation is 2%, this means that although the nominal account balance will increase 2% in a year, the real value will remain flat. When talking about past money, it is common to use CPI data to talk about the equivalent in today’s dollars. When talking about future money, discounting returns by about 2% per year to come up with a real, present day value of future money is common. If the stock market returns 10% in nominal returns in a particular year, this is probably about 8% in real returns, due to inflation.

Here are some items I intend to define in future posts:
Market Timing, Retirement, Sequence Risk, Single-Stock Risk, Index Fund, Tax-Gain Harvesting, Mutual Fund, Exchange-Traded Fund, Diversification, Tax Brackets, Payroll Taxes, Income Taxes, Tax Avoidance, Investment Management Fees, Load Fees, Dividends, Capital Gains

Here, I will seek to define several common personal finance terms that are often conflated and misunderstood.

Financial Literacy: There is no consensus definition of financial literacy, but I would say it is mainly concerned with having financial knowledge. However, personal finance is an eclectic field; having a high level of financial literacy requires knowledge in other areas, such as behavioral economics, psychology, information literacy, law, and even nutrition. Although financial literacy is usually correlated with good financial practices, this is not a given; one can easily have expertise but fail to apply it, or succumb to believing they are exceptional and can earn more in the stock market than others, or miraculously avoid a probable, deleterious outcome.

Financial Capability: I would define this as financial literacy combined with demonstrated financial competence, which hinges on consistently making good financial decisions, given one’s available choices and opportunities. What constitutes a “good” financial decision is not always clear, but we can often put items in rank order. For example, taking a payday loan is objectively worse than taking a credit card cash advance, because payday loans have far higher interest rates. One can have financial capability but not be able to do much with it—for instance, marginalized peoples and those in adverse situations. Conversely, privileged people may squander a portion of their privilege due to low financial capability. To be financial capable, one must not only make good financial decisions but also know why their decisions are good, and why they selected them over alternative courses of action. Such expertise should result in repeated beneficent decision-making, whereas someone of low financial capability might make a good choice by chance, but is unlikely to reliably do so.

Gambling: Many people conflate gambling and investing, but they are not the same thing. I define gambling as an act or series of acts where you are more likely to lose money than not, meaning that your expected returns are negative. However, there is an exception for insurance that insures against unmanageable losses, including losses that may potentially be unlimited (e.g., health insurance). Obviously, insurance companies have to come out ahead overall, but insurance is worthwhile to insure against unlikely but highly deleterious financial events. Returning to the element of likelihood, any student of statistics knows that if you gamble $1 with a 49% probability of coming away with $2 but a 51% probability of coming away with zero, your odds of making money are close to 50:50. But, if you keep making this bet again and again, your probability of losing money overall gets closer and closer to 100%. This is how lotteries and casinos produce guaranteed profits. When you invest in a broad swath of the stock market (e.g., an S&P 500 index fund), your probability of making money on any one trading day is about 54%. However, in a given year, it is about 83%, and in a given 10-year span, it is about 91%. Assuming you don’t need the money for a long time, this is investing, not gambling. However, if you try to pick stocks or put all your money in your company’s stock, your expected return might be negative, and there is a large risk of catastrophic loss. This is gambling. A kinder word is speculating, but it is certainly not investing.

Speculating: If you pick individual stocks or even entire market sectors, you are basically speculating. Buying gold, silver, oil, or corn futures is speculation. Buying BitCoin is speculation. These assets don’t have a solid track record of producing real returns (after adjusting for inflation). Modern portfolio theory tells us that holding uncorrelated (diversified) assets can be advantageous, so it makes sense to have gold—but not more than a small percentage of your assets. Speculation is often better than gambling, but certainly worse (as a decision) than investing. Although you might have fantastic results from speculating, this just means you had the unlikely fortune of making a bad decision that resulted in a good outcome. However, if this inflates your ego, it can easily lead to future misfortunes!

Investing: Over time, investing results in a probability of real returns that approaches 100%. As Vanguard mentions, for an S&P 500 index fund, which consists of 500 of the largest U.S. public companies invested proportionate to the companies’ market valuations, your probability of positive returns on any given day is 54%, but in ten years it is 91% (based on 1988–2018 data, but others have shown similar results even going back 100+ years). Besides the stock market, one can be successful at investing in real estate, or even one’s education, as those with more education tend to be more happy and successful in life, including financial success. Of course, there is presently a student loan “crisis” going on, and it is important to avoid high-cost tuition and housing expenses while also finishing your degree. On another note, investments must have a high probability of succeeding within a reasonable timeframe, and what is investing for one person could be gambling for another based on how soon they need the money (e.g., older people should have “safer” investments meaning less risk of short- and medium-term losses and lower expected returns).

I will follow this up with a Part 2 in the near future.

Although income tax is more salient, most Americans pay more in payroll taxes. These are the Social Security and Medicare deductions you see on each paystub (a.k.a. FICA or OASDI). Income taxes are progressive, meaning taxpayers pay a progressively higher percentage of their incomes as their incomes increase. Payroll taxes, on the other hand, are regressive, meaning taxpayers pay a flat and/or decreasing percentage of their incomes as their incomes increase. This results in an unusual and unfair phenomenon where 76% of taxpaying Americans actually pay more payroll taxes than federal income taxes.

How do payroll taxes work? A fixed percentage of your gross wages are deducted by your employer each pay period, paid to the federal government. This percentage, as of 2018, is 6.2% for Social Security and 1.45% for Medicare, for a combined total of 7.65%. Many employees do not know this, but your employer also must contribute 6.2% for Social Security and 1.45% for Medicare behind-the-scenes, which is another 7.65% bringing your total tax to 15.3%. This means that when a job is advertised for $10.00 per hour, your employer actually is paying $10.77 per hour if we include their share of these taxes, and even more if we also consider unemployment tax, workers’ compensation insurance, and other obligations. Although payroll taxes do not apply to some employees and employers, such as myself as a Graduate Teaching Associate at University of Central Florida, these exceptions are uncommon.

If you are self-employed, you must pay the full 15.3% of payroll taxes out-of-pocket. This is a shock for many sole proprietors, such as freelancers. The IRS expects tax payments on a quarterly basis, rather than a lump sum after the tax year ends (if you were an employee, they would be getting the money in advance from each paycheck). Your business expenses, such as miles driven in a car, may be deducted to reduce the earned income to which payroll and income taxes apply (keeping excellent records and employing an accountant is recommended).

With income tax, nearly half of Americans get all the money back (or more) in their tax refunds. A good chunk of your income is exempt (the standard personal deduction), and tax credits, most notably the Earned Income Tax Credit, soak up whatever other tax is owed and provide a sizable refund for low- and middle-earning people who have children. This stands in stark contrast to payroll taxes, for which there is no refund. (Except in the unusual case where you had multiple employers and earned more than $128,400 [2018 cap] in combination between them, in which case you can get a refund from the IRS for the excess 6.2% Social Security tax you paid on amounts exceeding $128,400.)

The IRS, as directed by existing laws/regulations and the U.S. Congress, makes an important distinction between earned and unearned income. Earned income consists of typical employment wages, including self-employment, and is subjected to payroll taxes. Unearned income includes bank account interest, dividends, capital gains, and Social Security benefits, which are not subject to payroll taxes. With qualified dividends and capital gains, the income tax rates are lower too; about half that of ordinary, earned income. This is an enormous benefit to investors in equities (stocks), who already benefit from the huge capital gains that equities reliably provide over long periods of time. It’s also an enormous disadvantage to most Americans, who work but do not invest, and is a primary contributor to wealth inequality and disenfranchisement.

Although payment of payroll taxes is compulsory and factors into the amount of Social Security benefits you receive each month in retirement, in a U.S. Supreme Court case from 1960, it was decided that paying payroll taxes does not entitle you to anything. The plaintiff in this case was deported for being a communist, and thus his Social Security benefits were revoked despite having paid payroll taxes for 19 years, which the court upheld.

Nonetheless, most Americans can count on receiving their benefits if they survive to retirement age. However, many caution that the system will become unsustainable by the time today’s emerging adults reach retirement age. But, this is a product of tax policy: Social Security tax unfairly rewards high earners by pulling a vanishing act for wages above $128,400 per year. This means if someone earns $200,000 per year at one employer, the government collects 12.4% in Social Security tax on their first $128,400 in wages, but collects 0% on the next $71,600 of wages. Incredible. We could make Social Security solvent by eliminating the cap. Bernie Sanders suggested raising the cap to $250,000 in wages during his 2016 presidential campaign, which has been criticized as extending solvency only from 2034 to the year 2055, but removing the cap entirely would probably do the trick, while maintaining Social Security’s standing as a regressive tax. It would merely be less regressive than it is now.

With Medicare tax, which is 2.9% divided equally between employer and employee, there is already no cap. In fact, for earned income above $200,000, employees have to pay an extra 0.9%, bringing the total tax to 3.8%, and meaning the Medicare portion of payroll taxes might actually be classified as progressive. As we can see here, if removing the Social Security cap proves insufficient, there is already a precedent for having an uncapped payroll tax that also increases with higher earnings.

Because of the grossly unfair tax treatment that earned income receives, coupled with the power of investing in index funds of the whole stock market and the tax benefits one receives for doing so through lower taxes on capital gains, privileged tax treatment for retirement accounts (i.e., 401[k], 403[b], 457, IRA, thrift savings plans, etc.), and other incentives like the Retirement Savings tax credit, relying only on earned income and savings accounts is pretty much hopeless, if your goal is to achieve financial independence. This is why educating yourself (such as by reading Tippyfi) and improving your financial and investing capabilities sooner, rather than later, is critical.

Many people don’t even know where to begin when it comes to enrolling in their employer’s 401(k) or 403(b) programs, let alone choosing their investments. Here, I show an example of how one would do this at my employer, University of Central Florida (UCF).

First, you would seek out this one-page guide from UCF and choose one of three investment providers. I prefer Fidelity, which, like the others, has a portal to aid UCF employees in opening their account. After applying for an account at your chosen provider, at UCF you would complete the Salary Reduction Agreement form and submit it to the HR department. Because UCF is a public school (university), the plan is called a 403(b) instead of a 401(k), but is basically the same. When you put money into such plans, you generally cannot access it until Age 59.5 or older without incurring substantial penalties, so you should pay off high-interest debt and have a substantial emergency fund in an FDIC-insured savings account first.

The form, pictured above, has several options. First, you must decide if you want to make pre-tax (traditional) or post-tax (Roth) contributions, or a combination of the two. Generally, low earners should use post-tax (Roth) contributions because they are in a low tax bracket, while high-earners should use pre-tax (traditional) contributions to reduce their present tax burden. Second, you must choose an investment provider. UCF offers Fidelity, TIAA, and VALIC. Personally, I prefer Fidelity from these three, although I would pick Vanguard if it was available.

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