In March the financial advisors at Ruedi Wealth Management wrote 5 more “Finance 101” columns for The New-Gazette’s Business Extra section. Make sure to look for them every Sunday, but in case you missed the columns from March all five are below.
Flight to Safety
Paul R. Ruedi, CFP®
With the stock market having officially dipped into correction territory among worries about inflation and the evolving situation in Ukraine, you may have heard the financial media start to throw around another piece of financial jargon: “flight to safety.” This occurs when people become so nervous they sell riskier assets in favor of less-risky, “safe” assets. Clearly many people flee to safety when the market is down, but is that a good idea?
When investors are faced with a crisis and are worried their stock portfolio will go down, they naturally have an increasingly high preference for more stable investments. This generally results in them selling their stock holdings in order to flee to the safety of more stable bonds or cash. Fleeing to safety sounds like a sensible thing to do when faced with crisis – it brings up images of fleeing a hurricane, conflict zone, or other place where it is a good idea to leave. But fleeing to safety during an investment crisis is generally harmful to investors.
The idea of fleeing to safety and riding out a temporary decline in stocks only to repurchase those stocks once the storm has passed sounds good in theory. In practice, it is usually harmful to investors. That is because investors generally flee to safety during the midst of a crisis, at which point the value of their portfolio has already dropped. By fleeing to safety, investors turn temporary declines into actual losses.
Then comes the problem of when to buy back those stock investments. To which people generally respond that the time to get in would be “when things get better.” First of all, there likely won’t be a clear signal or specific indicator that things are better, you will be making that guess yourself one way or another. What usually happens is people end up waiting a long time and things inevitably do get better. But by that time the market has already increased. Investors who wait until things get better generally miss out on the recovery and buy back at higher prices than when they sold.
In theory fleeing to safety sounds like a good idea – and in most areas of life it is. But when it comes to investing, fleeing to safety almost always results in investors selling low, buying high, and permanently missing out on large portions of stock gains. Investors are much better off to pursue a disciplined buy and hold strategy, sticking with their investments through good times and bad.
Invest Like Ruedi Wealth Management
Paul R. Ruedi, CFP®
In the past people generally thought a financial advisor’s value was centered around selecting the right investments. At the time, a financial advisor’s investment portfolio was thought of as their “secret sauce.” But the world has changed, and decades of research has shown what works and what doesn’t as far as investing goes.
Consequently, there has been constantly increasing movement towards low-cost, well-diversified index funds across the financial advice industry. Since anyone can go out and buy these funds, the specific investment portfolio a financial advisor provides really isn’t all that special. Instead they must focus on creating value for their clients through financial planning and helping them stick with their investment portfolios.
If you want proof we don’t think our investment solution is our value, I’ll go ahead and provide the funds and percent weightings we use for the stock portion of the portfolios we use for our clients at Ruedi Wealth Management. But I want to first explain that a person really doesn’t need to complicate their life beyond a single fund if they don’t want to. A person could easily buy the low-cost and globally-diversified Vanguard Total World Stock ETF and be just fine.
Our portfolios start from the same investment philosophy as the Vanguard fund above: globally diversify across thousands of companies while keeping costs low. We primarily use two highly-diversified, broad stock market “Core” ETFs from Dimensional Fund Advisors. They are designed to slightly over-weight areas of the market that have historically provided investors with higher expected returns over long periods of time (like small companies and lower-priced value companies). On top of that, we include a slight amount in real estate for diversification purposes. When we have new client money that needs to go into stocks, we will put 66% in DFA’s US Core Equity 2 ETF (DFAC), 30% in DFA’s World EX US Core ETF (DFAX), and 4% in DFA’s US Real Estate ETF (DFAR). Since this portfolio is globally diversified and tilted towards small companies and value companies, it will behave differently than the benchmarks you see on TV.
As I mentioned earlier, this investment portfolio isn’t what we consider our value to clients. We can only provide value though planning to make the most of what that investment portfolio provides, and by helping investors stick with their portfolios during temporary declines. So feel free to consider this stock portfolio for your own investing goals. If you need help with financial planning or sticking with that portfolio, you may want to talk to a financial advisor.
Measuring Performance from Peaks
Paul A. Ruedi
I’ve noticed an interesting phenomenon tends to come up during market declines: people seem to be acutely aware of exactly how much their portfolio is down. The problem with this is they are almost always comparing their account balance now to their all-time-high account balance. If the market makes new highs around 1/3 of the time, that means it spends roughly2/3 of the time trading below all-time-highs. If you are always comparing your current account balance to its most recent high, you will feel like stocks just aren’t “working” for you the majority of the time.
There are several ways to deal with this. The first is not to keep such diligent track of your investment account balance numbers. Swings in the stock market are temporary, even forgettable in the grand scheme of a long-term investment horizon. But if you are acutely aware of every high and every low in your investment portfolio and the difference between the two, you will maximize the stress of every temporary decline to the fullest amount possible.
But of course, we are all human, and everyone likes to check their account balance every now and then. If this is the case, any time the stock market has been making new highs, don’t think of it as money in the bank. People get in trouble when they think of their stock portfolio gains as static, or somehow locked in, which of course they are not unless you have sold. I find it is helpful to look at particularly high account balances as somewhat “fake.” I constantly tell myself, “sure the number right now says ______, but at any given moment it could be worth half of that.” Anything you can do to keep yourself from anchoring your expectations of value to a peak in your portfolio is helpful.
Last but not least, if you find yourself upset because you are acutely aware of how much your portfolio has declined since the most recent peak, try measuring from somewhere else. Bummed your portfolio is down over 10% right now? Look at the return of your portfolio over the last two years, a time period that began at the bottom of the pandemic decline. Quite frankly, even with this most recent decline, stock investor returns over the past two years have been stellar, and something we should be grateful for.
Paul R. Ruedi, CFP®
Growing up in a financial advisor’s household, investing was something I never really thought twice about. Like eating your vegetables or looking both ways before crossing the street, investing was something you just did because you knew it was good for you. But when a question along the lines of “why invest at all?” was put to me at a wedding this past weekend, I struggled to answer it quickly.
This caused me to go down a line of thinking that ultimately required channeling my inner child and continually asking “why” in response to every answer I could think of. When I’d try to answer the “why invest” question with an answer like “so you can grow your wealth,” it would inevitably lead to yet another question: “why grow your wealth?”
The purpose of investing, forgoing consumption to take the risk of putting your money somewhere it has the chance of providing you with a return, is obviously to end up with more money than you began with. But this begs the question, “why do you need more money?” What I ultimately realized is the “why” for everyone is going to be different, but it is perhaps the most important part of investing. Without a “why” motivating you to reach a goal at the end of the tunnel, investing would be all pain and no gain.
Investing should not be driven by the arbitrary goal of having more money than you began with. It should be driven by your most important life goals. Everyone’s “why” for investing will be different. Someone’s “why” could be for them to have money to send their kids to college someday. Another person’s “why” could be to have enough to buy a vacation home down the road. And of course there is the “why” we most often deal with at Ruedi Wealth Management: I’d like to retire someday and still have money to live the life of my dreams.
The question “why invest” is a question I cannot hope to answer for anyone but myself. Fortunately, you don’t need me, or any advisor to give you your “why;” it must come from you. Your “why” is extremely important as it will serve as the motivation to begin investing and to stick with your investments during tough times. But just because you have goals serving as your why, does not mean you will get there; that will require deliberate financial planning. If you think you need help turning your investing “why” into reality, you may want to talk to a financial advisor.
Capital Gains Harvesting
Paul A. Ruedi
Capital gains taxes are calculated based on your income at a progressive rate –the higher the income, the higher the tax rate. Most people assume capital gains taxes are either 15% or 20%, but that is only the two highest brackets (not considering the 3.8% Medicare surtax on portfolio income). For 2022, single tax filers with under $41,675 of income, or married couples with under $83,350 of income pay 0% tax on their capital gains. This creates a planning opportunity for people who are below that income threshold now.
Referred to as “capital gains harvesting,” the process involves selling investments at a gain in a lower income year, to reduce or avoid taxes. But this can only be done to a point; you must be careful not to realize so much in gains that you accidentally kick yourself into a higher tax bracket. Take for example a couple that has a $100,000 portfolio, $40,000 of which is capital gains.
Suppose that couple is having a lower-income year where they expect to have $50,000 of taxable income after claiming the standard tax deduction, but will expect their income to go back above the $83,350 threshold in future years. That couple could theoretically sell enough of their portfolio to realize up to $33,350 in taxable gains ($83,350 –$50,000) and pay nothing in taxes on those gains. This would result in a permanent tax savings of $5,002.50.
However, should that couple sell their entire portfolio, their income would be $90,000 ($50,000 income plus $40,000 capital gains) putting them into the 15% capital gains tax bracket. This would cause a 15% capital gains tax to be applied on $6,650 in gains ($90,000 -$83,350).
When harvesting capital gains you can sell the position, and immediately buy it back, essentially eliminating the risk of missing out on market returns. This is a significant advantage over tax-loss harvesting, where the wash sale rules extend over a 61-day period. Aside from the possibility of accidentally kicking yourself into a higher tax bracket if you do the math wrong, there is practically no downside to capital gains harvesting.
If you find you are temporarily in a low tax bracket and have capital gains you must realize at some point, you may want to think about harvesting those gains. If that whole process sounds too complicated, you may want to talk to a financial advisor who can explain the process, as well as how it could affect Social Security taxation, or other benefits and tax credits.
Disclaimer: Past performance is no indication of future results. You should not make any investment decisions without first performing your own due diligence and consulting your financial advisor.