Cumulative losses as the psychic cost of investing

I was playing around with a pretty cool tool called Portfolio Visualizer and got to thinking about the difference between how finance professionals and ordinary people talk about investing.For finance types, an asset or a portfolio has an expected return, which might be calculated using historical returns or a forward-looking rule like Jack Bogle's "reasonable expectations" formula, and then it experiences volatility, typically expressed as a standard deviation around that average return. So the stock market has higher expected returns than bonds, which are supposed to compensate for their higher volatility, which financiers also sometimes confusingly call "risk."But ordinary people aren't concerned with volatility; they're concerned with losses, and to a lesser extent gains. No civilian would say "I'm worried because I was expecting an 8% return but instead received a 20% return; this asset is too risky." Nor would they say "I was expecting a 1% return but instead lost 0.5% thanks to the asset's low risk."But it's even worse than that! Even when financiers describe an asset or portfolio's falling price, they express it in percentage terms, while ordinary people describe their gains and losses in dollar terms. Losing $20,000 in a $100,000 portfolio may hurt more than losing $10,000 in a $20,000 portfolio, despite the decline being 60% smaller in percentage terms.While pondering this, I thought of a simple way of describing how risky a portfolio would be experienced by an actual investor.

The pain ratio

The pain ratio looks not at average annualized returns, but instead dollar returns, which means it takes into account the fact that smaller percentage declines in a larger portfolio can be more painful than larger percentage declines in a smaller portfolio. To calculate it, I plugged three simple portfolios into Portfolio Visualizer, a 40/60, 60/40, and a 90/10 stock/bond portfolio, and looked at dollar returns over a 30-year time horizon from 1987 to 2017.Over this period, as you'd expect, the 90/10 portfolio outperformed the 60/40 portfolio, which outperformed the 40/60 portfolio, and was also much more volatile, with an average annualized return of 10.04% and standard deviation of 13.51%, compared to the 40/60 portfolio's return of 8.19% and standard deviation of 6.56%, respectively.Over 30 years, that means $10,000 invested in the 90/10 portfolio in 1987 returned a net of $184,117 compared to the $104,671 returned by the 40/60 portfolio. However, that net return is composed of two figures: the total gains experienced by the portfolio and the total losses. In the same 30 years, the 40/60 portfolio experienced just $10,273 in losses in just 3 down years, while the 90/10 portfolio lost $51,917 in 6 down years (meaning it also experienced $236,034 in gross gains).You can find all the raw data I used and my calculations here.

Sequence of return risk and the pain ratio

When people refer to "sequence of return" risk they often mean the risk that a retiree will experience large losses early in retirement and that withdrawals from that lower base will permanently impair their ability to meet their needs in retirement.But the pain ratio illustrates a different kind of sequence of return risk: that large dollar losses late in an investor's accumulating years will permanently scare them into lower-returning assets, locking in both a lower asset value and lower future returns.It seems to me that the answer is for investors and their advisors to look at expected returns and potential losses not just in percentage terms, but in dollar terms as well, and to consider moving into less risky assets before a relatively small percentage decline in a large enough portfolio scares them into locking in permanent underperformance.Note that this is totally distinct from moving into less risky assets as you approach or enter retirement; it's solely a function of the size of your portfolio and how you'll subjectively experience the conversion of even small percentage declines into concrete dollar losses. This is just as risky for a young investor as an older one, since the pain ratio is based exclusively on the dollar size of the portfolio.

Wrapping my head around variable annuities

I've written before about indexed annuities, one of the most expensive, abusive, unnecessary financial products known to man, but I've recently had a couple occasions to learn more about variable annuities, the confusingly-similarly-named product offered at lower cost by more reputable firms, like Vanguard and Fidelity.

Variable annuities are expensive

There are two expenses that go into a variable annuity: the wrap fee and the fee for the underlying funds your money is invested in.For example, Vanguard charges 0.29% in annual administrative and "mortality and expense risk" fees, plus investment portfolio expense ratios ranging from 0.11% (Total International Stock Market Index Portfolio) to 0.42% (Growth Portfolio).Meanwhile, Fidelity charges 0.25% in fees plus portfolio expense ratios between 0.10% (Fidelity VIP Index 500) and 1.54% (PIMCO VIT CommodityRealReturn Strategy).Since you're a sophisticated investor, say you combine the best of both worlds and invest only in the cheapest fund with each provider. You'll pay 0.4% annually to invest in the total international stock market with Vanguard, and 0.35% annually to invest in the S&P 500 with Fidelity.Is that a lot? Well, it's over 3 times more expensive than buying Vanguard's Total International Stock Index Fund Admiral Shares and almost 9 times more expensive than buying Vanguard 500 Admiral shares, but it's not objectively very expensive, so if variable annuities offered tangible benefits, they wouldn't have to be very valuable to make back that difference.So, do they offer tangible benefits?

Variable annuities are not tax efficient

The first problem with variable annuities is they swap the extremely favorable tax treatment of capital gains and qualified dividends for the extremely unfavorable treatment of ordinary income. This happens in a fairly complicated way that I still don't fully understand, but essentially withdrawals from variable annuities are done against an after-tax contribution portion (which is untaxed on withdrawal) and an earnings portion which is taxed as ordinary income, a bit like how non-qualified withdrawals from 529 plans work (except more complicated).The advantage of this trade (capital gains for ordinary income) is theoretically that you can defer capital gains taxes during your high-earning years, when you might pay up to 23.8% on them, and then make withdrawals during your low-earning retirement years, when your marginal tax rate on ordinary income is lower.If capital gains were taxed as ordinary income (as I would prefer), this argument would be airtight, and variable annuities would be a commonsense way to smooth your tax burden over a lifetime. People would use variable annuities instead of taxable brokerage accounts for all their savings in excess of qualified retirement accounts, paying less in capital gains taxes during their working years and more in ordinary income taxes during retirement.The problem is that capital gains aren't taxed as ordinary income: they're taxed at preferential rates, and those preferential rates extend high up the income scale. The 23.8% rate I mentioned above is the highest rate paid on capital gains, while taxable income in excess of $82,500 is taxed at 24%, and rates only climb from there.Between Social Security old age benefits and required minimum distributions from IRA's and 401(k)'s, taking taxable withdrawals from a variable annuity can easily put someone's taxable income in the range where they're actually paying more on their gains than they would have if they'd simply held their investments in a taxable account and benefited from preferential capital gains tax treatment.

Variable annuities are terrible estate planning

When the owner of a taxable investment account dies, their heirs inherit their assets with a "stepped up" basis: the owner's unrealized, untaxed capital gains receive a new, higher cost basis and those capital gains will never be taxed.When a variable annuity is inherited, the account retains the distinction between contributions and earnings, and earnings will still be taxed on withdrawal at the heir's ordinary income tax rate.Heirs can either take a lump sum distribution of the account's balance (potentially paying up to 37% of the earnings in taxes), or spread the distribution out over 5 years. In either case, rather than the owner saving money on taxes in retirement, the account's gains are taxed at the likely higher tax rate of the inheritor.

The best case for variable annuities

I gather that I come across as a bit of a scold in this post, but I always try to find the good in everyone and in every financial product, so after a little bit of thinking, I came up with a perfectly reasonable use case for variable annuities.Consider a high earner who knows she wants to retire early. Because she's a high earner during her working years, she exclusively uses traditional IRA's and 401(k)'s to reduce her taxable income. Likewise because she's a high earner, she'll pay 23.8% in taxes on any dividends and capital gains distributions during her working years for assets held in taxable accounts.Instead, he contributes to variable annuities, perhaps splitting his contributions 50/50 between the lowest cost options at Vanguard and Fidelity (I don't know why Fidelity doesn't have a low-cost international stock portfolio. Or, rather, I do know why).If she contributes, say, $50,000 per year to her variable annuities, compounding at 5% annually over 20 years, she'll end up with $1.736 million, of which $1 million will be contributions and $736,000 will be earnings.At age 59 1/2 (when variable annuity withdrawals become penalty-free), he gives two weeks notice and start withdrawing 9.1% of the balance per year, or $158,000, of which $91,000 will be tax-free contributions and $67,000 will be earnings taxed as ordinary income (this is not exactly how it works, but close enough). Assuming no other taxable income, he'd owe a nominal amount of tax on that amount.Then, at age 70 she would file for her much higher Social Security old age benefit and at age 70 1/2 start collecting required minimum distributions from her traditional IRA and 401(k) accounts.In other words, since delaying filing for Social Security is so lucrative, even someone retiring early should find a way to delay claiming their Social Security old age benefit as long as possible. If they have no earned income in retirement, then the relatively unfavorable tax treatment of variable annuity withdrawals is irrelevant, as long as their total taxes paid on withdrawals is lower than the capital gains tax payments they would have owed during their working years had the assets been held in a taxable account.

The relationship between cost and confidence

A longtime reader asked me the other day, "how do you convince someone that actively managed funds are worse than passive?" I think it's a good question, not because it's possible to convince someone that actively managed funds are worse than passive funds (it's not possible to convince people of anything, in my experience), but because answering the question highlights one of the most important relationships in investing: the relationship between cost and confidence.

All active investors get the market's return

When you buy a mutual fund or exchange-traded fund linked to a market-capitalization-weighted index, you've decided to "settle" for the market's return. Your investment will rise and fall along with the index, since the fund's holdings are linked to the market capitalization of the index's components.If all passive investors get the market return, then by definition all active investors also get the market return, minus trading costs, since active investors are trading against each other: each active investor's winning bet is another active investor's losing bet, minus trading costs on each side.

Good active management is cheap at any price

If you knew your active fund manager was going to beat the market indices by as little as 1% per year, after taxes and fees, you should be willing to pay virtually any amount for their services. Over long enough time horizons, even modestly higher investment returns result in enormous increases in the final value of an investment.

I know of no way to identify good active management in advance

After the fact, all the people who selected "good" active managers will end up much richer than all the people who selected "bad" active managers. But as an investor, your task is not to identify who outperformed in the previous 10, 20, or 30 years, which you can easily look up online, but who will outperform in the next 10, 20, or 30 years.As if that weren't unfair enough, over the course of their careers active managers move from fund to fund, and eventually leave the business, one way or the other, so the benefits of correctly identifying the best active manager have a built in time limit, whether it's retirement or the grave.

How many times do you have to be right?

Passive, market-capitalization-weighted index funds don't absolve you of the responsibility, or consequences, of investing your money well. If you invest in Vanguard's Total Stock Market Index Fund instead of the Vanguard Total International Stock Index Fund, and the latter outperforms the former, then you made the wrong choice and performed worse than someone who made the opposite choice.But when you pay an active mutual fund manager to decide, over and over again, which stocks to buy and which to sell, you're not just counting on that person to be a better stock picker than you are. You're counting on that person to be enough better a stock picker than you are to make up for the management fees you have to pay them whether or not they outperform.When you know, by definition, that all investors in actively managed funds will underperform all investors in passively indexed funds, due to the higher fees charged by actively managed funds, the core question becomes clear: no matter how good you are at picking active managers, how many times do you have to be right to make up for all the fees you have to pay whether you're right or wrong?When you're wrong, you pay higher management fees and underperform. When you're right, you pay higher management fees and outperform. How sure are you that your excess returns will exceed your excess losses? It appears to me that there is no evidence whatsoever that individual investors have any capacity to select skilled active managers even once, let alone over and over again throughout an investing lifetime.So I choose to invest in passive funds, because I think the amount I save in management fees is greater than the amount I could realistically squeeze out of a lifetime of hopping from one expensive actively managed fund to another.But if a Wall Street Journal from 2048 fell into my lap, I'd happily change my mind!

Idiosyncratic bets on real estate: homeownership or mutual funds?

I've written before about the ways homeownership in the United States is heavily subsidized by the federal government, at the expense of current and future taxpayers:

• preferential tax treatment of capital gains on primary residences, with $250,000 or $500,000 (depending on filing status) of a home's appreciated value being completely tax free;
• the tax deductibility of mortgage interest (on the first $750,000 of a home's value for new mortgages);
• a federally backed system of securitization which ensures liquidity for mortgage backed securities and encourages banks to issue mortgages while taking on virtually no risk themselves;
• and the exclusion from taxable income of "imputed rent," the amount of value a homeowner receives by occupying a dwelling they also own, instead of paying (taxable) rent to someone else.

Different policy makers, journalists, and think tanks focus on different elements of this system, but I don't want to litigate any one piece of this policy puzzle. I'm merely pointing out that these policies create an enormous federal tax and regulatory subsidy for owner-occupied housing of all kinds.What is missed in criticism (much of which I agree with) of this system is that it exists in order to encourage Americans to make a totally idiosyncratic bet, not on the value of land in the United States, or the trajectory of residential housing prices in the United States, but on the value of a specific parcel of land, structure, or condominium unit.No matter how sure you are in a stock pick, commodity bet, or options strategy, you wouldn't put 80-100% of your net worth into one of them without a significant amount of downside protection. Since we decided homeownership was an important goal of American economic policy, we decided to create an enormous subsidy to encourage people to make what would be, under any other circumstances, an extremely unfavorable bet.

Comparing idiosyncratic bets on real estate

I started to wonder: if you wanted to make an idiosyncratic bet on US real estate, and have somewhere to live, would you be better off buying a house and living rent-free in it, or buying the Vanguard Real Estate Index Fund (VGSIX) and paying your rent with distributions from the fund?Both vehicles should provide access to the US real estate market and a stream of income. The mutual fund provides access to a diversified portfolio of US real estate investment companies and periodic dividend distributions, while the single-property option is a concentrated bet on a particular parcel and income in the form of imputed rent you're (not) paying yourself.To answer this question, first I pulled the price and distribution data of VGSIX back to January, 1997, and compared it to the Median Sales Price of Houses Sold for the United States (MSPUS) data available through the St. Louis Federal Reserve's FRED project. Since the median sales price in January, 1997, was $145,000, I used that as the starting value of the mutual fund investment as well.The two numbers we're interested in are capital appreciation (the market value of the mutual fund or the house) and income distributions (the annual income received by owning the asset). Once you have those numbers, you can slice and dice them in a variety of interesting ways.

Why a real estate mutual fund?

Before I get into the numbers, you might be asking, why would you want to get your rent from a real estate mutual fund, instead of a diversified portfolio of stocks and bonds? Isn't that an awfully concentrated bet on a particular sector, and wouldn't it be better to diversify?The answer is yes, which is precisely the point of this analysis: if you think a large sector-specific bet on real estate is too much concentration in your investment portfolio, you should be even more skeptical about a bet not just on the real estate sector, but on a particular unit in a particular building on a particular plot of land.

VGSIX and median home prices do track each other over long time periods

The first question we can ask is simple: over the entire time period, does the Vanguard Real Estate Index Fund actually provide access to the same asset class as individual homeownership?An investment of $145,000 in the median US home in 1997 would be worth $305,125 in 2016, while the same investment in VGSIX would be worth roughly $309,474 (the average of the starting and ending balance in 2016). The maximum deviation was in 2009, when REIT prices bottomed out, while the median home price was more resilient.

VGSIX is much more volatile than median home prices

During the 20-year period I looked at, VGSIX experienced 3 minor and 2 major decreases in market value:

• Between January and December 2002, between January and December 2013, and between January 2015 and December 2015, VGSIX dropped up to 3%.
• Between January 1998 and December 1999, the investment in VGSIX dropped 22%.
• And between January 2007 and December 2008, VGSIX dropped over 52%

Meanwhile, the median home price only fell once, between 2007 and 2009, when it dropped from $244,950 to $215,650, a decline of 12%.

VGSIX distributions fall more often, but by less

Remember, the point of this comparison is to look at the possibility of using real estate distributions to pay rent. That means the volatility of mutual fund distributions matters more than the volatility of the fund's price. During the 20 years I looked at, VGSIX distributions fell in 8 years. However, the peak-to-trough drawdowns were relatively modest, except during the global financial crisis.

• Between 1998 and 1999, distributions fell 4% before recovering in 2000 to above their 1998 level;
• Between 2000 and 2002, distributions fell 7%;
• Between 2005 and 2010, distributions fell a total of 48%, with year-on-year drops between 3% and 35%.

The risk of the strategy, then, comes from experiencing a large decline in distributions after anchoring your expectations to a particular value. Given that VGSIX has experienced a peak-to-trough fall in distributions of 48% in just the last 20 years, you should be prepared to withstand a drawdown of at least that much in the money you have available to pay rent.

Case study: what will the median home price buy you today?

In 2017 VGSIX paid out $1.13 per share in distributions (including dividends and return of capital).In the 4th quarter of 2016, the median home price was $310,900, which would have bought 11,305 shares of VGSIX, distributing (in 2017) $12,775, or about $1,065 per month.Were that to be reduced by 48% to just 59 cents per share, however, you would only left with $556 per month to pay your landlord. Of course, renters also have the luxury of following prices down, so if radical cuts to dividend distributions reduce your spending power, as a renter you'd have the option of moving to a more affordable unit or location, or renegotiating your rent. Likewise as distributions increased you'd have more money available to move to a more expensive location.

Taxes, liquidity, distribution, leverage, and timing

There are some limitations and nuances to this kind of analysis, so let's take a quick look at them, if for no other reason than to abbreviate the arguments in the comments section.First of all, the issue of taxes. The United States has a fairly curious system of taxation whereby the owners, rather than the occupants, of real estate pay taxes on it. I call this curious because it means a homeowner has to personally cut a check to the city or state every year, while a renter usually has no idea what portion of their rent is going to their landlord as income and which portion is going to pay property taxes. In states with limits on property tax increases, two tenants paying the same amount in rent may have totally different allocations of that rent between their landlord and the state, depending on how long the landlord has owned the property.Meanwhile, a tenant paying rent with mutual fund distributions pays capital gains taxes, decreasing the amount of taxable distributions that can be spent on rent, while an owner-occupant receives the imputed rent of the property tax-free. This is an important nuance to be aware of, but is too dependent on local tax policy for me to provide any general insight. I suspect the value of tax-free imputed rent is somewhat higher than any potential benefit to a tenant of avoiding property taxes, but that's an empirical question I don't know the answer to.Second, the issue of liquidity cuts strongly in favor of the mutual fund owner. I used market values in this analysis but the term "market value" means something very different in the two cases: in the case of the mutual fund, it's the actual amount you would receive for selling your shares on any day the stock markets are open. In the case of the median home, it's the price that home sold for after days, weeks, or months sitting on the market and before paying fees to one or more real estate brokers.Third, that brings me to the question of the distribution of home prices. I used the median home price in each year, which is the price above which and below which 50% of homes sold at. That is not, however, the price of the same house, because the distribution of property values shifts over time around the country. While the median home price in 1997 was $145,000, and the median home price in 2016 was $305,125, the median house in the first case might be in Illinois and in the second in Arizona. VGSIX did a good job of tracking median home prices over the 20-year period, but your particular home is virtually certain to deviate from the median by more than VGSIX did — either by appreciating more than the median, or failing to keep up with it.Fourth, leverage is another area where the homebuyer has a key advantage: due to the federal system of subsidies, you can buy $145,000 in housing for just $29,000. It's true you could also use leverage to buy VGSIX (or, more easily, VNQ, the exchange-traded version of the fund), but you'd find yourself paying higher, non-deductible interest rates, and be subject to margin calls should the fund's value drop enough to leave you underwater. By contrast, as long as you keep making your mortgage payments, you can stay in an underwater home for as long as you'd like.Finally, there's the issue of timing. The key feature of the mutual fund strategy is that you can move without selling. Just take your rent budget and spend it somewhere else. Homeownership means that in order to liberate the imputed rent you've been using to live on, you have to sell your home entirely, at whatever price you're able to get, and then make the decision whether to rent or buy all over again.

Conclusion

In the absence of the enormously expensive regime of subsidies provided to owner-occupied housing, I believe the financial advantages of mutual fund investing would swamp those of homeownership:

• if imputed rent were taxed as ordinary income the way other rents are, then homeowners would have to more carefully consider if they're getting as much value from their homes as a potential renter would;
• if mortgage interest were not tax deductible, after-tax mortgage interest rates would be more closely aligned with rates charged on other kinds of secured loans, making leveraged housing purchases less attractive compared to other kinds of debt;
• if a federally-backed system of securitization didn't exist, banks would be less willing to make mortgage loans to marginal buyers, requiring shorter terms, variable interest rates, or higher down payments;
• if capital gains on residences were taxed the same as gains on other capital assets, there would be less incentive to use housing as a form of tax-advantaged savings account.

Without those benefits, the idea of making a leveraged bet on residential real estate in a particular time and place would make as much sense as making a leveraged bet on the price of Apple stock, pork bellies, or bitcoin.However, given the existence of those benefits, the picture becomes much murkier and almost completely contingent on the specific buyer, location, and property.

Why do so few people use non-conflicted financial advisors?

I was listening to the latest episode of the "Animal Spirits" podcast with Michael Batnick and Ben Carlson, and they mentioned a statistic in this (paywalled) Wall Street Journal article: just 2% of the 285,000 professionals giving financial advice in the United States are fee-only financial advisors, who are held to a fiduciary standard that requires them to put the interests of their clients first.An ocean of digital ink has already been spilled over the Department of Labor's aborted fiduciary rule requiring advisors on retirement accounts to act as fiduciaries, and the SEC's decade-long refusal to impose a similar rule on all financial advisors, so I'm not going to repeat that history here.Instead, I think it's worth considering why so few investors who, in principle, are the ones that should be most interested in ensuring their assets are invested with their best interests in mind, use fee-only financial advisors. No one would go to a doctor they knew was being paid by a pharmaceutical company to prescribe a certain drug, or a lawyer they knew was being paid to file in a certain jurisdiction, so why do investors go to financial advisors being paid to work contrary to their interests?

There aren't very many fiduciaries

Unless you stop to think about it, you might not notice just how many "financial advisors" are out there.I didn't think about it until I recently drove through a struggling area of central Illinois, and even in a town with blocks of empty storefronts, burned-out buildings, and crumbling houses, there was an Edward Jones office offering "retirement" services. Of course the only "retirement" services they offer are high-cost, variable fixed income annuities with big commissions for the agent who closes the deal.How is the average investor in central Illinois supposed to even find out how abusive these products are, and that there are financial advisors who put the investor's interest first? Google? All they'll find there are another thousand agents trying to sell variable indexed annuities!Almost every Chase, Bank of America, Citi, US Bank, and Wells Fargo branch in the country has a desk with a little sign next to it saying "financial advisor." That's what financial advice means to the overwhelming majority of individual investors.

They're not accepting new clients

My buddy George Papadopoulos (not that one, the other one) is a fee-only planner in Michigan. He seems skilled and conscientious, and his clients seem satisfied with his work. And he hasn't accepted new clients since 2017.It's not his fault: providing skilled, conscientious, fiduciary advice is hard work. Why would anybody do any more of it than they absolutely have to?By contrast, nobody's ever been turned away from a Chase branch because the branch "has enough clients already." Make an appointment (or don't!) and somebody will be able to see you the same day, they'll have all the forms ready for you to move your assets over, and you'll be on your way in no time.

They have transparent fees

The most common argument made by the non-fiduciary crowd is that sure, they might churn accounts a little bit than they should, they might buy and sell securities that aren't strictly speaking in the best interest of the client, but if they weren't allowed to do that, then investors wouldn't get any advice at all because investors aren't willing to pay for it.And anyway, the products still have to be "suitable," and maybe sometimes they'll even outperform the market!Compare that to a fee-only financial advisor who gets paid directly by the client, instead of through commissions, marketing fees and sales charges. It's a lot less fun to pay a fee you're billed directly than one that's extracted one trade at a time whenever your broker has a hot new investment idea.I think unbiased financial advice is worth paying for (if you're willing to take it), but it never feels good to pay for something, especially when down at the bank they're telling you that all of their fees are "included."

They're boring

Since the correct thing to do with your investments in 99.9% of circumstances is nothing, the client of a fee-only advisor often finds herself in the bizarre situation of paying someone to tell her not to do anything, and that everything will be fine.Meanwhile, a commission-based advisor can't wait until the next big market downturn, or upturn, or increase in volatility, or decrease in volatility, so they can tell you the market environment has completely shifted and it's time to incur another batch of trading commissions.Yield curve flattening? Better do something. Dollar weakening? Better do something.But a fiduciary who puts your interests first should know better than to chase performance, overtrade, and overpay for active management that's almost certain to underperform low-cost mutual funds (and ETF's, if you're so inclined) over the medium and longer terms.

Quality is tough to measure

A fee-only advisor acting as a fiduciary can't accept the legalized bribes that non-fiduciary advisors accept. But it's not enough for a doctor to free of conflicts with the pharmaceutical industry, you'd also like them to be a skilled medical professional. It's not enough for a lawyer to be unconflicted, you'd also like them to win your case.Likewise, a financial advisor without any conflicts at all can still give bad advice, and for someone without any investing experience bad advice sounds pretty much the same as good advice.Just like buying socks, toothpaste, or contact lenses, if you don't know how to distinguish good products from bad products in advance, you can either buy the more expensive version (hoping that price does the work for you) or the cheapest (hoping that you save more in cost than you lose in quality).Unfortunately, when it comes to financial advice, the question of whether it's good or bad depends just as much on you as it does on the person doing the advising. A fee-only, fiduciary financial advisor is perfectly free to advise a strategy of building a highly-leveraged real estate empire, a fleet of lobster boats off the coast of Maine, or a pile of gold in a safe deposit box in Switzerland. They just can't be paid by anyone else to suggest it.If you don't know what kind of investor you are (or want to be), it's almost impossible to identify a financial advisor that's able to help you meet your goals."Fee-only" is used as a kind of talisman by the financial planning industry, but you should think of it as a necessary, not sufficient, requirement for your financial advisor.

Basics of IRA recharacterizations

Like aircraft flying at very low altitudes, the US tax code does strange things when very low incomes are involved. Most people know about, or have at least heard of, the earned income credit, which phases in quickly as "earned income" (which includes wage and self-employment income) rises, then phases out somewhat more slowly.I think that's bad program design, since it creates a weird higher marginal tax rate in the phase-out range, which then drops again when the credit is fully phased out, and I think the tax code should feature steadily rising marginal tax rates, not ones that bounce around all over the place, but economists like these "phase-outs" and the economists won.If the earned income credit has an unfortunate design, it's nothing compared to the retirement savings contributions credit, which has two abrupt adjusted gross income thresholds that reduce the value of the credit by 60% and 50% at $18,501 and $20,001, respectively, for single filers, before being eliminated completely at $31,001 in adjusted gross income. Those cutoffs have no economic rationale, but presumably they reduce the cost of the program since low-income folks tend to have more volatile income and will bounce around between the income bands.These cutoffs mean fine-tuning your adjusted gross income can make an enormous difference to your total tax liability, and IRA recharacterizations are a great way to fine-tune your adjusted gross income.

The 2017 tax reform did not affect recharacterizations

This gets a bit confusing, since there was a change in the 2017 tax bill that affected a particular tax planning strategy involving IRA's. That strategy involved transferring a tax-deductible traditional IRA balance into an after-tax Roth account, then reversing the transaction if the account fell in value before the tax filing deadline, a sort of heads-I-win-tails-I-win method of managing current and future income tax liability.That strategy was eliminated by Congress in the 2017 tax reform bill by stipulating that Roth conversions cannot be reversed: if you convert a traditional IRA to a Roth IRA, you are liable for income taxes on the amount of the conversion whether the Roth account rises or falls in value.All of this is made even more confusing by the fact that people use the terms "conversion" and "recharacterization" interchangeably. In this post I'm calling converting an existing traditional IRA balance into a Roth IRA account a "conversion" and redirecting an IRA contribution to a different account type a "recharacterization."And there was no change to the ability to recharacterize contributions, which can be done in either direction: contributions to a Roth IRA can be recharacterized as contributions to a traditional IRA, and vice versa (subject to Roth IRA income limits).

Recharacterizations were intended for high-income taxpayers

Since Roth IRA contributions can only be made by taxpayers with modified adjusted gross incomes below a relatively low limit ($133,000 for single filers in 2017), but many people (in my view, rightly) make weekly, biweekly, or monthly contributions throughout the year, there needed to be some mechanism for taxpayers whose income turned out to be above the contribution threshold to correct their mistake.That mechanism is the recharacterization, whereby a contribution (legal or illegal) can be recharacterized from one account type to the other. In a recharacterization, both the original contribution and any earnings or losses on the contribution are transferred, meaning it's irrelevant which account type you contribute to during the year: whether it gains or loses value, in a recharacterization everything is calculated as if you had made the contribution to the other account type in the first place.

Recharacterizations are great for fine-tuning low incomes

Low-income workers are the biggest beneficiaries of Roth IRA's, since the "post-tax" contributions they make to them are generally "post" a tax of $0. That means they feature the enormous benefit of tax-free contributions, tax-free internal compounding, and tax-free withdrawals. A good deal!But due to the "ground effects" of the retirement savings contribution credit I described above, it can be extraordinarily valuable to fine-tune the income of low-income workers, since the difference of a dollar in adjusted gross income can mean the difference between a credit that covers your entire tax liability and one that leaves you owing $418!That means a low-income worker's "core" retirement savings account should be a Roth account, but with a traditional IRA on the side to fine-tune their AGI before filing their taxes each year.

My 10-minute recharacterization call with Vanguard

I made very slightly more money in 2017 than I did in 2016, and when I plugged my numbers into Free File Fillable Forms my adjusted gross income was about $4,900 over the $18,500 threshold needed to claim the maximum retirement savings contribution credit.This was a purely unforced error. I have a solo 401(k) for my self-employment activities, into which I split contributions 50/50 between the pre-tax and Roth subaccounts. If I had made only traditional contributions, I would have been just a few bucks away from the $18,500 target and could have just topped up the traditional account with retroactive contributions, which is what I've done in previous years.But five grand is a lot of money, and I'm poor, so it was time to learn about recharacterizations.Once I'd identified the precise dollar amount I needed to recharacterize, I called Vanguard, where my Roth IRA is held. After the security questions, I told the agent what I needed to do and he immediately understood. Since I didn't have a traditional IRA with Vanguard, he told me to open one online while he waited. After I reached the confirmation screen, he refreshed his view and saw the account.After I told him the amount of the 2017 contribution I needed to recharacterize, he plugged it into his computer and immediately returned with the amount of earnings on that amount (2017 was a good year).Note that you have the option to identify specific contributions to recharacterize. I had 52 (give or take) contributions in 2017 so didn't bother with specific identification, but it's an option that's available if you want to recharacterize only the most-appreciated or least-appreciated contributions (most-appreciated if you're recharacterizing to Roth, least-appreciated if you're recharacterizing to traditional).Then he asked me which securities in my Roth IRA I wanted to move. Vanguard moves securities in-kind internally, so you don't have to sell to cash before recharacterizing. I told him to move all my TIPS and take the remainder from my Vanguard 500 holdings.Since I held Admiral shares of the Vanguard 500, he warned me that Vanguard would eventually downgrade them to higher-cost Investor shares unless I topped up the balance to the $10,000 minimum.The entire call, including opening a new traditional IRA account, took 10 minutes.

Conclusion

As I'm fond of saying, the overwhelming majority of financial advice is targeted at people who can afford it and don't need it, rather than people who need it and can't afford it.The retirement savings contribution credit is the major tax benefit available to filers who make too much to qualify for the earned income credit, and claiming the maximum benefit is the easiest way most low-income filers have to increase the amount of their federal income tax withholding returned to them as a refund each year.IRA contribution recharacterizations are an easy way to maximize the amount of your retirement savings permanently shielded from taxes, while also giving your savings as much time as possible to work in the markets.

Prepaid tuition plan roundup

This week I wrote about the prepaid tuition plans offered by Washington state and Virginia. To close out the week I wanted to share a brief roundup of the other prepaid tuition programs still out there.First, take a look at the overview, then I'll offer some brief commentary:

State	Plan	Premium (discount) to current tuition	In-state public benefit	In-state private benefit	Out-of-state benefit
Washington	Guaranteed Education Tuition	8.80%	Tuition and mandatory fees at most expensive Washington public college or university	Tuition and mandatory fees at most expensive Washington public college or university	Tuition and mandatory fees at most expensive Washington public college or university
Virginia	Prepaid529	0%	Tuition and mandatory fees	Payments made plus the actual rate of return	Payments made plus a reasonable rate of return
Florida	Prepaid	6.5%	Tuition, tuition differential fee and other specified fees	Average rate payable to in-state public institution	Average rate payable to in-state public institution
Mississippi	MPACT	6.5%	Public in-state standard undergraduate tuition rates and mandatory fees	Weighted-average tuition and mandatory fees at Mississippi public colleges and universities	Weighted-average tuition and mandatory fees at Mississippi public colleges and universities
Maryland	Prepaid College Trust	(20.4%)	In-state or in-county tuition and mandatory fees	Tuition and mandatory fees up to the Weighted Average Tuition	Tuition and mandatory fees up to the Weighted Average Tuition
Massachusetts	U.Plan Prepaid Tuition Program	0%	Lock in a percentage of current tuition and fees at participating public and private schools in Massachusetts	Return of investment plus CPI	Return of investment plus CPI
Nevada	Prepaid Tuition Program	(6.1%)	Tuition at rate selected on contract	Paid at rate selected on contract	Paid at rate selected on contract

For each plan, I calculated the cost based on the most comprehensive plan available (usually a four-year university plan) for someone born this year (most of the plans get more expensive the closer your beneficiary is to graduation). I then calculated the premium or discount paid compared to the amount paid for someone using their benefits this year at the most expensive in-state institution.The prepaid tuition plans follow three basic models.

Fixed payout rate

This is the model used by Washington and Nevada. You buy a certain number of investment units at a fixed price today, and then are paid out at a different, hopefully higher value in the future. In Washington the payout rate is based on the most expensive public university in the state, while in Nevada it's based on the "credit hour cost" set by the Nevada Board of Regents.Washington charges a premium of 8.8%, meaning tuition and fees at the University of Washington would need to rise that much before a contract would start to show a profit.Nevada, on the other hand, charges less per credit hour than the current payout rate: you can buy 120 university credit hours for $24,285, or $202.38 per credit, while the current payout rate is $215.50 per credit hour.Both programs allow you to receive the same benefit at in-state public, private and out-of-state schools, making them by far the most flexible prepaid tuition programs.

Tuition and fees

Virginia, Florida, Mississippi, and Maryland allow you to use your prepaid tuition plan to cover in-state tuition and fees at public schools. Mississippi and Florida have the additional cool benefit of guaranteeing beneficiaries in-state tuition, even if they're not residents of the state when they enroll.The premium I show above is the difference between the cost of a prepaid tuition contract and the current value at the most expensive public institution. If your beneficiary attends a less expensive school, the premium goes up, since contracts cost the same whether you attend the University of Virginia or the College of William & Mary (the latter is more expensive).The discount shown for Maryland's plan is an artifact of my methodology, due to the outlier expense of attending St. Mary's College of Maryland, where tuition and fees for four years cost $57,984 and a four-year university plan costs just $46,135. At the University of Maryland Baltimore County, the second-priciest public university in the state, four years costs just $46,072, leaving the Prepaid College Trust with a small premium.One final thing to point out here: the weighted averages used by Florida, Mississippi, and Maryland to calculate the benefits payable to beneficiaries attending private and out-of-state schools will be much lower than the maximum benefits I used to calculate the premium and discount rates. In Maryland, the weighted average tuition for four-year colleges is $10,033, giving the Prepaid College Trust a premium of 14.8% (the amount the weighted average tuition would have to rise before your contract broke even).

Massachusetts

The Massachusetts model is fascinating. Instead of only applying to in-state tuition at public universities, the U.Plan Prepaid Tuition Program has a long list of participating Massachusetts public and private schools.Accounts owners make a dollar-denominated contribution to their account and then that contribution is converted into a percentage of tuition and fees at the prevailing rates at every participating school.So, to use this year's table, a $1,500 contribution today buys 2.86% of tuition and fees at the (expensive) Amherst College and 29.94% at the (cheap) Berkshire Community College. Next year, if Amhert's tuition rises by more than Berkshire's, the same $1,500 contribution might buy 2.5% at Amherst and 29.5% at Berkshire.The two contributions together, then, buy a total of 5.36% at Amherst or 59.44% at Berkshire — whichever one you end up enrolling in.This plan has one big advantage: it lets you lock in today's tuition prices, and at a wider range of schools than just the public institutions available in the other plans, including premier institutions like Amherst, Wellesley, Smith, and Mount Holyoke.But that advantage comes paired with a big downside: if you attend a non-participating institution, you get nothing. Well, not exactly nothing; you get your money back, but without any investment returns at all.That creates an obvious bind: the earlier you contribute, the lower the tuition rate you're able to lock in, so if you anticipate that Baumol's cost disease will continue to ravage the higher education sector, you should accelerate contributions early on. On the other hand, the earlier you contribute, the more years of investment returns you sacrifice if your beneficiary ends up attending a non-participating school!

Conclusion

Now you know everything I know about prepaid tuition plans. A few closing thoughts:

• A sufficiently wealthy resident of Washington or Nevada, with sufficiently young kids, should consider buying the maximum contract if they want to place a bet on the trajectory of public higher education costs. Both programs are fully funded (Washington at 135% and Nevada at 132% of liabilities), so I don't see any reason to worry about the programs being unable to pay the promised benefits.
• Residents of Florida, Mississippi, or Maryland with young enough children might consider combining a prepaid tuition plan with a 529 college savings plan. If their children attend private or out-of-state schools, then the weighted average tuition paid by the prepaid tuition plan should have steady, bond-like returns, allowing them to take more investment risk in their college savings plan. If the beneficiaries do end up attending an in-state public institution, then they'll receive a bonus payoff in the form of discounted tuition. Note that the beneficiary should be young enough to give rising tuition plenty of time to overcome the premium paid.
• Residents of Massachusetts or Virginia with enough children may consider opening a prepaid tuition plan in order to lock in today's tuition rates, since the ability to change the account's beneficiary from one child to the next increases your odds of being able to claim the benefit, by attending a participating school in Massachusetts or a public university in Virginia.

How to think about prepaid tuition plans: Virginia Prepaid529

Yesterday I described the best prepaid tuition plan I know of, Washington state's Guaranteed Education Tuition plan, which allows you to place a tax-free bet on the trajectory of tuition inflation at Washington public universities. It's a weird investment vehicle, but you could see how it might play a speculative role in the portfolio of a sufficiently wealthy person, especially because it comes with all the tax advantages of a 529 college savings plan.By way of comparison, today I want to describe the wrong way to invest in a prepaid tuition plan: the Virginia Prepaid529 plan.

Virginia Prepaid529

The Virginia Prepaid529 plan differs in important ways from Washington's GET program:

• Prepaid529 uses "semesters" as the unit of investment, rather than GET's "units." A "semester" is equal to the cost of one semester at a Virginia public 4-year university or 2.6084 semesters at a Virginia 2-year college.
• The price paid per semester varies depending on the age of the beneficiary. While GET allows all enrollees to buy units for the same price, set somewhat above the current payout value of a unit, Prepaid529 charges less for semesters purchased closer to the beneficiary's enrollment. For example, a newborn beneficiary is charged $8,825 per semester, while a 9th-grade beneficiary is charged $8,145 per semester. By way of reference, mandatory tuition and fees for undergraduates enrolling at the University of Virginia in 2017 are about $8,390 per semester (this information is remarkably difficult to find).
• Accounts must be opened by the end of the enrollment period during the beneficiary’s ninth grade year (as far as I can tell — Virginians feel free to correct me if I'm wrong).

So far, the plan looks pretty similar to GET. In-state tuition and fees at the University of Virginia are somewhat more expensive than at the University of Washington, so prepaying tuition is somewhat more expensive, but not radically so. The difference comes in when it's time to redeem your prepaid semesters:

• At Virginia public colleges and universities, you can redeem one semester investment unit for one semester of mandatory tuition and fees (2.6084 semesters at two-year and community colleges).
• At Virginia private colleges and universities, you can redeem one semester investment unit for the lesser of the payments you made plus the actual rate of return Prepaid529 earned on those payments or the highest Virginia public institution tuition and mandatory fees.
• At colleges and universities outside Virginia, you can redeem one semester for the lesser of your payments plus a "reasonable rate of return" or the average Virginia public institution tuition and mandatory fees. I can't find any record of that average on Prepaid529's site, but it will always be much lower than the highest tuition and fees used in the above calculation.

What is a "reasonable rate of return?" Prepaid529 helpfully defines it as "the quarterly performance of the Institutional Money Funds Index as reported in the Money Fund MonitorTM by iMoneyNet." As far as I can tell that's essentially 0%. Reasonable!

Do not invest in Virginia's Prepaid529 plan...

Virginia has essentially set up a three-tiered outcome structure:

• Some number of Prepaid529 beneficiaries will attend Virginia public colleges and universities. They'll receive the number of semesters of tuition and fees they paid for, at the price they paid for them. In exchange, Prepaid529 gets to invest their money during the intervening period. If Prepaid529's investments outperform tuition inflation, Prepaid529 gets to keep the difference. If they underperform, they (hopefully) still pay out as promised. This is a traditional single-premium annuity or insurance contract.
• Some number of Prepaid529 beneficiaries will attend Virginia private colleges and universities. If Prepaid529's investments underperform tuition inflation, they'll receive a lower payout amount based on that performance. If Prepaid529's investment outperform tuition inflation, the beneficiary doesn't participate in that outperformance; instead they receive an amount based on the highest Virginia public university tuition and fees. In other words, you participate fully in the downside and only partially in the upside, like a twisted variable indexed annuity contract.
• Some number of Prepaid529 beneficiaries will attend out-of-state colleges and universities, and receive their money back, plus a nominal return.

The one thing I'll give Prepaid529 is that this structure allows them to charge lower prices per semester compared to Washington's GET. You can buy 10 semesters of in-state tuition and fees for a newborn today for $88,250, about a 5.2% premium over current tuition and fees, while 500 GET units would cost $56,500, a premium of about 8.8% over the current $51,930 payout value. That's not nothing.But in exchange for the relatively low Prepaid529 premium, you are buying into the three-tier payout structure I described, in which the investment returns on the payments of students attending private and out-of-state schools subsidize the guaranteed tuition of students attending in-state public schools. Meanwhile, the higher GET premium buys you a return based on Washington state public tuition inflation regardless of where you decide to enroll.For an older student with their heart set on attending the University of Virginia, that might make sense. But for a younger beneficiary who may or may not even decide to enroll in higher education, investing using a 529 college savings plan offers all the benefits of internal tax-free compounding without the larcenous payout structure of Virginia's prepaid plan.

...with one exception

If you or your beneficiary is a Virginia resident in the 9th grade year of your beneficiary and you think there's even a chance the beneficiary will attend a Virginia public college or university, you might consider rolling over a 529 college savings plan into the Prepaid529 plan. Why? Because if you plan on spending your 529 assets for higher education (instead of for estate planning), those assets should be mainly in cash and bonds anyway by the time your beneficiary reaches high school, in order to preserve their value against stock market volatility. If you're going to earn a low rate of return on 529 assets anyway, you may as well get a cheap hedge against tuition inflation.The same logic doesn't apply to Washington state's GET program because the purchase price of investment units is too high compared to the near-term payout value of those units.In other words, the best course is to invest your 529 assets in GET as early as possible, and invest them in Prepaid529 as late as possible.

How to think about prepaid tuition plans: Washington's Guaranteed Education Tuition plan

I've written extensively about 529 college savings plans, which are a way for the wealthy to permanently shield intergenerational transfers of appreciated assets from taxation while also allowing those assets to internally compound tax-free. However, there's a second kind of investment vehicle conceived of by section 529 of the Internal Revenue Code: prepaid tuition plans.While every state, the District of Columbia, and Puerto Rico all offer 529 college savings plans, only a few states took section 529 seriously and endeavored to set up prepaid tuition plans.

Washington State's Guaranteed Education Tuition (GET) plan

Washington's GET plan has a simple structure:

• At any time, you can buy any number of "units" at a purchase price determined by GET's actuaries each year, until the total number of units purchased per beneficiary has reached 600.
• When the beneficiary enrolls in a qualified educational institution, you can request disbursement of up to 150 units per year at a unit payout value equal to 1% of the tuition and mandatory fees charged by the most expensive public university in Washington state.

A few things to note here:

• In any given year, the unit purchase price will be higher than the unit payout value. This year, the unit purchase price is $113, while the unit payout value is $103.86. That's because they're not selling this year's tuition and fees, they're selling tuition and fees at an unknown point in the future.
• 600 units is equal to 6 years of tuition and fees at the most expensive Washington public university, but you can redeem up to 150 units per year, so if you bought 600 units, you could be reimbursed for 150% of that amount against the tuition and fees at a more expensive four-year college (like all 529 plans, you can only request tax-free distributions for qualified expenses).

To give an extreme example, you could purchase 600 units today for $67,800. You would break even when tuition and fees in Washington rose to $11,300 per year, about 8.8% higher than they are today. As tuition and fees rose still further, you'd experience the same tax-free appreciation of your investment seen in 529 college savings plans, except instead of depending on stock or bond market performance, your returns would depend on the trajectory of Washington state education funding.This is, needless to say, a curious investment. It combines a credit risk (will Washington state honor the terms of the program in 10, 20, or 50 years?), an inflation hedge (the "purchasing power" of your investment is protected from tuition increases as long as you attend a Washington public college or university), and a speculative bet (Washington state tuition inflation will outpace the performance of your public market investments).

What happens if tuition and fees go down?

I'm glad you asked, since that very thing happened in 2015!In that year, the Washington legislature passed the "College Affordability Plan" which reduced tuition and fees from $11,782 to $11,245, and then to $10,171. By rights, this should have reduced the unit payout value of accounts from $117.82 to $101.71, a decrease of 13.7%.But it didn't. By special dispensation from the state legislature, GET was allowed to maintain the higher unit payout value, and then when they finally reset the unit payout value to match the new, lower tuition and fees, they compensated account holders by increasing the number of units in their accounts by a corresponding amount!Look: I'm not a Washington state taxpayer. I don't own and am not the beneficiary of a GET account. But this kind of "heads-I-win-tails-I-win" policymaking is a textbook example of moral hazard. If GET investors participate fully in the upside of tuition inflation and are protected from the downside of tuition deflation they're going to be the beneficiaries of huge wealth transfers from their fellow citizens of Washington state, and the country as a whole.

Should you invest in a prepaid tuition plan?

A few years back I learned about the story of Bert Fingerhut, who, as a wealthy and successful Wall Street investment banker, criss-crossed the country opening accounts in his own name and the names of anybody else he could think of at so-called "mutual savings banks," so that if they ever reorganized as publicly traded entities he would be entitled to pre-IPO shares. What he was doing was perfectly legal, he just wasn't satisfied with only claiming shares for himself, so he fraudulently opened accounts of which he was the beneficial owner.When researching the Washington state GET plan, I was reminded of poor old Bert, whose only crime was that he got greedy. I think if I were a sufficiently wealthy Washington resident, with a sufficiently young child, I'd buy my 600 GET units, not because such an investment is guaranteed to outperform the public markets, but because it's an investment different enough from the public markets that it's likely to perform differently from the low-cost stocks and bonds in a 529 college savings account like the ones offered by Vanguard and others.After all, the most you can lose in a $67,800 investment is $67,800. If tuition and fees at the most expensive Washington public universities rises at the same rate as median hourly wages, the maximum rate currently allowed by law, then based on data between 1990 and 2016, you'd expect your investment to return an average of 2.9% per year. If that cap is lifted and tuition and fees rise faster, you'd do even better, and if tuition and fees are cut again, there's precedent for being made whole by the state legislature.And all these returns are, of course, completely tax-free.

Should long-term taxable investors consider dividend-minimal funds?

I've been thinking lately about the role taxes play in calculating investment returns. It's not a question that's very relevant to most people, since for the vast majority of Americans investments are best made in accounts that offer tax-free compounding, whether that's an IRA, 401(k), HSA, or 529 account.But once you start to think about it, there are potentially interesting implications for determining the best investment strategy for long-term taxable investors.

Over long time horizons growth and value stocks offer near-identical pre-tax returns

This may be somewhat difficult to grasp if you have a prior commitment to "value" investing, but if you think about value and growth stocks "overperforming" and "underperforming" over different time horizons, it becomes more clear.Take two funds that have been available since November, 1992: VIGRX, the Vanguard Growth Index Fund, and VIVAX, the Vanguard Value Index Fund.

• Between November 2, 1992, and August 31, 2000, VIGRX outperformed VIVAX handily, returning an average annualized return of 21.66%, compared to the Value Fund's 16.42%.
• Between September 1, 2000, and May 31, 2007, VIVAX outperformed VIGRX, returning an average annualized return of 6.1%, compared to the Growth Fund's negative 2.65% average annualized return.
• Between June 1, 2007, and February 28, 2009, VIGRX outperformed VIVAX, returning a mere negative 28.39% average annualized return compared to the Value Fund's negative 37.14% average annualized return.
• And from March 1, 2009, to February 28, 2018, VIGRX outperformed VIVAX, returning an average annualized return of 18.37%, compared to the Value Fund's 16.76%.

But between November 2, 1992, and February 28, 2018, their returns were virtually identical: 9.42% annualized in the case of VIGRX, and 8.85% annualized in the case of VIVAX. As a reference, the Vanguard 500 returned 9.23% annualized over the same period, falling smack dab in the middle, just as you'd expect.

This is meaningless to tax-advantaged investors

A tax-advantaged investor without any special investing insight should invest in a broad global portfolio of stocks and bonds, with the precise allocation between domestic and international stocks and bonds depending on their risk tolerance, time horizon, and other sources of retirement income, like Social Security or workplace pensions.You can see in the four time periods I outlined above that if you knew what was going to happen in advance, even a tax-advantaged investor would want to invest in growth stocks in the first time period, value stocks in the second time period, hold cash for the third time period, and then growth stocks in the fourth time period. But if they have no special insight into what's going to happen, then a tax-advantaged investor should just buy, hold, and very occasionally rebalance.

Taxable long-term investors should think about dividend-minimal funds

What differentiates the returns between the Vanguard Growth Fund and Value Fund I described above is not their total return over the past 26 years, which is nearly identical: it's the form those returns took. The Growth Fund experienced more price appreciation and less dividend and capital gains reinvestment, while the Value Fund experienced more dividend and capital gains reinvestment and less price appreciation.I was trying to think of a way to illustrate this involving all sorts of calculations, but realized the easiest way is also the simplest:

• Between November 2, 1992, and February 28, 2018, a $100,000 initial investment in the Vanguard Growth Fund experienced a price appreciation of $650,700 and distributed $97,483 in dividends and capital gains.
• Between November 2, 1992, and February 28, 2018, a $100,000 initial investment in the Vanguard Value Fund experienced a price appreciation of $315,000 and distributed $193,666 in dividends and capital gains.

Under the current US tax code, the price appreciation is completely tax free, while the dividends and capital gains are taxed at a maximum marginal federal income tax rate of 23.8%. If that rate were in effect for the entire investment period (it wasn't) then a taxable Value Fund investor would have paid $22,891 more in federal income taxes over the 26-year period than the Growth Fund investor, almost twice the amount by which the Value Fund investment outperformed the Growth Fund investment. If those tax savings were invested and allowed to compound over time, the Growth Fund investor would have done even better.

Useless, but good, advice

As I mentioned above, the overwhelming majority of Americans hold the overwhelming majority of their investments in accounts that offer tax-free internal compounding, so this information is properly useful only to the tiny sliver of people who have both an investing time horizon of 25 years or more and substantial taxable investments.This is obviously something of a contradiction: by the time you've reached the point in your career where you're maxing out all your tax-advantaged savings vehicles and have funds left over for taxable investments, you're usually too late in your career to have a 25-year investment horizon!Meanwhile if you struck it rich early enough to both have large taxable savings and retire early, you're paying a 0%, not 23.8%, marginal income tax rate on your qualified dividends.But just because advice isn't very useful doesn't mean it's not good: if you have a long enough investing time horizon to not mind the achingly long periods of underperformance, then it can make perfect sense to hold lower-dividend mutual funds in your taxable investment accounts.

If you care about deficits, this is what you should care about

I do not, as a rule, care about the United States budget deficit. This is for three main reasons:

• the United States issues dollar-denominated debt, and so has no risk of default, short of political (versus economic) catastrophe;
• the United States spends such an extraordinary amount on national defense that we have a "peace dividend" available on demand should we choose to spend less on our periodic wars of choice;
• the United States has an overall tax burden far lower than the OECD average, giving us a lot of headroom to increase taxes should budget deficits become a problem in the real economy.

But of course the financial solvency of the US government is not the issue of concern to an individual American; the question is, what do accelerating budget deficits mean for your own finances — the ones you need to pay the rent, buy gas, send your kids to college, and retire with dignity?

Accelerating budget deficits can have two effects

As the budget deficit accelerates, part of the increased nominal economic activity will be absorbed by previously unemployed workers joining the workforce and adding to the nation's total economic activity.But in addition to that, part will be absorbed through higher interest rates, as the increased supply of Treasury bonds forces down their price, and part will be absorbed through inflation, as more money chases an amount of goods and services that doesn't keep up with the supply of money. Whether inflation or higher interest rates predominates is completely up to the Federal Reserve's Open Market Committee. They can raise interest rates faster and keep inflation muted, or keep interest rates depressed and allow inflation to run ahead of their target.

What do accelerating budget deficits mean to a worker?

The single most important effect government fiscal and monetary policy has for individual Americans is the effect on their income and livelihood. If inflation accelerates, workers' incomes will fall in real terms unless they're able to negotiate raises that keep up with their cost of living (economy-wide this would have the effect of accelerating inflation even more).If interest rates rise, companies will lay off workers and consolidate their operations.For the average American, this is the overwhelming consequence of accelerating deficits: either a lower standard of living, or a more precarious existence.

What do accelerating budget deficits mean to an investor?

As an investor, the picture is somewhat different, depending on whether you think the condition is temporary or permanent.If you think accelerating budget deficits are a permanent feature of American economic life, then American firms will be in constant competition with risk-free Treasuries for financing, and experience a consistently higher cost of capital, reducing the present value of their future income. In that case, you might consider investing in international companies, who will see their currencies depreciate and exports increase as the US dollar attracts additional capital inflows from abroad.If you think accelerating budget deficits are a temporary feature of American life, then temporarily higher interest rates are a short-term buying opportunity for US equities, whose depressed valuations will bounce back once a comprehensive fiscal solution is found.But I think investors in general fail to take investing literally enough. If your best guess is that your retirement goals require a 6% real return for the next 30 years, and 30-year Treasury inflation-protected securities are returning an inflation protected 6% return, why would you own anything else?To be clear: 30-year TIPS aren't earning 6% today. But if US deficits continue to accelerate, and we manage to avoid another global financial crisis or recession, they will be within the next 3-6 years. At the point, the question will be, do you want to lock in sufficient inflation-adjusted savings to meet your retirement needs, or do you want to swing for the fences by gambling on US or international equities?After all, long-term US Treasuries have underperformed US equities in the current bull market, but they haven't underperformed bonds. They've performed exactly as you'd expect long-term bonds to perform.

Conclusion

So that brings me full circle: if you're worried about accelerating US budget deficits, what, exactly, are you worried about?

• are you worried about losing your job? You can prepare by saving more, studying harder, learning a trade, or making more friends.
• are you worried about inflation? You can buy international equities or inflation-protected bonds.
• are you worried about high interest rates? You can hold more cash or reduce the average duration of your bond holdings.
• are you worried about a stock market crash? You can pay for a put strategy that protects you from big downside losses.
• are you worried about the Republican Party gutting Social Security and Medicare? You can vote.

In other words, there's no worry that doesn't have a solution, but if you can't identify what, exactly, you're worried about, you're not going to be able to deal with it in a way that lets you get on with the business of actually living your life.

Should you use the Vanguard 529 Plan?

State-sponsored 529 savings plans are tax-advantaged estate planning tools that can also be used to save for "higher education" expenses, a category which was recently expanded to include private and religious K-12 tuition.I've had an account with the Utah Educational Savings Plan, which was recently rebranded as My529, for years and have been very satisfied with their selection of very low-cost Vanguard investment funds and low account maintenance fee of 0.2%.My brother recently asked me about the Vanguard 529 Plan, and after doing a little bit of research, I thought I'd share what I found.

How to select a 529 plan

There are three factors that should go into your decision of which 529 plan or plans to choose:

1. Tax benefits. Check every state where you earn taxable income and find out whether there are deductions or credits available for contributions to 529 plans. Some states, like Pennsylvania, allow residents to take the deduction for contributions to any state's 529 plan, while others, like Arkansas, only allow deductions for contributions made to in-state plans. Credits and deductions may only be available to residents; check with your tax professional.
2. Investment options. While I would look for low-cost Vanguard index funds, it's not the end of the world if you have to choose low-cost index funds from another provider, but stay away from plans that only offer high-cost, actively-managed, or more complex investment vehicles. Washington State, for example, has a prepaid tuition savings plan that, as far as I can tell, is a way to make a tax-advantaged bet on public higher education tuition outpacing the stock market (and Washington State not going bankrupt).
3. Fees. In addition to the underlying expense ratio of the mutual funds you invest in, 529 plans also charge account maintenance fees, which you should also attempt to minimize.

The key thing to realize is that since you can open multiple 529 plans, you can optimize these factors in multiple ways. For example, an Arkansan can contribute $5,000 per year ($10,000 for married couples) to Arkansas's relatively expensive 529 plan in order to secure the maximum state income tax deduction, then direct additional contributions to lower-cost, out-of-state plans.

How does Vanguard compare to My529?

When it comes to state tax benefits, the plans are identical except for residents of Utah, who can claim an annual 5% state income tax credit on up to $1,920 ($3,840 for married couples) in contributions per beneficiary to My529 plans. That $192 per year, per beneficiary, may not seem like much, but it swamps the differences in fees between the two plans.What are those differences? Unlike My529, Vanguard somewhat annoyingly rolls the asset-based account maintenance fee into the expense ratio for each investment option. So while My529 offers the "Vanguard Total Stock Market Index" with a 0.02% expense ratio and 0.2% "Administrative Asset Fee" for a total of 0.22%, Vanguard offers the "Total Stock Market Portfolio" which charges 0.18%, including both the underlying expense ratio and the account maintenance fee.The spread isn't a constant 0.04%, unfortunately, so the actual difference in fees will depend on your weighted asset allocation. For international stocks, My529 charges a total (including Administrative Asset Fee) of 0.27% while Vanguard charges 0.25%.So basically, for non-Utah residents, Vanguard is the clear, if slight, favorite. For Utahns, the question is how much hassle you're willing to go through managing two 529 accounts. If that exceeds your hassle threshold, then using My529 exclusively is a perfectly reasonable, low-cost choice. If your hassle threshold is higher, stick $1,920 per beneficiary, per year, into My529 and use Vanguard for the remainder of your contributions.

Vanguard 529 balances count towards Voyager status

Unrelated to the tax and cost advantages of 529 savings plans, Vanguard has one additional slight advantage: your 529 balances count towards your qualification for Voyager, Voyager Select, and Flagship services. Vanguard "elite status" doesn't have very many advantages, but if you have any account types, like a solo 401(k), that charge annual account maintenance fees, those fees are waived once your total Vanguard balance across all account types reaches $50,000. That can take a long time if you're just saving $5,500 per year in an IRA, so the ability to goose your overall Vanguard balance with 529 contributions may help you save money on fees in addition to the lower cost of the investments themselves.

You got your tax cut. Now what?

I had an interesting exchange in the comments of this post with reader sh on the subject of portfolio protection. I won't relitigate the question here since you can go read our exchange, but sh got me thinking about public markets and what they are, and aren't, for.I take for granted that the price level of public market equities, that is to say without dividends reinvested, will be flat over the next 5-to-10 years. Far from being valuable insight, however, this conviction is completely worthless. That's because I have not the slightest inkling about the path of public equity prices in the next 5-to-10 years. A "flat" intermediate-term prediction can describe a market that drops 80% and then quintuples, a market that doubles and then drops 50%, or a market that just staggers along for the foreseeable future.And of course that leaves totally aside the fact that my seemingly-precise expression "5-to-10 years" masks a difference of five whole years!

Remember what high stock prices and low interest rates are for

Almost a year ago I wrote about the Federal Reserve's plan to save the American economy: sell everything and start a business. The plan was and is marvelously simple: by buying up trillions of dollars in government bonds, the Fed was able to drive the interest paid on safe securities to extremely low levels. That forced investors seeking returns that used to be available on risk-free assets to buy riskier assets. It forced investors seeking returns that used to be available on risky assets to buy even riskier assets. And, ultimately, it was supposed to make returns so low, funds so cheap, and equities so overpriced, that people would be enticed to borrow money, issue equity, start businesses, hire employees, and get the American economy moving again.

You got your tax cut. Now what?

The Republican party felt compelled, for aesthetic reasons, to include adjustments to individual tax rates in their recently-enacted changes to the tax code, but the overwhelming impact, in both practical and budgetary terms, was on corporate taxes. Those changes mean that in the short term, US corporations with assets owned by international subsidiaries will be able to retitle those assets in the name of the parent corporation at discounted rates, permitting the US company to use the assets to pay dividends and reduce their share count (offset by the shares issued to their executive suite, of course).Whether you think the 2018 year-to-date rise in the stock market's price level was "caused" by those changes to the tax code or not, it has certainly risen, and if you're invested in public market equities, you may have noticed their increased value (even though you shouldn't peek).The question I have to ask is, now what? Still-low Federal Reserve interest rates have now been combined with a shot of adrenaline from Congress to push public market equities to all-time highs. But what's the plan? Or rather, what's your plan?

Imagine the opposite conditions

People even a little younger than me won't remember this, but in the early 2000's it was possible to earn 6% APY, or higher, on a totally liquid money market savings account (mine was with PayPal). People older than me may remember when US Treasuries were paying well over 10% APY in the early 1980's. What would be the appropriate response to conditions like those?Logically, you'd want to get the highest-paying job you could, work as many hours as your boss let you, spend as little as possible, and save every penny you could in the longest-dated securities you could. Treasury Inflation-Protected Securities weren't issued until 1997, but if those high-interest, high-inflation conditions existed today you'd probably want to give up a few points of interest and buy 30-year TIPS. Of course, public market equities were also very depressed, so in general saving as much of your income as possible and scooping up as many securities as possible was the right move, and you would have been richly rewarded for it.

Last call for this business cycle

We've reached full employment and employers are having to raise wages and working conditions and lower hiring standards to attract additional workers. Inflation is starting to fitfully show signs of life. The Federal Reserve has raised interest rates off the floor and may accelerate the pace of increases this year.Eventually, these conditions will converge, growth will collapse, and it will be time to start scooping up cheap stocks and bonds again. But we're not there yet. If a year ago the time was right to start a business, today the time is perfect to start a business.So, what now?

Thinking about portfolio protection

Downside risk protection is one of the more interesting things to think about in investing. After all, if you ask me, "should I own US stocks or international stocks?" my answer will be "yes." We can quibble or even fight about what proportion of your equities should be large cap, small cap, growth, value, etc., but those are all ultimately battles around the margin. The fact is, owning equities is the best way to participate in the profits of publicly traded companies, so if you want to participate, you should own them.So, if investing in global capitalism has a positive expected return, why would you worry about downside risk at all? The answer isn't war on the Korean peninsula, or Chinese industrial espionage, or the first of what I can only assume will be many US government shutdowns in the coming years. The reason is (almost) entirely behavioral: if you, personally, are going to make decisions you know to be bad when your portfolio tanks, then one way to avoid making those bad decisions is to put in place protections that will keep your portfolio from tanking.Faithful readers know about my unfortunate literal tendency, and it's remarkably difficult to find any concrete descriptions of how a person might implement a strategy to protection their portfolio from downside risk. So, I thought I'd take a swing at it.

Options

It's easy to find people online who are happy to sell you options trading strategies with a positive expected return. I do not believe those people and don't think you should either. But options really do exist, and you really can use them to provide portfolio protection — as long as you're willing to pay for it.To see how this would work, let's use the example of SPY, the S&P 500 SPDR and the most heavily-traded ETF in the world every single day. SPY is currently at $280.41 and, in 2017, paid $4.79 in dividends, which we can use as a baseline (under most — but not all! — market conditions dividends are stable or rising). Assume a portfolio of 100 shares of SPY, which paid $479 in 2017 dividends.According to Nasdaq's information at the time of writing, you could buy 100 option contracts giving you the right to sell SPY for $280 per share at any time before April 20, 2018, for $543. That would give you downside protection should the price of SPY fall by more than $0.41. Of course, it would also mean giving up $543 of your $479 in 2017 dividends. If the price of 3-month options remained constant quarter-to-quarter (more on that in a moment), you'd end up paying $2,172 in annual options premia, turning a modestly positive 1.71% yield into a negative 6.04% yield.If you were able to do that, would it be worth doing? Well, that depends. How bad a decision do you think you'll make if the markets tank? If your portfolio loses half its value, will you sell everything and never touch stocks again? In that case, giving up 7.75% in annual returns might be cheap.Of course, this exercise has insisted on complete downside protection using at-the-money puts covering an entire portfolio. Naturally, there are other strategies you could use to provide partial downside protection.Since options are cheaper the further out of the money the strike price falls, you could buy out-of-the-money put options, for example corresponding to your portfolio's dividend payout. In the case of SPY, $118 (roughly a quarter of the $479 2017 dividend) would buy you 100 put options with a $252 strike price, roughly 10% lower than SPY's last closing price. You would sacrifice a 1.71% dividend yield for protection from any fall in the price of SPY of more than 10%, while fully participating in any price rise. This is, incidentally, essentially how variable indexed annuities work, although they cap upside participation as well as downside risk.One problem with such a strategy is that options prices are not constant quarter-to-quarter, so the same amount of protection could cost more when your contracts expire and you need to replace them. One solution would be to buy longer-dated puts.Rather than paying $543 for an April at-the-money put contract, then in April replacing it with a July at-the-money contract, then replacing that in July with an October contract, and finally replacing that with a January contract, you could buy a January at-the-money put today for $1,402. It may take a moment to realize why the January contract doesn't cost four times (or more) the April contract: the strike price of the January put doesn't reset each quarter, and since SPY has a positive expected return, the option is priced on the (reasonable) assumption that it will be very far out of the money by the time it expires. In other words, if you want to reset your option's strike price each quarter, you have to pay up.Incidentally, for the $2,172 you'd pay for four equally-priced quarterly put options you could buy a January, 2019, SPY put with a strike price of $295, locking in a 5% price increase (but you shouldn't).

Put strategy funds

Instead of getting involved in options trading yourself, you could pay somebody to do it for you. For example, Cambria Funds offers what they call a "tail risk" ETF, ticker symbol TAIL [full disclosure: I own two (yes, two) shares of TAIL in my Robinhood account]. Their strategy is slightly different from the ones I described above, since the fund uses bonds instead of equities to generate income that they then use to buy out-of-the-money puts. You can see their actual holdings here, they only have 13 positions so it's pretty easy to understand the strategy, although for reasons I don't entirely understand the ETF also pays a small dividend.One thing to keep in mind is that since TAIL holds 95.5% of its value in Treasuries, you would want to use it to replace bonds in your portfolio, since it's basically an intermediate-term Treasury fund with a small allocation to put options.

Sell part

The single easiest thing you can do to protect yourself from a fall in asset prices is to simply sell now, before the fall. If your equities have doubled or tripled since the depths of the financial crisis, there's no rule that says you have to hold onto them forever. If holding some cash, or short-term treasuries, or inflation-protected securities, is going to make you more psychologically resilient against the inevitable crash, just hold some cash!In tax-sheltered accounts that may be as easy as pushing a button, although for assets in taxable accounts be sure to consult with a fiduciary financial advisor or tax professional to understand the tax implications of selling appreciated assets. If you are still making contributions to IRA's or workplace retirement accounts, you can also adjust how your ongoing contributions are allocated in order to build up a defensive position.

The problem of asset location

That last point raises an issue that I've only begun to struggle with, the problem of asset location, which arises because different investment vehicles have different rules about contribution limits and contribution timing.For example, since funds in IRA's compound tax-free, you'd ideally like them to be fully invested in assets with the highest expected returns. But since there are annual contribution limits, you'd also like to keep some of the value of the account in safe assets, or assets that are uncorrelated with the account's most volatile investments. Once solution, counter-intuitively, could be to hold each year's contribution in a high-yield taxable account (I like Consumers Credit Union's Free Rewards Checking) and delay contributions until as late in the year as possible, in order to determine whether each additional contribution should be added to the high-risk or low-risk portion of a portfolio. Contribution limits are so low to such accounts that delays are unlikely to have much effect one way or the other in the accounts of high-net-worth individuals, however.Likewise, workplace retirement plans that are funded through paycheck withholding require you to specify how your biweekly or monthly contribution is to be allocated. Whether or not you can accelerate contributions in response to events in the market depends on your payroll department and the time of year, and in any case you're subject to annual caps on elective employee contributions, meaning for some people there may be strategic value in holding less-volatile assets even within an account that internally compounds tax-free.

What did you "miss" in the bitcoin bubble?

I take almost no interest in bitcoin or any other cryptoasset as a store of value or investment (although there's no reason the technology couldn't be useful in other ways), but there's one specific mistake I often see people make that I want to offer a friendly correction to.

Bitcoin are not discrete units

When people talk about stocks they frequently say things like, "if you had bought Berkshire Hathaway stock in 1964 for $19 per share you'd be worth more than Bill Gates," or "if you had bought a share of Amazon at $20 in 2001 your investment would be worth a zillion dollars today." That's because, as a general rule, shares of common stock are bought and sold in indivisible units (or even in blocks of 100 shares).Lazy journalists and thinkers try to port that logic over to bitcoin and say things like, "if you had bought a bitcoin for $1 in 2011 it would be worth $13,000 today."But bitcoin isn't like stock, in that rather than being indivisible, it's extremely divisible — into 100 millionths of a bitcoin (a "satoshi"). If $1 is the amount of bitcoin you think you should have bought in 2011 (which I consider an appropriate amount of bitcoin to own as a speculative investment), you can still buy $1 in bitcoin. Of course, instead of buying 1.0 bitcoin, you'll be buying 0.00036615 bitcoin, but who cares?

You didn't miss anything

I don't know what the price of bitcoin will do tomorrow (or even what it will do today). But I don't know what the price of the S&P 500 will do tomorrow either, and that doesn't stop me from owning it. That's not what investing is about. Investing is about making appropriately-sized bets based on your level of confidence (which may be no confidence!) in the best information you have available (which may be no information!).I have no information about bitcoin and no confidence in it, so I hold a diversified portfolio of low-cost equity mutual funds. But if your own information and confidence makes you think it's appropriate to invest 0.5%, 1%, or 50% of your portfolio in bitcoin, there's no reason to let the price of 1.0 bitcoin stop you. If bitcoin goes up even more, you can sell it off and rebalance into underperforming parts of your portfolio, and if it goes down, you can buy more up to your desired portfolio allocation, just as you would have done if you'd bought it at $1, $10, or $100 per bitcoin.If what you regret is not buying 100 bitcoin at $1 and then not selling as it swamped every other part of your portfolio in value, then what you're talking about isn't investing, it's gambling. Gambling is, of course, extremely fun, but there's no reason to let the price of 1.0 bitcoin stop you from gambling with an amount of money you're prepared to lose, any more than you should stop betting when a craps player has a long winning streak or a blackjack dealer busts over and over again.

Is this the next high interest savings opportunity?

My go-to resource for high-interest savings and checking accounts has long been depositaccounts.com, which has a pretty good list of accounts offering unusually high interest rates on deposits when you meet certain requirements, usually connected to either debit or credit card spending activity, or both. Such accounts are great; what's not to love about high-interest, FDIC- and FCUA-insured deposits?When people complain about low interest rates on savings, I usually point to these accounts and argue that this is precisely how we'll see higher interest rates trickle through the economy: through products offered by regional banks and credit unions that are confident they'll be able to deploy the deposits profitably within their service areas.But I stumbled across the subject of today's post in a totally different way.

Somebody has sold the nation's credit unions on "round-up savings" accounts

Like many folks with my areas of interest, I have accumulated quite a few memberships in regional credit unions over the years, and today I opened my mail to discover an unusual offer. One of my credit unions has launched a product called "Round-Up Savings."The program works like Bank of America's "Keep The Change" program, rounding up each debit card purchase to the next dollar and depositing it in a savings account. Via Henry Fung on Twitter, I learned that program used to match contributions up to $250 per checking account — a good deal!This Round-Up Savings program works slightly differently: instead of matching your savings contribution, it pays 20% APY (through February) and then a "high interest rate" thereafter.Knowing that virtually all credit unions deal with the same traveling salespeople, it occurred to me to look around to see if any other credit unions had bought into this scheme.They had.The best one I found on the first couple pages of Google search results is a credit union in Kentucky which offers:

• a 100% match for the first 90 days;
• a 5% match thereafter (the two matches are capped at a combined $250, I believe);
• a 5% APY dividend rate (oddly the dividend is paid annually instead of monthly, but it's advertised as APY which in principle is supposed to control for compounding frequency).

How do you fund these accounts?

Every Round-Up Savings account I found allows the account to be funded exclusively through round-up transactions; you can't just deposit your life savings into your new 5% (or 20%!) APY account.What you have to do is make purchases with your linked debit card that end in as small a cent figure as possible, ideally while minimizing the dollar figure — $0.01 purchases would be ideal, for example.Assuming the best case scenario, that you have access to a tool that lets you charge $0.01 to your linked debit card an unlimited number of times, you're then faced with a grim reality: such a transaction only deposits $0.99 into your account. One thousand (1,000!) such transactions would only result in a deposit of $990.So the opportunity is throttled by your patience, the tools you have available, and the willingness of your credit union to entertain your antics. That's going to dissuade virtually everyone from pursuing these high-interest accounts aggressively.And that's the real reason arbitrage opportunities last as long as they do.

The only investment you'll ever make that matters

I was having a conversation with a young investor yesterday when I mentioned in passing my view that the latest clue that the market cycle is ending is when an enormous corporate tax cut became not a possibility, but a certainty, and share prices didn't budge. In other words, the market had already fully priced in the special dividends and share buybacks we'll see over the next year.Then the investor asked me a question I wasn't expecting: "So what should I do?""Do?" I replied, "What do you mean, do?""You just told me the market cycle is ending and we're headed to a collapse, at least in share prices, and possibly in the whole economy. I've been living within my means and investing as much of my paycheck as possible for the last two years. You're telling me that after all those sacrifices, my investments are about to go up in smoke. So what should I do?"

Maybe market timing is possible, but what makes you think you can do it?

Before deciding to time the market, you need to have reasonable confidence in two separate, independent propositions:

1. It is possible to time the market. Using indicators either publicly (CAPE ratios, length of bull market, timing of Federal Reserve rate hikes) or privately (satellite imagery of parking lots, conversations with CEO's, credit card transaction volume) available, a person is able to conclude whether the market is likelier to rise or fall in the proximate future.
2. You are one of the people who can time the market. Once you have concluded market timing is possible, you then have to be sufficiently confident in a totally separate proposition: that you are one of the people who is able to properly synthesize public indicators or the specific private indicators you have access to in order to reach a correct conclusion about the direction of the market.

This calculus is easy for me. I do not have any confidence that market timing is possible, and I know for a fact that I, personally, am incapable of market timing.

The only investment that matters is the investment in justice

I'm happy to tell you the same thing I told that young investor: how much you save, and the performance of the markets between now and when you start drawing on your savings, may affect the neighborhood you can afford to retire in, it may affect the car you can afford to drive, and it may affect the amount of money you'll have left to pass on to your favorite children, relatives, churches, or charities.But there's no amount of personal virtue, self-deprivation, market performance, or astute asset allocation that can pay for a serious medical emergency, a chronic disease, or a decade or more in a dedicated nursing facility. The amounts of money involved are simply different orders of magnitude.I save a high percentage of my income. I invest in a very aggressive portfolio of global equities. But I don't think for a moment that I'll ever have enough money to pay for treatment for pancreatic cancer out of pocket.And yet, while I don't have any interest in contracting pancreatic cancer, I don't think pancreatic cancer would render me homeless, dying on the street as the cancer consumes my body. How is that possible? It's possible because we have begun, as a nation, to work towards universal access to affordable, comprehensive health insurance. We haven't taken the straight path, but we've taken many steps along the winding path to universal coverage.And that's why I say the only investment that matters is the investment in justice.When you register to vote, when you vote, and especially when you help others to vote, you are investing in your future in a way that a low-cost index fund will never provide — no matter how well it performs. When you contact your representatives to oppose cuts to Medicaid, Medicare, and SNAP, when you demand that CHIP be funded before millions of children lose access to healthcare, when you rally against Social Security privatization, you are securing your own future and the future of the nation in a way that a diversified portfolio does not and never will.

Conclusion

The fact that we denominate even unpayable expenses in dollars leads to a kind of category confusion, whereby people come to think that if they have "enough" money they'll be able to escape financial hardship. But the only protection any of us have is in our mutual and collective support for one another.The work you do to create a just society is the best investment you'll ever make.

The effect of estate tax repeal on the 529 scam

One of the first posts I wrote here was about the 529 scam. I explained that 529 plans are a way for wealthy individuals to permanently shield an almost unlimited amount of assets from taxation, and that the scam was made sustainable by the very large number of middle class people saving a very small amount of money who are absolutely convinced that 529 plans are a way to save money for college, rather than a way for the wealthy to shield their assets from taxation.Like the mortgage interest, the state and local tax, and charitable contribution deductions, the actual benefits of 529 plans accrue to a tiny population of wealthy heirs and heiresses, who are protected from blowback by a large population of earnest upper-middle-class professionals.

What are the benefits of 529 college savings plans?

There is so much nonsense out there about 529 college savings plans that it's important to understand what the actual benefits of the plans are. There are only three:

• Internal tax-free compounding. Dividends and capital gains from the underlying investments are untaxed as long as they remain in the account, while they would be taxed if held in a taxable brokerage account.
• Tax-free withdrawals. Under certain conditions, withdrawals from the accounts are tax-free, while they would be taxable if the securities were instead held in a taxable brokerage account.
• Transfer of ownership of a 529 account is not a taxable event at the death of the account's owner, while it might be if the owner of a taxable brokerage account dies (although in that case the heir would benefit from the stepped up basis rule).

What are the limits on 529 college savings plans?

It is commonly believed that there is a limit of $14,000 in annual contributions to 529 college savings plans, or $70,000 if contributions are made upfront and reported over a 5-year period. This is precisely false.$14,000 ($70,000) is the annual (quinquennial) amount you can contribute without filing a "Gift (and Generation-Skipping Transfer) Tax Return."The actual limit on the amount you can contribute to a 529 college savings plan is the plan's maximum contribution balance. For my preferred 529 plan, the Utah Educational Savings Plan, the maximum contribution is $430,000. You can't contribute any more to the plan as long as your balance is at least that amount, but in case of a decline in the value of the account, you can "top up" the account to $430,000 again. As UESP helpfully explains:

"UESP will accept contributions for a beneficiary until all UESP account balances for that beneficiary reach $430,000. It is possible that balances may exceed $430,000 because of market performance. Contributions or portions of contributions that exceed this maximum will be returned to the contributor."

How would repeal of the estate tax affect the 529 scam?

In the absence of the estate tax, there would be no reason for our beloved oligarchs not to contribute the maximum account value to every 529 plan in the country. Without an estate tax, there would be no estate tax exclusion that such contributions could count against, and there would be no return that would need to be filed to record such transactions.To use UESP as an example again, in the absence of the estate tax, at birth every wealthy child in the country could receive a $430,000 transfer, invested in the stock market, that would compound tax-free forever, and with tax-free withdrawals when spent on eligible expenses.

About those eligible expenses

Here readers think they have caught me in some kind of trap. "A-ha," you say, "what good is an enormous tax-free inheritance that can only be spent on certain eligible expenses?"Don't worry, Ted Cruz is on the case. Senator Cruz included in the Senate version of the Republican tax reform bill a provision allowing $130,000 to be withdrawn for K-12 private school expenses, in addition to the undergraduate and graduate school withdrawals that were already allowed tax-free.Even if you're a responsible middle class professional, think about the logic of this provision. A diligent middle class saver starts investing money at the birth of their child and starts withdrawing it a few years later for private kindergarten expenses, so it's had perhaps 2 or 3 years of tax-free internal compounding. A wealthy person inherits a multi-million dollar 529 plan and is able to withdraw $10,000 per year for 13 years that has never been and will never be taxed. Then they can withdraw an unlimited additional amount, also tax-free, up to the total cost of attendance at their kid's private college and graduate school.Finally, as I mentioned in my original post, it's important to understand that a huge portion of the intergenerational transfer of wealth is precisely the transfer of educational opportunities and credentials. Far from being a "restricted" or "limited" form of inheritance, "forcing" your heirs to use a portion of their inheritance on the best private schools is far from a drawback of the 529 plan scam. For many of our oligarchs, it's the whole point.

The real reason arbitrage opportunities last so long

Every once in a while you come across a seemingly insignificant coincidence that gives a different perspective on a question you thought you understood the answer to.I had one of those moments the other day when, for the second time in the course of a few weeks, a popular economics Twitter account dismissed my suggestion that he open a high-interest checking by saying "That is a ton of small print" (it looks like the first thread was deleted but you can find it cached here for now).This made me reconsider the question: why do arbitrage opportunities last so long?

I thought arbitrage opportunities lasted because people were lazy

When you tell someone they can put their savings into a checking account that earns 50 or 100 times as much interest as their existing savings account, as long as they're willing to execute a few debit card transactions on the first day of every calendar month, it has always seemed to me the logical response should be "oh thank God!" or "how did I not know about this?" That's certainly the reaction I had when I learned about high-interest checking accounts.When people did not have that reaction, I thought I knew why. They might be lazy, and not be willing to meet the high-interest requirements. They might know themselves well enough to know that they would let the requirements slip through the cracks. Or they might simply not understand how compound interest works and what the advantages of high-interest accounts are over low-interest accounts.These can all be basically filed under the categories of laziness and ignorance.

Smart, energetic people's reaction to arbitrage opportunities is suspicion

The reaction of these two prominent Twitter personalities gave me a different perspective. Their reaction was not "I can't be bothered," or "that sounds like too much work," or "higher interest rates aren't worthwhile." Indeed, I was responding specifically to their individual complaints that they were earning too little interest on their savings.Instead, their reaction was suspicion. "That is a ton of small print." "You realize this is just a dang cash back credit card arrangement right."Instead of being upset for having missed out on higher interest rates on their savings for so long, they didn't believe it was possible they had missed out on higher interest rates for so long.There had to be a catch. But there is no catch. Arbitrage opportunities really are everywhere.

People need to get a grip on how late capitalism works

Many people, particularly those unfortunate enough to be educated in economics, still believe that late capitalist economies function by distributing global savings through capital markets to the investments which will produce the most economic output when the requisite amount of labor is applied to them. This is the "money market" described in Walter Bagehot's brilliant book "Lombard Street," in which the profitable agricultural estates of southern England send their excess cash to London for the bill brokers to lend out to the new manufacturing firms in the North.Late capitalism is not like that. Under late capitalism, the United States Mint (and Canadian Mint!) accepted credit card payments for the sale of dollar coins at face value. Under late capitalism, online mattress companies will let you try a mattress for 100 nights and then refund your money while shipping the mattress to a landfill. Under late capitalism, Uber has perfected the flow of money from venture capitalists to consumers and car-owners.In other words, arbitrage opportunities are everywhere.

If you're going to be suspicious, be suspicious of the right things

That's not to say that everything is free and easy under late capitalism. On the contrary, late capitalism goes hand in hand with what I call the "scam economy:" deals which sounds too good to be true because they are.A reader turned me on to the idea of paying folks to use my Uber referral link; it worked ok, but I barely broke even after going back and forth with the South Asian scammer I used on Fiverr.On the other hand sites like Prosper, Lending Club, Wunder Capital, and the now-ubiquitous non-traded REIT companies offer abnormally high returns, but they do so because people are rightfully suspicious about their ability to meet their debt service obligations. The higher returns they offer are compensation for higher risk, rather than arbitrage opportunities.That means before pursuing an arbitrage opportunity it's absolutely right and proper to establish what kind of protection you have, how well-established or profitable a company is, whether the company is based in the United States or elsewhere, and so on.But if a FDIC- or FCUA-insured bank or credit union is offering unusually high interest rates for meeting a couple of simple requirements each month, the logical reaction is to read the fine print, fill out the online application, and move your cash savings there — or else please stop complaining about the low interest rate on your savings account.

What is a 30-year fixed-rate mortgage?

The title of this post may sound like a rhetorical question, but I assure you I don't mean it that way. It's a question I've been pondering for a while as I come across weird datapoints from the history of home financing around the world. A 30-year fixed-rate mortgage is maybe best defined by what it is not: it's not a one-year floating-rate mortgage.

What would a one-year floating-rate mortgage look like?

There's no mechanical reason a one-year floating-rate mortgage couldn't exist. At the beginning of the first year, a home-buyer would take out a loan for the purchase price of a house, secured by the house as collateral. They'd make payments throughout the year at whatever the prevailing interest rate was (the borrower and lender could agree on whether payments would fluctuate or whether payments would be fixed and the amount of interest and principal paid would fluctuate), and then at the end of the first year, the home-buyer could either repay the remaining principal or take out another one-year floating rate mortgage to repay the balance of the original one.While there's no mechanical reason such a system couldn't exist, it has some obvious drawbacks:

• Vulnerability to changes in house value. In a rising housing market, such a system would be the equivalent of annual cash-out refinancing. In a falling housing market, it would be an annual cash call, since the borrower would have to pay the previous year's lender the amount borrowed, even if the next year's lender was unwilling to lend the full amount given the lower value of the house in year 2.
• Uncertain total repayment term or uncertain payments. In a period of rising interest rates, each year the borrower would repay less and less of their loan's principal (or face rising monthly payments). That means it might take many more than 30 years to fully own a home, even if at the beginning of each year you intend to pay off one thirtieth of your remaining principal. Uncertain monthly payments also would make it difficult to plan your expenses in advance.
• Borrower credit risk. Even if economy-wide interest rates remained steady, the interest rate an individual borrower might be forced to pay could vary from year to year as their personal credit profile changes. A higher income might lower their monthly payment in one year, while a lost job might make it impossible to roll over their loan at all — even if they have the next year's worth of payments saved up in cash!
• Lender risk. In case of an economy-wide shock to the credit market, it might not be possible to refinance a loan at all, even for the most credit-worthy borrowers. Mass foreclosures and evictions based on banking sector malfeasance would be a constant risk in an economy of one-year mortgages.
• Huge transaction costs. Presumably such a system would create streamlined refinancing offers (perhaps even interest rate discounts after a certain number of years) but verifying the credit and income of a borrower and the value of a home each year would still require an enormous amount of work, and create enormous scope for human error.

That said, there are some obvious advantages as well, for both borrowers and lenders:

• Lower interest rates. If lenders didn't have to squint at the horizon and forecast the future trajectory of interest rates, they would be able to offer much lower interest rates today. You can see this in the interest rate differential between 30-year and 15-year fixed-rates mortgages. It would be reasonable to expect the rate to be even lower for one-year floating-rate mortgages.
• Less prepayment risk. When a lender makes a mortgage loan today, they're forced to take into account the risk that if interest rates fall their customers are likely to repay their loans early and refinance into a lower-rate mortgage. That creates an unpredictable, one-way risk for the lender and for the buyers of mortgage securities. Rolling one-year loans would drastically reduce that risk, since few people would be willing to go through the hassle of refinancing a loan mid-year.
• Reduce borrower debt. Since each year borrowers would only borrow the amount they needed to repay the balance of the previous year's loan, they could use annual savings to reduce the amount borrowed each year. This is the same logical process as accelerating payments on a 30-year mortgage, but the annual refinancing process might provide a sense of immediacy or urgency to the process, or simply given borrowers a chance to look at their household assets and expenses.
• Increase home equity. Lenders would presumably insist on large down payments in order to shield themselves from the risk of a decline in the house's value between the time they make a loan and the time the borrower seeks another. Much higher home equity might contribute to fewer foreclosures and evictions in general.

A 30-year fixed-rate mortgage is a one-year floating-rate mortgage with a bunch of riders

That brings me back to the question, what is a 30-year fixed-rate mortgage? In the same way that a delayed variable annuity is an immediate fixed annuity with a bunch of riders on the contract, I think of 30-year fixed-rate mortgages as one-year floating-rate mortgages with a bunch of riders:

• instead of a floating interest rate, a fixed interest rate;
• instead of variable payments, fixed payments;
• instead of annual credit assessment, assessment just once at the beginning of 30 years;
• instead of having mandatory cash calls for any change in your home equity at the end of each year, never having a cash call for declines in your home equity;
• instead of being vulnerable to changes in the supply of credit, being guaranteed the same terms as long as you stay current on your payments.

Of course, just as with a delayed variable annuity, each of these riders comes at a cost, generally in the form of higher interest rates.

Once you know you're paying for each rider, you could decide which ones are worth paying for

What got me thinking about this most recently was seeing the statistic that the median length of tenure in single-family owner-occupied housing is 15 years (6 years for multi-family condo owners). In other words, 50% of single-family homeowners move before spending 15 years in their home. But between 85% and 90% of mortgages are for 30 years. That means 35-50% of home buyers are paying for riders they don't use: fixed interest rates and payments and credit insurance for the second 15 years of their mortgage.That begs the question: do the 50% of homeowners who move within 15 years know in advance they'll move within 15 years? If so, they're overpaying for those 15 years; they'd be strictly better off with a 15 year mortgage (even if that meant a balloon payment in year 15, by which point they plan to sell the house anyway). If not, what they're paying for is an insurance policy so that if they end up belonging to the 50% that stays longer than 15 years, they won't have to renegotiate new terms and be susceptible to intervening changes in the credit market.That insurance is worth something, without a doubt. But the price is higher interest payments and lower principal payments during each of the first 15 years. By saving that money instead, home buyers could "self-insure" against the same risk, with the potential upside of being able to keep the savings if they do, in fact, move before then.

The problem with the federal housing finance agencies is that they subsidize one particular set of riders

On the one hand, the idea of securitizing standardized mortgages and making it possible for investors to select the particular borrower and loan characteristics they are looking for while freeing up bank capital to underwrite and issue new loans is a fairly reasonable idea. On the other hand, the private sector has demonstrated absolutely no interest in doing so, and it was left up to the federal government to create the so-called "government-sponsored enterprises," or GSE's (the failure of the GSE's in 2008-2009 suggests one possible explanation of the reluctance of the private sector to undertake this enterprise).The problem is not that the government has decided to subsidize homeownership. The problem is that doing so has made offering unsubsidized mortgages uneconomical, since mortgages that don't qualify for sale and securitization have to be held on the lender's books or privately securitized (i.e. without an implicit government guarantee), tying up that capital until the loan is repaid, while qualified mortgages can be immediately sold and the same money lent again to another borrower, with a new set of origination fees piled on top.Freddie Mac has this fairly hilarious document signed by their "VP Chief Economist" Sean Becketti explaining that:

"The considerable benefits of the 30-year fixed rate mortgage to consumers are beyond question. However, this type of mortgage isn't a natural fit for lenders. All the features that benefit the consumer—long term, fixed interest rate, and the option to prepay the loan without penalty—create serious headaches for lenders. As a result, the federal government created Freddie Mac and other institutions that allow lenders to hand these headaches over to the capital markets, where sophisticated portfolio managers have the tools and expertise to manage the investment risks of the 30-year mortgage."

Now, 15-year (and shorter) fixed-rate and floating-rate mortgages are still available, and under the right circumstances may even be qualified mortgages for securitization purposes. But balloon loans, which require repayment or refinancing in the final year of the mortgage, are decidedly verboten. In other words, for a mortgage to be qualified for GSE securitization, it has to be repayable in equal payments over the term of the mortgage, which in practice forces people who have no intention of staying in their home for 30 years into 30-year mortgages — and paying the correspondingly higher interest rates for each of the years they actually remain in the home.

Disclosure

I own 50 common stock shares of Freddie Mac and of Fannie Mae. I've lost about $150 on them since I bought them, but remain hopeful that the current administration will sell out the American public by allowing the GSE's to recapitalize and start paying dividends again, in which case I'll make a fortune.