Market Timing for Fun and Someone Else’s Profit – Don’t Do It

Harold Evensky CFP® , AIF® Chairman

A broker stands looking out of the window of his sumptuous office down at the marina thirty stories below with his client at his side. “See those yachts down there?” says the broker to his client. “The one on the left is mine, the one in the middle is my partner’s, and the one on the right is our office manager’s.”

“Where are your clients’ yachts?”

David Samuel: Hello, Harold. It’s David Samuel again. I know you have that AAII meeting coming up next week, but this can’t wait. My brother said he just got a call from his broker, who told him to bail out of the market at least for the next few months because the firm’s technicians said they see a major correction coming within weeks. I assume you’ve probably seen the same and agree, but I just wanted to double-check.

Harold Evensky: David, I just want to be sure I have this straight. You’re saying the broker is confident enough in his crystal ball to say that everyone should run to cash?

DS: You got it.

HE: Hum, I know he works for a big wire house; I wonder if that firm has moved all its money to cash? I don’t think so, because a move of that magnitude would have made the papers, and none of the managers we monitor have made significant liquidations recently. It somewhat makes you wonder what your brother’s broker knows that no one else does.

DS: Well, I understand that he’s been in the business for decades and he’s a senior VP at the firm, so he must know something.

HE: I’m sure he knows how to sell, because the impressive title comes with generating big commissions for the firm. There are many quality SVPs who earn their commissions from long-term quality advice.

Unfortunately, there are some who succeed by focusing on generating commissions independent of the client’s needs. That’s the basis for the old joke: “How do you make $1,000,000 in the market? Start with $2,000,000.” In deciding whether market-timing advice is something you want to follow, remember, when market timing, a broker earns a commission for the sale of each and every one of the positions their clients sell and another commission when they repurchase those positions. Here are a few things you might want to consider:

Can you name the top ten musicians of all time? The top ten baseball players? The top ten presidents? Of course, you can. We might argue about the list but most people can make up a list.

Now, tell me the top ten market timers of all time? Can’t even name one, can you? Your brother’s broker may be the first, but do you really want to bet on that?

What do market reality and statistics tell us? There are innumerable problems with market timing, including transaction and tax drag. But there are two major problems. You have to make two correct calls: 1) when to get out and 2) when to get back in. Factoring in transactions and taxes, research indicates you need to be correct about 70 percent of the time.

Markets don’t just drop precipitously, but they recover quickly, so waiting for confirmation of the end of a bear market usually means missing a significant part of the recovery. That makes for a tough hurdle.

For example: In a study covering the period 1987–2007, research found that the annualized return for someone invested for 5,296 days was 11.5 percent. Unfortunately, if you missed the ten best days (less than 2/10 of 1 percent), your return would have dropped to 8 percent,

Why would you be likely to miss those best days? Because those best days occurred within two weeks of a worst day 70 percent of the time. And they occurred within six months of a best day 100 percent of the time!

In an industry study in 2008, researchers found that although the annualized market return for the prior twenty years was 11.6 percent, the average stock fund investor earned a paltry 4.5 percent. It turned out that for most investors, market timing was mighty expensive. And, David, unless you’ve recently obtained a working crystal ball, it’s likely to also prove costly for you.

To make money in the market, you have to be in the market through thick and thin. In fact, if you remember our discussion on rebalancing, you’ll remember that bear markets are great buying opportunities for long-term investors. So, my advice is to stop listening to so-called experts spouting nonsense and go back to making money in your business.

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.

Start Thinking about End-of-Year Tax Planning Now

David L. Garcia, CPA, CFP®, ADPA® Principal, Wealth Manager

Most folks hate to think about paying taxes, let alone end-of-year tax planning strategies. Unfortunately, ignoring tax planning can lead to paying Uncle Sam more than is required. The last four years have seen the introduction of new income-based Medicare premium increases along with increases in the top income tax, capital gains, and dividend rates. Starting to plan as early as possible is crucial since most strategies need to be completed prior to year end. Depending on your situation, it may make sense to either accelerate or delay deductions and income. This blog post briefly discusses some of the most often used tax planning strategies, but is by no means an exhaustive list. Tax planning strategies can be complex and should always be considered in close consultation with your accountant and financial advisor to make sure decisions are made with your unique tax situation in mind.

Harvesting Losses

At first glance, it may seem silly to intentionally sell an investment for a loss. However, opportunistic tax loss harvesting can boost after-tax returns. Suppose you have a $50,000 investment in the U.S. stock market via a broad market index fund that loses 10% of its value this year. You can sell this index fund and turn around at the same time and buy a very similar U.S. index investment, losing no market exposure but banking a $5,000 loss for tax purposes. This can be a beneficial tool for reducing taxes while maintaining your asset allocation and risk/return profile. Even if you do not have any gains to apply the loss to in the year of sale, up to $3,000 can be used against ordinary income items such as wages. Further, any excess unused loss is carried forward to be used in future tax years.

There are some important limitations to tax loss harvesting that should be kept in mind. The IRS will not let you sell an investment and at the same exact time buy back that identical investment just to create a tax loss. IRS rules state you must wait 30 days to purchase the identical investment sold for the loss or you violate what is commonly referred to as the “wash sale rule.” A wash sale disallows the loss for tax purposes. However, IRS rules do allow you to purchase a very similar investment, preferably one that is highly correlated with the investment sold for a loss, without breaking the wash sale rule. For example, selling the S&P 500 SPDR and replacing it with the Vanguard total stock market index would give almost identical market exposure while not violating the wash sale rule.

The bottom line is that actively managing capital gains and losses near year end can increase after-tax returns over time. Just be sure to consult with your accountant or investment advisor to make sure you do not run afoul of any limitations.

Medicare Premiums for High-Income Earners

In 2016, some Medicare recipients began to see an additional 16% base premium increase set into motion by two different laws. One law says that ordinary recipients can’t have their standard premium go up by more than the Social Security cost of living increase for that year. Since there was no cost of living increase in 2016, this benefited about 70% of beneficiaries. Unfortunately, another law shifted the burden of increasing Medicare costs onto the remaining 30% of beneficiaries. This unlucky 30% includes folks who don’t deduct Medicare premiums from their Social Security checks, those who didn’t receive Social Security in 2015, and high-income earners.

If that wasn’t bad enough, on top of the 16% base increase, Medicare also penalizes about 5% of high-income beneficiaries with premium surcharges. The surcharges begin at adjusted gross income levels above $85,000 for singles and $170,000 for married folks filing jointly. To make matters worse, the income thresholds are currently not indexed for inflation, so more people will be affected by the surcharges in coming years. Tax planning can help reduce the bite of surcharges.

The Medicare surcharges are determined by a taxpayer’s modified adjusted gross income (MAGI). For most folks, this is adjusted gross income plus tax-exempt interest. This number is calculated before itemized deductions, so the usual deductions like charitable donations and mortgage interest won’t help. However, if you are charitably inclined, there is one strategy that might help reduce your MAGI. If you have to make a required minimum distribution (RMD) from your IRA every year, the distribution goes on your 1040 as ordinary income and increases your MAGI. The IRS allows you to give up to $100,000 of your RMD to charity and have it avoid your 1040 all together, thereby directly reducing your MAGI. Other strategies beneficiaries may want to consider include harvesting capital losses to offset gains that increase MAGI, moving forward or putting off income events in the current tax year, and utilizing Roth accounts for income. The bottom line is that a little planning could save you a lot in Medicare premiums.

Roth Conversions

In 2010 Congress repealed the income limit on Roth IRA conversions affording taxpayers, regardless of their income, the opportunity to pay off the embedded tax liabilities in their IRAs. Taxpayers who take advantage of Roth conversions should consult with their tax professionals and financial advisors to make sure converting to a Roth IRA makes sense for their particular situation. Even though converting traditional IRA assets to a Roth IRA creates current income tax, there are several situations where it may make sense to perform a Roth conversion. Perhaps you have retired recently and find yourself in a low tax bracket, making a Roth conversion less expensive. Many people convert IRA assets because they want to create a tax-free retirement asset for their heirs or to use up operating losses from their business. Whatever your reason, your future tax bracket, time horizon, estate plans, and whether you have cash outside of your IRA to pay the conversion taxes should all figure into your decision.

Conclusion

Tax planning is an important part of everyone’s financial plan. Most people approach tax issues in a reactive manner instead of being proactive. By starting to think about your current tax circumstances before year end, you may save yourself taxes and take advantage of opportunities on which you may otherwise miss out.

Feel free to contact David Garcia with any questions by phone 305.448.8882 ext. 224 or email: DGarcia@EK-FF.com.

 

Kitces, Michael E. “Planning for the New 3.8% Medicare Tax on Unearned (Portfolio) Income.” Nerd’s Eye View. N.p., Apr. 2010. Web. <www.kitces.com>.

“Medicare Premiums: Rules for Higher-Income Beneficiaries.” Social Security Administration. N.p., Jan. 2016. Web. <www.socialsecurity.gov>.

“Advanced Tax Strategies Using a Roth IRA Conversion.” Putnam Investments. N.p., n.d. Web. 19 July 2016. <www.putnamwealthmanagement.com>.

Cubanski, Juliette, Tricia Neuman, Gretchen Jacobson, and Karen E. Smith. “Raising Medicare Premiums for Higher-Income Beneficiaries: Assessing the Implications.” Kaiser Family Foundation. N.p., Jan. 2014. Web. <www.kff.org>

The Three Ps of Investing: Philosophy, Process and People

Harold Evensky CFP® , AIF® Chairman

In Real Estate, it’s location, location, location. In investing, it’s philosophy, process, and people. Most investors look at past performance when evaluating a manager. That’s a rearview mirror approach. If you’re driving forward, keeping your eyes on the rearview mirror is dangerous. Looking backward is equally dangerous for investors. You can’t buy past performance, so don’t invest based just on looking backward. To avoid that mistake, here’s a simple process that works for any investment manager you might hire—mutual funds, separate accounts, or alternatives.

Philosophy

When you are evaluating money managers, find out what their  investment philosophy is. What is their unique view of the investment world? How is it different from those of their competitors? Is it credible that a manager can overcome the drag of expenses and taxes and provide risk-adjusted returns better than other alternatives? Basically, you’re looking for a good and credible story. How might you find it? Read the manager’s letters, prospectus and marketing material; look for something more than “we buy low and sell high.”

Process

A good story is nice, but how does the manager make it work in the real world? Answers to this question may be harder to pin down, but remember, it’s your hard-earned money at risk.

People

Philosophy and process are essential, but ultimately it’s people who make the difference. People will be making investment decisions about your money.

Don Phillips is a managing director and board member of Morningstar. He is a good friend of mine and one of the most-respected professionals in finance. He has some simple advice regarding people: “You want people with passion for the job of money manager.”

Did the managers you are considering invent the firm’s philosophy and process or have they at least been around long enough to have developed a passion for it? If not, even if the investment passes the test of the first two Ps, move on to your next investment alternative.

Testing the Ps

In this conversation with a gentleman I will call Happy Promoter, I put the three Ps to the test.

Happy Promoter (HP): Good morning, Mr. Evensky. My name is Happy Promoter. I’m familiar with your firm and I appreciate your taking the time to see me this morning.

Harold Evensky (HE): Mr. Promoter, it’s my pleasure. I understand you represent Sophisticated Hedge Fund Strategies and you have a new offering available. My friend Mr. Jones suggested I meet with you; I’m always interested in learning about new potential investments for our clients. Please tell me about your program.

HP: It’s a very sophisticated long-short strategy based on an evaluation of a myriad of market dynamics that guide our trading algorithms to ensure that we provide consistent alpha in all markets. Because we can profit in both rising and falling markets, we can mitigate downside risk, and by the judicious use of margin, we can provide returns that significantly exceed the S&P 500. We’ve backtested our strategy for the last ten years and the results substantiate the success of our strategy.

Well, at this point, I’m thinking I need to know a lot more before I take Mr. Promoter’s pitch seriously. Backtesting is a common but questionable way of evaluating a new investment strategy. It mathematically simulates how the strategy would have fared if it had existed in the past. One obvious problem is that unless the strategy is 100 percent automatic—no active decisions or modifications are made by the manager along the way—there is no way of knowing if the simulation is a fair representation of how the strategy will be implemented in the future. An even bigger problem is that there’s no reason to believe that future markets will mirror the historical environment used for the backtesting. Bottom line: because it theoretically would have worked in the past is no reason to believe it will succeed in the future. The financial world is full of failed investment strategies that had wonderful backtest results.

So, I decide I need to take Mr. Promoter through the process I call the “three Ps.”

HE: Mr. Promoter, what you’ve said sounds good, but I need more meat to the story. Can you tell me what your basic investment philosophy is? What do you see in the financial markets that the thousands of other professional investment managers don’t? After all, the market is a zero-sum game. For everyone who makes a buck, there has to be someone else losing one.

HP: Harold—may I call you Harold?

HE: Certainly.

HP: We believe that our sophisticated algorithms will provide the edge.

HE: I understand that, but can you be more specific?

HP: No, I’m afraid that our process is quite confidential and proprietary.

HE: Well then, can you at least give me some details about the procedures you use to implement your sophisticated process?

HP: Good lord, no! Our system is a black box and all the details are carefully guarded secrets. It’s the “secret sauce” that enables us to provide the low-volatility, high returns your clients are seeking.

HE: I see. Then I guess I’d have to look to the experience and quality of the intellectual capital behind your strategy. Will you tell me who developed your sophisticated strategy and what experience they have in implementing it?

HP: Harold, I’m the lead creator of the strategy and I’m supported by a two-man team of MBAs. My educational background is a master’s in History; however, I’ve been fascinated by the market for decades and I spent the last few years studying market movements. I finished developing my strategy just last month. I know that as a sophisticated practitioner you’re aware that alternative managers with well-established track records work only with large institutional clients and have no interest in dealing in the retail market, so a new manager such as I can provide your clients with the best alternative.

Mr. Promoter seemed like a nice guy, but he miserably failed the three Ps, so I thanked him for his time. My only thought after this brief meeting was, “What a waste of time; wait until I get hold of Jones!”

This blog is a chapter from Harold Evensky’s “Hello Harold: A Veteran Financial Advisor Shares Stories to Help Make You Be a Better Investor”. Available for purchase on Amazon.