Monday Morning QB – Market Observations:

Volatility Returns to the Stock Market as a China/U.S. Trade Deal Takes a Major Hit
Monday’s Trade War Escalations from both the U.S. and China Lead to the First 3% plus Market Decline of 2019
Turnaround Tuesday takes Away Some Investor Pain
Currency Manipulation Becomes the New Battleground of the Trade War
If You Invest for Yield Better Buy Stocks

Monday Morning QB – Market Performance:

Volatility was the outcome of growing trade tensions between the world’s two most important economies. The major indexes suffered their worst day of the year at the beginning of the week as China let its currency fall below the key symbolic threshold of 7 Yuan to 1 U.S. dollar that has stood over the past decade.

In addition, the Chicago Board Options Exchange Volatility Index (VIX) hit its highest level since late last year. But a big turnaround on Tuesday and Thursday of almost 1,000 Dow points gave some hope that the storm had calmed.

The Dow Jones Industrial Average retreated 197 points, or -0.75%, to end the week at 26,287. The technology-heavy NASDAQ Composite fell to 7,959 or -0.6%.

By market cap, large caps fared the best with the S&P 500 giving up just 0.5%, while the S&P mid-cap 400 and small-cap Russell 2000 lost 0.7% and 1.3%, respectively.

Volatility Began with the China Driven Monday Sell Off – China Lets the Yuan Depreciate

The retaliation for the U.S. threat of additional tariffs of 10% on Chinese goods did not take long.

The Chinese will suspend purchases of all U.S. agricultural products as well as allow the Chinese currency (Yuan) to decline below a level against the dollar that has not been breached since the Financial Crisis (2008).

The “Red Line” was 7 Yuan to 1 Dollar. In the past, China had previously stepped in to support the currency before reaching the 7:1 level.

The reaction from the U.S. stock markets was immediate and swift.

• Dow dropped 2.90% (767 points) – closed at 25,717
• S&P 500 dropped 2.98% (87.31 points) – closed at 2,844
• Nasdaq dropped 3.47% (278 points) – closed at 7,726

Adding to the Volatility, the U.S. Officially Labels China a “Currency Manipulator”

For the first time since 1994, the U.S. Government has officially labeled the Chinese as a “currency manipulator”.

The Trump Administration has long complained that the effect of the tariffs has been lessened by the Chinese lowering the value of the Yuan against the dollar. This action by the Chinese makes Chinese goods cheaper on the global markets.

The “currency manipulator” label does not mean much. It’s like calling a bully a “bully”. Being called a bully is not likely to change the behavior of the bully.

Being called a “currency manipulator,” from everything I have read, is a largely symbolic gesture but with the potential to aggravate the situation.

The expectation from the investment community going into Tuesday was, “Hold on. Things are about to get a lot worse!”

Volatility Continues on Turnaround Tuesday – China Instills a Sense of Calm about the Yuan, At Least for Now!

In the governmental game of chicken, it would be the Chinese who blinked first.

The Chinese Central Bankers gave the market a needed lift after Monday’s sell-off. China’s central bank chose to stop the Yuan from continuing to depreciate against the dollar.

The setting of the Yuan at a less aggressive level against the dollar was largely seen as a sign that the Chinese were trying to avoid further escalating the already contentious relationship with the U.S.

Well, at least for the rest of the week anyway.

The action by the Central Bank of China created an investment roll coaster ride for the week. We got on the ride Monday with an extreme drop, followed by a nice upswing Tuesday and Thursday. The S&P 500 finished the week down less than a half percent.

We got off the investment roller-coaster ride at almost the same place we started.

Volatility Returns Just in Time for the “Weak” Season

The back and forth jabs from both the U.S. and China threaten the very agreement that most of us assumed would occur.

The belief that a deal was inevitable helped markets advance to new highs in 2019. This past week’s action seemed to thwart even the best intentions of a deal.

With the guarantee of a deal all but faded, the markets will likely be swayed by whatever trade news dominates the day, especially since the next potential trade meeting will not occur until September.

Good news brings the market up and bad news sends it down.

August and September have a history of being volatile months, so hang on- it’s likely to be a bumpy ride.

The Yield Problem – How do Investors Create Income in the Current Volatile Investment Environment?

For investors whose priority is the yield (the income produced by an investment), a precarious dilemma has re-occurred after last week’s market action.

Yield investors typically buy bonds because they pay more interest than stocks. The riskier the bond is the higher the yield.

For the reason of safety, income-chasing investors prefer longer-term government bonds versus stocks or riskier higher-yielding bonds.

However, the yield on the 10-year Treasury note fell below the average yield of the stocks that make up the S&P 500.

I believe this has now occurred 8 times in the history of the stock market. That makes this a rare occurrence. Except it’s not!

All 8 times have occurred after the “Great Recession” of 2008-2009.

For those who argue that the Fed’s “Quantitative Easing” experiment has had little unintended consequences, they only need to look at this relatively new yield phenomenon. The effect on bond investors is potentially disastrous.

Bond investors are forced to give up the security of knowing that their investment dollars will be returned at the maturity of the bond against the potential of getting less money from a bad stock choice- a bad stock choice that still paid a good dividend.

The new term being floated to these bond investors is “Quality” stocks. Stocks are volatile no matter what the quality.

The cost of building wealth is volatility.

This is a lesson bond investors buying stocks should not forget. Enron was a “Quality” stock until it wasn’t!

Monday Morning QB – Market Observations:

• Momentum putting Stocks on Pace for Best June in 50 Years
• Federal Reserve Readies a More Accommodative Approach…A July Rate Cut is in the Air
• Hope and Enthusiasm Prevail ahead of Trade Talks between Presidents XI and Trump…Let’s Keep the Momentum Going
• Combination of Headlines (The Fed & Trade Talks) Creates Momentum in Stock Market
• S&P 500 is up over 7% in June
• Crude Oil Rallies on Tensions with Iran
• This Week’s G20 Meeting of World Leaders on June 28th and 29th Will Highlight the Need for Global Monetary Stimulus and a Solution with Iran
• If You Have Underperforming Stocks in June Considering Cutting the Cord

Monday Morning QB – Market Performance:

The Federal Reserve helped the momentum story for stocks in June.

The Fed held interest rates steady and reinforced investor expectations for an interest rate cut later this year, powering strong gains for stocks and lifting the large-cap S&P 500 index to a new record high.

The Dow Jones Industrial Average surged 629 points to 26,719, a gain of 2.4%. The technology-heavy NASDAQ Composite rose over 3% regaining the 8,000-level and closing at 8031.

By market cap, the large-cap S&P 500 index rose 2.2%, while the mid-cap S&P 400 gained 1.5% and the small-cap Russell 2000 added 1.8%.

So Far the Typical June Swoon for Stocks is Non-existent in 2019

Instead of the market going into a lull for the summer (June Swoon), a three-part momentum may be creating a perfect storm for stocks.

First, we needed more accommodative (dovish) language from the Federal Reserve. Fed Chair Jerome Powell in his prepared statement and remarks, delivered the “rate cut” optimism that investors were looking for.

Secondly, we needed some positive movement in the U.S.-China Trade front. A Trump tweet about a private meeting was enough to start a rally last week.

An extended meeting between the two leaders, followed by a hopeful joint statement, will likely start the next wave of advancement for stocks. Wouldn’t another 2% week be nice!

Lastly, another better than expected earnings season that takes the S&P 500 above 3000 starting the second week of July could be the icing on the cake.

Let’s look at each of these pieces.

The Fed-Fueled Momentum Rally

The Federal Reserve two-day dance ended last week on Wednesday with a steady hold on interest rates for now.

A rate cut last week would have dialed up the stock market feeding frenzy. Investors would have likely piled into stocks. For now we will have to settle for the likely cut to come after their two-day meeting at the end of July.

Oh, and last week was still pretty good for the stock market!

The certainty of the rate cut forecast came from the mouth of chairmen Powell, who said, “It’s really trade developments and concerns about global growth that are on our minds.”

The Federal Reserve statement omitted the word “patient” in describing their current stance on guidance regarding their interest rate plans. (Certainty can also be part of your chosen omissions.)

Of course, what they did choose to say is important as well. The Federal Reserve included the rate cut announcement language best described as a bad poker player’s tell about what cards are in his hand.

The Fed said, “Uncertainties about the economic outlook have increased.” This phrase has been used in past periods to cut rates. The use here was not an accident.

Chairman Powell closed with noting the Federal Reserve will react quickly and aggressively to any weakness.

The Federal Reserve knows that everything they say and choose not to say is carefully parsed. The stock market got what it was looking for.

With a rate cut all but in the books for July, all eyes will turn to the G20 Summit and the highly anticipated meeting between President Trump and Chinese President Xi Jinping.

Keep the Momentum Going – It’s Time to Play “Let’s Make a Deal”

What can I say about the future? Not much. No one knows how this week will play out.

The stock market likely does not have to see an agreement in place between China and the U.S. to push the market higher.

The talks have all but stalled, so the bar for the two Presidents’ side meeting during the G20 Summit is low. Any language from both that hints toward progress will likely be enough to move the market higher.

Without such a statement at the end of their private meeting the market will likely move lower.

The million-dollar question is, “How much lower?” now that the Federal Reserve has hitched its rate cuts to the outcome. Could a bad meeting lead to a 0.5% percent cut versus the expected 0.25% percent cut at the end of July? A little extra juice for the stock market, perhaps?

As mentioned above, the Fed will not meet again until the end of July. The rate decision at the time will come from the benefit of seeing how the trade talks progress as well as the beginning of the earnings season. The Fed will have plenty of data to mull over before making their decision.

Earnings Season to Complete the Momentum?

The stock market may benefit from bad news or from good news.

If the trade talks resume with earnest or the earnings season meets or beats expectations, the stock market will likely continue the momentum.

However, if neither of these events occurs the Federal Reserve will cut rates perhaps by 0.5% percent. Rate cuts typically create momentum for stocks.

Either scenario will likely benefit the stock market.

Momentum Playbook – Sell Your Losers

With momentum fueling the stock market into an unsettled nervousness about where stocks go from here, the question is what to do with your current investments.

Many investors have been running from the stock market to join the bond market rally. Bond prices have risen as interest rates declined. What worked in May has fallen flat so far in June. The stock market momentum is biased to the upside now.

If you stayed invested through the May drop and the June revival to a new high on the S&P 500, then you have some valuable data to help in your decision-making.

A timeless investing adage comes to mind. Let your winners run and sell your losers.

When the S&P 500 Index hits a new 52-week high, it’s easy to tell your winners from your losers. For the S&P 500 to hit new highs, many of the stocks that make up the index must be hitting new highs as well.

So, review the stocks within your portfolio. Keep your stocks that are making new highs and sell the ones that have not.

If a stock fails to make a new high along with the market or worse has not participated in the June rally then there is something wrong there.

Time to cut bait. Sometimes the obvious cannot be overstated. Let your winners run and sell your losers.

The same rationale can be applied to mutual funds and exchange-traded funds within your portfolio. If they are underperforming then let them go!

Warren Buffett “Oracle of Omaha” – Three Tips to Investment Success!

Can We Invest Like Him?

Every year around the Berkshire Hathaway annual meeting, the investing world pauses to listen to the wisdom of Warren. And why not, he is brilliant and willing to share some of that wisdom. Taking it a step farther, CNBC created a synopsis from their interviews with Warren over the years; boiling his sage advice into his best three investment tips. In CNBC’s view, the three best tips are –

• “Circle of Competence” – Judging the Future Economics of a Business
• “Piece of Business” – You are Not Buying a Stock but a Piece of a Business
• “Margin of Safety” – Your Purchase Price should be Lower Than your Valuation Price

Does the business have a superior product which you and your friends use and will continue to use? If yes, why not buy some stock in the company? You use the product which cost you money; why not invest in the company and earn some money back?

You are buying into their business; the stock is just the means to do so. At what price is the stock attractive? Cheaper, than it is today, sounds good. I will buy when the stock market drops, for whatever reason, purchasing the company stock on sale. If I can do these three things, I will invest well; just like Warren. Right?

What I just described, in my opinion, is the general interpretation of Mr. Buffett’s advice. On the surface the advice seems easy to follow; We can all be Warren Buffet! And that is exactly what CNBC is selling. I don’t know for sure, but I’m willing to guess CNBC’s ratings are higher when Warren takes up all three hours of the networks morning show.

First, these three tips are solid advice. Second, they are very difficult to put into action without working knowledge of advanced financial concepts developed with more than a casual background in quantitative math.

I’m not trying to discourage you. What I hope to offer is briefly enlightening you on these three investment concepts, followed by a “working persons” guide to investing. You probably will not end up a billionaire, but there is nothing wrong with only being a millionaire! Mr. Buffet joked that if he invested $10,000 in an index fund when he bought his first stock, he would only have $51 million today. Sounds Okay to me and you do not have to be a genius to buy an index fund! You don’t know what you don’t know!

#1 – Circle of Competence: Judging the future economics of a business

Predicting rain doesn’t count. Building arks do.

Warren Buffett

What are the companies within your area of expertise? I love this question, playing video games does not make one an expert in technology no more than owning a car makes one an automotive insider! Don’t take this the wrong way, I believe a suitable place to start looking for investing ideas involves simply looking around your house or apartment for the products that you use. Chances are good if you like the product so do other people. This speaks to the future economic benefit of the company.

However, just because you use today’s great product does not mean that the company will produce the next “Great Thing” or because you use the company product, the company is the next “Great Thing.”

The reference to this point is how does the company make its money and what is the sustainability of its profit margins over the long run?

The answer to this question is quite complicated. How much does the company spend on research and development? How effective has the R&D department been over the years? What stage of the business cycle is the company in? How much debt does the company have? How much free cash flow does the company generate? Have all their financials been trending? How do these trends compare with the competition?

Google a list of financial ratios. Not only do investors like Warren Buffett know all these ratios, including how to calculate them and analyze them, they also have access to the books and corporate officers of companies. Do you?

#2 – Piece of the Business: You don’t buy a stock you own a piece of the business

If a business does well, the stock eventually follows.

Warren Buffett

One of my favorite Warren Buffett stories goes back to the 90s when a company called “Long-Term Capital Management” was about to collapse and take the stock market down with it. The Treasury Secretary, the Federal Reserve Chairman, and the CEO’s of some of the world’s largest banks were all in a room trying to determine what to do. They tried to call on Warren Buffett for help, hoping he would take over all or some of the company assets for pennies on the dollar. They had trouble getting in touch with Mr. Buffett; he was taking a donkey ride in the Grand Canyon with his good buddy. Bill Gates and his cell phone was having trouble finding a signal.

The only part of this story that most of us can relate to is the lack of cell phone reception on vacation! You are buying the stock because you can’t buy enough shares to be a part of the business. Warren Buffet and Uber were in the news recently because the two sides could not make a deal to each party’s liking. Warren did not invest more than $1 billion into Uber! Would Uber Management take your call?

#3 – Margin of Safety – Pay less for a company then your valuation price

Price is what you pay. Value is what you get.

Warren Buffett

So what valuation method do you use? The Dupont System to analyze the return on equity? Or maybe you prefer a model that takes into account a company’s expected return such as the Capital Asset Pricing Model or the Security Market Line? Maybe you believe a company is only as good as its future income stream, so you use a discounted cash flow model such as the dividend discount model. If you have no idea about anything in that last few sentences you are not alone, and you will not likely get an analyst job at a Wall Street firm making a nice six figure income!

More important to this article, not only does Warren Buffett understand all of these methods but he has worked with other geniuses to create their methods of evaluation. One of my favorite old commercials was the be like Mike from Nike. One could be just like Michael Jordan if they wore Nike shoes. To this day Nike stills sells a lot of “Jordan’s” but there is only one Michael Jordan, just like there is only one Warren Buffett!

Three Simple Wealth Building Tips for Us Regular Folk

#1 – Buy an Index Fund or ETF – A cheap diversification strategy

Rather than having all the risk of one stock investment: the risk if something should happen to only your stock plus the risk of the stock market in general. An index fund eliminates (diversifies away) the company risk leaving you with general stock market risk.

When buying anything, cost matters and index funds/ETFs generally are less expensive than actively managed funds/ETFs. Their passive style keeps the trading cost within the fund or ETF to a minimum, and you don’t have to pay a manager, so your administrative cost should be negligible.

Think of cost as a hurdle. The more you pay, the higher the hurdle your money needs to jump before you make any money on your investment. For example, if your return is 5% and the total cost (seen and unseen) of the investment is 2%; the fund/ETF made 7%, but you netted 5% because the investment cost you 2%. If the expenses were only .06%, (many index funds/ETFs charge between .03% to .20%), then your return would have been 6.94%.

I would rather make 6.94% than 5% for owning the same thing! Cost matters

#2 – Do the DRIP – reinvest your dividends

Free money: Who does not love free money! That essentially is what a dividend is to you. A dividend refers to a stock’s payment to its shareholders, expressed in terms of yield which is a percentage of the stock’s current price.

The SPDR S&P 500 ETF (SPY) pays an annual dividend yield of around 1.80%. If you own the ETF for the full year, you will receive an additional 1.80% return on your investment. With this 1.80%, you can receive the money or reinvest it. The name of the game when investing is accumulating as many shares as you can. When you reinvest your dividend, you are using the money, not out of your pocket, to buy more shares.

Doing the DRIP also helps to lower your potential taxes, but that is for a different post.

#3 – Always have a Dollar Cost Averaging Strategy Working – buy every month no matter what

People can talk about all the superior investment strategies and math know how they want, but for me, merely buying an investment every month still is the best use of an irrefutable math principle.

Everyone knows that the key to successful investing is Buy Low: Sell High. Oddly enough, our emotions tend to lead us to do just the opposite. When the stock market is going gangbusters, everyone wants in, but when the market is losing money hand over fist, most people buy nothing.

Dollar Cost Averaging forces you to employ the correct behavior. When the market is going gangbusters, your monthly money buys fewer shares because the price is too high and when the market is in free fall your monthly money is busy buying up shares at the reduced price. The most important thing when you are still in accumulation mode is to acquire as many shares as you possibly can. It sure is easier to acquire more shares when the price is low.

Remember, The number of shares x Price = Wealth

You have zero control over the price of an investment, but you can control the number of shares you obtain. Dollar Cost Averaging is the most proven method to accumulate shares over time in any investment.

For example, I save our family vacation money, every paycheck, through a dollar cost averaging arrangement into an EFT which cost .03%. All dividends are reinvested, and this strategy has not cost us a trip to Disney World yet. I hope this helps!

How to Go From Debt to Savings in the Least Amount of Time

It’s that time of year; the annual lawn and flower bed beautification ritual to create the clean, crisp, weed-less yard for you and your neighbors to enjoy. Like most things in life, the enjoy part does not come without a fair amount of labor. The weeds always appear before the flowers, and if unattended, they will take over leaving you with the worst lawn in the neighborhood.

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The same is true of your money. The financial weeds are anything that stops you from first, getting out of debt, and second, saving money. The weeds are easy to see but hard to stop. These are the things we spend money on that we never intended. When making a budget, you should prioritize your spending and predetermine your wants from your needs. Label each of your expenses and assign a dollar figure, like this: Needs vs. Wants. If you are about to spend money on anything that does not appear in one of these columns, then you’re in the weeds. If you are about to overspend on a budgeted item, you’re in the weeds. The point of this is not whether you should spend the money or not; only you can make that choice. There are, however, unintended consequences to any additional spending choices you make. If you have overspent, you will need to make more money, cut back on something else, or add debt to cover the additional spending. Adding debt is the usual choice because it is perceived to be less painful. This choice is the trap that keeps people in debt.

The additional expense is likely a material possession, and until you evaluate the item against your needs vs. wants budget, you should not purchase it. Don’t impulse buy! Go home and think about it. Use the 48-hour rule for any item not included in your budget. Use that 48 hours to first add the purchase to its proper place in your budget. Next, look at the effect on your current budget to determine if the expenditure will set you back from achieving your goal of getting out of debt and becoming a saver. Lastly, if you still intend to make the purchase then determine how you will adjust your budget to accommodate the additional expense. The 48 hours buys you time to decide if it is worth it to alter your budget or to determine if it is a purchase that can and should be avoided or postponed. This process is a helpful exercise in weed prevention.

Ok, so that’s weed prevention. But how do we get rid of our current weeds in the yard? We spray “Round-Up” because it is known as the weed killer. Round-Up kills the weeds all the way down to the root. You can then finish by pulling the dead weed. This process guarantees a weed-less yard, not necessarily a good looking yard! A plush, attractive yard requires a lot of work; spreading fertilizer, aeration, mowing, and mulching. Luxurious yards require time and effort much the same as having control over your finances.

The Financial Round Up Method

If you want to get rid of your current financial weeds, debt, and have a plush investment portfolio in the future, then consider the roundup method. When my wife and I got married, we also had matrimony of several credit cards with high interests rates, a couple of car loans, and a student loan. Each month we would sit and determine the minimum payment on each bill. We did not have a lot of money, but we knew we would never get out of debt by paying the minimum payment, so we rounded up the minimum on each bill to pay more. I think a lot of people do this and while not a bad idea, the strategy needs some refining to maximize it’s potential.

The first problem with the round up method, as described above, is that no attention is given to the effective interest rate. The debts need to be listed out in descending order from the highest interest rate to the lowest. Include the effective interest rate for each debt item. Also, in another column, include the minimum payment for each debt. Then create another column labeled the “Round Up” column.

The typical “Round-Up” amount is either $10, $20, or $50 based on your budget. The “Round-Up” amount will be added to the minimum payment for each debt item you listed. For example, if the minimum payment was $25 and your round-up amount is $10 then round the payment to $35. Do this for every item of debt you listed at the start of this exercise. If rounding by $10 is not leaving your cash flow in a state of panic, then round up by $20 and keep moving the round-up amount higher until your bills are gone.

The Advanced Financial Round Up Method

To get the most out of this method, you need an additional step. You need to add up the minimum payment column and round up the column and subtract the difference. The difference is the amount you should pay, along with the minimum payment, against the highest interest rate debt. Pay the minimum payment for the rest.

Paid in Full

Once the first debt is paid off, apply the minimum payment on the old debt plus the round-up amount plus the minimum payment on the next highest interest rate debt. Do this every month until all the debt is eliminated. Use this worksheet each month (Debt Payment Scenario) and compare the worksheets as you go. It is important to see your hard work paying off as you go from a yard of weeds to a beautifully manicured one.

Another key is never paying less per month than the original round-up amount. You made a commitment to yourself to use a certain amount of your monthly cash flow toward debt reduction. Reducing this amount will only prolong your indebtedness. Of course, you can increase the amount but again, try not to decrease it. This is an important habit because once you have eliminated your debt, all of the money committed to getting you out of debt can now be saved. Since you are not used to spending this money, it should be easy to switch your strategy from debt reduction (now that you are debt free) to building your savings. My wife and I took this point one step further.

Now, Become a “Saver”

We created a separate checking account which we called the “Debt Fund.” This was a checking account at our bank, separate from our other banking accounts, that had checks but no debit card attached. This money was strictly for debt reduction and eventually the beginning of our wealth building.

“Pay Yourself First”

At the beginning of each pay period, we would transfer the “round up” amount before any bills were paid, we would transfer the “round up” amount to the “debt fund” account. Once the debts were paid, this same account became a “Savings Fund.” From here the money can be applied to all kinds of investment vehicles (but we’ll cover that another time!). This money is easily saved because you are not used to spending it. Don’t spend it! Save it instead.

The holiday season is now in full swing. So what better time for a discussion about your potential 2019 tax bill. Or more appropriately, how to avoid paying additional taxes. We will assume most investors would rather pay less in taxes than more.

“Tax Loss Harvesting” is a simple strategy that can be applied within the portfolio to help save you some of your hard-earned money. This strategy is an effective way to both offset gains and reduce or eliminate laggard positions within your taxable portfolio before 2019 begins.

Your end of the year tax planning must include a discussion regarding any unrealized gains or losses hiding within your taxable accounts. We will center the discussion around mutual funds, individual stocks, and exchange-traded funds (ETF’s) since these investments are the most widely used.

What is “Tax Loss Harvesting”?

First, tax loss harvesting is a concept that only applies to taxable accounts. This concept will not apply to your non-taxable retirement accounts.

Second, you are selling stocks, ETF’s or mutual funds that you currently have a loss in. You harvest the loss by selling the security for less than you paid for it.

Third, should you want to maintain your current exposure to whatever you just sold, you will need to make a subsequent purchase. You cannot buy back the same security that you sold until 30 days have passed. This is known as the “wash rule.”

No, the investment police will not come through your computer and stop you from buying the same stock you just sold but, should the IRS audit you, they will certainly disallow your loss.

Your brokerage firm may account for any wash sales on your year-end 1099 as well. You will need to buy something new!

Why Should We Do This, It Sounds Complicated?

There are a couple of good reasons to go through the time and effort to complete the tax loss harvesting exercise.

First, you can use losses to offset current gains. If you have sold off some of your investments for gain throughout the year and you do not want to pay some or all the capital gain, you can sell the losses within your portfolio, which will lessen or eliminate the tax bill.

Second, you can pool your losses to offset future capital gains. For example, in the scenario described above, after you sold the investments within your portfolio that had a loss, you ended up with more losses than gains. What happens to the leftover losses? Losses can be pooled and used later to offset future gains.

Tax loss harvesting is an important part of any investment strategy. It is also one of the key benefits of investing outside of a retirement account. Tax loss harvesting is a prudent investment strategy that allows you to keep more of what you make. Let’s take a look at an example to help clarify what we have just discussed.

A Traditional Scenario

In some years finding losses to harvest is easier than others. However, given the recent volatility in the market, there is no shortage of stocks that are in negative territory for the year or down a considerable amount from their record high.

We will start with the following assumptions:

• You own stock and are considering selling it for a loss.
• The stock is a substantial component of an ETF (Exchange- Traded Fund) or mutual fund.

For example, the top holding in SPY, an S&P 500 Index ETF, is Apple. Apple has fallen more than 20% from its recent high price.

I know for many people, Apple can do no wrong! Therefore, let’s assume you would like to maintain exposure to Apple. If this is the case, why not consider selling the stock to realize a loss, “harvest” the tax write-off, and then use the proceeds to replace this exposure with an ETF (SPY). Or you could run a search for the ETF’s with the largest exposure to Apple and buy from the search result. Another option would be to commit heresy and buy Microsoft.

The idea is to immediately re-deploy the cash, maintaining similar overall risk exposure, without having to wait for the 30-day wash-sale window to expire to buy back the same stock you just sold.

If you would prefer to own Apple over the ETF or an alternate stock, then simply sell the ETF/stock in 30 days when the wash rule expires. Use the sale proceeds to repurchase your position in Apple.

The Tax Bomb – Another Reason to Dislike Mutual Funds

Many investors use mutual funds which come with a potential built-in tax bomb known as embedded capital gains. This tax bomb is another reason in the long list of many why we try to avoid mutual funds altogether. For the mutual fund owners out there, the end of the year requires some effort on your part. A lack of effort could cost you a lot of money.

What Causes Embedded Gains Within a Mutual Fund?

Mutual funds must distribute all their realized capital gains or in other words the profits from the sale of stocks sold within the fund throughout the year. Sometimes the sale of stocks within the fund occurs because the manager wants to reposition the portfolio, hoping for better growth. Another reason is to cover redemptions.

Yes, often the shareholders are their own worst enemy. In years like 2018 where investors have run to the exits, generally at the same time, there is not enough cash available to cover the distribution requests. Therefore, the manager is forced to sell stocks to cover the requests.

The more distribution requests, the less efficient the manager can be with selling the stock selection. The manager will eventually have to sell stocks with capital gains. The capital gains are passed on to the remaining shareholders. The fewer shareholders, the higher the percentage of the tax paid by each remaining shareholder.

Don’t be the last one out of a Ponzi scheme. The pigs get fat where the hogs get slaughtered!

Buyer Beware at the End of the Year

You need to find out the date that all remaining owners will share in the embedded gains. To avoid having to pay this cost, you must sell the mutual funds before the declaration date. Should you purchase shares of a mutual fund during December make sure you know if the mutual fund will have embedded capital gains. There is nothing worse than receiving none of the benefits of growth but having to share in the tax cost.

In closing…

Anyone who has long held stocks in their portfolio today most likely has at least one optimistic vein in their body and may not want to sell because they know/hope/pray that their stock will improve along with the broader market. The good news is there is some historical precedent for that.

Knowing how difficult the psychology of selling losers is for many of you, harvesting losses may be a terrible exercise. Many individual investors will sell winners with little thought other than, “Yes, I won!” These same investors will hold on to losses far too long because they think selling a loser admits defeat.

At Hayden Royal of Wilmington, we try to live by the saying “Let your winners run and sell your losers.” This psychology helps with tax loss harvesting because we do not mind selling a stock especially if the loss is realized for our benefit – paying less in taxes.

Let me start by saying this: not all mutual funds are bad. However, it takes effort to decipher the good from the bad. The financial industry has done an excellent job of selling the ease of investing in mutual funds and an even better job of hiding their deficiencies. Behind the scenes, we call them relics because mutual funds exist in a shroud of secrecy in a financial world that is crying out for more transparency. These dinosaurs could be on the verge of extinction.

 

Modern, more sophisticated investors, we believe, will seek out alternatives to the archaic mutual fund world. Cost is a significant driver of the current change we see in the financial and banking industry. Cost, however, is not the only problem in the mutual fund world. Other key drivers of change are transparency and honesty. We teach this to our kids and expect it from our other relationships in life, so shouldn’t we demand it from the mutual fund companies that hold our hard-earned investment dollars? The answer is a resounding YES. This trend toward transparency has been in progress for better than a decade but sill not fast enough in our humble opinion. Below is an archaeological dig into the nine reasons for the extinction of the mutual fund:

1. Cost – The Higher the Cost the Less Potential Return.

• Administration Fee – This helps to cover the general expense for the mutual fund to be in existence. This fee is to help the mutual fund family to pay their cost of doing business or as one fund family describes “these fees reflect the benefits of the shared resources of the firm.” Nice! This expense is listed in the prospectus.
• Distribution Cost (12b-1 fee) – A shareholders portion for advertising expenses, marketing expenses, and commissions. This expense is listed in the prospectus.
• Transaction Costs – Typically the largest hidden cost. The mutual fund company will tell you the turnover rate of the fund but not how much the turnover cost each fund shareholder. Keep in mind that as soon as the quarter is over, they have the cost information. They know the exact trades made on your behalf and how much those trades cost the fund. They simply will not make the information public. This expense is not listed in the prospectus.
• Sales Charges – Unless you buy a “No-Load Fund,” you are paying a sales charge to cover the cost of your alleged unbiased advice from your broker. The “load” is the broker’s first-year commission. This fee is listed in the prospectus and is designated by share class. Different share classes have different costs; a fact left out by many a salesperson (i.e., your broker).
• Payments to Broker-Dealers and Other Financial Intermediaries – “If you purchase shares of the fund through a broker-dealer or other financial intermediary (such as a bank), the fund and its related companies may pay the intermediary for the sale of fund shares; and related services. These payments may create a conflict of interest by the fund over another investment.” So, I copied this from an actual prospectus because it is that unbelievable. Just think, you are getting the “best-unbiased advice” that can be bought by a mutual fund company. What a joke!

2. The Big Tax Bill

The potential capital gains tax is based on the buy and sell dates of each investment within the fund. You pay the gain but do not get the loss to help your tax bill. The fund part occurs in a year where your fund loses money but generates a tax bill. The trading done within the fund created a taxable gain based on the holding period of the stocks while the calendar year performance created a loss. Did your broker call you to give you a heads up? Did he/she let you know that if you sell the fund before a certain date, toward the end of the year, you can avoid paying the tax?

3. What say you?

Mutual fund managers are not in the habit of calling you to discuss their investment philosophy and if changes should be made to better equip the fund to help with your situation. Well, not unless you have invested millions of dollars with them. What about the little guy? Sorry, only the biggest investors are worth the time of the mutual fund manager. Next time you talk with your advisor, ask for him to set up a phone meeting with the mutual fund manager. Let us know if you get a meeting.

4. Fund Names are for Marketing

Does this feel balanced?
The fund name, in many cases, tells you nothing about how your money will be invested. The name is designed to catch your attention and to persuade you to take a look. Don’t assume you understand what your money is doing based on the name. You must read the prospectus to determine how your money will be invested.

For example, if the fund name uses the word “Balance” in the title; one could reasonably conclude that money will be evenly distributed between stocks and bonds. The right action is to read the prospectus for the stated balance of the fund. If the prospectus indicates the maximum percentage of stocks allowed in the fund is 80%; that is NOT balanced! The potential risk is much greater than the balanced title would indicate.

5. How did the Risk of my Investment Strategy Change?

To begin with, each fund is classified by “style” so people can best determine where a fund might fit into a diversified investment strategy. Over time, many things change beliefs, opinions, the manager and the result. This is what we call style drift. For example, you invested in small-cap fund; however, over time, many of the companies have grown and are no longer small cap but mid-cap stocks. The manager does not get rid of them because the companies have performed. Now the fund is a small/mid-blend rather than a small cap fund. Your risk level is different, and you may have too much money invested in mid-caps. So much for diversification. This may not seem like a big deal but minor changes over time can turn into the elephant in the room.

6. The Fund Manager Merry-Go-Round

Manager turnover is a fact of life. When a manager leaves, so do the track record of the mutual fund.

Did you look at the returns of the fund before making the investment? Would you have invested your money if the track record had been “too new to tell?” Do you want the new manager to learn with your hard-earned dollars? To combat this problem, funds have been listing their manager as “Team.” Nice fix! Now you will never know whose track record you are basing your investment decisions on. This fix was not in your best interest. It was just a way to avoid the problem altogether. Don’t invest in “team”.

7. What Diversification?

This is one of our personal favorites. When someone tells me they are diversified because they own funds with dissimilar styles, we get a little chuckle. How do you know if you have overlap? If you have heard of overlap, then you probably know you can run an analysis to see how many of the same stocks are held by your different stock funds. This helps, but it certainly does not guarantee that overlap is eliminated. The overlap is based on the released fund information which is at the end of the previous quarter. You have no idea what stocks the funds currently own nor if any of your funds own some of the same stocks.

8. Too Big to Fail

Can a fund have so much money invested in it that it can no longer meet its objectives? Too little money and too much money can negatively impact the returns of the fund. The Peter Lynch story is a well-documented cautionary tale. Lynch was a victim of his own success. The better his returns, the more people threw money at his fund. This continued until the fund was so big he looked for investments that were outside of the stock world. He found junk bonds and when they underperformed, so did his fund. Lynch went from the penthouse to the outhouse.

9. Window Dressing

As discussed in point 7, funds only disclose what they own at the end of the quarter. Window dressing occurs when the manager sells out of stocks he/she does not want you to know they owned and purchases the stocks that have performed the best in the prior quarter. Sell your losers and buy the winners to make yourself look better. Window dressing is the more enjoyable way of saying “whip cream on a pile of poo.” You go to look at the fund: You are very impressed by the quality stock picking in the information released to the public. However, those same stocks could have already been sold, and other stocks purchased. This practice also adds to the transaction cost referenced in point 1.

From an early age, we are taught that “nothing in life is free.” So, naturally, when people started asking about filing their taxes for free online, the hair on the back of our necks stood up. Companies offering these services, Intuit, HR Block, and Credit Karma to name a few, are not charitable institutions. So, what’s the catch?

 

First, they are legit services. And, no, you don’t have to give them your credit card to get started with the free service. Add on services and/or upgrades are available at an additional cost. The biggest cost, however, is hidden, and it comes in the form of pimping your most vital financial information. I was shocked to learn that the information on your tax return was available to the company’s business partners and affiliates. What information, you ask? Well, all of it, really. Your name, address, date of birth, income, and the last 4 digits of your social security number are all up for grabs.

The privacy statements we reviewed do acknowledge that the user must consent to the dissemination of information. But really, who reads the long disclosures before ordering a service or product that they’re excited to use?Most of us just click “OK” so we can get to the transaction finish line.

Clicker beware!

You have been warned of blind consent!

Is consent all bad? The information is used to target products and services that may be beneficial to you. Whether the sales information is from the best companies with your best interest at heart is an entirely different story. After all, how does a company pick its partners and affiliates? Well, that’s another story for another day, but in our experience, it usually centers around money, not who can help you (the client) the most.

If you are part of one of the fastest-growing categories in tax preparation and filing (people who prepare their own return using the internet rather than desktop software), our advice is to take the time to read the privacy statement. And, if you do not want your tax return shared with the marketing world, look for the opt-out button before divulging any of your most personal financial data.