Archives For Stocks

Quiz!

Which of the following is typically true?

  1. It is best to buy insurance for most risks for peace of mind.
  2. It is best to avoid insurance and invest money in stocks, because stocks grow fast and can be used to cover the otherwise insured risks.
  3. It is best to insure against devastating risks.
  4. It is best to insure against non-devastating risks, and buy stocks to handle devastating risks.

Insurance vs. Diversified Stocks

The table below presents a basic comparison between diversified stocks and insurance. The first two rows show similar benefits, while the remaining rows show where each approach shines.

Topic Diversified Stocks Insurance Comments
Distribute risk at any point The growth of 1,000 stocks overshadows one company’s bankruptcy. By pooling 1,000 homeowners, the premiums paid cover the cost of one flooded house. Both help diversify risks at a given instant.
Distribute risk over time The growth of stocks over a full cycle overshadows the decline periods within the cycle. The premiums paid by a large group of homeowners over time cover hurricane damages to a large group of homeowners. Both help diversify risks over time.
Devastating risks House burns down without big money saved => bankruptcy. House burns down => covered by insurance. Insurance is critical for covering risks that would devastate you.
Non-devastating risks Can sell from stocks to cover the low risks. Otherwise, the saved insurance premiums that are invested in stocks are likely to grow dramatically over a lifetime. The insurance premiums are lost. Stocks are typically more beneficial for risks that are not devastating.
Availability The money is available for you at all times, without being at the mercy of an insurance company, but the value will be lower during stock declines. Claims can be declined for various reasons. Insurance: Read carefully the exclusions list for insurance, and have money set aside for declined claims.
Stocks: Have plenty more than the self-insured amounts, to account for stock declines.
Negotiated pricing Not applicable This applies for some types of insurance. Health insurers negotiate lower prices. You get negotiated healthcare costs even with high deductible health insurance, in case this item tips the scale for you.
Risk of under-treatment Risk of avoiding treatment that would otherwise be covered by insurance. Having low-deductible health insurance can encourage treating high-risk problems that seem minor at first If choosing self-insurance using stocks (e.g. by having high-deductible health insurance), be careful to not avoid necessary treatments that you would get with low-deductible insurance.
Overhead No overhead Insurance involves administrative costs and profits to the health insurer, that you pay for. Unless you are a high risk person for using the insurance, your overall average cost may be higher with insurance.

Quiz Answer:

Which of the following is typically true?

  1. It is best to buy insurance for most risks for peace of mind.
  2. It is best to avoid insurance and invest money in stocks, because stocks grow fast and can be used to cover the otherwise insured risks.
  3. It is best to insure against devastating risks. [The Correct Answer]
  4. It is best to insure against non-devastating risks, and buy stocks to handle devastating risks.

Explanations: Read the article for explanations.

Disclosures Including Backtested Performance Data

Quiz!

Brazil is in the midst of a devastating recession – the worst on record, with GDP of -3.5% for 2016 following -3.8% for 2015. Can you guess the returns of Brazil’s stock market for 2016?

  1. -70%
  2. -62%
  3. -14%
  4. 0%
  5. +24%
  6. +66%

Can you Guess the Top Performing Country Last Year?

As an Investment Advisor, a fiduciary that is responsible for the life’s savings of entire families, you would expect to count on me to follow the economic news closely and be ready to react to any new developments. Do I do this? I do the exact opposite – I separate my investment decisions from economic news. If I were to depend on the news for investment decisions, I could hurt your life’s savings badly.

A recent example from 2016 can demonstrate this counterintuitive point. Brazil spent the entire year in a devastating recession – the worst on record (over more than 100 years). Unemployment climbed throughout the year from 9% to 11.9%. The president was impeached and there were numerous corruption scandals. Predicting this year could have made you a fortune by shorting (making money when stocks decline) Brazilian stocks in 2016, right? Not so fast. The Brazilian stock market gained +66% in 2016. Not only did it not decline – it was the top performing country for the year.

How is it possible to get stellar returns during the worst economic decline on record? The answer is simple – ignoring prices. The consensus view was for a long and deep economic decline, which would hurt Brazilian companies. In reaction, people sold Brazilian stocks to avoid the declines. The problem was that people kept selling these stocks without regard to prices. Why is this a problem? Say that in normal times a basket of Brazilian stocks is worth $100. Now comes a big recession, and the new realistic value is, say, $80. You would expect rational people to sell until the price reaches $80. But many investors see a struggling economy and sell with disregard to the price. Others cannot imagine a turnaround and sell to reflect a multi-year depression. So, the continued selling brought the basket to a much lower value, say $40. This reflects an unusually bad expectation – far worse than reality. Now comes additional moderately negative news, lowering the realistic value from $80 to $75. With the news being far less negative than expected, people become more positive, and are more likely to accept a value closer to reality. They are ready to correct some of the excess decline, leading to a surge from $40 to, say, $66.40 (a gain of 66%), all while the economy is doing poorly. While the numbers in this example where made up, the mechanism explains what could have led to the surge of Brazilian stocks.

As of 9/30/2016, Brazil represented 6.82% of emerging markets, while the allocation to it in the emerging market portion of QAM’s portfolios was 9.19%. This emphasis reflects the deep value focus (a focus on low priced stocks) of these portfolios, something that often leads to outperformance compared to the general market during recovery years.

Quiz Answer:

Brazil is in the midst of a devastating recession – the worst on record, with GDP of -3.5% for 2016 following -3.8% for 2015. Can you guess the returns of Brazil’s stock market for 2016?

  1. -70%
  2. -62%
  3. -14%
  4. 0%
  5. +24%
  6. +66% [The Correct Answer]
Disclosures Including Backtested Performance Data

Quiz!

What are the outcomes of consistently adding to a portfolio during declines of 20% + 20% followed by a 2 year recovery (25% + 25%), instead of using a stable 10%-per-year investment for the new money?

  1. You throw good money after bad – you lose money while feeling lousy.
  2. You lose money, but at least you stay conservative by sticking with your plan. Once there are new peaks, your entire investment will enjoy future growth.
  3. Not only you make money by buying low – you magically outperform the consistent 10% portfolio.
  4. You make money by buying low, and with the new peak your entire investment will enjoy future growth.

Can You Make Money in a Down Market?

Imagine living through a long decline period. If you are retired and your entire life’s savings are invested in your portfolio according to your plan, you can relax knowing that your low withdrawal rate is likely to sustain your money for as long as you live.

If you are still in saving mode, or have money that was not put to work in your portfolio, you have choices. Let’s review two different options:

  1. You wait for the portfolio to recover to gain more comfort, and after it proved itself, you add more money to it. You don’t add money to a losing portfolio.
  2. You add all money available, whether it is savings from work, money invested elsewhere, equity in your home that you can borrow (subject to a risk assessment), or an inheritance.

Let’s continue with an example: Say you had 1M that declined for 2 years, and then recovered in 2 years. Also, say you had 100k to add per year. During the declining period, you choose between diverting to a portfolio that gained 10% per year and adding to the portfolio that simply declined and recovered with no new gains (as described in 1 & 2 above, respectively). Let’s see the financial impact of the 2 options:

1M Portfolio state Value of

original 1M

Value of new investments
Option #1: Invest at 10% Option #2: Invest in portfolio
20% decline + saved 100k 800k 100k 100k
20% decline + saved 100k 640k 100k + 10% + 100k = 210k 100k – 20% + 100k = 180k
25% gain + saved 100k 800k 210k + 10% + 100k = 331k 180k + 25% + 100k = 325k
25% gain to full recovery 1M 331k + 10% = 364k 325k + 25% + 100k = 506k
Performance of deposits 364k / 300k – 1 = 21% 506k / 300k -1 = 69%

After 4 years, option #1 would result in 364k, while option #2 would result in 506k.

In option #1, your entire mental focus is on the wait for a recovery, to regain comfort with the portfolio. You have no good feelings about the portfolio until you fully regained the lost grounds. In the meantime, you feel good about growing your new savings at 10% per year, and are happy that you did at least one smart thing.

In option #2, you keep adding to the portfolio, ignoring its behavior. At first, you feel good buying low. As the decline continues, you are tempted to feel that you are throwing good money after bad, but you remind yourself that the portfolio is far more attractive the lower it gets, and the new money can enjoy this benefit. After one year of gains, you can already celebrate the impact on your recent deposit. So, instead of focusing on the remaining path to recovery, you can enjoy the hard dollars that you gained during the initial part of the recovery. By the full recovery, you enjoy far better results than 10% per year even though you added to a portfolio that had 0% returns from peak to the new peak.

Quiz Answer:

What are the outcomes of consistently adding to a portfolio during declines of 20% & 20% followed by a 2 year recovery, instead of using a stable 10%-per-year investment for the new money?

  1. You throw good money after bad – you lose money while feeling lousy.
  2. You lose money, but at least you stay conservative by sticking with your plan. Once there are new peaks, your entire investment will enjoy future growth.
  3. Not only you make money by buying low – you magically outperform the consistent 10% portfolio. [The Correct Answer]
  4. You make money by buying low, and with the new peak your entire investment will enjoy future growth.

The article above provides an explanation.

Disclosures Including Backtested Performance Data

Bonds are typically less tax efficient than stocks, leading to a common recommendation to hold bonds in retirement accounts and stocks in taxable accounts. This article challenges this advice for certain investors.

This article applies if you follow a plan devised by Quality Asset Management, or:

  1. You optimize your use of bonds: Income during stock declines and no other use.
  2. Your stock investments are highly diversified globally, with no market timing and no individual stock selection.
  3. Your stock investments have high average returns and a low turnover (i.e. limited annual sales of stocks; e.g. index mutual funds).

Bonds are less tax efficient than stocks

The notion that bonds are less tax efficient than stocks is the basis for the idea that bonds are a better investment to shelter from taxes, by putting them into retirement accounts. This notion is correct as seen in the table below:

  Bonds (mainly interest) Stocks (mainly capital gains)
Taxation frequency Done every year Mainly deferred to sale. Index funds hold each stock for a number of years on average.
Tax rate Ordinary income tax rate Mainly long-term capital gains

A deeper analysis can challenge the conclusion above.

Considering investment horizon

Given that you use your bonds whenever there are stock declines (assumption #1 at the top), as soon as you experience a stock decline, you would withdraw the money, and would not be able to put it back in. This would result in losing the retirement account tax benefit forever, due to a single stock decline.

There is a sophistication that can help you get around this limitation, but is not very practical due to its complexity and excessive trading.1

Comparing tax amount instead of tax rate

While the tax-rate of bond investments is higher than stocks investments, there is an offsetting factor. The average growth rate of stocks is much higher than bonds, magnifying the total tax amount , and offsetting the benefit of the low tax rate . A full analysis may become complex, given the combination of long-term gains and short-term gains, dividends and capital gains distributions. Instead, I will provide a simplified example to demonstrate the point:

  1. The tax on a bond fund with 5% interest at about 40% tax rate (federal 35% & state 10% minus a deduction of state taxes from federal taxes) is 2%.
  2. The tax on a stock fund with 15% growth taxed at 10% tax rate (federal 15% & state 10% minus 15% for the fact that taxation is mostly deferred) is 1.5%.

The faster growth of the stock investment keeps raising the tax amount. If we start with a $10,000 investment, here is the tax amount over a few years (under the assumptions above):

Tax on $10,000 investment in bonds vs. stocks Difference
Year Bonds (5% growth 2% tax) Stocks (15% growth 1.5% tax)
Principal Tax Principal Tax
1 $10,000 $200 $10,000 $150 -$50
2 $10,300 $206 $11,350 $170 -$36
3 $10,609 $212 $12,882 $193 -$19
4 $10,927 $219 $14,621 $219 $0
5 $11,255 $225 $16,595 $249 $24
6 $11,592 $232 $18,835 $283 $51

The faster growth of the stock investment resulted in a higher tax amount within 5 years, despite the lower tax rate.

While this example ignores some variables, and has simplified assumptions, it demonstrates the point that higher growth can result in higher taxes, even when the tax rate is lower and most of the taxation is deferred.

Summary

The rule of thumb: “hold bonds in retirement accounts, due to their worse tax treatment”, does not hold for investors that optimize their bond and stock investments, for two main reasons: (1) when withdrawing bonds from the retirement account during stock declines you lose the tax benefit forever; (2) the higher growth of stocks results in higher tax amounts over time.


1 Say you need $10k from bonds during a stock decline. You can do the following:

Taxable account: sell $10k stocks

Retirement account: sell $10k bonds, buy $10k stocks

Once your stock portfolio recovers, you can move the stocks in the retirement account back to bonds (sell $10k stocks, buy $10k bonds).

Disclosures Including Backtested Performance Data

Imagine that you decided to hold off on investment in stocks until there was more certainty about the economy. While you held the money in cash or bonds, your diversified stock portfolio surged more than 10% in a single month. At this point you feel bad missing out on such a gain, but are even more nervous investing the money, given the risk of a correction – a decline that corrects excessive recent gains. This article reviews the performance after all months with 10%+ gains in recent history.

Note that this article applies only to Long-Term Component by Quality Asset Management.

The chart below presents the Long-Term Component performance after all months with 10%+ gains, based on simulated data since 1970. For example, the 2 year returns (the middle bar) following these high-gaining months were anywhere from +2% to +47%, with an average of +23%.

2012-02 Returns after 1-month 10

Observations

  1. After these high gaining months (10%+ returns), there were typically no corrections. The following month still had positive returns, on average. This was true in all other measured periods (1-5 years).
  2. Not only returns were typically positive after these high gains, they were substantially higher than the average returns.
    1. The average monthly return after 10%+ monthly returns was 5%, more than double the typical monthly returns.
    2. The average 1-year return, 31%, was about double the average performance of the portfolio in an average year.
    3. The 2-, 3-, and 5-year returns were still higher than average, typically 20%+.

Surprised?

If you are surprised seeing these results, it is for a good reason. Stocks go up by a certain average in the long run. It is reasonable to expect extreme outperformance in one month, to be corrected with poorer performance following that. The results above contradict this logic, and show continued outperformance both in the short-term (the following month) as well as long periods afterwards – 1, 2, 3 and 5 years.

Explanation

Extreme gains, such as 10%+ in one month cannot typically be justified by exceptional performance of the companies. They usually occur as a correction to poor performance.

This is typically accompanied by low valuations, i.e. low price-to-book or price-to-earnings, which would justify price appreciation above and beyond any growth in the book value of the companies.

At times like this, the 10%+ gain is often one of the initial phases of a correction, which explains the continued exceptional returns.

How can you use this information?

If you are a disciplined investor, and adhere to your plan at all times, this information does not have much practical value to you, other than giving hope for potentially exceptional gains following months with extreme gains.

If you deviated from your plan, and kept more reserves than specified, this article should give you the courage to go back to sticking to your plan. While there are no guarantees for gains in all cases, and the future can be different than the past, the historic numbers combined with the logic behind them should give you comfort that you are at least going with the odds.

Disclosures Including Backtested Performance Data