Investment Management

Preparing For A Market Decline

I am not one to predict a stock market crash.

If market history has taught us anything, it's that even so-called “experts” are notoriously poor at predictions. I don’t know when the market will go down, but I know it will at some point.

History of Corrections and Bull Markets

Industries love their jargon, and finance is no exception. There are 3 common terms that refer to declining markets: a correction, a bear market, and a crash.

A correction is a market decline of 10% or more. A bear market is a market decline of at least 20%. A crash is a general term that refers to a sharp market decline, usually over a short period of time.

Capital Research and Management examined all the corrections and bear markets since 1900. They studied market declines and how often, on average, they occur. Their findings are as follows:

  • 5% declines happened about 3 times a year
  • 10% declines happened about once per year
  • 15% declines happened about once every 2 years
  • 20% declines happened about once every 3.5 years
Source:  Wealthfront

Source: Wealthfront

It can be hard to believe that these types of declines are so common. It is easy to forget when we're in the middle of a market that has been increasing since 2009.

We know that declines have happened and will happen in the future, we just don't know when.

So, how can you prepare?

What Can You Do?

1. Don't Predict

Predictions are tricky things. No one has a magic formula to determine the future movement of the markets. Economists and investment managers alike have pitiful records trying to foresee downturns. Economist Paul Samuelson once said, “The stock market has called nine of the last five recessions.”

If the pros can’t do it, you shouldn’t either.

2. Expect It

As you can see above, stock market declines are a regular part of investing. So, it should not come as a surprise when the market inevitably drops (again… and again).

3. Stay the Course

People love to gloat about how they got out of the market at the right time. But you hardly ever hear them brag about how they got back in at the right time. You can't just be right once, you have to be right twice- on the way out and on the way in. Both are equally unlikely.

Markets fall, but they have always recovered. Trying to time the market will almost always fail. People (professionals too) who try end up getting out too late, and back in after most of the recovery. They hurt themselves on both ends, rather than staying the course.

A recent DALBAR study found that investors who consistently exit the markets when they drop cost themselves, on average, 4% a year!

4. Check Your Allocation

Your best protection from a market downturn is a well-diversified and allocated portfolio.

A well-diversified portfolio consists of many types of holdings, companies, and industries. Just because you have a lot of holdings, doesn't mean that you're diversified. Sometimes a single fund can be more diversified than 10. 

A well-allocated portfolio is one that reflects your risk tolerance, time horizon, and goals. The closer you are to pulling money from your investments, the more conservative they should be.

These two things won't protect you from losing money in the market, but they will help you mitigate that risk.

The last thing you want is to have a short time horizon and poor diversification and allocation when the market drops.

5. Rebalance

One of the most important things that you can do is to rebalance your investments regularly. In a well-diversified portfolio, different asset classes produce different returns. This means that your allocation changes over time. Periodically, you need to bring your investments back to their original allocations. This process ensures that you are not taking on more risk than you should be. It also forces you to sell things that are high in the portfolio and buy things that are low- a core discipline of investing.

There has been a lot of debate and study over how often you should rebalance. I’ll spare you the extensive research and let you in on the consensus:

The average investor should monitor their portfolio at least annually and rebalance any positions that exceed 5% more or less than the original allocation.

 

What To Do With an Inherited IRA

What is it?

An Inherited IRA, also called a Beneficiary IRA, is simply a retirement account that has been passed along from a deceased individual to another person.

What can you do with it?

In regard to contributions, you cannot make any additional contributions to the account. In regard to withdrawals, you have several options. If you are the spouse of the decedent, you can just assume the IRA as your own, but if you are a non-spouse beneficiary, you have several options.

You Have 4 Options:

  1. Open an Inherited IRA: This is often called a Stretch IRA. With this option, you can keep it in a retirement account and continue to defer paying taxes on the account for your lifetime. You will, however, be subject to annual Required Minimum Distributions (RMDs). The required distribution amount will be a factor of your life expectancy. You can calculate this required distribution here.
  2. 5-Year Option: With this option, you can elect to receive the entirety of the account over a 5-year period. During this 5-year window, you can withdraw the funds however you like, without penalty, as long as the account is empty by the end of the period. Each distribution is considered taxable income.
  3. Lump-Sum Option: You can elect to receive the entirety of the account at once. The whole distribution will be counted as taxable income in the year you receive it. With this option you may end up with a sizable tax bill, plus you will be forgoing the benefit of tax-deferred investing.
  4. Disclaim It: You actually have the right to refuse to accept an inheritance. When you do this, your portion of the inheritance will be distributed among the other primary or contingent beneficiaries. You will have zero say over what happens to the funds with this route. You generally have 9 months from the original owner's date of death to make this decision. It is important to consult with your attorney if you decide to go this route to ensure that you are meeting all legal requirements.

Which Option is Best?

There are many factors to consider when making your decision and some options may make sense in some situations, but not in others. Generally speaking, for a young individual, keeping the money in an IRA can be a powerful benefit over the long-term. Keep in mind this hypothetical example from Charles Schwab:

When six-year-old Tara inherited a $30,000 IRA from her grandfather, her parents decided to open an Inherited IRA with the money. By doing so, and by limiting Tara’s annual withdrawals (RMDs) to the minimum amount required, they ensured that the majority of her legacy had the potential to grow tax-deferred for decades. If the account earns 8% annually and Tara withdraws the required minimum amount over her 82-year life expectancy for 76 years, her grandfather’s initial $30,000 legacy could turn into a cumulative inheritance of $2.1 million.

How Should You Invest It?

When making any investment, you always have to keep in mind your time horizon and your tolerance for risk. Your time horizon lets you know how much risk you can afford to take on (your risk capacity), and your risk tolerance is completely unique to you. 

There is a caveat with inherited accounts that change things a little bit: the RMDs. Depending on your age, the annual required distributions can start getting quite large. When you're young they're relatively small in relation to the value of the account, but as you approach your own retirement, they grow. The reason this is an important factor to consider is because with other tax-deferred retirement accounts, you don't have to worry about taking money out until you retire or age 70½, but with an inherited account, you don't have a choice. 

You should structure your investments in a way that allows you to account for you annual distributions.

Conclusion

Inherited retirement accounts can be a tricky mix of tax, estate and investment planning and your decision should not be taken lightly. Before you act, you should carefully consider your options and make an informed decision.

Resources

https://www.irs.gov/publications/p590b/ch01.html

http://www.schwab.com/public/schwab/investing/retirement_and_planning/understanding_iras/inherited_ira

 

40 Stock Market Terms Every Beginner Should Know

While I don't think that every investor needs to know all of these terms in order to be successful, the following terms are a great foundation to start with. The graphic below, courtesy of Visual Capitalist, is a really neat visual of some key investing terminology.

Courtesy of: Visual Capitalist

Small Business Guide to Selecting a Retirement Plan

If you're self-employed or run a small company, it can be overwhelming to try and figure out what retirement plan would be best for you and your company. 

Use the graphic below to help you get an idea of which plan may be right for you.

Infographic based on the  American Funds  question guide

Infographic based on the American Funds question guide

Keep in mind that the graphic above does not include every single option available to employers, nor is it a definitive guide to selecting a retirement plan. The graphic above merely helps you to begin the conversation on choosing a retirement plan with the right questions.

Below is a brief overview of each of the different plans mentioned above. All of the following plans have the same tax status of contributions, meaning that your contributions are tax-deferred (up to certain limits).

SIMPLE IRA

Eligibility: Any employer with 100 or fewer employees that does not maintain another retirement plan.

Key Advantages: This plan allows for direct salary reductions with less administrative burden. It is also typically one of the least expensive plans to set up and maintain.

Who Contributes and What are the Limits?: Both the employer and the employee contribute to this plan. The employee funds the plan directly through a salary reduction. The employer is required to contribute either: 1) a 100% match of up to 3% of employee salary contributions (match can be reduced to 1% in 2 of 5 years), or 2) a 2% contribution for all eligible employees, whether they contribute to the plan or not.

The maximum contribution for this plan is $12,500 for 2017, plus a $3,000 additional for those that are age 50 and over (2017). 

Administration: By doing one of the two required options above, it removes all requirements for costly audits of the plan (top-heavy testing, highly compensated employee identification, etc.). There are also no annual filing requirements from the plan (form 5500) as with a 401(k), which brings down the plan cost and administrative burden of the plan. The employees are always 100% vested in both their contributions as well as the contributions of the employer.

Key Disadvantage(s): The SIMPLE IRA has lower contribution limits when compared to a 401(k) or a SEP IRA for employees of higher income levels ($60,000+).

SEP IRA

Eligibility: Any employer with one or more employees. 

Key Advantages: This plan is easy to set up and maintain. It is typically a more popular option with sole proprietors due to its higher contribution allowances for those with higher levels of income.

Who Contributes and What are the Limits?: The employer is the only one who can contribute to the plan.

The employer can contribute the lesser of 25% of employee compensation or $54,000 to the plan (2017). The employer must contribute the same percentage to employee accounts in each year that a contribution is made to their own account. 

Administration: There are no annual filing requirements (form 5500) on behalf of the plan. The employees are always 100% vested in both their contributions as well as the contributions of the employer. 

Key Disadvantage(s): A disadvantage of the SEP is that only the employer can only contribute to the plan, not the employees. The employer must also contribute the same percentage of contribution for their employees that they do in their own account (ie. if the employer contributes 15% of their own salary to the plan, they must also contribute 15% of each employee's salary to their plan as well).

Payroll Deduction IRA

Eligibility: Any employer with one or more employees.

Key Advantages: Easy to set up and maintain. No required employer contributions.

Who Contributes and What are the Limits?: The employees are the only ones who can contribute. They contribute via payroll reductions. 

Employees can contribute up to a maximum of $5,500 per year, plus an additional $1,000 if they are age 50 or older (2017).

Administration: There are no annual filing requirements for the plan. The only administration of the plan is the payroll deduction.

Key Disadvantage(s): This plan has the lowest contribution limits of all the plans. It also does not allow for employer matching.

401(k)

Eligibility: Any employer with one or more employees.

Key Advantages: This plan permits a high level of salary deferrals by employees. This plan also offers the most customization, with many different features (loans, vesting, matching, profit sharing, Roth capability, etc.). 

Who Contributes and What are the Limits?: Both the employer and employee can contribute to the plan. The employer is not required to contribute to the plan, but if no safe harbor contributions are made, the plan must undergo annual nondiscrimination testing.

Employees can contribute up to $18,000 via salary deferral, with an additional $6,000 if they are age 50 or older (2017). The employer can match up to 25% of employee compensation, but the combined employer and employee contribution cannot exceed $54,000 (excluding over age 50 catch-up contributions).

Administration: Annual nondiscrimination testing is required. For 5500 must be filed each year for the plan. A Third Party Administrator (TPA) is typically required for most 401(k) plans.

Key Disadvantage(s): 401(k) plans are typically the most expensive and complicated to administer. With greater customization comes greater cost and administration.

Solo 401(K)

Eligibility: Self-employed individuals or business owners with no other employees other than their spouse.

Key Advantages: This plan has all the advantages of a standard 401(k) plan. It has the added benefit of not having to conduct nondiscrimination testing for the plan as long as the business owner does not have any employees. 

Who Contributes and What are the Limits?: Both the employer and employee can contribute to the plan, assuming that the employee is the business owner or their spouse. 

The combined employer and employee contribution cannot exceed $54,000 just as in a standard 401(k) (excluding over age 50 catch-up contributions).

Administration: Form 5500 must be filed annually once the plan exceeds $250,000 in assets.

Key Disadvantage(s): Comparatively, these plans are typically more expensive for individuals looking to set up a retirement plan up for only themselves.

 

In short, there are many retirement options available to small businesses. It can be overwhelming trying to navigate the decision by yourself. It is worth taking the time and effort to evaluate your options and choosing a plan that fits your company like a glove. Doing so can save you a significant amount of money and headaches down the road.

 

Need help selecting a retirement plan for your small business, or evaluating an existing one? Let us know!

We can benchmark your plan with comparable ones on the market, as well as determine if your current plan is the right solution for you.

 

 

Resources:

 

IRS Small Business Retirement Plan Resources

DOL Guide to Choosing a Retirement Plan for Your Small Business

Investing in the Wake of a Divisive Election

The market doesn't like surprises and it sure got one on November 8th with the election of Donald Trump. Immediately after the election results came in, we knew the market was headed for some dramatics ups and downs, a term we call volatility. People have varying degrees of responses to volatile markets. Some want to sell everything and wait until things calm down, others see it as an opportunity to invest more. Which camp do you fall into?

Is This Year Historically Significant?

In one sense yes, but in another sense no. According to data by Dow Jones, the average change on the day after Election Day is negative 0.9%. The top declines are listed below:

Election Winner Election Day % change day after Election Day
Barack Obama (D) 11/4/2008 -5.27
Harry S. Truman (D) 11/2/1948 -4.61
Franklin D. Roosevelt (D) 11/8/1932 -4.42
Franklin D. Roosevelt (D) 11/5/1940 -3.32
Barack Obama (D) 11/6/2012 -2.37
George W. Bush (R) 11/7/2000 -1.58
Jimmy Carter (D) 11/2/1976 -1.14
Dwight D. Eisenhower (R) 11/6/1956 -1.03
Ronald Reagan (R) 11/6/1984 -0.73
Bill Clinton (D) 11/3/1992 -0.67

Where Do We Go From Here?

Jonathan Lemco, Ph.D., a senior strategist at Vanguard Investment Strategy Group and former professor of political science at Johns Hopkins University stated, "The markets don't like uncertainty, and presidential elections, by definition, add another layer of uncertainty."

According to research by Vanguard, it typically takes about 100 to 200 days after a presidential election for the resulting volatility to largely subside. After that, tracing back to 1853, history has shown that market returns are virtually identical regardless of which party controls the White House.

So What Can You Do?

  1. Remain Calm: You're going to hear a lot of noise. News outlets will (and have already) release stories with loaded language and outrageous predictions designed solely to garner your attention. Media outlets love to describe the market as "plummeting," "surging," "booming," "crashing," etc. Why? Because they get paid in attention: clicks, views, and papers sold. Calm doesn't sell— panic and greed do. Tune out all of the noise and focus on the long-term.
  2. Make A Plan and Stick to it: The biggest investment mistakes are not typically made based on careful, methodical planning based on historical data. Rather, they are usually made when an investor makes a knee-jerk reaction. Your biggest enemy of your investments isn't the presidential candidate of the opposite party, it's you. Too many people end up chasing goals that are not their own. The majority of world news and market events have no impact on your personal goals. Your plan should include allocating your money in a way that is in line with your goals and your tolerance for risk.
  3. Expect Volatility: Returns can never be guaranteed in investing. They can be expected, based on reasonable historical data and projections, but never guaranteed. One thing that can be guaranteed is volatility. If you are an investor in any capacity, you should mentally prepare yourself for the inevitable ups and downs of investing. If you can't seem to stomach the risk even after educating yourself, maybe it's time to change how your investments are allocated. If your investments will reach your goals on paper, but you're losing sleep at night, maybe something needs to change. Not in a reactionary, panicked way, but rather a planned and methodical shift.

 

Resources

How the stock market performs on, and after, Election Day

Worried about the election's impact on your portfolio? Markets are nonpartisan long-term

Stick with your plan...even when the market gets scary

Six strategies for volatile markets

The Election and Your Investments

The graphic below, courtesy of Fisher Investments, is a great big picture view of how the market has performed throughout various election cycles.

Elections and Market Outcomes - An infographic by the team at Fisher Investments