The latest tax legislation released by the House Ways and Means Committee on September 13th includes several impactful tax proposals, deviating substantially on some issues from the American Families Plan released by the Biden administration in April. This legislation creates several potential implications for an extremely small subset of the population such as ultra-high net worth families, taxpayers with more than $5 million of annual income, or individuals who have built IRAs in excess of $10 million.

Rather than cover all the details of the legislation or the strategies that only apply to a very narrow subset of the population, we highlight five immediate planning strategies that would have broader reach if the legislation passes. Of course, there is still a lot of political jockeying to be had and hills to be climbed before any of this becomes law so it would be wise to treat the following as actionable suggestions if the legislation passes in its current form.

1) High income earners should accelerate income into 2021.

This becomes relevant for married taxpayers (married filing jointly – MFJ) with taxable income above $450,000 and single taxpayers with taxable income above $400,000. For example, a single taxpayer with $400,000 of taxable income in 2021 will pay 35% federal tax on an additional dollar of income in 2021 versus 39.6% on an additional dollar of income in 2022 – assuming the current legislation passes. In the event it does become law, business owners or other individuals who can accelerate the recognition of income (excluding capital gains) into 2021 at the lower tax rates would be advised to do so.   

2) High income earners should defer discretionary deductions to 2022.

Married taxpayers with income in excess of $450,000 and single taxpayers with income in excess of $400,000 who expect that income to be relatively consistent in 2022 would be well-served to defer discretionary deductions (i.e., charitable contributions)¹ to 2022 if the current legislation become law. Such deductions become more valuable in 2022 under the latest legislation – saving as much as 4.6% for every dollar of deductions next year versus this year. It is also worth noting that any changes to the “SALT” deduction – which were not part of the original legislation but seem likely to be added – would further increase the advantage of deferring deductions to 2022 for many taxpayers.

3) Anyone with after-tax dollars in a 401k plan or an IRA needs to consider a Roth conversion before year-end.

The new legislation – if enacted – would prohibit the conversion of after-tax dollars to a Roth account after December 31, 2021. This means that anyone who has after-tax contributions in an IRA or 401k would have until year-end to convert those dollars to a Roth account. Should they? In the case of individuals with after-tax dollars in a 401k, the answer is an emphatic yes – provided the employer allows in-service distributions. In the case of individuals with after-tax dollars in an IRA, the answer depends on a number of variables with the most important variable being the amount of after-tax dollars relative to the total value of IRA assets.

4) Anyone who planned to do a backdoor Roth contribution for 2021 should get it done before year-end.

This December 2020 post outlined ten predictions for the next decade with one being the termination of backdoor Roth contributions (prediction #8). Unfortunately, one of those predictions may come true in the first year if the recent legislation passes and any conversions of after-tax dollars are no longer permitted. As a result, anyone who was planning to wait until early 2022 to make backdoor Roth contributions for the 2021 tax year (normally a deadline of April 15) should go ahead and complete the full backdoor Roth process (contribution and conversion) before year-end. There is no harm to making the backdoor contribution this calendar year whereas procrastinating until early 2022 could result in a lost opportunity.

5) Harvest capital losses – but maybe not until 2022.

Because the legislation release date (September 13) is the specific line of demarcation for the new, higher capital gains tax rate of 25%, there is no benefit for most taxpayers² to recognize gains before year-end in hopes of avoiding higher rates next year.³ That said, a higher capital gains tax rate increases the value of tax loss harvesting for high income taxpayers as the offsetting losses would now provide greater tax benefit.⁴

But before anyone starts harvesting capital losses (assuming the legislation passes), it is worth evaluating whether such losses will be more valuable in 2021 or 2022. It really boils down to whether the losses would offset gains/income from 2021 or from future gains/income. If the losses would be offsetting capital gains realized before September 13th, 2021, then it may actually be better to defer realizing those losses until 2022 when they will be more valuable.

Closing Comments

Again, all of these recommendations are based on a piece of legislation that still has many hills in front of it. If you are a Golden Bell client, you can rest assured that we are actively monitoring the legislation and that we will reach out to you (if not already) about any of these strategies that require action or evaluation for your unique situation. In the meantime, do not hesitate to contact us if you have any questions about the legislation or the strategies summarized above.

More and more these days, investment managers and investment advisors promote “liquid alternatives” as a replacement for high grade bonds in this environment of dramatically low interest rates. The idea is that bonds will earn a near-zero return because of the low yields and that investors would do better to shift their bond allocation towards liquid alternatives.

I have already explained why owning bonds in this low rate environment still makes sense for investors so I will not relitigate that argument. And before I explain why liquid alternative investments are not a sure-fire solution to low interest rates, it may first help to explain what is meant by “liquid alternatives”. In basic terms, “liquid alternatives” describes hedge fund strategies employed in a mutual fund or exchange traded fund (ETF) structure. In more advanced syntax, this includes hedge fund strategies like long-short equity, relative value arbitrage, distressed debt, and other absolute return strategies run under the structure of a fund that provides regular liquidity (unlike hedge funds run as limited partnerships which typically only allow investors to redeem their investments every 3-24 months, depending on the strategy).

It is also important to be clear on one thing: I am not an opponent of alternative investments. I fundamentally believe that alternative investments – employed in the right structure – can be very useful for diversifying portfolios. As a matter of fact, I launched and managed a hedge fund of funds in a limited partnership format as the chief investment officer for a large registered investment advisor. The primary objective was to give our clients simplified exposure to uncorrelated, “absolute return” investments beyond traditional stocks and bonds.

That said, I believe that investors who look to liquid alternatives as a significant replacement for bonds in this low rate environment are potentially doing far more harm than good. Consider four primary reasons why I believe this to be true:

1) Most liquid alternative investment returns are directly linked to interest rates. Low interest rates mean lower expected returns for liquid alts.

Nearly 100% of absolute return funds and other alternative investment strategies use some form of leverage – whether it is borrowing assets to short, purchasing futures contracts (inherent leverage), employing swaps (inherent leverage), or using other forms of leverage. Any time that leverage is used, the fund holds collateral to protect the counterparty. This collateral is usually some form of safe, liquid asset such as 90-day Treasury Bills. The net result is that a component of the return from alternative investments comes from interest rates. All else equal – when rates are low, alternative investment returns are lower because the return on the collateral declines.

How significant is this relationship? According to a regression of the HFRX Absolute Return Index over 36-month intervals since 1998, the 90-day Treasury Bill rate over the same periods explained 67% of the HFRX Index return. From a statistical standpoint, this significant relationship should abruptly discredit the idea that alternative investments are immune from low interest rates. Regrettably, most investors or financial advisors fail to appreciate the strong connection between alternative investment strategies and interest rates. And the fairy tale of liquid alternatives being a place to hide from low interest rates suits the alternative investment industry quite well and so there is no incentive to correct this fallacy.

2) Liquid alternatives face the same supply/demand challenge as traditional investments.

To be clear, the world is awash in liquidity. The Federal Reserve and other central banks have spent the past 13 years pumping cash into the financial system to fight deflationary forces and the result is too much cash chasing too few investments. It is fair to call this environment a global liquidity glut. As a result, we have interest rates hovering near historic lows, junk bond yields at record lows, and stocks at their richest valuations on record save for the final months of the dot-com boom.

Alternative investment strategies do not exist in a vacuum. Investors with excess cash seek out alternatives to stocks and bonds, offering explanation to the dramatic demand for investments like NFTs and cryptocurrencies. There may be pockets of opportunity but massive inflows into hedge fund strategies chasing the same opportunities reduce relative value spreads, arbitrage spreads, and distressed debt yields, resulting in lower expected returns for investors.

3) Alternative investments fail to offer dependable protection during stock market shocks.

The global financial crisis in 2008 provided the spark for liquid alternative mutual funds. Investors pursued anything that offered protection during bear markets and alternative investment mutual funds were quick to promote such protection. The problem became one of overpromise and under-delivery. While most alternative investment mutual funds have managed to avoid the same level of stock market declines during market selloffs over the past decade, they have also overwhelmingly failed to provide protection.

Consider the most extreme stock market losses of the past decade when the novel coronavirus sparked a dramatic selloff in stocks during the 1^st quarter of 2020. Of the nine largest hedge fund strategy mutual funds, none delivered positive returns during the stock market selloff and the average performance of the funds during this period was -15.4%.

While many of these liquid alternative funds may have outperformed stocks, they did not exactly provide insurance or protection. Alternatively, an investment in long term Treasury bonds over the same 22 trading day period achieved a positive 13% return.

4) Liquid alternative mutual funds have a lousy track record.

Since day one, the marketing pitch of liquid alternative mutual funds has been: “We are going to bring the same best of breed alternative strategies that large pensions and endowments utilize to the masses in a liquid, low fee structure.”

But here is the first big challenge that has existed since the beginning: the best hedge fund managers – the ones with a unique advantage – can make approximately 10x more money with a fee tied to performance in a limited partnership format than what they can make managing money within a mutual fund. In a capitalist society where the scarce resource is talent, it makes sense that the managers with an advantage or skill will go where they can get paid the most (managing via a limited partnership structure) and the managers without any real advantage are just happy to get paid (managing via a pooled mutual fund structure).

The second big problem is that the best hedge fund strategies do not work in a daily liquid mutual fund structure. Some require more leverage than the structure permits. Other strategies use investments that the structure does not allow. Still more use illiquid investments that require holding periods of years rather than days or weeks and would blow up a daily liquid mutual fund. Mutual fund sales departments overlooked these hurdles (still do), catering instead to the demand and the fees they could earn. One hedge fund manager describes it well: “The main issue with liquid alts is you are trying to put a square peg in a round hold. You can push liquidity only so far for a hedge fund strategy before they lose their ability to generate alpha. Investors are starting to figure this out.”   

A third big challenge for these investments is that while the fees may be lower than limited partnership alternative investment funds, they are still egregiously high relative to most stock and bond mutual funds. Those fees are easier to overlook when interest rates are high and returns approach double digits but they provide a dramatic hurdle when rates are low and returns are in the low single digits.

As a result of these challenges, the absolute return, hedge fund, and private equity strategies available as daily liquid mutual funds are overwhelmingly garbage. The dismal track record bears this out as evidenced here, here, here, and here. Nearly all the alternative investment mutual funds that launched with fanfare in the 2005-2010 timeframe have either shutdown or delivered unimpressive returns. 

Closing Comments

I would love to honestly say that there is a great place to hide from low interest rates – an investment category that could still produce attractive returns while providing stability and protection from stock market selloffs. There is not. Rebalancing from bonds to some other alternative investment category just trades one risk for another.

The allure of liquid alternative investments seems to be that they are not bonds and that they can provide more attractive returns in a low rate environment. Perhaps. But investors are being fooled by Wall Street and the investment advisor community if they are led to believe that liquid alternative investments are the ideal solution to low interest rates. Caveat emptor.

The following is an excerpt from the quarterly investment commentary we recently sent to clients.

It is hard to escape the inflation topic these days. The recent surge in consumer prices elevated the core inflation rate to its highest level since the last year of George H. W. Bush’s presidency. That is to say that it has been a really long time since we faced legitimate inflation.

There are two competing views on where go from here.

The first view – espoused by the Federal Reserve – is that recent inflation is “transitory” due largely to temporary supply chain bottlenecks. The sudden, V-shaped spike in demand for goods and services faced off against insufficient supply of semiconductors, flight attendants, restaurant staff, clementines, truck drivers, and lumber – among many other items. The Fed – along with many economists – makes the case that these supply chain disruptions will be resolved in the coming months as global lockdowns ease, as factories reopen to full capacity, and as temporary unemployment benefits expire bringing more workers back online. Moreover, the categories of the economy that experienced the largest uptick in inflation of late were categories that suffered the biggest deflation last spring (airlines and hotels). This suggests that recent inflation figures are simply a byproduct of pandemic-impaired industries reestablishing pre-pandemic prices.

The competing view is that many of the inflation pressures are long-term and that we could be dealing with rising prices for years, not months. The first defense of this view is that accelerated government debt issuance and ballooning budget deficit required to fund the monetary and fiscal stimulus programs will be long-term inflationary. Furthermore, some economists cite the stockpile of household savings that consumers built up during the pandemic as a key driver of demand that will enable businesses to raise prices. Adding to this argument is the view that employers will compete for limited labor as the economy reopens, forcing higher wages to attract the limited pool of employees.

So which is it? Is this inflation transitory or persistent?

The only honest and forthright answer is that we do not know. And while plenty of economists, market forecasters, and outspoken friends will confidently express their view as an indisputable reality, the truth is that all of them are likely to be lousy inflation forecasters. Historically, nobody forecasts inflation well. Not economists, not bond traders, and not consumers.

The economy is incredibly complex and, as a result, both economic activity and inflation are highly unpredictable. Austrian School Economists have made the case for two decades that increased money supply and huge budget deficits in the US would result in inflation. Such predictions – while justified in theory – have fallen flat in practice. Japan has been the most indebted developed country in the world for nearly 3 decades (debt/GDP of more than 260%) and has fought deflation – not inflation – for the past 30 years. Despite government debt in the US increasing to a level larger than our annual GDP over the past decade, inflation has remained well under 2% before the recent uptick.

It is worth noting that some of the transitory inflation pressures are already dissipating. Case-in-point: lumber prices increased by nearly 300% from the start of the pandemic through May 2021 as home renovation projects skyrocketed and supply could not keep pace. It was not necessarily a shortage of lumber – just the complications of getting trees cut, wood processed, and lumber shipped during the pandemic. Since early May 2021 – as some of the supply disruptions were addressed – lumber prices have plummeted more than 50%.

But a lot of experts are predicting that inflation is on the horizon, right?

Yes, and dart-throwing chimps have been better historically at forecasting inflation and economic growth than the most astute and experienced “experts”. In fact, robust evidence finds that the more confident a forecaster is about the future, the less likely such predictions turn out being.

The Cleveland Fed uses objective data from the bond market and futures market to estimate the market’s expected rate of inflation over the next 10-years. At the end of June, that figure was 1.58%. This is as good an estimate as any for the inflation rate over the next decade. 

Is my portfolio protected against inflation?

Yes. But we have to be clear about what “protected” means. Protected does not mean we are making a binary-payout gamble where you own a few concentrated assets that profit handsomely if inflation rises (beyond what is expected) or lose dramatically if inflation falls below expectations. Protected means that your portfolio is designed to increase purchasing power (real growth, after inflation) across different inflation environments.

Although lacking glamour, the best way to achieve this inflation protection is via a diversified portfolio. No one knows how assets will respond to unexpected inflation but the stocks in your diversified portfolio should be a good long-term hedge as companies with pricing power will benefit from higher revenues as the prices of goods and services rise. Additionally, domestic inflation would likely be accompanied by a weakening dollar which benefits foreign stock investments (foreign stocks rise in US dollar terms as the dollar loses value, all else equal).

I hear about gold as a good inflation hedge. Should I buy gold?

Gold has a reputation as an inflation hedge but that reflects good – albeit misleading – marketing rather than historical evidence. Here is the empirical truth: gold is an effective inflation hedge if the measurement period is centuries. But gold has been an overwhelmingly unreliable and poor inflation hedge over more practical time periods such as months, years, and decades.

I recently listened to a CFA Society podcast where the interviewee succinctly described the ideal characteristics of an inflation hedge: it should be positively correlated with inflation, it should have relatively low volatility, and it should have a positive expected real return. Now consider how gold stacks up to those three criteria. Since gold futures began trading in 1975, there has been effectively zero correlation between gold prices and unexpected changes in inflation. The volatility of gold has been 25% higher than that of stocks. And gold does not have a positive expected real return. All told, gold has exactly zero characteristics of an ideal inflation hedge.

What about other investments like commodities or TIPS?

The evidence with commodities is very much like that of gold. They are extremely volatile and have produced negative real (after-inflation) returns since they became widely available for retail investment in the early 2000’s.

TIPS (Treasury Inflation Protected Securities) provide better characteristics as an inflation hedge because of their automatic inflation adjustments and we maintain a healthy long-term allocation to these bonds in Golden Bell portfolios. But they are far from perfect. Notably, the current expected real return of TIPS is negative such that if you buy 5-year TIPS today and hold until maturity, you lose 1.6% per year to inflation. Moreover, the price of TIPS between issuance and maturity moves based on several other factors such that they only protect against inflation if the bond term matches up perfectly with the investment horizon you are seeking to hedge.

Why own high-grade bonds right now with rising interest rates on the horizon?

To be clear, there is zero assurance of rising bond rates on the horizon. “Experts” have inaccurately forecasted rising interest rates for more than two decades running now. Moreover, no one would be buying 10-year Treasuries today at 1.3% if they knew with clarity that 10-year rates would be higher in 6, 12 or 18 months from now. Buyers would back off and yields would rise to attract buyers into to the market and reflect the expectation of higher future rates. This is how markets work. Current inflation expectations are reflected in current bond prices so avoiding bonds when inflation expectations are already high is akin to buying home insurance after a fire.

But the Federal Reserve just indicated that they are likely to hike rates twice in 2023. Don’t we want to avoid owning bonds when that happens?

Nothing gets me more discouraged for consumers and frustrated for the profession of financial advice than when I hear financial advisors suggest that high grade bonds do not deserve space in a portfolio right now because yields are low or because the Federal Reserve is going to increase rates in the future and that is going to negatively impact bond prices. Such claims are uninformed and reflect alarming confusion about how markets work.

Really, really, really important and misunderstood point: The Federal Reserve’s open market operations only directly impact the front-end of the yield curve: bank savings accounts, 6-month CDs, floating rate mortgages, etc. The Federal Reserve does not set or directly control intermediate and long-term interest rates that matter to bond prices. The Fed hikes short-term rates to starve off inflation pressures that impact longer-term rates but the collective market determines where the level of bond yields should be based on the collective expectation of future inflation. Each of the last two times that the Federal Reserve began hiking short-term rates, 10-Year Treasury yields were lower one year later. 

OK, but bond yields are really low so even if interest rates don’t go up, aren’t high grade bonds still a lousy investment?

Bonds will always have a lower expected return that stocks. Less risk, lower return. Rinse. Repeat. The purpose of high grade bonds in a portfolio is insurance and protection. Always. They are in a portfolio to counter the shock of a stock market collapse, to help reduce the downside risk of a portfolio, and to help you sleep at night. None of this changes because interest rates are low or high.

Moreover, stocks and real estate and alternative investments all have lower expected returns when interest rates are lower. Investments do not live in a vacuum. I wrote more on this topic to discredit the concept that now is a bad time to own bonds.

What all this means to you…

One of the flaws of the human brain is that it causes us to think we know more than we do, to think we are better investors than everyone else, and to think we can forecast the future. Yet most times, as highlighted above, there are two sides to a coin. We should not believe everything we read or hear without understanding the other side.  

Part of the role of a quality financial planner is to understand current market dynamics to help make wise investment and financial planning decisions for the long-term. Another part of the role is to help explain and decipher those market dynamics to you so that you can better make sense of things. I hope that this has helped in that respect and welcome any questions you might have about investments, finances, or your retirement plan.

As reported on Thursday, President Biden is expected to release a tax proposal this coming week to help finance the ambitious American Families Plan. There is still uncertainty as to what will be included in this proposal, when such changes would be effective (retroactive to Jan 1, 2021?), and most importantly, whether any of the proposed tax changes would get through Congress. It is important to keep in mind that tax law does not come from the executive branch so any proposals from the President would simply be proposals that Congress could choose to act on or not.

It is even more important to remember that the Senate is split across parties at 50/50 – limiting options for the Democrats to make any meaningful changes to tax law. Without 60 votes to avoid a filibuster, Senate Democrats hoping to push through tax reform are left to choose one of three options:

a) compromise with Republicans so as to get at least 60 votes and avoid filibuster;

b) use budget reconciliation measures which can bypass the filibuster but come with important restrictions; or

c) take the highly controversial step of changing Senate rules to eliminate the filibuster.

The most likely of these options is the budget reconciliation route and because it still requires the votes of all 50 Senate Democrats, any tax reform through budget reconciliation will have to accommodate even the most moderate Democrats who may be opposed to more extreme measures.

Because a few clients have recently asked about the proposals and the related financial planning implications, I felt it may be useful to summarize the major tax proposals. Obviously, we are dealing with significant uncertainty right now so none of this is intended as a call to action. As we all learn more about the specific proposals and the likelihood of the proposals advancing into law, the advice will become more specific and tailored to the unique circumstances of each Golden Bell Financial client.

Income Tax

Here is what we know: President Biden wants to increase the top marginal rate from its current level of 37.0% back to 39.6% where it was before the 2017 Tax Cuts and Jobs Act. What is unclear is whether the top rate would just shift from 37% to 39.6% (affecting income above $628,300 for married filers; above $523,600 for single filers) or whether taxpayers with income above $400,000 will also be subject to this higher 39.6% rate. Also, we do not know when such a change, if enacted, would be effective. While anything is possible in Washington DC and law permits for tax reform to be retroactive (see the Tax Reform Act of 1993), it seems unlikely that any changes to income tax would begin before January 1, 2022 just due to the significant political challenges (needing to get all 50 Democrats on board would make it very challenging to pass a retroactive income tax change).

Planning Implications: This one would be a non-event for all taxpayers earning under $400,000/year and perhaps for taxpayers earning under $628,300 (it is unclear where the “line” will be drawn for individuals). For higher income taxpayers who stand to be affected, there is some talk of accelerating Roth conversions before any tax changes to take advantage of the lower rates that exist today before the increase. Personally, I think that annual strategic Roth conversions for retirees before age 72 continue to be a great planning idea regardless of changes to the highest income tax rate. However, the advice of large one-time Roth conversions is a terribly flawed planning idea for all but ultra high net worth taxpayers.

Consider a married couple in their early 50’s who currently earn $800,000/year, have roughly $3 million saved, and face a marginal tax rate of 37% on any additional income under the current tax law. They are worried about that rate increasing to 39.6% and are considering an immediate $400,000 Roth conversion which would result in an added tax liability of $148,000 (37% x $400,000). The reality is that when they retire in the next ten years, their marginal tax rate will likely drop to either 12% or 22% as their only taxable income will be dividends and interest from their taxable investment portfolio. As a result, a Roth conversion today would simply accelerate taxes at the 37% rate that they could have waited to convert at dramatically lower tax cost upon retirement (they pay taxes earlier and at a much higher rate – neither of which is good).

There is one case where a large one-time Roth conversion could makes sense as a planning opportunity in light of the proposed income tax change to 39.6%: the ultra-high net worth taxpayer who reasonably expects to stay in the highest tax bracket into retirement. This tends to be someone with at least $25-$30 million of investment assets (where interest and dividends would likely get to the highest bracket) or someone who has a pension that will pay more than $400,000/year upon retirement.

Capital Gain Tax

The expected recommendation is to tax long-term capital gains as ordinary income for taxpayers earning more than $1 million. This fits with what the Biden camp proposed during the campaign. For taxpayers with less than $1 million of income, there would be no impact. For taxpayers earning over $1 million, this is expected to work as a marginal tax where only gains above the $1 million level would be subject to the higher rate. The marginal tax rate on such gains would increase from a current rate of 23.8% (accounting for the net investment income tax of 3.8%) to 43.4% (39.6% + 3.8%).

Planning Implications: If this new tax goes in as outlined in the recent White House leaks, married filers with annual income below $1 million would see no impact on their personal taxes (uncertainty again as to where the line would be for individual taxpayers). For taxpayers who annually earn more than $1 million and hold appreciated assets or just for taxpayers with annual income below $1 million who own highly appreciated assets, the tax calculus will get really interesting and really case specific. Some people will be well-served to realize large gains in 2021 whereas many others will be best-suited to do nothing or hold on to assets until retirement when their income is expected to decline. This is going to be an area where quality financial planners and tax accountants will be extremely valuable and bad advice will be really expensive.

One quick note: There is precedence for mid-year updates to the capital gains rate so it is not a foregone conclusion that this change – if enacted in 2021 – would be deferred until January 1, 2022. The Jobs and Growth Tax Relief Reconciliation Act of 2003 imposed a new (lower) capital gains rate for gains realized after May 6th of that year. That said, I expect that this proposed change to capital gains – again because of the political complexity of implementing it mid-year – would not take effect until 2022, at the earliest.

Basis Step-Up at Death

Under current law, individuals do not pay any tax on appreciated assets at death and beneficiaries who inherit assets only pay tax on the growth that occurs after the grantor’s date of death under a provision referred to as the “step-up in basis”. In conjunction with the proposal to increase the capital gains rate for high income individuals, the step-up in basis would also be eliminated (albeit likely with an exemption of $1 million that some Senate Democrats want to see included). Increasing the capital gains rate without also eliminating the step-up in basis would just further incentivize high net worth taxpayers to hold assets until death, thereby skirting the higher capital gain rates. It is expected that appreciated assets (above the exemption amount, if there is one) would be deemed sold at death and the gain subsequently taxed – akin to the “deemed disposition” laws present in Canada.

Planning Implications: This one would have significant implications and likely impact far more people than just the high income earners impacted by the new capital gains rate – especially if the primary residence is not given its own exemption. First, it will be a record keeping nightmare for inheritance beneficiaries who have to go determine how much grandma paid for XYZ stock in 1973. Additionally, individuals who planned to hold highly appreciated assets until death to let heirs benefit from the step-up in basis will need to consider staged liquidations. The use of appreciated assets for charitable giving will become even more of a no-brainer strategy than it already is. Planning strategies – again – will be highly specific to circumstances such as projected income levels, expected inheritance amount, wealth of targeted heirs, and the current level of asset appreciation.

Estate Tax

During his campaign, President Biden suggested a decrease in the estate tax exemption (and similarly gift tax exemption) from $11.7 million per person to the same $5 million level (possibly indexed for inflation) that was in place prior to the Tax Cuts and Jobs Act (TCJA). This change is scheduled to happen in 2026 by way of TCJA sunset without any new legislation.

Planning Implications: Remember that for married couples, the estate/gift tax exemption effectively doubles the individual exemption meaning that a married couple can currently gift up to $23.4 million to their heirs without any gift or estate tax implications. Reducing the exemption back to $5 million per person ($10 million for married couples with a possible inflation index, making the married exemption figure closer to $11 million) before the scheduled sunset in 2026 does not have any impact on families who expect/intend to leave estate values below these levels to their heirs. But if changes to the estate tax gain support, high net worth individuals and married couples who intend to leave estates in excess of $10 million to heirs will want to immediately consider strategies to take advantage of the current gift tax exemption. Such strategies such as gifts to a grantor retained annuity trust (GRATs) or spousal lifetime access trust (SLATs) will become popular for ultra high net worth families if the potential for exemption change seems likely. That said, professional help is warranted to avoid significant problems if any estate tax change is made retroactive to the start of 2021.

Social Security Tax

Currently, only the first $142,800 of employment income is subject to the 6.2% Social Security tax. President Biden has proposed imposing the tax for employment income above $400,000 – creating a doughnut hole between $142,800 and $400,000.

Planning Implications: There will not be much planning here other than the increased popularity of S-corporations for self-employed individuals and small business owners who earn more than $400,000/year.

Itemized Deductions – SALT Limit

There is growing advocacy – especially by Congressional Democrats from blue states such as New York, New Jersey, and California – to repeal the $10,000 deduction limit on the state and local taxes (SALT) enacted by the Tax Cuts and Jobs Act. The interesting thing about repealing the SALT limit is that the biggest beneficiaries would be high income earners with expensive homes – not usually the demographic that Democrats seek to protect. As a result, this is likely to be a proposal where both Democrats and Republicans are divided within their own parties.

Planning Implications: While this doesn’t have the momentum of other tax proposals, the impact would be much more widespread than the income tax and capital gain tax proposals. Repeal of the SALT tax has specific planning implications related to the value of mortgage interest and the value of charitable deductions. If the repeal gained support and seemed likely to be effective starting in 2022, many taxpayers would be wise to defer charitable contributions until 2022 to take advantage of a higher deduction.

Retirement Plan Deduction Elimination

A change that Joe Biden proposed on several occasions during his campaign was an elimination of the deduction for retirement plan (401k/403b) contributions and replacing the deduction with a tax credit (no clarity on the credit percentage although 26% and 28% have garnered attention). This proposal was described by President Biden as “equalizing” the benefit of retirement plan contributions for high and low income workers.

Planning Implications: This tax change would completely reverse the math on Roth vs. Traditional retirement plan contributions. For most taxpayers today, the higher your income is, the more beneficial that Traditional 401k/403b contributions are. Alternatively, the lower your income, the more beneficial that Roth contributions are.

If the current deduction gets replaced with a 26% or 28% credit for retirement plan contributions, the majority of individuals would want to immediately reverse what they are doing now (assuming that what they’re doing now is economically rational). Anyone in a low income year (including semi-retired individuals with reduced income who face a marginal tax rate of 24% or less – below $329,850 of income for a married couple) would want to switch from Roth contributions to Traditional contributions to get the higher tax credit.

Conversely, most high income earners would want to immediately switch to Roth contributions because continuing to make Traditional retirement plan contributions would effectively be penalized by a double tax. Consider an individual in the proposed 39.6% bracket who continued to make Traditional 401k contributions for which he received a 26% tax credit. He pays a 13.6% tax now on any 401k contributions (39.6% – 26%) and then pays tax again upon withdrawing the money in retirement (perhaps an additional 39.6% tax for a combined tax rate of 53.2%).

Closing Comments

We expect to get some specifics later this week on the revenue proposals from President Biden although a lot has to happen before any of those proposals become tax law. It is worth reiterating that even once the president lays out his proposals, a lot probably will change in the details before anything reaches the House or Senate floors for a vote. It will be a real challenge for the Senate to pass meaningful tax reform under budget reconciliation – both because of the restrictions and the need to get all 50 Senate Democrats on board with such reform. As a result, we should take all of the items above with a deep breath and a big grain of salt because there is significant uncertainty as to what, if any, tax reform will come to be this year.

Comments or questions? Please do not hesitate to leave them below in the Comments section and I will do my best to promptly respond.

Public sentiment seems to be that now is a bad time to buy bonds or to own bonds. We have heard and seen variations of this sentiment over the past several years but the frequency of this narrative during the past year is alarming. To be clear, it is not simply coming from unsophisticated retail investors. This “bonds are bad to own right now” narrative originates from financial advisors and investment professionals. Professional advisors cite low interest rates as a reason to look for bond alternatives and to move out of investment grade bonds into higher yielding investments or into more stocks. The message is that because interest rates are really low, high grade bonds will provide almost no return and that investors need to go find yield and returns from other asset classes. This message is clearly resonating because most of the sales pitch voice mails and emails we regularly get from investment management firms begin with the promise of an improved alternative to low yielding bonds.

Is this message wrong? Should investors really be leaving high grade bonds for stocks, for higher yielding bonds, for real estate, for alternatives?

Consider the chart below which reflects monthly data back to the inception of the Bloomberg Barclays Aggregate Bond Index in January 1976. The horizontal axis reflects the 10-Year US Treasury yield at the beginning of each month since January 1976. The vertical axis reflects the return of bonds relative to stocks over the subsequent 10 years.

We randomly highlighted a data point from September 1, 1988 to help better understand the information reflected in this chart. At the start of September 1988, the 10-year Treasury yielded 9.3% (horizontal axis). Over the subsequent 10 years (Sep 1, 1988 – August 31, 1998), stocks (represented by the S&P 500 Index) returned 17.0% per year and bonds (represented by the Bloomberg Barclays Aggregate Bond Index) returned 9.3% per year. Bonds trailed stocks over this 10-year stretch by 7.7% per year as reflected on the vertical axis.

With that explanation, let’s consider the important takeaways of all this data in the chart above:

The starting yield for bonds is useless in predicting how bonds will perform relative to stocks over the subsequent 10-years.

In statistical terms, the R-squared of the plots in the chart above is 0.013. This means that the starting yield for bonds explains just 1.3% of the variation in the relative performance for bonds over the next 10 years. Because the plots represent overlapping time periods, 1.3% is actually overstating the explanatory utility of interest rates.

The takeaway? It is naïve and/or intellectually dishonest to cite the current level of interest rates as a rationale that bonds are unattractive relative to stocks. There is no relationship between interest rates and the expected future return of bonds relative to stocks. Shifting from bonds to stocks right now because of the low starting yield for bonds is just assuming more risk in the hopes of a higher return.

Over most 10-year periods, bonds underperform stocks.

Although there were some 10-year periods in which bonds outperformed stocks, every one of these plots overlapped with the 2000-2002 and the 2008-2009 bear markets. Not just one of the bear markets – both of them. The return advantage for bonds in these periods had everything to do with the miserable performance of stocks over the 10 years – not some really attractive starting yield for bonds. Had you known in the late 1990’s that the next 10 years would encounter the two worst stock market declines since World War II, you would have wanted to back up the truck for as many high grade bonds as you could get, regardless of whether the starting bond yield was 1% or 10%. These types of environments (2000-2002, 2008-2009) are precisely the reason to own a consistent allocation of high grade bonds in a portfolio. Because the stock market is risky and stocks can lose 50% or more of their value without any warning.

If you’re buying high grade bonds for their return, you’re doing it wrong. Not just in 2021. In 2005. In 1982. In 1957. In 2057.

The annualized return advantage for stocks over the 45-year period in the chart above was 4.4% per year. Starting with $100,000 investment in 1976 and buying stocks rather than bonds, you end up with an additional $12.2 million by February 2021.

At every single point in history dating back to the beginning of capital markets, high grade bonds have been a lousy ex-ante investment choice if the alternative is stocks and the goal is to maximize expected return. It is all too easy to forget this perpetual and most fundamental concept: the role of high grade bonds in a portfolio is safety. The role of high grade bonds is return of capital, not return on capital. High grade bonds are insurance to the risky activity you undertake by owning stocks.

Bonds do not exist in a vacuum.

Low interest rates do not just impact bonds. They impact money market yields, resulting in less return from holding cash. They impact stock prices, resulting in lower expected returns for stocks. They impact capitalization rates on commercial real estate and expected rental yields on residential real estate.

We know that high grade bond returns will be lower over the next 10 years. The chart below is identical to the first chart above except that instead of using the relative return of bonds to stocks on the vertical axis, it simply uses the absolute return of bonds. There is obviously a much stronger relationship here as evidenced by an R-squared of 0.88. With a low starting yield for bonds, the expected return over the next 10-years will be lower. But here’s the thing: thinking or pretending that low interest rates do not diminish the expected return of all investment categories is likely to be financially deleterious.

So, is it a bad time to invest in bonds?

Now is no better or worse a time to invest in high grade bonds than at any other point in the past? Granted, interest rates are low and that means the nominal return for bonds over the next decade will be low. But, the same is likely to be true for all the alternatives to bonds including cash and stocks. What we should expect over the coming decade is for bonds to outperform cash and for stocks to outperform bonds and for the return of all investments to be lower than they have been, historically.

Again, the real purpose of high grade bonds in a portfolio is always safety and protection. They belong in a portfolio to counter the shock of a stock market collapse, to help reduce the downside risk of a portfolio, and to help you sleep at night. None of this changes because interest rates are low or high. So if a financial professional suggests that reducing bond exposure is a good idea right now because of low interest rates, consider following up by asking whether getting rid of your home, auto, and life insurance right now might also be a good idea.

Less than three months ago – in this December 30^th post – we presented the following chart to highlight the historic disconnect between value stocks and growth stocks.

The underlying point then, which still holds today, was that growth stocks – familiar names with exciting narratives such as Tesla, Amazon, Facebook, Snapchat, and Apple – were dramatically more expensive than their value stock brethren. In fairness, growth stocks deserve richer valuations because they represent companies with exciting prospects and attractive growth opportunities. Keep in mind, however, that growth stocks being dramatically more expensive than value stocks refers to the current relationship relative to the normal relationship. In this context, growth stocks are roughly 5.5 standard deviations more expensive to value stocks than the long-term average (using price/book as the measurement of value). In a normally distributed sample of monthly data, a relationship this extreme should occur about once every 2.2 million years.

We have all learned from experience that extreme events in finance occur more frequently than would be expected in a normally distributed sample. Yet this does not change the fact that calling growth stocks “dramatically more expensive than value stocks” – even if not a once every 2.2 million year phenomenon – probably falls on the side of understatement.

A hypothesis used to explain this unique relationship stems from the environment of historically low interest rates. The theory is that growth stocks are akin to long-term bonds with an underlying value that depends largely on future cash flows many years in the future (think of an unprofitable company like Uber where the stock’s value depends entirely on expected profitability at some point in the future). Declining interest rates make these future profits more valuable because of the reduced opportunity cost of investment alternatives (reduced discount rate). Growth stocks – because they tend to be companies relying on an expectation of high future profits – are then the beneficiaries of low or falling interest rates (just like long-term bonds). Conversely, value stocks are hypothesized to behave more like short-term bonds since they are often mature companies with current profitability where the stock price is not as dependent on large profits many years from now. Keeping with the hypothesis, growth stocks have been the overwhelming beneficiaries of historically low interest rates over the past several years. The other side of this is that rising interest rates – if and when – should favor value stocks relative to growth stocks.

In fairness, academics and practitioners debate about this interest rate hypothesis and the robustness of the relationship between interest rates and the relative performance of value and growth. Debates aside, here is what we can say with clarity right now:

• Interest rates have a clear relationship with stock prices (not value or growth stock prices…value and growth prices). All else equal, higher interest rates mean that future profits are less valuable (higher discount rate).
• Value stocks tend to be less dependent on future profits than growth stocks. All else equal, that makes growth stocks more negatively impacted by higher interest rates. Interest rates may not be the dominant factor impacting this value/growth relationship, but they are a factor.
• Interest rates have sharply increased since the start of the year as evidenced below.

• Value stocks have significantly outpaced growth stocks since the start of the year, largely in tandem with the rise in interest rates.

• Traditional value sectors such as energy and financials have been the best performing sectors in 2021 after suffering the worst performance in 2020.
• The technology sector – dominated by growth stocks – has been the worst performing sector in 2021 after posting the highest gains in 2021.

The recent rally in value stocks is a welcome result for evidence-based investors who tilt toward value stocks because of the robust historical support for a value premium. Whether this recent value resurgence is the start of a multi-year trend or not will be eventually be determined by history but the conditions are in place for it to be a multi-year trend, regardless of what happens with interest rates. It may just be that the abrupt northbound move of interest rates this year was the catalyst needed to spark a long-awaited reversal for value stocks.

1) In the middle of a crisis, things are scary and the future is uncertain. Outcomes always seem obvious in hindsight. As we grow removed from each crisis, our hindsight fools us into underappreciating how uncertain it was when we were in it and misremembering how obvious it was that we would get past it.

2) Humility should be the default position when thinking about trying to outsmart the markets. Humans are comforted by predictions – about the sports game, the election, the economy, and the stock market – even if these predictions are literally of zero value. Overwhelming data demonstrates that education, expertise, and even knowledge of confidential information are not useful determinants of forecasting success. 

3) Anytime we catch ourselves suggesting that anything is obvious on the investing front, there’s likely way more risk of the alternative than we perceive. There are three types of investors: 1) Those who don’t know they don’t know the future; 2) Those who know they don’t know the future but act as if they do; 3) Those who know that they don’t know what lies ahead. 

4) Diversification is the best respnse to an always uncertain future. The first step to financial success is humility and admission that we cannot predict the future. The second step is intelligently diversifying across asset classes so as not to have all the chips tied to one outcome. Because things won’t turn out as most forecasters expect.

5) Patience tends to be the greatest superpower an investor can have. My good friend, David Hultsrom, recently wrote an excellent article explaining that the primary difference between successful people and unsuccessful people is their time horizon. Unsuccessful people have very short time horizons while successful people have long time horizons. Such is especially true during the most trying times.

6) It does not help to take more risk than you can stomach during good times because you will pay a hefty fine during bad times. You will do better to accept your predisposed risk tolerance, try not to stretch it, and invest accordingly so as to stomach the inevitable bad times. 

7) Having a long-term plan and sticking to an investment policy usually beats speculating on the recent news, on emotion, or on short-term predictions.

8) The world always seems unusually uncertain. But it is not unusual. There are always significant risks and there will forever be scary headlines. Always and forever.

9) We never repeat the same crisis. This time is always different. But here’s what is the same: Every crisis is scary; purported experts will always opine on how much worse it’s going to get; and every crisis eventually wind down with life returning to normal and stocks fully recovering.

10) Headlines are already priced into stocks. To clarify: you are not getting the news before everyone else. In fact, you are likely getting the news long after the investor on the other side of the trade who is selling to you or buying from you. Once newspaper headlines start reporting of a pandemic or of an election result, the implications are already reflected in stock prices.

11) The stock market does not require good news to go up. It needs a less bad future than was expected yesterday. A lesson that very few investors ever learn, despite ample time and opportunity, is that stocks often fall on positive news and rise on negative news. It is not about the news. It is typically about whether uncertainty is higher or lower than yesterday and about the result today versus the expectation yesterday.

12) The stock market is not the economy and the economy is not the stock market. Say it three times. Write it down. The stock market is a forward-looking gauge of the economy, not vice-versa. Historical evidence shows that countries with the highest rates of economic growth tend to have the worst stock market returns and vice versa. The stock market is a forward-looking gauge of corporate profits. It is an aggregation of prices which move based on human perception and emotion. What the stock market does not reflect is a measure of economic growth or contraction.

13) Never underestimate the importance of monetary policy. You can perfectly predict everything that is going to happen in the future related to the economy, elections, geopolitics, inflation, etc. but all of that is largely futile if you do not correctly forecast what seven people occasionally meeting in a board room decide to do in response.

14) Market reversals are often fast and not telegraphed. At the peak of uncertainty and fear –on March 23, 2020 – the S&P 500 began one of the greatest rallies in market history. It gained 24.6% over 13 trading sessions a reasonable return for 3-5 years, let alone 13 days. For historical context, quick reversals from sharp market selloffs also occurred in 2009, in 2003, in 2011, and in 1987. 

15) Waiting for “things to get better” or for “the market to settle down” is a lousy investment strategy. The worst time to invest is generally the time when you feel the most comfortable. The best time to invest is generally when you feel the most uncomfortable.

16) Waiting until election results are known and there is “more clarity” is a lousy investment strategy. See 2020, 2016, and 2012 as recent examples. Also, this.

17) In the short run, stocks move for unpredictable and irrational reasons. Knowing what lies ahead in the world does not consistently result in investment success. See numbers 3, 11, 12, and 13 above.

Yogi Berra famously said, “It is tough to make predictions, especially about the future.” We strongly concur. Yet “expert forecasters” continue to make economic and market prognostications about the coming year despite the fact that human experts are worse than rats at such predictions and that these experts have demonstrated zero success in forecasting the stock market or the economy. And we continue giving them the stage to do so because human braves are wired to detest the chaos of an uncertain future. Even if prognostications do not provide any clarity at all, they satisfy our brains with the false perception of clarity. Our brains are wired to what behavioral economist Jason Zweig labels “the prediction addiction”.

To quell the itch for 2021 market predictions, I offer two of my annual favorites from authors Barry Rithlotz and Jonathan Clements. Their predictions about the upcoming year are likely to be more accurate than 99% of the alternative forecasts. Moreover, we offer below our 10 financial predictions about the next decade. Making predictions about the next 10 years is admittedly far less exciting or glamorous than predicting what sectors will outperform in 2021 or what stocks to buy in 2021 but it is a far more reasonable undertaking. And – speaking from a point of sincere humility – it will require more time to be proven wrong.

1) Value stocks will outperform growth stocks by at least 1.5% annually.

Between 1926 and the end of 2019, US value stocks outpaced their growth stock kin by an average of 4.4% per calendar year. However, the past decade has witnessed a sharp disconnect from this tendency with growth stocks besting value stocks in 6 of the prior 7 years. Growth stocks have become – as a result – dramatically more expensive relative to value stocks than at any point in history – including the historic dot-com boom of the late 1990’s. As we explained in this recent post, the single most important phenomenon in the stock market right now is this unprecedented value/growth relationship that sets up very well for value stocks going forward.

Measurement: Russell 1000 Value Index vs. Russell 1000 Growth Index 

2) Developed foreign stocks will outperform US stocks by at least 1% annually.

The case for this forecast is driven by the dramatic valuation gap between foreign stocks and domestic stocks. US stocks, in aggregate, are expensive by nearly every valuation metric whereas foreign stocks offer much more attractive valuations. If the relationship between the two reverts towards historic averages, we would expect foreign stocks to outperform US stocks by 2%-6% per year over the coming decade.

Measurement: MSCI EAFE Index vs. S&P 500 Index

3) Emerging market stocks will outperform US stocks by at least 1% annually.

There is a compelling case to be made for emerging markets over the next 25 years based strictly on demographics with a faster growing and younger population to counter the developed world’s graying population. Demographics have historically played an important role in stock market returns over extended time periods. However, we can ignore the demographics case and focus strictly on the valuations where depressed emerging market valuations set the stage for outsized returns over the coming decade.

Measurement: MSCI Emerging Markets Index vs. S&P 500 Index

4) US stocks earn a nominal return of less than 6.0% per year

Many long-term forecasts for the US stock market that use a quantitative framework would look at 6.0% per year over the next ten years as extremely optimistic. Morningstar calculates an expected annual return of 1.7%. Research Affiliates estimates a 0.3% annual real return while Vanguard estimates a nominal range of 3.5% – 5.5%. The foreboding problem for US stocks is they they are extremely expensive based on almost every measurement. Using the popular price/earnings ratio, the S&P 500 is more than double its historic average. Using a better predictive measure – the cyclically adjusted price/earnings ratio – US stocks trade at nearly 2.3 standard deviations above their long term mean. 

Even if US stocks don’t revert to historic averages but just maintain these rich levels for the next 10 years, the case for returns approaching 6% per year would depend largely on inflation running at 4% or more over that stretch – definitely not something that retirees should be hoping for.

Measurement: S&P 500 annualized total return

5) US bonds earn a nominal return of less than 2.0% per year

The 10-year Treasury yield dropped below 1.0% in March 2020 and has not eclipsed that level since. Although non-government high grade bonds (corporates, mortgage backed securities, etc.) may have higher yields, the expected long-term return for such bonds tends to converge closer to Treasuries as downgrades, defaults, and other credit events impact long-term results. As a result (and as evidenced by the chart below), the current 10-year Treasury yield provides an extremely useful way to forecast the 10-year forward return for bonds. Based on current yields and the mathematical ceiling imposed on bond returns by these yields, it is hard to envision a scenario (aside from the one where interest rates went sharply negative) where the total annualized return for US bonds exceeds 1.5% – 2.0% over the next decade.

Measurement: Bloomberg Barclays Aggregate Bond Index Total Annualized Return

6) Cash produces a negative real return

The Federal Reserve has publicized its playbook: an expectation to keep short-term interest rates near zero through at least 2023 and the scrapping of historic policy to promptly raise rates in response to a drop in unemployment levels. As long as the Fed sticks to this recently outlined playbook, it seems apparent that at least the first half of the next decade will provide a poor environment for cash and a decline in purchasing power. This result would simply continue a consistent trend as 1-Month US Treasury Bills – a proxy for cash returns – have lost money to inflation every calendar year since 2009. 

Measurement: 30-Day T-Bills vs. Consumer Price Index

7) Social Security taxes are significantly expanded to include income above the current limits.

The most recent Social Security Trustees’ Report estimates that the Old-Age and Survivors Insurance and Disability Insurance trust fund reserves will be depleted in 2035 and that just three-quarters of the scheduled benefits will be available from Social Security tax income after such time. With the clock inching closer to this deadline and confidence in Social Security’s health waning, policymakers will have to address the impending shortfall over the next decade. Although there are several possible solutions that could be part of the fix including an increased retirement age or changes to the annual cost of living adjustments, the most politically feasible solutions based on public sentiment would be on the revenue side rather than any changes to the benefits equation. It seems likely based on this sentiment and political discourse that a broad expansion or outright elimination of the cap on Social Security earnings ($142,800 in 2021) is in store at some point over the next decade.

Measurement: Social Security wage base limit > $300,000 by the end of 2030       

8) The Backdoor Roth contribution loophole is closed

In February 2016, I outlined three financial planning strategies that were likely to end up on the chopping blocks over the coming years. One of those items – the “stretch IRA” – effectively died when the SECURE Act was passed in December 2019. Another item from that list that seems unlikely to survive for the next decade is the Backdoor Roth Contribution – an unintended loophole resulting from a 2010 tax law change that allows some high income earners to circumvent the income limits for making Roth IRA contributions. As long as it exists, the backdoor Roth contribution is worth exploiting but just don’t expect the opportunity to last forever. 

9) There will be at least three market corrections (decline of more than 10%) over the next decade

The S&P 500 Index has experienced 27 market corrections since World War II – an average of one every 2.8 years. Given rich market valuations which bake in lofty expectations and allow less margin for error, it is not going out on a limb to forecast that we confront at least three market reversals of more than 10% each over the next ten years. Predicting when such corrections occur, how deep they go, and how long they last is decidedly a fool’s errand.

10) The six largest stocks (Apple, Amazon, Facebook, Tesla, Google, and Microsoft) underperform an equal weighted S&P 500 Index

These six tech companies represent nearly 24% of the S&P 500 – more than the combined value of 371 other stocks within the S&P 500. Such massive concentration is historically unusual and while this alone doesn’t necessarily portend bad news to come for the companies, it reflects the stock market’s already lofty expectations for their forward-looking growth. Historically, the largest stocks underperform after they get large for the same reasons that growth stocks historically underperform value stocks – including the tendency of investors to extrapolate recent growth and overestimate the persistence of such growth. In addition to the challenge of extremely high expectations, several of these companies also face the threat of antitrust regulation over the decade to come.

Measurement: Equal-weighted basket of these 6 stocks vs. S&P 500 Equal Weighted Index

Barring any dramatic market swings in the final two weeks of 2020, we will experience the greatest calendar-year stock market recovery in history. On March 23, the S&P 500 was down 33.9% from where it started the year. As of December 14, the same index was up 13.5% in 2020 – representing a trough-to-peak gain of 64%. Chalk up another record for the year that is 2020.

There are plenty of lessons to be learned – or just to be reminded of – from this year. Among the valuable reminders is that doing nothing in the midst of sharp market losses (or gains) is negligent and irresponsible.

What’s that you say? You thought investment fiduciaries long preached a buy-and-hold approach that avoids market timing as the tried and true path to long-term financial success. Don’t such fiduciaries usually discourage market-timing? Did 2020 change that?

Nope. Still 100% advocates of a long-term, buy-and-hold approach. It is, however, requisite to understand that the long-term, buy-and-hold mantra is not a do-nothing strategy. It is a stay-the-course strategy. There’s a big difference between letting the wind take you wherever it will and readjusting the ship’s direction to maintain the targeted course. This is a fundamental but misunderstood concept of prudent buy-and-hold investing.

Consider that there are really three broad approaches to volatile markets:

1) Do nothing

2) Stay the course

3) Change the course

The change-the-course strategy is a market reaction strategy that historically has the worst results of the three. It is the equivalent of turning the ship around because of unexpectedly strong winds as if we did not anticipate that there would be difficult conditions along the way. Dignified investors who reduce risk in the midst of losses tend to label it as “going to cash until things settle down” or a more professional sounding theme like “market-based hedging”. Whatever it is called, 2020 produced another stain on the track record of the change-the-course strategy that sells stocks amidst market losses. And while 2020 was unique in a number of ways, it was not unique here. Four times during the past decade, the stock market suffered a drawdown of more than 15%. In all four of those instances, stocks quickly reversed and had fully recovered all losses within 138 trading days.

What about the do-nothing strategy? Consider the case of Rudolph in 2020. He started the year with 60% stocks (iShares All Country World Index ETF) and 40% bonds (Vanguard Total Bond Market) and did absolutely nothing – resulting in a 2020 gain of 10.8% (through December 14). Contrast this with Rudolph’s mentor, Vixen, who used rebalancing rules to apply a stay-the-course strategy to his investments. When the stock allocation departed the 60% target by more than 10% in either direction (54% / 66%), Vixen immediately rebalanced back to the 60% target. Employing this stay-the-course approach meant that he rebalanced investments on March 16 to buy stocks and on June 8 to pare back his stocks. Diligently setting the ship back to course during the choppy markets resulted in a return of 13.5%.

In sanguine times, there is little or no difference between staying-the-course and doing nothing. They are effectively one and the same. But when the stock market experiences a year’s worth of volatility in a few hours or posts several of the 20 most volatile days in stock market history as it did in March and April 2020, there is distinct opposition between staying the course and doing nothing.

Case in point: just 56 trading days into 2020 – and without any corrective rebalancing – Rudolph’s do-nothing portfolio that started as 60% stocks and 40% bonds became 50.6% stocks and 49.4% bonds. Whereas Rudolph started the year with 20% more in stocks than bonds, the two allocations were nearly equivalent by mid-March.

Lessons Learned from 2020

There are a lot of lessons to learn from 2020. But keeping to the topic of investing and market volatility, here are a handful of the fundamental takeaways:

1. Staying the course does not mean doing nothing. When a target investment allocation is established, it will immediately deviate from target as the market moves. It is practical to let the allocation drift from target within reason. Letting the allocation drift materially off course as occurred for nearly all investors in 2020 without any correction (rebalancing) defeats the purpose of even having a target in the first place. It is the functional equivalent of setting sail from New York to London but letting the wind redirect you to Senegal without correcting course.
2. 2020 provided a textbook case for the benefits of rebalancing. We covered a simple 60/40 example above but the results were similarly beneficial regardless of the targeted stock/bond allocation. The uniqueness of 2020 was that because of the dramatic intra-year volatility, the rebalancing benefits played out over a very short window of weeks rather than over years.
3. One of the primary reasons that disciplined rebalancing works is because it contra-trades relative to human emotions. Rebalancing inherently reduces risk when risk premiums are low (fear is low) and adds risk when risk premiums are high (fear is high). The profits from rebalancing come from the bulk of individual investors who do the opposite – trade based on emotions (buying when perceived risk is low, selling when perceived risk is high) rather than trading based on a discipline.
4. 2020 provided support of “tolerance band” rebalancing as optimal to calendar rebalancing. Tolerance band rebalancing is simply a disciplined approach like the one employed by Vixen where allocations are allowed to fluctuate within tolerance bands but when they “break the bands”, the allocations are rebalanced back to targets. Alternatively, calendar rebalancing tends to rebalance once a year on a preset schedule, regardless of intra-year volatility. In a year like 2020 where there is dramatic intra-year volatility, once-a-year calendar rebalancing often fails to extract the significant benefits of rebalancing. An investor who simply evaluates her portfolio every December would find roughly the same allocation in December 2019 as December 2020, losing out on the intra-year rebalancing premiums. While there are varying methods to apply Vixen’s tolerance band rebalancing approach, the evidence demonstrates that any reasonable form of his approach is optimal to calendar year rebalancing.
5. Annual rebalancing is practical but suboptimal. For individual investors who do not have time to regularly monitor their allocations, calendar rebalancing is a reasonable balance between optimization and practicality. For advisors who charge a fee to monitor and manage portfolios, there is really no excuse in the Internet age to maintain a legacy calendar rebalancing approach in light of all the benefits of tolerance band rebalancing and the pervasive technology to perform it.

Have questions, comments, or general thoughts on the concepts above? Please use the comments section below to share.