Roth IRA Contribution Limits 2021

Roth IRA Contribution Limits for 2021

The Roth IRA contribution limits for 2021 are $6,000 per person with an additional $1,000 catch-up contribution for people who are 50 or older.

Retirement Calculator

Roth IRA income limits for 2021

Roth IRA contribution limits for 2021 are based on your annual earnings. If you are single and earn $125,000 or less, you can contribute up to the full amount of $6,000 per year.  If your aggregated gross income is between $125,000 and $140,000 you can still make contributions but with a lower value.

Married couples filing jointly can contribute up to $6,000 each if your combined income is less than $198,000.  If your aggregated gross income is between $198,000 and $208,000 you can still make reduced contributions.

What is a Roth IRA?

Roth IRA is a tax-free retirement savings account that allows you to make after-tax contributions to save towards retirement. Your Roth investments grow tax-free. You will not owe taxes on dividends and capital gains. Once you reach retirement your withdrawals will be tax-free as well.

Roth vs Traditional IRA

Roth IRA allows you to make after-tax contributions towards retirement. In comparisons. Traditional IRA has the same annual contributions limits. The Traditional IRA contributions can be tax-deductible or after-tax depending on your income. Additionally, your Traditional IRA savings grow tax-deferred. Unlike Roth Roth, you will owe income taxes on your withdrawals.

Roth IRA Rules

The Roth IRA offers a lot of flexibility and few constraints.  There are Roth IRA rules that can help you maximize the benefits of your tax-free savings account.

Easy and convenient

Opening a Roth IRA account is a great way to start planning for your financial future. The plan is an excellent saving opportunity for many young professionals with limited access to workplace retirement plans. Even those who have 401k plans with their employer can open a Roth IRA.

Flexibility

There is no age limit for contributions. Minors and retired investors can invest in Roth IRA as well as long as they earn income.

No investment restrictions

There is no restriction on the type of investments in the account. Investors can invest in any asset class that suits their risk tolerance and financial goals.

No taxes

There are no taxes on the distributions from this account once you reach 59 ½. Your investments will grow tax-free. You will never pay taxes on your capital gains and dividends either.

No penalties if you withdraw your original investment

While not always recommended, Roth IRA allows you to withdraw your original dollar contributions (but not the return from them) before reaching retirement, penalty and tax-free. Say, you invested $5,000 several years ago. And now the account has grown to $15,000. You can withdraw your initial contribution of $5,000 without penalties.

Diversify your future tax exposure

Roth IRA is ideal for investors who are in a lower tax bracket but expect higher taxes in retirement. Since most retirement savings sit in 401k and investment accounts, Roth IRA adds a very flexible tax-advantaged component to your investments. Nobody knows how the tax laws will change by the time you need to take out money from your retirement accounts. That is why I highly recommend diversifying your mix of investment accounts and take full advantage of your Roth IRA.

No minimum distributions

Unlike 401k and IRA, Roth IRA doesn’t have any minimum distributions requirements. Investors have the freedom to withdraw their savings at their wish or keep them intact indefinitely.

Earnings cap

You can’t contribute more than what you earned for the year. If you made $4,000, you could only invest $4,000.

IRA Contribution Limits 2021

IRA Contribution Limits for 2021

The IRA contribution limits for 2021 are $6,000 per person with an additional $1,000 catch-up contribution for people who are 50 or older.

Retirement Calculator

What is an IRA?

IRA or Traditional IRA is a tax-deferred retirement savings account that allows you to make tax-deductible contributions to save towards retirement. Your savings grow tax-free. You do not owe taxes on dividends and capital gains. Once you reach retirement age, you can start taking money out of the account. All distributions from the IRA are taxable as ordinary income in the year of withdrawal.

IRA income limits for 2021

The tax-deductible IRA contribution limits for 2021 are based on your annual income. If you are single and earn $125,000 or less, you can contribute up to the full amount of $6,000 per year.  If your aggregated gross income is between $125,000 and $140,000 you can still make contributions but with a smaller amount.

Married couples filing jointly can contribute up to $6,000 each if your combined income is less than $198,000.  If your aggregated gross income is between $198,000 and $208,000 you can still make reduced contributions.

Spousal IRA

If you are married and not earning income, you can still make contributions. As long as your spouse earns income and you file a joint return, you may be able to contribute to an IRA even if you did not have taxable compensation. Keep in mind that, your combined contributions can’t be more than the taxable compensation reported on your joint return.

IRA vs 401k

IRA is an individual retirement account.  401k plan is a workplace retirement plan, which is established by your employer. You can contribute to a 401k plan if it’s offered by your company.  In comparison, anyone who is earning income can open and contribute to a traditional IRA regardless of your age.

IRA vs Roth IRA 

Traditional and Roth IRA have the same annual contribution limits.  The Traditional IRA contributions can be tax-deductible or after-tax depending on your income. In comparison. Roth IRA allows you to make after-tax contributions towards retirement. Another difference, your Traditional IRA retirement savings grow tax-deferred, while Roth IRA earnings are tax-free.

 

15 Costly retirement mistakes

15 Costly retirement mistakes

15 Costly retirement mistakes… Retirement is a major milestone for many Americans. Retiring marks the end of your working life and the beginning of a new chapter. As a financial advisor, my job is to help my clients avoid mistakes and retire with confidence and peace of mind.  Together we build a solid roadmap to retirement and a gameplan to achieve your financial goals. My role as a financial advisor is to provide an objective and comprehensive view of my clients’ finances.  As part of my process, I look for any blind spots that can put my clients’ plans at risk.  Here is a list of the major retirement mistakes and how to avoid them.

1. Not planning ahead for retirement

Not planning ahead for retirement can cost you a lot in the long run. Delaying to make key decisions is a huge retirement mistake that can jeopardize your financial security during retirement. Comprehensive financial planners are more likely to save for retirement and feel more confident about achieving their financial goals.  Studies have shown that only 32% of non-planners are likely to have enough saved for retirement versus 91% of comprehensive planners.

Reviewing your retirement plan periodically will help you address any warning signs in your retirement plan. Recent life changes, economic and market downturns or change in the tax law could all have a material impact on your retirement plans. Be proactive and will never get caught off guard.

2. Not asking the right questions

Another big retirement mistake is the fear of asking the right question. Avoiding these

Here are some of the questions that my clients are asking –

  • “Do I have enough savings to retire?”
  •  “Am I on the right track?”.
  • “Can I achieve my financial goals?”
  • “Can I retire if the stock market crashes?”.
  • “Are you fiduciary advisor working in my best interest?” (Yes, I am fiduciary)

Asking those tough questions will prepare you for a successful retirement journey. Addressing your concerns proactively will take you on the right track of meeting your priorities and achieving your personal goals

3. Not paying off debt

Paying off debt can be an enormous burden during retirement. High-interest rate loans can put a heavy toll on your finances and financial freedom. As your wages get replaced by pension and social security benefits, your expenses will remain the same. If you are still paying off loans, come up with a plan on how to lower your debt and interest cost. Being debt-free will reduce the stress out of losing viable income.

4. Not setting goals

Having goals is a way to visualize your ideal future. Not having goals is a retirement mistake that can jeopardize your financial independence during retirement. Without specific goals, your retirement planning could be much harder and painful. With specific goals, you have clarity of what you want and what you want to achieve. You can make financial decisions and choose investment products and services that align with your objectives and priorities. Setting goals will put you on a successful track to enjoy what matters most to you.

5. Not saving enough

An alarming 22% of Americans have less than $5,000 in retirement savings. The average 401k balance according to Fidelity is $103,700. These figures are scary. It means that most Americans are not financially ready for retirement. With ultra-low interest rates combined with constantly rising costs of health care,  future retirees will find it difficult to replace their working-age income once they retire. Fortunately, many employers now offer some type of workplace retirement savings plans such as 401k, 403b, 457, TSP or SEP IRA. If your employer doesn’t offer any of those, you can still save in Traditional IRA, Roth IRA, investment account or the old fashioned savings account.

6. Relying on one source for retirement income

Many future retirees are entirely dependent on a single source for their retirement income such as social security or pension.  Unfortunately. with social security running out of money and many pension plans shutting down or running a huge deficit, the burden will be on ourselves to provide reliable income during our retirement years.  If you want to be financially independent, make sure that your retirement income comes from multiple sources.

7. Lack of diversification

Diversification is the only free lunch you can get in investing and will help decrease the overall risk of your portfolio. Adding uncorrelated asset classes such as small-cap, international and emerging market stocks, bonds, and commodities will reduce the volatility of your investments without sacrificing much of the expected return in the long run.

A common mistake among retirees is the lack of diversification. Many of their investment portfolios are heavily invested in stocks, a target retirement fund or a single index fund.

Furthermore, owning too much of one stock or a fund can cause significant issues to your retirement savings. Just ask the folks who worked for Enron or Lehman Brothers who had their employer’s stocks in their retirement plans. Their lifetime savings were wiped out overnight when these companies filed for bankruptcy.

8. Not rebalancing your investment portfolio

Regular rebalancing ensures that your portfolio stays within your desired risk level. While tempting to keep a stock or an asset class that has been on the rise, not rebalancing to your original target allocation can significantly increase the risk of your investments.

9. Paying high fees

Paying high fees for mutual funds and high commission insurance products can eat up a lot of your return. It is crucial to invest in low-cost investment managers that can produce superior returns over time. If you own a fund that has consistently underperformed its benchmark,  maybe it’s time to revisit your options.

Many insurance products like annuities and life insurance while good on paper, come with high upfront commissions, high annual fees, and surrender charges and restrictions.  Before signing a contract or buying a product, make sure you are comfortable with what you are going to pay.

10. No budgeting

Adhering to a budget before and during retirement is critical for your confidence and financial success. When balancing your budget, you can live within your means and make well-informed and timed decisions. Having a budget will ensure that you can reach your financial goals.

11. No tax planning

Not planning your taxes can be a costly retirement mistake. Your pension and social security are taxable. So are your distributions from 401k and IRAs. Long-term investing will produce gains, and many of these gains will be taxable. As you grow our retirement saving the complexity of assets will increase. And therefore the tax impact of using your investment portfolio for retirement income can be substantial. Building a long-term strategy with a focus on taxes can optimize your after-tax returns when you manage your investments.

12. No estate planning

Many people want to leave some legacy behind them. Building a robust estate plan will make that happen. Whether you want to leave something to your children or grandchildren or make a large contribution to your favorite foundation, estate, and financial planning is important to secure your best interests and maximize the benefits for yourself and your beneficiaries.

13. Not having an exit planning

Sound exit planning is crucial for business owners. Often times entrepreneurs rely on selling their business to fund their retirement. Unlike liquid investments in stocks and bonds, corporations and real estate are a lot harder to divest.  Seling your business may have serious tax and legal consequences. Having a solid exit plan will ensure the smooth transition of ownership, business continuity, and optimized tax impact.

14. Not seeing the big picture

Between our family life, friends, personal interests, causes, job, real estate properties, retirement portfolio, insurance and so on, our lives become a web of interconnected relationships. Above all is you as the primary driver of your fortune. Any change of this structure can positively or adversely impact the other pieces. Putting all elements together and building a comprehensive picture of your financial life will help you manage these relationships in the best possible way.

15. Not getting help

Some people are very self-driven and do very well by planning for their own retirement. Others who are occupied with their career or family may not have the time or ability to deal with the complexities of financial planning. Seeking help from a fiduciary financial planner can help you avoid retirement mistakes. A fiduciary advisor will watch for your blind spots and help you find clarity when making crucial financial decisions.

IRA Contribution Limits 2020

IRA contribution limits 2020

The IRA contribution limits for 2020 are $6,000 per person with an additional $1,000 catch-up contribution for people who are 50 or older.

Retirement Calculator

What is an IRA?

IRA or Traditional IRA is a tax-deferred retirement savings account that allows you to make tax-deductible contributions to save towards retirement. Your savings grow tax-free. You do not owe taxes on dividends and capital gains. Once you reach retirement age, you can start taking money out of the account. All distributions from the IRA are taxable as ordinary income in the year of withdrawal.

IRA income limits for 2020

The tax-deductible IRA contribution limits for 2020 are based on your annual income. If you are single and earn $124,000 or less, you can contribute up to the full amount of $6,000 per year.  If your aggregated gross income is between $124,000 and $139,000 you can still make contributions but with a lower value.

Married couples filing jointly can contribute up to $6,000 each if your combined income is less than $196,000.  If your aggregated gross income is between $196,000 and $206,000 you can still make reduced contributions.

Spousal IRA

If you are married and not earning income, you can still make contributions. As long as your spouse earns income and you file a joint return, you may be able to contribute to an IRA even if you did not have taxable compensation. Keep in mind that, your combined contributions can’t be more than the taxable compensation reported on your joint return.

IRA vs 401k

IRA is an individual retirement account.  401k plan is a workplace retirement plan, which is established by your employer. You can contribute to a 401k plan if it’s offered by your company.  In comparison, starting in 2020, anyone who is earning income can open and contribute to a traditional IRA regardless of your age.

IRA vs Roth IRA 

Traditional and Roth IRA have the same annual contributions limits.  The Traditional IRA contributions can be tax-deductible or after-tax depending on your income. In comparison. Roth IRA allows you to make after-tax contributions towards retirement. Another difference, your Traditional IRA retirement savings grow tax-deferred, while Roth IRA earnings are tax-free.

 

Roth IRA Contribution Limits 2020

Roth IRA contribution limits for 2020

The Roth IRA contribution limits for 2020 are $6,000 per person with an additional $1,000 catch-up contribution for people who are 50 or older.

Retirement Calculator

Roth IRA income limits for 2020

Roth IRA contribution limits for 2020 are based on your annual earnings. If you are single and earn $124,000 or less, you can contribute up to the full amount of $6,000 per year.  If your aggregated gross income is between $124,000 and $139,000 you can still make contributions but with a lower value.

Married couples filing jointly can contribute up to $6,000 each if your combined income is less than $196,000.  If your aggregated gross income is between $196,000 and $206,000 you can still make reduced contributions.

What is a Roth IRA?

Roth IRA is a tax-free retirement savings account that allows you to make after-tax contributions to save towards retirement. Your Roth investments grow tax-free. You will not owe taxes on dividends and capital gains. Once you reach retirement your withdrawals will be tax-free as well.

Roth vs Traditional IRA

Roth IRA allows you to make after-tax contributions towards retirement. In comparisons. Traditional IRA has the same annual contributions limits. The Traditional IRA contributions can be tax-deductible or after-tax depending on your income. Additionally, your Traditional IRA savings grow tax-deferred. Unlike Roth Roth, you will owe income taxes on your withdrawals.

Roth IRA Rules

The Roth IRA offers a lot of flexibility and few constraints.  There are Roth IRA rules that can help you maximize the benefits of your tax-free savings account.

Easy and convenient

Opening a Roth IRA account is a great way to start planning for your financial future. The plan is an excellent saving opportunity for many young professionals with limited access to workplace retirement plans. Even those who have 401k plans with their employer can open a Roth IRA.

Flexibility

There is no age limit for contributions. Minors and retired investors can invest in Roth IRA as well as long as they earn income.

No investment restrictions

There is no restriction on the type of investments in the account. Investors can invest in any asset class that suits their risk tolerance and financial goals.

No taxes

There are no taxes on the distributions from this account once you reach 59 ½. Your investments will grow tax-free. You will never pay taxes on your capital gains and dividends either.

No penalties if you withdraw your original investment

While not always recommended, Roth IRA allows you to withdraw your original dollar contributions (but not the return from them) before reaching retirement, penalty and tax-free. Say, you invested $5,000 several years ago. And now the account has grown to $15,000. You can withdraw your initial contribution of $5,000 without penalties.

Diversify your future tax exposure

Roth IRA is ideal for investors who are in a lower tax bracket but expect higher taxes in retirement. Since most retirement savings sit in 401k and investment accounts, Roth IRA adds a very flexible tax-advantaged component to your investments. Nobody knows how the tax laws will change by the time you need to take out money from your retirement accounts. That is why I highly recommend diversifying your mix of investment accounts and take full advantage of your Roth IRA.

No minimum distributions

Unlike 401k and IRA, Roth IRA doesn’t have any minimum distributions requirements. Investors have the freedom to withdraw their savings at their wish or keep them intact indefinitely.

Earnings cap

You can’t contribute more than what you earned for the year. If you made $4,000, you could only invest $4,000.

Essential Guide to Your Employee Stock Purchase Plan (ESPP)

Employee Stock Purchase Plan (ESPP)

What is Employee Stock Purchase Plan (ESPP)?

Employee Stock Purchase Plan (ESPP) is a popular tool for companies to allow their employees to participate in the company’s growth and success by becoming shareholders. ESPP gives you the option to buy shares of your employer at a discount price. Most companies set a discount between 10% and 15%. Unlike RSUs and restricted stocks, the shares you purchase through an ESPP are not subject to any vesting schedule restrictions. That means you own the shares immediately after purchase. There are two types of ESPP – qualified and non-qualified. Qualified ESPP generally meets the requirements under Section 423 of the Internal Revenue Code and receive a more favorable tax treatment. Since most ESPP are qualified, I will only talk about them in this article.

How ESPP works?

Your company will typically provide you with information about enrollment and offering dates, contribution limits, discounts, and purchasing schedules. There will be specific periods throughout the year when employees can enroll in the plan. During that time, you are required to decide if you want to participate and set a percentage of your salary to be deducted every month to contribute to the stock purchase plan. The IRS allows up to $25,000 limit for Employee Stock Purchase Plan contributions. Make sure you set your percentage, so you don’t cross over this limit.

At this point, you are all set. Your employer will withhold your selected percentage every paycheck. The contributions will accumulate over time and will be used to buy the company stock on the purchase date.

Offering period

Offering periods of most ESPPs range from 6 to 24 months. The longer periods could have multiple six-month purchase periods. Your employer will use your salary contributions that accumulate with time to buy shares from the company stock on your behalf.

ESPP look-back provision

Some Employee Stock Purchase Plans offer a look-back provision that will allow you to purchase the shares at a discount from the lowest of the beginning and ending price of the offering period.

Employee Stock Purchase Plan  Example

Let’s assume that on January 2nd, your company stock traded at $100 per share. The stock price had a nice run and ended the six month period on June 30 at 120. Your ESPP will allow you to buy the stock at 15% of the lowest price, which is $00. You will end up paying $85 for a stock worth $120.

The price discount is what makes the ESPP attractive to employees of high growth companies. By acquiring your company stock at a discount, the ESPP lowers your investment risk, provides you a buffer from future price declines, and sets a more significant upside if the price goes up further.

When to sell ESPP stock?

Some ESPPs allow you to sell your shares immediately after the purchase date, realizing an instant gain of 17.65%. Other plans may impose a holding period restriction during which you cannot sell your shares. Find out more from your HR.

ESPP Tax Rules

Employee Stock Purchase plans have their own unique set of tax rules. All contributions are pretax and subject to federal, state, and local taxes.

Purchasing and keeping ESPP stock will not create a tax event. In other words, you don’t owe any taxes to IRS if you never sell your shares. However, the moment you decide to sell is when things get more complicated.

The discount is as ordinary income

The first thing to remember is that your ESPP price discount is always treated as ordinary income. You will include the value of the discount to your regular annual income and pay taxes according to your tax bracket.

Qualifying disposition

To get a preferential tax treatment on your stock gains, you need to make a qualifying disposition. The rule requires that you sell your shares two years from the offer date and one year from the purchase date. Your gains will be taxed as long-term capital gains. The long-term capital gain tax rate varies between 0%, 15%, and 20% depending on your income. 

Disqualifying disposition

If you sell your shares less than two years from the offer date or less than one year from the purchase date, the sale is a disqualifying disposition. You will pay taxes on short-term capital gains as an ordinary income according to your tax bracket.

ESPP Dividends

Many publicly traded companies pay out dividends to shareholders. If your employer pays dividends, they will automatically be reinvested in the company shares. You will owe ordinary income tax on your ESPP dividends in the year when you receive them. Usually, the plan discount does not apply to shares purchased with reinvested dividends. Additionally, these shares are treated as regular stock, not part of your Employee Stock Purchase Plan.

Investment risk

Being a shareholder in a solid high growth company could offer a significant boost to your personal finances. In some cases, it could make you an overnight millionaire.

However, here is the other side of the story. Owning too much stock of a company in bad financial health could impose a significant risk to your overall investment portfolio and retirement goals. Participating in the ESPP of a company with a constantly dropping or volatile stock price is like catching a falling knife. The discount price could give you some downside protection, but you can continue to lose money if the price continues to go down. The price of General Electric, one of the oldest Dow Jones members, went down more than 65% in one year.

Remember Enron and Lehman

Many of you remember or heard of Enron and Lehman Brothers. If your company seizes to exist for whatever reason, you could not only lose your job, but all your investments in the firm could be wiped out.

You are already earning a salary from your employer. Concentrating your wealth and income from the same source could jeopardize your financial health if your company fails to succeed in its business ventures.

As a fiduciary advisor, I always recommend diversification and caution. Try to limit your exposure to your company stock and sell your shares periodically. Sometimes paying taxes is worth the peace of mind and safety.

Conclusion

Participating in your employer’s Employee Stock Purchase Plans is an excellent way to acquire company stock at a discount and get involved in your company’s future.

Owning company stock often comes with a huge financial upside. Realizing some of these gains could help you build a strong foundation for retirement and financial freedom. When managed properly, it can help you achieve your financial goals, whether they are buying a home, taking your kids to college, or early retirement.

Keep in mind that all ESPPs have different rules. Therefore, this article may not address the specific features of your plan.

 

All you need to know about Restricted Stock Units (RSUs)

Restricted Stock Units (RSU)

Restricted Stock Units are a popular equity compensation for both start-up and public companies. Employers, especially many startups, use a variety of compensation options to attract and keep top-performing employees. Receiving RSUs allows employees to share in the ownership and the profits of the company. Equity compensation takes different forms such as stock options, restricted stock units, and deferred compensation. If you are fortunate to receive RSU from your employer, you should understand the basics of this corporate perk. Here are some essential tips on how to manage them.

What are RSUs?

A restricted stock unit is a type of equity compensation by companies to employees in the form of company stock. Employees receive RSUs through a vesting plan and distribution schedule after achieving required performance milestones or upon remaining with their employer for a particular length of time. RSUs give an employee interest in company stock but they have no tangible value until vesting is complete.

Vesting Schedule

Companies issue restricted stock units according to a vesting schedule.
The vesting schedule outlines the rules by which employees receive full ownership of their company stock. The restricted stock units are assigned a fair market value when they vest. Upon vesting, they are considered income, and often a portion of the shares is withheld to pay income taxes. The employees receive the remaining shares and can sell them at their discretion.

As an employee, you should keep track of these essential dates and figures.

Grant Date

The grant date is the date when the company pledges the shares to you. You will be able to see them in your corporate account.

Vesting Date

You only own the shares when the granted RSUs are fully ‘vested’.  On the vesting date, your employer will transfer the full ownership of the shares to you. Upon vesting, you will become the owner of the shares.

Fair Market Value

When vesting is complete, the restricted stock units are valued according to the fair market value (FMV)  at that time. Your employer will provide you with the FMV based on public price or private assessment.

Selling your RSU

Once the RSUs are converted to company stock, you become a shareholder in your firm. You will be able to sell all or some of these shares subject to companies’ holding period restrictions. Many firms impose trading windows and limits for employees and senior executives.

How are RSUs taxed?

You do not pay taxes on your restricted stock units when you first receive them.  Typically you will owe ordinary income tax on the fair market value of your shares as soon as they vest.

The fair market value of your vested RSUs is taxable as personal income in the year of vesting. This is a compensation income and will be subject to federal and local taxes as well as Social Security and Medicare charges.

Typically, companies withhold part of the shares to cover all taxes. They will give employees the remaining shares. At this point, you can decide to keep or sell them at your wish. If your employer doesn’t withhold taxes for your vested shares, you will be responsible for paying these taxes during the tax season.

Double Trigger RSUs

Many private Pre-IPO companies would offer double-trigger RSUs. These types of RSUs become taxable under two conditions:
1. Your RSU are vested
2. You experience a liquidity event such as an IPO, tender offer, or acquisition.

You will not owe taxes on any double-trigger RSUs at your vesting date. However, you will all taxes on ALL your vested shares in the day of your liquidity event.

Capital gain taxes

When you decide to sell your shares, you will pay capital gain taxes on the difference between the current market price and the original purchase price.

You will need to pay short-term capital gain taxes for shares held less than a year from the vesting date.  Short-term capital gains are taxable as ordinary income.

You will owe long-term capital gains taxes for shares that you held for longer than one year. Long-term capital gains have a preferential tax treatment with rates between 0%, 15%, and 20% depending on your income.

Investment risk with RSUs

Being a shareholder in your firm could be very exciting. If your company is in great health and growing solidly, this could be an enormous boost to your personal finances.

However, here is the other side of the story. Owning too much of your company stock could impose significant risks to your investment portfolio and retirement goals. You are already earning a salary from your employer. Concentrating your entire wealth and income from the same source could jeopardize your financial health if your employer fails to succeed in its business ventures. Many of you remember the fall of Enron and Lehman Brothers. Many of their employees lost not only their jobs but a significant portion of their retirement savings.

As a fiduciary advisor, I always recommend diversification and caution. Try to limit your exposure to your employer and sell your shares periodically. Sometimes paying taxes is worth the peace of mind and safety.

Key takeaways

Receiving RSUs is an excellent way to acquire company stock and become part of your company’s future. While risky owning RSUs often comes with a huge financial upside. Realizing some of these gains could help you build a strong foundation for retirement and financial freedom. When managed properly, they can help you achieve your financial goals, whether they are buying a home, taking your kids to college, or early retirement.

A financial checklist for young families

A financial checklist for young families

A financial checklist for young families…..Many of my clients are young families looking for help to build their wealth and improve their finances. We typically discuss a broad range of topics from buying a house, saving for retirement, savings for their kids’ college, budgeting and building legacy. As a financial advisor in the early 40s, I have personally gone through many of these questions and was happy to share my experience.

Some of my clients already had young children. Others are expecting a new family member. Being a dad of a nine-month-old boy, I could relate to many of their concerns. My experience helped me guide them through the web of financial and investment questions.  

While each family is unique, there are many common themes amongst all couples. While each topic of them deserves a separate post, I will try to summarize them for you.

Communicate

Successful couples always find a way to communicate effectively. I always advise my clients to discuss their financial priorities and concerns. When partners talk to each other, they often discover that they have entirely different objectives.  Having differences is normal as long as you have common goals. By building a strong partnership you will pursue your common goals while finding a common ground for your differences

Talking to each other will help you address any of the topics in this article.

If it helps, talk to an independent fiduciary financial advisor. We can help you get a more comprehensive and objective view of your finances. We often see blind spots that you haven’t recognized before.

Set your financial goals

Most life coaches will tell you that setting up specific goals is crucial in achieving success in life. It’s the same when it comes to your finances. Set specific short-term and long-term financial goals and stick to them. These milestones will guide you and help you make better financial decisions in the future.

Budget

There is nothing more important to any family wellbeing than budgeting. Many apps can help you budget your income and spending. You can also use an excel spreadsheet or an old fashion piece of paper. You can break down your expenses in various categories and groups similar to what I have below. Balance your budget and live within your means.

Sample budget

Gross Income ?????
Taxes ???
401k Contributions ??
Net Income ????
Fixed Expenses
Mortgage ?
Property Taxes ?
Utilities (Phone, Cable, Gas, Electric) ?
Insurance ?
Healthcare/Medical ?
Car payment ?
529 savings ?
Daycare ?
Non-Discretionary Flexible Expenses
Groceries ?
Automotive (Fuel, Parking, Tolls) ?
Home Improvement/Maintenance ?
Personal Care ?
Dues & Subscriptions ?
Discretionary Expenses
Restaurants ?
General Merchandise ?
Travel ?
Clothing/Shoes ?
Gifts ?
Entertainment ?
Other Expenses ?
Net Savings ???

Consolidate your assets

One common issue I see amongst young couples is the dispersion of their assets. It’s very common for spouses to have multiple 401k, IRAs and savings accounts in various financial institutions and former employers. Consolidating your assets will help you get a more comprehensive view of your finances and manage them more efficiently.

Manage your debt

The US consumer debt has grown to record high levels. The relatively low-interest rates, rising real estate prices and the ever-growing college cost have pushed the total value of US household debt to $13.25 trillion. According to the New York Fed, here is how much Americans owe by age group.

  • Under 35: $67,400
  • 35–44: $133,100
  • 45–54: $134,600
  • 55–64: $108,300
  • 65–74: $66,000
  • 75 and up: $34,500

For many young families who are combining their finances, managing their debt becomes a key priority in achieving financial independence.

Manage your credit score

One way to lower your debt is having a high credit score. I always advise my clients to find out how much their credit score is.  The credit score, also known as the FICO score, is a measure between 300 and 850 points. Higher scores indicate lower credit risk and often help you get a lower interest rate on your mortgage or personal loan. Each of the three national credit bureaus, Equifax, Experian, and TransUnion, provides an individual FICO score.  All three companies have a proprietary database, methodology, and scoring system. You can sometimes see substantial differences in your credit score issued by those agencies.

Your FICO score is a sum of 64 different measurements. And each agency calculates it slightly differently. As a rule, your credit score depends mainly on the actual dollar amount of your debt, the debt to credit ratio and your payment history. Being late on or missing your credit card payments, maximizing your credit limits and applying for too many cards at once will hurt your credit score.

Own a house or rent

Owning your first home is a common theme among my clients. However, the price of real estate in the Bay area, where I live, has skyrocketed in the past 10 years. The average home price in San Francisco according to Zillow is $1.3 million. The average home price in Palo Alto is $3.1 million. (Source: https://www.zillow.com/san-francisco-ca/home-values/ ). While not at this magnitude, home prices have risen in all major metropolitan areas around the country. Buying a home has become an impossible dream for many young families. Not surprisingly a recent survey by the Bank of the West has revealed that 46% of millennials have chosen to rent over buying a home, while another 11% are staying with their parents.  

Buying a home in today’s market conditions is a big commitment and a highly personal decision. It depends on a range of factors including how long you are planning to live in the new home, available cash for a downpayment, job prospects, willingness to maintain your property, size of your family and so on.

Maximize your retirement contributions

Did you know that in 2019 you can contribute up to $19,000 in your 401k? If you are in your 50s or older, you can add another $6,000 as a catch-up contribution. Maximizing your retirement savings will help you grow your wealth and build a cushion of solid retirement savings. Not to mention the fact that 401k contributions are tax-deferred and lower your current tax bill.

Unfortunately, many Americans are not saving aggressively for retirement. According to Fidelity, the average person in their 30’s have $42.7k in their 401k plan. people in their 40s own on average 103k.

If your 401k balance is higher than your age group you are already better off than the average American.

Here is how much Americans own in their 401 plan by age group

  • 20 to 29 age: $11,500
  • 30 to 39 age: $42,700
  • 40 to 49 age: $103,500
  • 50 to 59 age: $174,200
  • 60 to 69 age: $192,800

For those serious about their retirement goals, Fidelity recommends having ten times your final salary in savings if you want to retire by age 67. They are also suggesting how to achieve this goal by age group.

  • By the age of 30: Have the equivalent of your starting salary saved
  • 35 years old: Have two times your salary saved
  • 40 years old: Have three times your salary saved
  • 45 years old: Have four times your salary saved
  • 50 years old: Have six times your salary saved
  • 55 years old: Have seven times your salary saved
  • 60 years old: Have eight times your salary saved
  • By age 67: Have 10 times your salary saved

Keep in mind that these are general guidelines. Everybody is different. Your family retirement goal is highly dependent on your individual circumstances, your lifestyle, spending habits, family size and alternative sources of income.

Know your risk tolerance level

One common issue I see with young families is the substantial gap between their risk tolerance and the actual risk they take in their retirement and investment accounts.  Risk tolerance is your emotional ability to accept risk as an investor.

I have seen clients who are conservative by nature but have a very aggressive portfolio. Or the opposite, there are aggressive investors with a large amount of cash or a large bond portfolio. Talking to a fiduciary financial advisor can help you understand your risk tolerance. You will be able to narrow that gap between your emotions and real-life needs and then connect them to your financial goals and milestones.

Diversify your investments

Diversification is the only free lunch you will get in investing. Diversifying your investments can reduce the overall risk of your portfolio. Without going into detail, owning a mix of uncorrelated assets will lower the long-term risk of your portfolio. I always recommend that you have a portion of your portfolio in US Large Cap Blue Chip Stocks and add some exposure to Small Cap, International, and Emerging Market Stocks, Bonds and Alternative Assets such as Gold and Real Estate.

Invest your idle cash

One common issue I have seen amongst some of my clients is holding a significant amount of cash in their investment and retirement accounts. The way I explain it is that most millennials are conservative investors. Many of them observed their parents’ negative experience during the financial crisis of 2008 and 2009. As a result, they became more risk-averse than their parents.  

However, keeping ample cash in your retirement account in your 30s will not boost your wealth in the long run. You are probably losing money as inflation is deteriorating the purchasing power of your idle cash. Even if you are a very conservative investor, there are ways to invest in your retirement portfolio without taking on too much risk.

Early retirement

I talk about early retirement a lot often than one might imagine. The media and online bloggers have boosted the image of retiring early and made it sound a lot easier than it is. I am not saying that early retirement is an illusion, but it requires a great deal of personal and financial sacrifice. Unless you are born rich or rely on a huge payout, most people who retire early are very frugal and highly resourceful. If your goal is to retire early, you need to pay off your debt now, cut down spending and save, save and save.

Build-in tax diversification

While most of the time we talk about our 401k plans, there are other investment and retirement vehicles out there such as Roth IRA, Traditional IRA and even your brokerage account. They all have their own tax advantages and disadvantages. Even if you save a million bucks in your 401k plan, not all of it is yours. You must pay a cut to the IRS and your state treasury. Not to mention the fact that you can only withdraw your savings penalty-free after reaching 59 ½. Roth IRA and brokerage account do not lower your taxes when you make contributions, but they offer a lot more flexibility, liquidity, and some significant future tax advantages. In the case of Roth IRA, all your withdrawals can be tax-free when you retire. Your brokerage account provides you with immediate liquidity and lower long-term capital gains tax on realized gains.

Plan for child’s expenses

Most parents will do anything for their children. But having kids is expensive. Whether a parent will stay at home and not earn a salary, or you decide to hire a nanny or pay for daycare, children will add an extra burden to your budget. Not to mention the extra money for clothes, food, entertainment (Disneyland) and even another seat on the plane.

Plan for college with a 529 Plan

Many parents want to help their children pay for college or at least cover some of the expenses. 529 plan is a convenient, relatively inexpensive and tax-advantageous way to save for qualified college expenses. Sadly, only 29% of US families are familiar with the plan. Most states have their own state-run 529 plan. Some states even allow state tax deductions for 529 contributions. Most 529 plans have various active, passive and age-based investment options. You can link your checking account to your 529 plan and set-up regular monthly contributions. There are plentiful resources about 529 plans in your state. I am happy to answer questions if you contact me directly.  

Protect your legacy

Many young families want to protect their children in case of sudden death or a medical emergency. However, many others don’t want to talk about it at all. I agree it’s not a pleasant conversation. Here in California, unless you have an established estate, in case of your death all your assets will go to probate and will have to be distributed by the court. The probate is a public, lengthy and expensive process. When my son was born my wife and I set up an estate, created our wills and assigned guardians, and trustees to our newly established trust.  

The process of protecting your legacy is called estate planning. Like everything else, it’s highly personalized depending on the size of your family, the variety of assets you own, your income sources, your charitable aptitude, and so on. Talking to an experienced estate attorney can help you find the best decision for yourself and your family.

I never sell insurance to my clients. However, if you are in a situation where you are the sole bread earner in the household, it makes a lot of sense to consider term life and disability insurance, which can cover your loved ones if something were to happen to you.

Plan ahead

I realize that this is a very general, kind of catch-all checkpoint but let me give it a try. No matter what happens in your life right now, I guarantee you a year or two from now things will be different. Life changes all the time – you get a new job, you have a baby, you need to buy a new car, or your company goes public, and your stock options make you a millionaire. Whatever that is, think ahead. Proper planning could save you a lot of money and frustration in the long run.

Conclusion

I realize that this checklist is not complete. Every family is unique. Each one of you has very different circumstances, financial priorities, and life goals. There is never a one-size-fits-all solution for any family out there. If you contact me directly, I will be happy to address your questions.

 

Will Emerging Markets Continue to Rally

Will Emerging Markets Continue to Rally

Will Emerging Markets Continue to Rally

Emerging Markets are up 26% so far year. But can they sustain the rally?

If you invested in one of the large EM ETFs like EEM (iShares MSCI Emerging Markets ETF) or VWO (Vanguard FTSE Emerging Markets Index Fund ETF Shares) ten years ago, you would have earned nearly zero as of September 29, 2017. At the same time, you would have doubled your money if you invested in S&P 500 (SPY) as long as you stayed put during the market crisis of 2008 – 2009.

So is this just a fluke? Or maybe after a lost decade of volatile price swings, EM stocks are finally ready to turn the page. While we recognize the long-term opportunity in EM, we also understand this could be a bumpy ride.

Learn more about our Private Wealth Management services

 

What is an Emerging Market?

In the investment world, the countries are divided into three main categories – developed, emerging and frontier. Developed countries include countries with developed capital markets and relatively high GDP per capita. The list consists of USA, Canada, Japan, UK, Australia, Germany, Italy, France and several others. Emerging markets have some similarities with the developed economies including functioning capital markets and a banking system, but they lack certain characteristics including lower market liquidity and transparency. They also have more political influence and less strict accounting standards.

The list of Emerging economies includes Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and UAE.

Just to make things a little more complicated, FTSE  indices classify Korea as a developed economy. However, other index providers such as MSCI and Dow Jones include Korea in the EM group.

What makes the emerging markets an attractive investment?

Economic growth

EM has been characterized by higher growth than most developed economies. According to IMF, emerging markets GDP is expected to grow by an average of 4.7% in 2017. Furthermore, despite the recent slowdown, next year projections are the first time in six years when we see an acceleration in the growth forecast.

For comparison, US GDP is expected to grow at 2.6% in the next two years, while EU is projected at 1.7%.

Also, according to World Bank consumption growth per capita in emerging is expected to grow by an average of 5.5% versus 1.5% for developed markets.

This growth differential provides an opportunity for companies with strong presence in these markets to benefit and increase their revenues as a result of the expected economic growth.

Population trends

According to Euromonitor, developing countries account for 90% of the world population under 30.  For instance, the average age of the Philippines is 24, India is 26, Mexico is 27, and Brazil is 31. For comparison, the median age in the USA is 37.2. Japan and Germany are at 46.1.  Emerging economies have a young population base which will help them support future economic and consumption growth. In fact, developing markets now account for more than 75% of global growth in output and consumption, almost double their share in just two decades.

Attractive Valuations

With US stocks equities almost fully priced, investors are starting to look for better opportunities abroad. At 16x current price-to-earnings, emerging market equities (EEM) are considerably cheaper than US large cap-equities.  For comparison, SPY currently trades at 23.7 times price-to-earnings. Furthermore, Emerging Market price-to-book ratio is 1.63x versus 2.85 for SPY.

Even with the 25% return so far this year, EM stocks are still trading at nearly 50% discount to US large cap stocks. This valuation gap creates opportunities for investors to transfer some of their assets to less expensive assets.

Diversification

For investors looking to diversify some of their risks, EM represents a compelling alternative. EM stocks traditionally have a lower correlation to the US equity markets.

For instance, a broad EM ETF such as EEM has a correlation of 0.80 to the S&P 500, while its R-squared (explained returns) ratio is 62.7%. As a comparison, a US Small Cap stocks (IJR) have a 0.92 correlation ratio and 78.7% R-squared to the large US cap index.

 

What are some of the risks?

Volatility of returns

Owning EM stocks comes with a lot of risks. The EM equity performance has been inconsistent for the past ten years. $1,000,000 invested in EEM ETF in Jan 1, 2007 would have produced $ 1,005,620 by Dec 2015 and $1,433,727 by Sep 2017. This is the equivalent of 0.06% and 3.45% annualized rate of return. As a comparison, the same one million invested in SPY would have made 1,735,171 in 2015 and 2,215,383 in Sep 2017 or an average of 6.31% and 7.68% respectively.

This return volatility shows the unpredictability and large swings of returns in EM stocks, which brings us to the next point.

Furthermore, investors who are willing to invest in EM have to stomach the higher volatility associated with these stock. To illustrate, EEM has a beta of 1.29 vs. 1 for S&P 500 and 10-year Standard deviation of 24.59% vs. 15.74% for S&P 500. The maximum drawdown of EEM was -60.44% versus -50% for SPY.

Company concentration

A handful of large corporations and conglomerates are consistently dominating all EM country indices. For example, the top 5 holdings in the China Large-Cap index make up 38% of the entire market. In Korea, top 5 companies make up 33%, with Samsung dominating the market with 20%. In India, top 5 companies’ weight is 36%, in Russia, 35% and Mexico, 40%.  As a comparison, top 5 stocks in the S&P 500 index (SPY) make up 11% of the total.

This high concentration leaves the Emerging markets exposed to the fortunes of the handful of companies dominating their markets.

Political instability

Another risk associated with emerging economies is their heavy dependence on local politics. Just in the past few years, we saw North Korea nuclear threats, political scandals in Brazil, sanctions against Russia, the war in Syria. Changes in political power or any geopolitical turmoil will significantly impact the emerging economies and their neighbors.

 

 

About the author: Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm. Babylon Wealth Management offers highly customized Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans and other institutional clients. To learn more visit our OCIO page here.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing, Copyright: www.123rf.com

 

6 Saving & Investment Practices All Business Owners Should Follow

6 Saving & Investment Practices All Business Owners Should Follow

In my practice, I often meet with small business owners who have the entire life savings and family fortune tied up to their company. For many of them, their business is the only way out to retirement. With this post, I would like to offer 6 saving & investment practices all business owners should follow.

Having all your eggs in one basket, however, may not be the best way to manage your finances and family fortune. Think about bookstores. If you owned one 20-30 years ago, you probably earned a decent living. Now, bookstores are luxuries even in major cities like New York and San Francisco. Technology, markets, consumer sentiments, and laws change all the time. And that is why it is vital that you build healthy saving and investment routines to grow your wealth, protect your loved ones, and prepare yourself for the years during retirement.

Start Early

I always advise my clients to start saving early and make it a habit. Saving 10-20 percent of your monthly income will help you build and grow your wealth. For instance, by starting with $20,000 today, with an average stock market return of 6 percent, your investments can potentially accumulate to $115,000 in 30 years or even $205,000 in 40 years.

Saving and investing early in your career can build a buffer to correct for any sidesteps or slip-ups. Starting to build your wealth early will provide the necessary protection against market drops and economic recessions and prepare you for large purchases like a new home, college tuition, a new car or even expanding your business.

Build a Safety Net

Life can often be unpredictable in good and bad ways. Having an emergency fund is the best way to guard your wealth and maintain liquidity for your business. I typically recommend keeping 6 to 12 months of basic living expenses in your savings account.

Even though my firm does not offer insurance, I often advise my clients especially those who are sole bread earners or work in industries prone to accidents to consider getting life and disability insurance. Good insurance will guarantee protection and supplemental income for yourself and your loved ones in case of unexpected work or life events.

Manage Your Debt

The last eight years of a friendly interest environment has brought record levels of debt in almost every single category. Americans now owe more than $8.26 trillion in mortgages, $1.14 trillion in auto loans, and $747 billion in credit cards debt. If you are like me, you probably don’t like owing money to anyone.

That’s great, however, taking loans is an essential part of any enterprise. Expanding your business, building a new facility or buying a competitor will often require external financing. Keeping track of your loans and prioritizing on paying off your high-interest debt can save you and your business a lot of money. It may also boost your credit score.

Set-up a Company Retirement Plan

The US Government provides a variety of options for businesses to create retirement plans for both employees and owners. Some of the most popular ones are employer-sponsored 401k, self-employed 401k, profit-sharing, SIMPLE IRA, and SEP IRA.

Having a company retirement plan is an excellent way to save money in the long run. Plan contributions could reduce current taxes and boost your employees’ loyalty and morale.

Of the many alternatives, I am a big supporter of 401(k) plans. Although they are a little more expensive to establish and run, they provide the highest contribution allowance over all other options.

The maximum employee contribution to 401(k) plans for 2017 is $18,000. The employer can match up to $36,000 for a total of $54,000. Individuals over 50 can add a catch-up contribution of $6,000. Also, 401k and other ERISA Plans offer an added benefit. They have the highest protection to creditors.

Even if you already have an up-and-running 401k plan, your job is not done. Have your plan administrator or an independent advisor regularly review your investment options.

I frequently see old 401k plans that have been ignored and forgotten since they were first established. Some of these plans often contain high-fee mutual funds that have consistently underperformed their benchmarks for many consecutive years. I typically recommend replacing some of these funds with low-fee alternatives like index funds and ETFs. Paying low fees will keep more money in your pocket.

Diversify

Many business owners hold a substantial amount of their wealth locked in their business. By doing so, they expose themselves to what we call a concentrated risk. Any economic, legal and market developments that can adversely impact your industry can also hurt your personal wealth.

The best way to protect yourself is by diversification. Investing in uncorrelated assets can decrease the overall risk of your portfolio. A typical diversified portfolio may include large-, mid-, small-cap, and international stocks, real estate, gold, government, and corporate fixed income.

Plan Your Exit

Whether you are planning to transfer your business to the next generation in your family or cash it in, this can have serious tax and legal consequences. Sometimes it pays off to speak to a pro.

Partnering with someone who understands your industry and your particular needs and circumstances, can offer substantial value to your business and build a robust plan to execute your future financial strategy.

 

The article was previously published in HVACR Business Magazine on March 1, 2017

End of Summer Market Review

End of Summer Market Review

Happy Labor Day!

Our hearts are with the people of Texas! I wish them to remain strong and resilient against the catastrophic damages of Hurricane Harvey. As someone who experienced Sandy, I can emphasize with their struggles and hope for a swift recovery.

 

I know that this newsletter has been long past due. However, as wise people say, it is better late than never.

It has been a wild year so far. Both Main and Wall Street kept us occupied in an electrifying thriller of election meddling scandals, health reforms, political battles, tax cuts, interest rate hikes and debt ceiling fights (that one still to unfold).

Between all that, the stock market is at an all-time high. S&P 500 is up 11.7% year-to-date. Dow Jones is up 12.8%, and NASDAQ is up to the whopping 24%. GDP growth went up by 3% in the second quarter of 2017. Unemployment is at a 10-year low. 4.3%.

Moreover, despite record levels, very few Americans are feeling the joy of the market gains and feel optimistic about the future. US families are steadily sitting on the sideline and continuing to pile cash. As of June 2007, the amount of money in cash and time deposits (M2) was 70.1% of the GDP, an upward trend that has continued since the credit crisis in 2008.

End of Summer Market Review

Source: US Fed, https://fred.stlouisfed.org/graph/?g=dZn

Given that the same ratio of M2 as % of GDP is 251% in Japan, 193% in China, 91% in Germany, and 89% in the UK, US is still on the low end of the developed world. However, this is a persistent trend that can reshape the US economy for the years to come.

 

The Winners

This year’s rally was all about mega-cap and tech stocks. Among the biggest winners so far this year we have Apple (AAPL), up 42%, Amazon (AMZN), 27%, NVIDIA (NVDA), 54%, Adobe, 48%, PayPal, 55%. Netflix, 36%, and Visa (V), 33%,

Probably the biggest story out there is Amazon and its quest to disrupt the way Americans buy things. Despite years of fluctuating earnings, Amazon is still getting full support from its shareholders who believe in its long-term strategy. The recent acquisition of Whole Foods and announcement of price drops, only shows that Amazon is here to stay, and all the key retail players from Costco, Wall-Mart, Target, and Walgreens to Kroger’s, Home Depot, Blue Apron and AutoZone will have to adjust to the new reality and learn how to compete with Amazon.

The Laggards

Costco, Walgreens, and Target are bleeding from the Amazon effect as they reported- 0.49%, -0.74% and -21% year-to-date respectively. Their investors are become increasingly unresponsive to earnings surprises and massively punishing to earnings disappointments.

Starbucks, -0.74%, is still reviving itself after the departure of its long-time CEO, Howard Shultz, and will have to discover new revenue channels and jump-start its growth.

The energy giants, Chevron, -5%, Exxon, -12%, and Occidental Petroleum, -14.5% are still suffering from the low oil prices. With OPEC maintaining current production levels and surge in renewable energy, there is no light at the end of the tunnel. If these low levels continue, I will expect to see a wave of mergers and acquisitions in the sector. Those with a higher risk and yield appetite may want to look at some of the companies as they are paying a juicy dividend – Chevron, 4%, Exxon, 4%, and Occidental Petroleum, 5.4%

AT&T, -7% and Verizon, -5%, are coming out of big acquisitions, which down-the-road can potentially create new revenue channels and diversify away from the otherwise slow growing telecom business. In the near-term, they will continue to struggle in their effort to impress their investors. Currently, both companies are paying above average dividends, 5.15%, and 4.76%, respectively.

And finally, Wells Fargo, -4%. The bank is suffering from the account opening scandals last year and the departure of its CEO.  The stock has lagged its peers, which reported on average, 8% gains this year. While the long-term outlook remains positive, the short-term prospect remains uncertain.

 

Small Caps

Small Cap stocks as an asset class have not participated in this year’s market rally. Despite spectacular 2016 returns, small cap stocks have remained in the shadow of the uncertainty of the expected tax cuts and infrastructure program expansion. While I believe the Congress will come out with some tax reductions in the near term, the exact magnitude is still unclear. My long-term view of US small caps remains bullish with some near-term headwinds.

 

International Stocks

After several years of lagging behind US equity markets, international stocks are finally starting to catch up. The Eurozone reported 2% growth in GDP. MSCI EAFE is up 17.5% YTD, and MSCI Emerging Markets is up 28% YTD.

Despite the recent growth, International Developed and Emerging Market stocks remain cheap on a relative basis compared to US Stocks.  I maintain a long-term bullish view on international and EM stocks with some caution in the short-term.

Even though European Central Bank has kept the interest rates unchanged, I believe that its quantitative easing program will slow down towards the end of 2017 and beginning of 2018. The German bund rates will gradually rise above the negative levels. The EUR / USD will breach and remain above 1.20, a level not seen since 2014.

Interest Rates

I am expecting maximum one or may be even zero additional rate hikes this year. Under Janet Yellen, the Fed will continue to make extremely cautious and well-measured steps in raising short term rates and slowing down of its Quantitative Easing program. Bear in mind that the Fed has not achieved its 2% inflation target and any sharp rate hikes can ruin the already fragile balance in the fixed income space.

Real Estate

After eight years of undisrupted growth, US Real Estate has finally shown some signs of slow down. While demand for Real Estate in the primary markets like California and New York is still high, I expect to see some cooling off and normalization of year-over-year price growth

US REITs have reported 3.5% total return year-to-date, which is roughly the equivalent of -0.5% in price return and 4% in dividend yield.

Some retail REITs will continue to struggle in the near-term due to store closures and pressure from online retailers. I encourage investors to maintain a diversified REIT portfolio with a focus on strong management, sustainability of dividends and long-term growth prospects.

Gold

After several years of underperformance, Gold is making a quiet comeback. Gold was up 8% in 2016 and 14% year-to-date. Increasing market and political uncertainty and fear of inflation are driving many investors to safe havens such as gold. Traditionally, as an asset class, Gold has a minimal correlation to equities and fixed income. As such, I support a 1% to 5% exposure to Gold in a broadly diversified portfolio as a way to reduce long-term risk.

 

About the author: Stoyan Panayotov, CFA is a fee-only investment advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

 

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

 

6 Essential steps to diversify your portfolio

6 Essential steps to diversify your portfolio

Diversification is often considered the only free lunch in investing. In one of my earlier blog posts, I talked about the practical benefits of diversification. I explained the concept of investing in uncorrelated asset classes and how it reduces the overall risk of the investments.  In this article, I will walk you through 6 essential steps to diversify your portfolio.

 

1. Know your risk tolerance

Risk tolerance is a measure of your emotional appetite to take on risk. It is the ability to endure volatility in the marketplace without making any emotional and spur of the moment investment decisions. Individual risk tolerance is often influenced by factors like age, investment experience, and various life circumstances.

Undoubtedly, your risk tolerance can change over time. Certain life events can affect your ability to bear market volatility. You should promptly reflect these changes in your portfolio risk profile as they happen.

 

2. Understand your risk capacity

Often your willingness and actual capacity to take on risk can be in conflict with each other. You may want to take more risk than you can afford. And inversely, you could be away too conservative while you need to be a bit more aggressive.

Factors like the size of savings and investment assets, investment horizon, and financial goals will determine the individual risk capacity

 

3. Set a target asset allocation

Achieving the right balance between your financial goals and risk tolerance will determine the target investment mix of your portfolio. Typically, investors with higher risk tolerance will invest in assets with a higher risk-return profile.

These asset classes often include small-cap, deep value, and emerging market stocks, high-yield bonds, REITs, commodities and various hedge fund and private equity strategies. Investors will lower risk tolerance will look for safer investments like government and corporate bonds, dividends and low volatility stocks.

In order to achieve the highest benefit from diversification, investors must allocate a portion of their portfolio to uncorrelated asset classes. These investments have a historical low dependence on each other’s returns.

The US Large Cap stocks and US Treasury Bonds are the classic examples of uncorrelated assets. Historically, they have a negative correlation of -0.21. Therefore, the pairs tend to move in opposite direction over time. US Treasuries are considered a safe haven during bear markets, while large cap stocks are the investors’ favorite during strong bull markets.

See the table below for correlation examples between various asset classes.

Asset Correlation Chart
Source: Portfoliovisualizer.com

4. Reduce your concentrated positions

There is a high chance that you already have an established investment portfolio, either in an employer-sponsored retirement plan, self-directed IRA or a brokerage account.

If you own a security that represents more than 5% of your entire portfolio, then you have a concentrated position. Regularly, individuals and families may acquire these positions through employer 401k plan matching, stock awards, stock options, inheritance, gifts or just personal investing.

The risk of having a concentrated position is that it can drag your portfolio down significantly if the investment has a bad year or the company has a broken business model. Consequently, you can lose a substantial portion of your investments and retirement savings.

Managing concentrated positions can be complicated. Often, they have restrictions on insider trading. And other times, they sit on significant capital gains that can trigger large tax dues to IRS if sold.

 

5. Rebalance regularly

Portfolio rebalancing is the process of bringing your portfolio back to the original target allocation. As your investments grow at a different rate, they will start to deviate from their original target allocation. This is very normal. Sometimes certain investments can have a long run until they become significantly overweight in your portfolio. Other times an asset class might have a bad year, lose a lot of its value and become underweight.

Adjusting to your target mix will ensure that your portfolio fits your risk tolerance, investment horizon, and financial goals. Not adjusting it may lead to increasing the overall investment risk and exposure to certain asset classes.

 

6. Focus on your long-term goals

When managing a client portfolio, I apply a balanced, disciplined, long-term approach that focuses on the client’s long-term financial goals.

Sometimes we all get tempted to invest in the newest “hot” stock or the “best” investment strategy ignoring the fact that they may not fit with our financial goals and risk tolerance.

If you are about to retire, you probably don’t want to put all your investments in a new biotech company or tech startup. While these stocks offer great potential returns, they come with an extra level of volatility that your portfolio may not bear. And so regularly, taking a risk outside of your comfort zone is a recipe for disaster. Even if you are right the first time, there is no guarantee you will be right the second time.

Keeping your portfolio well diversified will let you endure through turbulent times and help your investments grow over time by reducing the overall risk of your investments.

 

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

 

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing, Copyright: www.123rf.com

Municipal Bond Investing

Municipal Bond Investing

What is a Municipal Bond?

Municipal bond investing is a popular income choice for many Americans.  The muni bonds are debt securities issued by municipal authorities like States, Counties, Cities, and related businesses. Municipal bonds or “munis” are issued to fund general activities or capital projects like building schools, roads, hospitals, and sewer systems. The size of the muni bond market has reached 3.7 trillion dollars. There are about $350 billion of Muni bond issuance available every year.

To encourage Americans to invest in Municipal Bonds, US authorities had exempted the muni bonds’ interest (coupon income) from Federal taxes. In some cases, when the bondholders reside in the same state where the bond was issued, they can also be exempted from state taxes.

Types of Municipal Bonds

Municipal entities issue general obligation bonds to finance various public projects like roads, bridges, and parks. General obligation bonds are backed by the full faith and credit of the issuing municipality.  Usually, they do not have a dedicated revenue source. The local authorities commit their abundant resources to pay off the bonds. Municipals rely on their unlimited power to tax residents to pay back bondholders.

Revenue bonds are backed by income from a particular project or source. There is a wide diversity of types of revenue bonds, each with unique credit characteristics. Municipal entities frequently issue securities on behalf of borrowers such as water and sewer services, toll bridges, non-profit colleges, or hospitals. These underlying borrowers typically agree to repay the issuer, who pays the interest and principal on the securities solely from the revenue provided by the conduit borrower.

Taxable Bonds. There is a smaller but growing niche of taxable municipal bonds. These bonds exist because the federal government will not subsidize the financing of certain activities, which do not significantly benefit the general public. Investor-led housing, local sports facilities, refunding of a refunded issue, and borrowing to replenish a municipality’s underfunded pension plan, Build America Bonds (BABs) are types of bond issues that are federally taxable. Taxable municipals offer higher yields than those of other taxable sectors, such as corporate or government agency bonds.

Investment and Tax Considerations

Tax-Exempt Status

With their tax-exempt status, muni bonds are a powerful tool to optimize your portfolio return on an after-tax basis.

Muni Tax Adjusted Yield

So why are certain investors flocking into buying muni bonds? Let’s have an example:

An individual investor with a 35% tax rate is considering an AA-rated corporate bond offering a 4% annual yield and an AA-rated municipal bond offering a 3% annual yield. All else equal, which investment will be more financially attractive?

Since the investors pays 35% on the received interest from the corporate bonds she will pay 1.4% of the 4% yield to taxes (4% x 0.35% = 1.4%) having an effective after-tax interest of 2.6% (4% – 1.4% = 2.6%). In other words, the investor will only be able to take 2.6% of the 4% as the remaining 1.4% will go for taxes. With the muni bond at 3% and no federal taxes, the investor will be better off buying the muni bond.

Another way to make the comparison is by adjusting the muni yield by the tax rate. Here is the formula.

Muni Tax Adjusted Yield = Muni Yield / (1 – tax rate) = 4% / (1 – 0.35%) = 4.615%

The result provides the tax-adjusted interest of the muni bond as if it was a regular taxable bond. In this case, the muni bond has 4.615% tax-adjusted interest, which is higher than the 4% offered by the corporate bond.

 The effective state tax rate

Another consideration for municipal bond investors is the state tax rate. Most in-state municipal bonds are exempt from state taxes, while out-of-state bonds are taxable at the state tax level. Investors from states with higher state tax rates will be interested in comparing the yields of both in and out-of-state bonds to achieve the highest after-tax net return. Since under federal tax law, taxes paid at the state level are deductible on a federal income tax return, investors should, in fact, consider their effective state tax rate instead of their actual tax rate. The formula is:

Effective state tax rate = State Income Tax rate x (1 – Federal Income Tax Rate)

Example, if an investor resides in a state with 9% state tax and has 35% federal tax rate, what is the effective tax rate:

Effective state tax rate = 9% x (1 – .35) = 5.85%

If that same investor is comparing two in- and out-of-state bonds, all else equal, she is more likely to pick the bond with the highest yield on net tax bases.

AMT status

One important consideration when purchasing muni bonds is their Alternative Minimum Tax (AMT) status. The most municipal bond will be AMT-free. However, the interest from private activity bonds, which are issued to fund stadiums, hospitals, and housing projects, is included in the AMT calculation. If an investor is subject to AMT, the bond interest income could be taxable at a rate of 28%.

Social Security Benefits

If investors receive Medicare and Social Security benefits, their municipal bond tax-free interest could be taxable. The IRS considers the muni bond interest as part of the “modified adjusted gross income” for determining how much of their Social Security benefits, if any, are taxable. For instance, if a couple earns half of their Social Security benefits plus other income, including tax-exempt muni bond interest, above $44,000 ($34,000 for single filers), up to 85% of their Social Security benefits are taxable.

Diversification

Muni bonds are a good choice to boost diversification to the investment portfolio.  Historically they have a very low correlation with the other asset classes. Therefore,  municipal bonds returns have observed a smaller impact by developments in the broader stock and bond markets.

For example, municipal bonds’ correlation to the stock market is at 0.03%. Their correlation to the 10-year Treasury is at 0.37%.

Interest Rate Risk

Municipal bonds are sensitive to interest rate fluctuations. There is an inverse relationship between bond prices and interest rates. As the rate goes up, muni bond prices will go down. And reversely, as the interest rates decline, the bond prices will rise. When you invest in muni bonds, you have to consider your overall interest rate sensitivity and risk tolerance.

Credit Risk

Like the corporate world, municipal bonds and bond issuers receive a credit rating from major credit agencies like Moody’s, S&P 500, and Fitch. The credit rating shows the ability of the municipality to pay off the issued debt. The bonds receive a rating between AAA and C, with AAA being the highest possible and C the lowest. BBB is the lowest investment-grade rating, while all issuance under BBB is known as high-yield or “junk” bonds. The major credit agencies have different methodologies to determine the credit rating of each issuance. However, historically the ratings tend to be similar.

Unlike corporations, which can go bankrupt and disappear, municipals cannot go away. They have to continue serving their constituents. Therefore, many defaults end up with debt restructuring followed by continued debt service. Between 1970 and 2014, there were 95 municipal defaults. The vast majority of them belong to housing and health care projects.

In general, many investors consider municipal debt to be less risky. The historical default rates among municipal issuances are a lot smaller than those for comparable corporate bonds.

Limited secondary market

The secondary market for municipal bonds sets a lot of limitations for the individual investor. While institutional investors dominate the primary market, the secondary market for municipal bonds offers limited investment inventory and real-time pricing. Municipal bonds are less liquid than Treasury and corporate bonds. Municipal bond investing tends to be part of a buy-and-hold strategy as most investors seek their tax-exempt coupon.

Fragmentation

The municipal bond market is very fragmented due to issuances by different states and local authorities. MUB, the largest Municipal ETF, holds 2,852 muni bonds with the highest individual bond weight at.45%. The top 5% holdings of the ETF make 1.84% of the total assets under management. For comparison, TLT, a 20-year old Treasury ETF, has 32 holdings with the largest individual weight at 8.88%. The top 5% make up 38.14% of the assets under management.

4 Steps to determine your target asset allocation

4 Steps to Determine your target asset allocation

One of the financial advisors’ primary responsibilities is to determine and document their clients’ target asset allocation. The target allocation serves as a starting point and guideline in diversifying the client portfolio and building future wealth. Clients’ unique financial goals, lifestyle, investment horizon, current and expected income, and emotional tolerance to market turbulence will impact their future asset allocation.

The target investment mix is not constant. It can shift from more aggressive to more conservative or vice versa with substantial changes in lifestyle, family status, personal wealth, employment, and age.

Assess your risk tolerance

Most advisors use questionnaires to evaluate their client’s risk tolerance. The length of these surveys varies from advisor to advisor. Furthermore, some assessments are available online for free. The idea behind all of them is to determine the investor’s tolerance to market volatility, and unpredictable macroeconomic and life events.

Individuals with high-risk tolerance have the emotional capacity to take on more risk. They can endure significant market swings in order to achieve a higher future return.

On the opposite side, investors with low-risk tolerance are willing to sacrifice higher returns for safer, low volatility assets which will have smaller swings during turbulent markets.

A free risk tolerance test is available here:

https://www.calcxml.com/calculators/inv01?skn=#top

Regardless of which test you take, if you answer all questions consistently, you should expect to get similar results.

Advisors, of course, should not rely solely on test results. They need to know and understand their clients. Advisors must have a holistic view of all aspects of client’s life and investment portfolio.

 

Set your financial goals

Your financial goals are another critical input to determine your target investment mix. Your goals can stretch anywhere from a couple of months to several decades. They can be anything from paying off your debt, buying a house, planning for a college fund, saving for a wedding, a trip or retirement, making a large charitable donation, and so on.

Each one of your goals will require a different amount of money for completion.

Having your goals in place will define how much money you need to save in order to reach them. The range of your goals versus your current wealth and saving habits will determine your target asset allocation.

More aggressive goals will require more aggressive investment mix.

More balanced goals will call for more balanced investment portfolio.

Sometimes, investors can have a conflict between their financial goals and risk tolerance. An investor may have low to moderate risk tolerance but very aggressive financial goals. Such conflict will ultimately require certain sacrifices – either revising down the investor’s financial goals or adjusting his or her willingness to take on more risk.

Define your investment horizon

Your investment horizon and the time remaining to your next milestone will significantly impact your investment mix.

529 college fund plan is an excellent example of how the investment horizon changes the future asset mix. Traditional 529 plans offer age-based investment allocation. The fund is initially invested in a higher percentage of equity securities. This original investment relies on the equities’ higher expected return, which can potentially bring higher growth to the portfolio. Over time, as the primary beneficiary (the future student), approaches the first year in college, the money in the 529 plan will gradually be re-allocated to a broadly diversified portfolio with a large allocation to fixed income investments. The new target mix can provide more safety and predictable returns as the completion of the goal approaches.

The same example can apply for retirement and home purchase savings or any other time-sensitive goal. The further away in time is your goal; the stronger will be your ability to take on more risk. You will also have enough time to recover your losses in case of market turmoil. In that case, your portfolio will focus on capital growth.

As the completion time of your goal approaches, your affinity to risk will decrease substantially. You also won’t have enough time to recover your losses if the market goes down considerably. In this situation, you will need a broadly diversified portfolio with refocusing on capital preservation.

 

 Know your tax bracket

The investors’ tax bracket is sometimes a secondary but often crucial factor in determining asset allocation. The US Federal tax rate ranges from 10% to 39.6% depending on income level and filing status. In addition to Federal taxes, individuals may have to pay state and city taxes.

Investors can aim to build a tax-efficient asset allocation.  They can take advantage of the preferential tax treatment of different financial securities among various investment account types – taxable, tax-deferred, and tax-exempt accounts. 

For instance, they may want to allocate tax-efficient investments like Municipal bonds, MLPs, ETFs and Index funds to taxable accounts and higher tax bearing investments like Gold, Bonds, and REITs into tax-advantaged accounts.

In any case, investors should attempt to achieve the highest possible return on an after-tax basis. Building a tax-efficient investment portfolio can add up to 1% or more in performance over an extended period.

A Guide to Investing in REITs

Investing in REITs

On August 31, 2016, S&P 500 will introduce a new sector – Real Estate. Up until now real estate companies, also known as REITs,  belonged to the Financial sector. They were in the company of large financial and insurance corporations. The new category will have 27 stocks, $567 billion of market capitalization and an approximate weight of 3% of the total S&P 500 market value.

With the addition of Real Estate as a separate sector in S&P indices, many active managers will have to aline their current portfolios with the new sector structure.

What is a REIT?

A real estate investment trust (REIT) is a company that owns and manages income-producing real estate. It represents a pool of properties and mortgages bundled together and offered as a security in the form of unit investment trusts.

REITs invest in all the main property types with approximately two-thirds of the properties in offices, apartments, shopping centers, regional malls, and industrial facilities. The remaining one-third is divided among hotels, self-storage facilities, health-care properties, prisons, theaters,  golf courses and timber.

The total market capitalization of all publicly-traded REITs is equal to $993 billion. The majority of it, $933 billion belongs to Equity REITs and the remainder to Mortgage and other financing REITs.

There are 219 REITs in the FTSE NAREIT All REITs Index. 193 of them trade on the New York Stock Exchange

Legal  Status

REITs are subject to several regulations. To qualify as a REIT, a real estate firm must pay out 90% of its taxable income to shareholders as dividends. The REIT can deduct the dividends paid to shareholders from its taxable income. Thus their income is exempt from corporate-level taxation and passes directly to investors. Other important regulations include:

  • Asset requirements: at least 75% of assets must be real estate, cash, and government securities.
  • Income requirements: at least 75% of gross income must come from rents, interest from mortgages, or other real estate investments.
  • Stock ownership requirements: shares in the REIT must be held by a minimum of 100 shareholders. Five or fewer individuals cannot (directly or indirectly) own more than 50% of the value of the REIT’s stock during the last half of the REIT’s taxable year.

Distributions

Dividend distributions for tax purposes are allocated to ordinary income, capital gains, and return on capital, each of them having different tax treatment. REITs must provide shareholders with guidance on how to treat their dividends for tax purposes.  The average distribution breakdown for 2015 was approximately 66% ordinary income, 12% return on capital, and 22% capital gains.

REITs distributions have grown substantially in the past 15 years. The total REIT distributions in 2000 were under $8 billion dollar. Just between 2012 and 2015, REITs distribution rose up from $28.8 billion to $44.9 billion, or 44%.

Tax implicationsThe majority of REIT dividends are considered non-qualified dividends and taxed as ordinary income, up to the maximum rate of 39.6 percent, plus a separate 3.8 percent Medicare surtax on investment income.

Capital gains distributions are taxable at either 0, 15 or 20 percent tax rate, plus the 3.8 percent surtax.

Return-on-capital distributions are tax-deferred. They reduce the cost basis of the REIT investment.

When a REIT distributes dividends received from a taxable REIT subsidiary or other corporation, those distributions are taxed at the qualified dividend rate of 0, 15, or 20 percent, plus the 3.8 percent surtax.

Timber REITs

One REIT sector makes an exception from the above rule. Timber REITs have a favorable tax treatment from the IRS. Distributions from timber REITs such as RYN, PCL, PCN & WY are considered long-term capital gains and therefore are taxable at the lower capital gain rate (0, 15% or 20% plus 3.8% Medicare surcharge).

 Economic Cycle 

Individual REIT sectors have different sensitivity to cyclical factors.  Industrial, hotel, and retail REITs have the biggest exposure to economics cycles. Their occupancy and rental rates are extremely sensitive to economic conditions. Cyclical downturns in the economy, recession, and weak consumer spending, can significantly hurt the revenue stream of these REITs.

On the other hand, health care REITs tend to have long-term rental agreements and are more sheltered from market volatility.

Interest Rates

Since many REITs use bank loans and other external financings to expand their business, they have benefitted significantly from the current low-interest-rate environment. Furthermore, many yield-seeking investors turned to REITs for higher income. If low-interest rates remain, REITs will likely expand their base to a broader range of market participants.

Interest rates can impact REIT’s performance differently depending on two main factors – debt and lease duration.

Loan maturities

As a result of the current low rates, many REITs have increased their leverage and therefore have high sensitivity to interest changes. If interest rates rise, REITs with near-term loan maturities will need to refinance at higher rates. Thus their interest payments will go up, which will lead to less cash available for dividends. Therefore, REITs with higher levels of debt and short-term maturities will perform worse than REITs with less debt and long-dated maturity schedules.

At the same time, REITs with lower debt levels relative to their cash flows, all else equal, will perform better in a rising-rate environment.

Lease duration

While higher interest rates would affect all REITs, industry subsectors would be affected differently, depending on lease durations. REITs with shorter lease durations will perform relatively better in a rising-rate environment because they can seek higher rents from tenants as rates rise than could REITs with longer lease durations. The higher rents can offset the negative impact of higher interest expense. Hotel REITs usually have the shortest lease durations, followed by multifamily properties and self-storage.

Healthcare, office, and retail REITs usually sign long-term leases. Therefore rising interest rates will potentially hurt these REITs due to their inability to adjust rental contracts to offset rising costs.

Risk and return

Real Estate Investment Trusts historically have been more volatile than S&P 500. The 40-year standard deviation of the REIT’s sector is 17.16% versus 16.62% for the S&P 500 and 10.07% for the 10-year Treasury. During this 40-year period, REITs achieved a 13.66% cumulative annual return versus 11.66% for S&P 500 and 7.39% for the 10-year Treasury. (www.portfoliovisualizer.com)

Furthermore, the 10-year (2006-15) standard deviation of the REIT sector is 22.01% versus 18.02% for the S&P 500 and 9.54% for 10-year Treasury. For the same period, REITs reported 7.83% cumulative annual return versus 6.96% for S&P 500 and 4.57% for 10-year Treasury. (www.portfoliovisualizer.com)

Among the best five-year REIT sector performers were Retail, Self-Storage, and Industrial. For the same period, worst performers were Mortgage, Hotel and Office RETS.

Valuations

With respect to pricing, REITs are reaching high valuations levels. The current Price to Fund to Operations ratio is hovering around 18, which is slightly above the historical average of 16. While the P/FFO ratio remain reasonable compared to historical figures, further price rally in REITs not supported by the increase in cash flows may impose a significant risk for sector overheating.

Diversification

Even though REITs are publicly traded companies, very often they are considered an alternative asset due to their weak relationship with the other asset classes – equities and fixed income. US REITs have a relatively low correlation with the broader stock market. The 40-year correlation is equal to 0.51, while the 10-year correlation is  0.73. The correlation between REITs and 10-year Treasury is equal to -0.06, while that with Gold is 0.09.

This low correlation with other asset classes makes the REITs a solid candidate for a broadly diversified investment portfolio.

 

Investing Strategies

Directly

There are 219 publicly-traded REITs. 27 of them are included in the S&P 500 index. If you decide to invest in a single REIT or basket of REITs, you need to consider company-specific risk, management, sub-sector, regional or national market exposure, leverage, lease duration, history, and distribution payments.

Real Estate ETFs

VNQ

VNQ dominates the REITs ETF space as the largest and second-cheapest ETF. It includes a broad basket of 150 securities. The ETF tracks the MSCI US REIT Index, which includes all domestic REITs from the MSCI US Investable Market 2500 Index. This ETF doesn’t include any mortgage, timber, and tower REITs. It has an expense ratio of 0.12% (second lowest to SCHH). It has $32.4 billion of assets under management and Morningstar rating of 4. The fund holds a diversified portfolio across all property sectors. Retail REITs are the largest holding, at 25% of assets, Specialized REITs make up 16.50%, office, 12.6% residential, 15.7%, healthcare, 12.3%, diversified, 8%, hotel and resort, 5.3%, and industrial, 4.7% REITs.

IYR

IYR tracks the Dow Jones U.S. Real Estate Index. It is the most diversified REIT ETF. Unlike other ETFs which hold only equity REITs, IYR holds mortgage, timber, prison and tower REITs including companies like American Tower, Weyerhaeuser Co, Annaly Capital Management NLY and Crown Castle International Corp. IYR has three stars by Morningstar and has an expense ratio of 0.45%. IYR’s holdings are broken by Specialized REITs, (27.09%), Retail, 19.74%, Residential, 12.70%, Office, 10.00%, Health Care, 9.88%, Mortgage REITs, 4.90%, Industrial, 4.56%, Diversified, 4.51%, Hotel & Resort, 3.56%, Real Estate Services, 2.06%

ICF

ICF tracks an index of the 30 largest publicly traded REITs excluding mortgage and tower REITs. The design of this index capitalizes on the relative strength of the largest real estate firms and the conviction for consolidation in the real estate market. The ETF includes Retail REITs, 24.84%, Specialized REITs, 18.71%, Residential, 18.08%, Office, 15.23%, Health Care, 14.41%, Industrial, 5.79%, Hotel & Resort REITs, 2.56%.

RWR / SCHH

RWR / SCHH are the smallest of the five funds. They track Dow Jones US Select REIT Index. The index tracks US REITs with a minimum market cap of $200 million. The index also excludes mortgage REITs, timber REITs, net-lease REITs, real estate finance companies, mortgage brokers and bankers, commercial and residential real estate brokers and real estate agents, homebuilders, hybrid REITs, and large landowners of unimproved land. The funds’ portfolio holds a diversified range of REITs across property sectors similar to other ETFs.

SCHH has the lowest expense ratio of 0.07% all REITs ETFs while RWR has an expense ratio of 0.25%.

Performance 

Comparing the performance of the top ETFs in the past ten years, we can see a clear winner. VNQ is leading by price return, total return, and Sharpe Ratio.  Next in line are RWR and ICF. IYR takes the last spot.

Having the largest number of holdings, VNQ overweights small size REITs relative to the industry average. Hence it benefited from the smaller REITs outpacing the growth of their bigger competitors.

IYR did not benefit from being the most diversified REIT ETF. The mortgage and specialized REITs have lagged behind the performance of the traditional equity REITs.

Mutual Funds

Mutual funds are actively managed investment vehicles. They typically use an index as their benchmark.  The goal of the fund manager is to outperform their benchmark either on a risk adjusted or absolute return basis.  The fund manager can decide to overweight a particular REIT if he or she believes the company will outperform the benchmark. Many times the managers will look for mispricing opportunities of individual REITs.

Active funds usually charge higher fees than passively managed ETFs due to higher research, management, administrative and trading costs. However, many investors believe that after subtracting their fees, active managers cannot beat the market in the long run.

In my analysis, I selected a pool of five actively managed funds which are open to new investors and have an expense ratio less than 1% – VGSLX,  DFREX, TRREX, CSRSX and FRESX.

All five funds have high ratings from Morningstar and robust historical performance.

VGSLX and DFREX have the largest number of holdings, 150 and 149 respectively, and maintain the lowest expense ratio. Both funds lean more towards small and micro-cap REITs relative to the average in the category.

The other three funds, TRREX, CSRSX and FRESX manage smaller pools of REITs. CSRSX and FRESX have the highest turnover: 58% and 34% respectively.

Performance

While the 1-year returns are quite variable, the long-term performance among the five funds is relatively consistent. Vanguard REIT Index Fund, VGSLX,  has the lowest fee and the highest 10-year return of 7.6%. Cohen & Steers Realty Shares Fund, CSRSX, is second with 7.5% annual return. CSRSX has the lowest 10-year standard deviation of 25.2%. VGSLX edges slightly ahead with the highest Sharpe Ratio of 0.39. Vanguard and DFA funds benefitted from low expense ratio and larger exposure to mid and small size REITs, which had better 10-year performance than larger REITs.

It is worth noting that the 10-year Sharpe Ratio for all REITs sector is lower than the Sharpe Ratio of S&P 500. The Sharpe Ratio calculated the risk-adjusted returns of a particular investment. In this case, the risk-adjusted returns of REIT lag behind the overall equity market.

When you consider investing in REITs mutual funds,  pay attention to management style, expense ratio, turnover, dividends, the number of holdings, and their benchmark.

Where to allocate REITs investments?

REITs are often attractive for their high dividend income. As I mentioned earlier, the majority of the REITs distributions are treated as ordinary income and therefore taxed at the investors’ tax rate. Investors in high tax brackets can pay up to 39.6% rate plus 3.8% Medicare surplus tax on the investment income.

Because of their unfavorable tax status, most REITs may not be suitable for taxable investment accounts.  Tax-sensitive investors may want to consider placing REITs in Tax Advantage accounts like Roth IRA, Traditional IRA, and 401k.

Since timber REITs receive favorable tax treatment, they are an exception from the above rule. Investors may choose to hold them in taxable investment accounts.

There are two scenarios under which REITs could be an appropriate fit for a taxable account.

First, investors in the lower tax bracket will be less impacted by the tax treatment of the REITs income.

Second, investing in REITs with a history of making significant capital gain and return on capital distributions. These types of payments have more favorable tax treatment at the lower long-term capital gains tax rate.

Introduction to portfolio diversification

Introduction

Portfolio diversification is one of the main pillars of retirement planning. The old proverb “Never put all your eggs in one basket” applies in full strength to investing.

Even the Bible talks about diversification. Ecclesiastes 11:2 says “Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth.”

Wealth and asset managers use diversification as a tool to reduce overall portfolio risk. Diversification of investments with little correlation to one another allows the portfolio to grow at various stages of the economic cycle as the performance of the assets moves in different directions.

What is portfolio diversification?

According to the Securities and Exchange Commission (SEC): “The Magic of Diversification. The practice of spreading money among different investments to reduce risk is known as diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.” – https://www.sec.gov/investor/pubs/assetallocation.htm

By combining low correlated and uncorrelated assets in a portfolio and being disciplined over an extended period, you aim to achieve the highest return per certain level of risk.

Diversification reduces your exposure to a single company or an asset class. As assets move up and down each year, a diversified portfolio will allow you to build a cushion for losses and avoid being dependent on one security in case it loses its value or has a rocky year.

The financial history remembers many examples of fallen stocks, such as Enron and Lehman Brothers. The employees of these companies who invested heavily in their employer’s stock without diversifying lost a significant amount of their retirement savings.

Correlated Investments

Correlated investments move in similar fashion driven by related factors. Owning two or more securities from the same industry or with similar risk profile does not contribute to your portfolio diversification. Hence, these securities will concentrate your exposure to the same market factors. 

These three pairs are an example for correlated stocks – Coca-Cola and Pepsi, Target and Costco, Verizon and AT&T. While there are some differences in their business model and historical performance, the pairs are exposed to the same economic factors, industry drivers, and consumer sentiments.

Uncorrelated Investments

The combination of uncorrelated investments decreases the overall portfolio risk

The classic example of uncorrelated investments is stocks, bonds, and gold. Historically these large asset categories have moved independently from each other.  Their returns were influenced by different events and economic drivers.

Even within the equity space alone, investors can significantly improve their portfolio diversification by looking at companies in various industries and exposure to regional and international markets.

The pair – Amazon and PG&E is a model for uncorrelated companies. Amazon is a global online marketplace that sells discretionary consumer items. Amazon business is dependent on the economic cycle and consumer spending sentiments. PG&E is a California-based utility company that provides electricity and gas to its customers. PG&E customers (being one of them) have a limited choice for service providers. Amazon competes with many large and small-size, local and foreign companies. PG&E has virtually no competition apart from renewable sources. Amazon has expansive market potential. PG&E growth is constrained to its local market. Therefore the difference between their core business models reflects on their historical price performance and risk profile. Their shares’ price depends on different factors and hence fluctuates independently.

Sharpe Ratio

Before we continue, I want to introduce a key performance metric in asset management called Sharpe Ratio. The ratio got its name from its creator the Nobel laureate William F. Sharpe.

The Sharpe ratio measures the excess return per unit of risk of an investment asset or a portfolio.  It is also known as the risk-adjusted return.

This is the formula:

Sharpe Ratio

 

 

 

Where:

Rp is the Return of your security or portfolio.

Rf is the risk-free return of a US Treasury bond

σp is the standard deviation of your portfolio. Standard deviation measures the volatility of your portfolio returns.

 

The Sharpe ratio allows performance comparison between separate portfolios and asset classes with different return and risk. As a rule of thumb, the Sharp metric penalizes portfolios with higher volatility.

Take a very simplified example; portfolio ‘A’ has 5% return and standard deviation of 10%. Portfolio ‘B’ has 6% return and standard deviation of 15%. The risk-free rate is 1%

‘A’ portfolio: Sharpe Ratio is equal to (5% – 1%)/10% = 0.4

‘B’ portfolio: Sharpe Ratio is equal to (6% – 1%)/15% = 0.33

Portfolio ‘A’ has the higher Sharpe ratio and therefore the higher risk-adjusted return. Despite its lower return, it benefited from its lower volatility.

Even though ‘B’ had a higher return, it was penalized for having a higher risk.

 

Test 1

We will continue the explanation of the benefits of diversification with an example with real securities.

We will use two ETFs – SPY which tracks the US Large Cap S&P 500 Index and IEF, which follows the performance of the 10-year US Government bond. Let’s create three portfolios – one invested 100% in SPY,  second invested 100% in IEF and third with 50%/50% split between both funds. Each portfolio starts with hypothetical $1 million. We track the performance for ten years (January 1, 2006, to December 31. 2015).

 

One key assumption is that at the end of each year we will rebalance the 50/50 portfolio back to the original target. We will sell off the excess amount over 50% for the overweight ETF, and we will buy enough shares from the underweight ETF so we can bring it back to 50%.

Results

Ticker Initial Balance Final Balance Average Return Standard Deviation Best Year Worst Year Max. Drawdown Sharpe Ratio US Market Correlation
IEF $1,000,000 $1,698,866 5.44% 6.46% 17.91% -6.59% -7.60% 0.68 -0.30
50/50 $1,000,000 $2,002,079 7.19% 7.11% 13.11% -9.45% -20.14% 0.86 0.87
SPY $1,000,000 $2,010,149 7.23% 15.23% 32.31% -36.81% -50.80% 0.47 1.00

Diversification2_1

 

The 100% SPY portfolio has the highest return of 7.23% and best overall final balance ($2.01m). The SPY portfolio has the largest gain in a single year, 32.3% but also the biggest yearly loss of -36.8%. It also has the highest measure of risk. Its standard deviation is 15.2%.  Its risk-adjusted return (Sharpe ratio) has the lowest value of 0.47.

IEF has the lowest return of the three portfolios, 5.44% but also has the “best” worst year, -6.6% and the lowest risk, 6.5%. Sharpe ratio is 0.68, higher than that of SPY.

The  50/50 portfolio has an average return of 7.19%, only 0.03% less than SPY alone. It has a standard deviation of 7.1%, only 0.65% higher than that of the 100% EIF. its market correlation is 0.87. Most importantly, the 50/50 portfolio has the highest risk-adjusted return, equal to 0.86.

The 50/50 portfolio illustrates the benefits of diversification. It provides almost the same return as the 100% large-cap portfolio with much lower risk and better returns consistency.

Test 2

In the second example, we will introduce two more portfolios.

Portfolio #4 holds 100% GLD. GLD is the largest and most liquid  ETF in the gold market.

In portfolio #5, we will split SPY and IEF into 45% each and will add 10% in Gold ETF. Same rules apply. Once a year we rebalance the portfolio to the original target allocation 45/45/10.

Results

Ticker Initial Balance Final Balance Average Return Standard Deviation Best Year Worst Year Max. Drawdown Sharpe Ratio US Market Correlation
IEF $1,000,000 $1,698,866 5.44% 6.46% 17.91% -6.59% -7.60% 0.68 -0.30
50/50 $1,000,000 $2,002,079 7.19% 7.11% 13.11% -9.45% -20.14% 0.86 0.87
SPY $1,000,000 $2,010,149 7.23% 15.23% 32.31% -36.81% -50.80% 0.47 1.00
GLD $1,000,000 $1,967,041 7.00% 19.20% 30.45% -28.33% -42.91% 0.39 0.07
45/45/10 $1,000,000 $2,028,238 7.33% 7.05% 13.92% -8.01% -16.75% 0.88 0.81

 Diversification4

 

The GLD portfolio has the highest volatility. Its standard deviation is 19.20%. It has the lowest risk-adjusted return of 0.39 and a second-lowest return of 7%.

Let’s look at our fifth portfolio – 45% SPY, 45% IEF and 10% GLD. The new portfolio has the highest return of 7.33%, the highest final balance of $2.28m, second lowest standard deviation of 7.05% and the highest risk-adjusted return of 0.88. It also has a lower correlation to the US market, 0.81.

Recap

Portfolio #5 is the clear winner of this contest. Why? We build a portfolio of uncorrelated assets, in this case, gold, 10-year Treasury, and large-cap stocks. Subsequently, we not only received an above average annual return, but we also achieved it by decreasing the risk and minimizing the volatility of our portfolio.

These hypothetical examples illustrate the benefits of diversification. Among them are portfolio risk mitigation, reduced volatility, higher risk-adjusted return, and more efficient capital preservation.

 

Asset correlation

So how do you determine the relationship between assets? Any financial software can provide you with this data.

If you are good at math and statistics, you can do parallel performance series for your securities and find the correlation between them.

There are a couple of free online tools, which you can use as well.

Beta

One easy way to get a sense of the correlation of your securities to the general stock market is Beta. Most financial websites like Google Finance and Yahoo Finance will give you this metric. Beta shows you the stock volatility compared to S&P 500. That said, the beta of S&P 500 is always 1. So for instance, if the beta of your stock is 2, you should expect twice as much volatility of your stock as compared to S&P 500. If the beta is 0.5, you would expect half of the volatility. If the beta is -0.5, then your stock and S&P will be negatively correlated. When one goes up, the other one will go down.

A quick search in Good Finance brought me these results for the securities we discussed earlier.

Beta for IEF is -0.20, SPY is 1, GLD is 0.07, Coca Cola, 0.51, Pepsi, 0.44, Target, 0.63, Costco, 0.55, Verizon, 0.22, AT&T, 0.29, Amazon, 1.1 and PG&E, 0.17,

Few other companies and ETFs of interest are: TLT, 20-year T-bond Index, -0.59, VNQ, REIT Index, 0.81, VYM, Vanguard High Dividend ETF, 0.81, USMV, iShares Low Volatility ETF, 0.68,  Google, 1.03, Facebook, 0.76, Wal-Mart, 0.19, Starbucks, 0.80, McDonalds, 0.51. Walt Disney, 1.32, Bank of America, 1.74.

The beta of the stocks can vary depending on market conditions, economic and business cycles. I recommend using in combination with other metrics like standard deviation, R-square, and Sharpe Ratio. This approach will help you gauge the expected volatility of your stock.

How many assets should you ideally keep in your portfolio?

Some theories call for 7-10 broad asset classes. This method is ideal for smaller-size portfolios. It will help control trading and rebalancing costs.

Other theories call for 20-25 asset classes. This approach is best suitable for large-size portfolios with more complex structure.

A regular portfolio should include these three groups with their subclasses.

Equity includes Large Cap, Mid Cap, Small Cap, Micro Cap, International Developed and Emerging Markets. In addition to that, you can add growth, value, dividend, low volatility, and momentum strategies.

Fixed Income includes US Treasuries, Municipal Bonds,  Investment Grade Corporate Bonds, High Yield, Preferred Stock, International, and Emerging Market Bonds

Alternative Investments include Real Estate, Precious Metals, Commodities, Infrastructure, Private Equity, Hedge Funds.

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

 

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation, and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions.  Various sources may provide different figures due to variations in methodology and timing. Image copyright: 123RF.com

 

 

 

How to build your 401k plan

How to build your 401k plan

401k plans are a powerful savings tool for retirement

With total assets reaching $4.8 trillion dollars 401k plans are the most popular retirement vehicle and are increasingly used by employers to recruit and retain key talent.  401k accounts allow employees to build their retirement savings by investing a portion of their salary. Contributions to the plan are tax-deductible, thus reducing your taxable income,  and the money allocated grows tax-free. Taxes are due upon withdrawal of funds during retirement years. In this article, I will discuss how to build your 401k plan.

Does your employer offer a 401k plan?

If you recently joined a new company, find out whether they offer a 401k plan. Some employers offer automatic enrollment, and others require individual registration.

Many companies offer a matching contribution up to a set dollar amount or percentage.

Contributions are usually deducted from each paycheck, but employees can also opt to contribute a lump sum.  The 2016 limit is $18,000 plus a $6,000 “catch-up” contribution for people age 50 and above.

How to decide on your investment choices

Employers must provide ongoing education and training materials about retirement savings plans.

401k plans can offer anywhere between 5 and 20 different mutual funds which invest in various asset classes and strategies.  Your choice will be limited to the funds in your plan. Hence you can not invest in stocks or other financial instruments.

The fundamental goal is to build a diversified and disciplined portfolio with your investment choices. Markets will go up and down, but your diversified portfolio will moderate your risk in times of market turmoil.

Index Funds

Index Funds are passively managed mutual funds. They track a particular index by mirroring its performance. The index funds hold the same proportion of underlying stocks as the index they follow. Many indexes are tracking large-cap, mid-cap, small-cap, international and bond indices. One of the most popular categories is the S&P 500 Index funds.

Due to their passive nature index funds are usually offered at a lower cost compared to actively managed funds. They provide broad diversification with low portfolio turnover. Index funds do not actively trade in and out of their positions and only replace stocks when their benchmark changes. Index funds are easy to buy, sell and rebalance.

Actively Managed Mutual Funds

Actively managed mutual funds are the complete opposite of index funds. A management team usually runs each fund. The mutual funds have a designated benchmark, such as the S & P 500, Russell 2000,  and MSI World. Often the management team aims to beat the benchmark either by a greater absolute or risk-adjusted return. Overall active funds trade more often than index funds. Their portfolio turnover (frequency of trading) is bigger because managers take an active approach and invest in companies or bonds with the goal of beating their benchmark.

There is a broad range of funds with different strategies and asset classes. Some funds trade more actively than others. Even funds that follow the same benchmark can gravitate towards a particular sector, country or niche. For instance, a total bond fund might be more concentrated into government bonds, while another fund may invest heavily in corporate bonds.

Active funds charge higher fees than comparable index funds. These fees cover salaries, management, administrative, research, marketing, and trading costs. Funds investing in niche markets like small-cap and emerging market will have higher costs. Fees are also dependent on the size of the fund and its turnover strategy.

It’s critical to do at least a basic research before you decide which fund to purchase. Morningstar.com is a great website for mutual fund information and stats.

Target Retirement funds

These are mutual funds that invest your retirement assets according to a target allocation based on your expected year of retirement. The further away you are from retirement, the more your target fund asset allocation will lean toward equity investments. As you get closer to retirement, the portion of equity will go down and will be replaced by fixed income investments. The reason behind target retirement funds is to maintain a disciplined investment approach over time without being impacted by market trends.

One significant drawback of the retirement funds is that they assume your risk tolerance is based on your age. If you are a risk taker or risk averse, these funds may not represent your actual financial goals and willingness to take the risk.

In addition to that, investors also need to consider how target retirement funds fit within their overall investment portfolio in both taxable and tax-advantaged accounts.

Most large fund managers offer target retirement funds. However, there are some large differences between fund families. Some of the discrepancies come from the choice of active versus passive investment strategies and fees.

Without endorsing any of the two providers below I will illustrate some of the fundamental differences between Vanguard and T. Rowe Price Target Retirement funds.

Vanguard Target Retirement funds

Vanguard Target Retirement funds offer low-cost retirement fund at an expense ratio of 0.15%. All funds allocate holdings into five passively managed broadly diversified Vanguard index fund.

Vanguard Target Retirement 2015 2025 2035 2045
Total Stock Market Index 28.44 39.86 48.75 54.07
Total Intl Stock Index 19.01 26.56 32.45 35.9
Total Bond Market II Index 30.32 23.66 13.23 7.05
Total Intl Bond Index 13.37 9.92 5.57 2.98
Short-Term Infl-Protected Sec Index 8.86
% Assets 100.00 100.00 100.00 100.00
By asset class
Equity 47.45 66.42 81.2 89.97
Fixed Income 52.55 33.58 18.8 10.03

T. Rowe Target Retirement funds

On the other spectrum are T. Rowe retirement funds. Their funds have a higher expense ratio. They charge between 0.65% and 0.75%. All target funds invest in active T. Rowe mutual funds in 18 different categories. T. Rowe target funds are a bit more aggressive. They have a higher allocation to equity and offer a wider range of investment strategies.

T. Rowe Target Retirement Fund 2015 2025 2035 2045
New Income 24.38 17.34 10.64 6.74
Equity Index 500 22.15 14.85 9.31 7.41
Ltd Dur Infl Focus Bd 11.01 3.53 0.54 0.53
International Gr & Inc 5.04 6.68 7.85 8.35
Overseas Stock 5.01 6.64 7.82 8.3
International Stock 4.42 5.78 6.8 7.26
Emerging Markets Bond 3.55 2.47 1.43 1.01
Growth Stock 3.43 11.74 17.84 20.26
International Bond 3.42 2.44 1.51 0.98
High Yield 3.26 2.32 1.42 0.91
Value 3.1 11.31 17.36 19.75
Emerging Markets Stock 2.88 3.87 4.49 4.71
Real Assets 2.1 2.78 3.28 3.5
Mid-Cap Value 1.85 2.46 2.95 3.12
Mid-Cap Growth 1.78 2.35 2.73 2.9
Small-Cap Value 0.93 1.23 1.48 1.55
Small-Cap Stock 0.88 1.15 1.41 1.53
New Horizons 0.72 0.94 1.1 1.12
% Assets 100 100 100 100
By Asset Class
Equity 54.29 71.78 84.42 89.76
Fixed Income 45.62 28.1 15.54 10.17

Which approach is better? There is no distinctive winner. It depends on your risk tolerance.

Vanguard funds have lower expense ratio and a lower 10-year return. However, they have a lower risk.

T. Rowe funds have higher absolute and risk-adjusted return but also carry more risk.

10-year Performance Analysis, 2045 Target Retirement Fund

  Standard 10-year Sharpe
Fund Name Deviation Return  Ratio
VTIVX Vanguard Target 2045 14.65 5.48 0.36
TRRKX T. Rowe Target 2045 15.82 5.89 0.38

 *** Data provided by Morningstar

Most 401k plans will offer only one family of target funds, so you don’t have to decide between Vanguard, T. Rowe or another manager. You will have to decide whether to invest in any of them at all or put your money in the index or active funds. For further information, check out our dedicated article on target date funds

ETFs

ETFs are a great alternative to index and active mutual funds. They are liquid and actively trade on the exchange throughout the day.

As of now, very few plans offer ETFs. One of the main concerns for adding them to retirement plans is the timeliness of trade execution. Right now this problem is shifted to the fund managers who only issue end of day price once all trades are complete.

I expect that ETFs will become a more common choice as they grow in popularity and liquidity. Many small and mid-size companies that look for low-cost solutions can use them for them as an alternative to their for their workplace retirement plans.

Company stock

Many companies offer their stock as a matching contribution or profit sharing incentive in their employee 401k plan. Doing so aligns employees’ objectives with the company’s success.  While this may have positive intentions, current or former employees run the risk of having a large concentrated position in their portfolios.  Even if your company has a record of high returns, holding significant amounts of company stock creates substantial financial risk during periods of crisis because one is both employee and shareholder.  Enron and Lehman Brothers are great examples of this danger.  Being overinvested in your company shares can lead to simultaneous unemployment and depletion of retirement savings if the business fails.

Allocation mix

You will most likely have a choice between a family of target retirement funds and a group of large-cap, mid-cap, small-cap, international developed, emerging markets stocks, a REIT, US government, corporate, high yield and international bond funds.

Your final selection should reflect your risk tolerance and financial goals. You should consider your age, family size, years to retirement, risk sensitivity, total wealth, saving and spending habits, significant future spending and so on.

You can use the table below as a high-level guidance.

401k asset allocation mix

Data source: Ibbotson Associates, 2016, (1926-2015). Past performance is no guarantee of future results. Returns include the reinvestment of dividends and other earnings. This chart is for illustrative purposes only. It is not possible to invest directly in an index. For information on the indexes used to construct this table, see footnote 1. The purpose of the target asset mixes is to show how target asset mixes may be created with different risk and return characteristics to help meet an investor’s goals. You should choose your investments based on your particular objectives and situation. Be sure to review your decisions periodically to make sure they are still consistent with your goals.
Source: https://www.fidelity.com/viewpoints/retirement/ira-portfolio?ccsource=email_monthly

Final recommendations

Here are some finals ideas how to make the best out of your 401k savings:

  • At a minimum, you should set aside enough money in your 401k plan to take advantage of your employer’s matching contribution. It’s free money after all. However, the vesting usually comes with certain conditions. So definitely pay attention to these rules. They can be tricky.
  • 2016 maximum contribution to 401k is $18,000 plus $6,000 for individuals over 50. If you can afford to set aside this amount, you will maximize the full potential of retirement savings.
  • If your 401k plan is your only retirement saving, you need to have a broad diversification of your assets. Invest in a target retirement fund or mix of individual mutual funds to avoid concentration of your investments in one asset class or security.
  • If your 401k plan is one of many retirement saving options – taxable account, real estate, saving accounts, annuity, Roth IRA, SEP-IRA, Rollover IRA or a prior employer’s 401k plan, you will need to have a holistic view of your assets in order to achieve a comprehensive and tax optimized asset allocation.
  • Beware of hidden trading costs in your plan choices. Most no-load mutual funds will charge anywhere between 0.15% and 1.5% to manage your money. This fee will cover their management, administrative, research and trading costs. Some funds also charge upfront and backload fees. As you invest in those funds your purchase cost will be higher compared to no-load funds.
  • If you hold large concentrated positions of your current or former employer’s stock, you need to mitigate your risk by diversifying the remainder of your portfolio.

If you have any questions about your existing investment portfolio or how to start investing for retirement and other financial goals, reach out to me at [email protected] or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

About the author:

Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm based in Walnut Creek, CA. Babylon Wealth Management offers personalized wealth management and financial planning services to individuals and families.  To learn more visit our Private Client Services page here. Additionally, we offer Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans, and other institutional clients. To find out more visit our OCIO page here.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

A beginner’s guide to ETF Investing

Guide to ETFs

What is an ETF?

ETF stands for an exchange-traded fund. The fund is a passively managed marketable security that tracks an index, a commodity, or a pool of bonds. ETFs trade on the stock exchange, and their price fluctuate throughout the day.

By design, ETFs do not produce positive alpha. Alpha is the difference between the fund and the benchmark performance.  They strictly follow their index, and as a result, their alpha is always zero.

ETFs popularity spiked in the past several years due to the rise of robo-advisers, an increase in competiton, and lowe management fees. At the same time, many emblematic active managers underperformed their benchmarks and saw significant fund outflows.

ETF history

The ETF industry was born as a result of the market crash in October 1987. The initial goal behind ETFs was to provide liquidity and mitigate volatility for market participants. Over the last 20 years, they became a favorite investment vehicle for individual investors and asset managers. Today, globally, there are 6,870 ETF products on 60 exchanges and over $5 trillion of assets under management.

ETF vs. Mutual Fund

The media and investors often compare ETFs with mutual funds.  In contrast with ETFs, the mutual fund managers actively look for securities in an attempt to beat their designated benchmark.

ETFs typically have higher daily liquidity and lower fees than most mutual funds.  This makes them an attractive alternative for many individual investors.

Underlying Index

There are significant variations in the index composition between indices tracking the same asset class.  The ETFs structure and performance reflect these differences.

In the small-cap space, for example, IJR tracks the S&P 600 Small-Cap index, and IWM follows Russell 2000 Small Cap index. As the name suggests, the S&P index has 600 constituents, while the Russell index has 2,000 members. While there are many similarities and overlaps between the two, there are also significant variations in their returns, risk, and sector exposure.

In the Emerging market space, indices provided by MSCI include South Korea in their list of emerging market countries. At the same time, indices run by FTSE exclude South Korea and have it in their developed country list.

Investors seeking to manage their exposure to a particular asset class through ETFs need to consider the index differences and suitability against their overall portfolio.

 Fees

The fees are the cost associated with managing the fund – transaction cost, exchange fees, administrative, legal, and accounting expenses. They are subtracted from the fund performance. The costs are reported in the fund prospectus as an expense ratio. They can be as low as 0.08% and as high as 2% and more. The percentage represents the total amount of management fees over the value of assets under management.

Consider two ETFs that follow the same index.  All else equal, the ETF with the lower fee will always outperform the ETF with the higher one.

Liquidity

The ETF liquidity is critical in volatile markets and flash-sales when investors want to exit their position.

Asset under management, daily volume, and bid/ask spread drive the ETF liquidity. Larger funds offer better liquidity and lower spread.

The liquidity and the spread will impact the cost to buy or sell the fund. The spread will determine the premium you will pay to purchase these funds on the stock exchange. The discount is what you will need to give up to sell the ETFs. The lower the spread, the smaller difference between purchase and sale price will be. Funds with less spread will have lower exit costs.

Exchange Traded Notes

Exchange Traded Notes are an offshoot of the ETFs products. ETNs are structured debt instruments that promise to pay the return on the tracking assets. This structure is very popular for Oil, Commodity, and Volatility trading. They offer flexibility and easy access for investors to trade in and out of the products.

I believe that long-term investors should avoid Exchange Traded Notes (ETNs), volatility (VIX) ETFs, inverse, and leveraged (2x and 3x Index) ETFs and ETNs products. While increasing in popularity and liquidity, they are not appropriate for long-term investing and retirement planning. These types of funds are more suitable for daily and short-term trading. They incur a higher cost and have a higher risk profile.

Smart Beta ETFs

Smart Beta ETFs are also increasing in popularity. While the name was given for marketing purposes, this particular breed of ETFs uses a single or multi-factor approach to select securities from a pre-defined pool – S&P 500, Russell 2000, MSCI world index, or others.

The Single Factor ETFs like Low Volatility or High Dividend are strictly focusing on one particular characteristic. They offer a low-cost alternative to investing in a portfolio of income generating or less volatile stocks.

The multi-factor ETFs are a hybrid of active and index management. ETF providers have established an in-house index that will follow the rules of their multi-factor model. The model will select securities from an index following specific parameters with the intention of outperforming the index. The fund will buy only the securities provided by the model. The multi-factor ETFs are competing directly with mutual funds, which use similar techniques to select securities. However, they have a lower cost, better transparency, and an  easy entry point.

Currency Hedged

Currency Hedged International ETFs is another newcomer in the space. Their goal is to track a foreign equity index by neutralizing the currency exposure. They can be attractive to investors with interest in international markets who are concerned about their FX risk.  Some of the more popular funds in this category include HEDJ, which tracks Europe developed markets, and DXJ, which follows Japan exporting companies.

How to invest?

ETFs are a great alternative to all investment accounts. Due to their passive management, low turnover, and tax-advantaged structure, they are a great option for taxable and brokerage accounts.

For now, they have not made their way to corporate 401k plans, where mutual funds are still dominating. I am expecting this to change as more small and mid-size companies are looking for low-cost solutions for their workplace retirement plans.

Tax-sensitive investors, however, need to consider all circumstances before adding ETF holdings to their portfolio. Their tax treatment follows the tax treatment of their underlying assets.