By Jeremy Runnels
"The hardest thing in the world to understand is the income tax." – Albert Einstein
The U.S. tax system is riddled with complexities that baffle the greatest of minds (even Albert Einstein’s!). This brief overview is geared toward providing you with a cursory view of Uncle Sam’s role in your pocketbook.
Let’s break it down to this key question: How does the U.S. tax system work?
The Federal income tax is progressive and utilizes marginal tax brackets.
In the U.S., the Federal income tax system is pay-as-you-go. As you earn income, you pay taxes on that income.
When you file your Federal tax return before April 15th, you settle with the government for the previous year.
Individual income taxes are the single largest category of revenue for the federal government, and Americans pay billions of dollars every year having their tax liability determined and their returns filed with the IRS. Taxes are complicated – there's no doubt about it. Our progressive tax system creates a common misconception that making more money will penalize you with higher taxes, but falling into a higher marginal tax bracket will likely still place you in a better economic position.
By Joe Ferreira
Chances are you’ve heard the phrase “Two wrongs don’t make a right”. Generally, this is very wise advice. But is it possible sometimes, just sometimes, a little bad could do some good?
As you probably assumed, this post won’t be a philosophical discussion about ethics or Sicilian vigilante justice. So let’s jump to the chase. What does this have to do with investing? The answer is a relatively unknown paradox called Shannon’s Demon.
First, let’s set the stage. You own a portfolio with two investments (not very diversified!). What happens if over time both investments lose money? Your immediate impulse is probably to say the portfolio would also lose money. Normally, you would be right. But is that always the case?
In reality, that portfolio could still produce a positive return despite both underlying investments losing money. How is that possible? The two key elements are correlation and rebalancing.
We covered rebalancing conceptually last time. We touched on correlation briefly in the first part of this series, but we will expand upon it now.
Correlation is how closely the performance of one asset is tied to another. If two assets are perfectly positively correlated, they would perform exactly the same. If one is up 5%, the other would be up 5%. Correlation can work the other way as well. If two investments are perfectly negatively correlated, they would be a mirror of each other. If one is down 5%, the other would be up 5%.
A diversified portfolio contains investments that do not have perfect positive correlation. Although ideally you want everything you own to always go up in value, we know investing isn’t that simple. All investors must deal with volatility (asset values going up and down). But volatility can be used for good if you have the discipline to rebalance in the face of it.
Now for Shannon’s Demon. The graph below shows the performance of two negatively correlated stocks and a portfolio split evenly with 50% in each stock. The portfolio rebalances (i.e. sells some of one and buys some of the other) the stocks back to 50% at the end of each time interval.
As you can see, both stocks lost money over the full period. In this example, if you had just bought and held both stocks, you would have lost about 33% of your money. However, if you had rebalanced after each time interval, your portfolio would have been up 15% - quite the difference!
Like all great magic tricks, there is no sorcery at work. In this case, pure math can defy logic and come up with a pretty interesting result. So the next time someone tells you “Two wrongs don’t make a right”, ask them if they’ve ever heard of Shannon’s Demon.
By Joe Ferreira
This Insight builds upon our earlier post “Diversification or Di-WORSE-ification", which I recommend you refresh on or read next.
“Buy low, sell high.” This is the core thesis of most investment strategies going all the way back to Thales of Miletus. For those who don’t know Thales, he was an ancient Greek mathematician who one winter decided to buy all the olive presses in his region – when prices were rock bottom since it wasn’t olive pressing season. When spring came and everyone needed to make olive oil, Thales was more than happy to sell his olive presses…for a huge profit.
Thales may have been the world’s first value investor (and he certainly didn’t believe in diversification!). Many would try to replicate this strategy over the next 2,500 years. Spoiler alert: the vast majority fail.
So how do you execute “buy low and sell high”? What secret method exists to help investors know when to buy and when to sell? The answer is discipline, and something called rebalancing.
As we discussed last time, performance of different asset classes varies over time. Some will do well and others not as well, and over time, the performance of each will vary considerably.
To start, you need a target for how aggressive you want your portfolio to be (we will discuss this in a future Insight). For the sake of ease, let’s assume your portfolio was 50% stocks and 50% bonds. Now say that stocks had a terrible year and were down 25% whereas bonds were up 5%. Your overall return for the year would have been -10%, with the small positive return from your bonds helping reduce your downside (score one for diversification!). Your portfolio now has about 60% in bonds and 40% in stocks as a result of the stocks doing so poorly.
What about next year? From a high-level simplistic view, you have two options: A) do nothing and stay the course or B) rebalance back to 50% stocks and 50% bonds.
Now let’s assume that stocks had a bounce back year and are up 25% while bonds earned 2%. If you did nothing (i.e. option A above), you would have earned an 11.6% return. How does that compare to option B?
If you had rebalanced your portfolio back to the original target by selling roughly 10% of your bonds and using that money to buy stocks, you would have made 13.5%! It may seem like a small amount of money, but over time that kind of outperformance will have an enormous impact on your portfolio.
Although this is a simplified example extending only 2 years, the concept is backed by a considerable amount of academic research.
So, are you telling me that I should blindly trade back to my target portfolio allocation without considering what the Wall Street Journal or CNBC says about how markets will perform next year? Yes, that’s exactly what we are saying! Follow in the footsteps of Thales - buy when things go down and sell when they go up. You’ll be happy you did.
by Joe Ferreira
There is an old proverb that people apply to investing: “Don’t put all your eggs in one basket.” On the surface, this appears to be very sound advice: spread your eggs into multiple baskets to reduce the risk of all your eggs breaking. However, the late 19th-century steel tycoon Andrew Carnegie provides a contrary take: “Put all your eggs in one basket, and then watch that basket.” Warren Buffett (aka The Oracle of Omaha) and other prominent investors share a similar “one basket” investment philosophy.
Who to believe? If you are of the basket spreading persuasion, how many baskets should you pick? If you are a proponent of the one basket theory, how do you pick the basket, and how do you know if you have the wrong one? What the heck is a “basket”?
The answer – like all great finance questions – is “it depends”. It depends on what you are trying to do and how dependent you are on being right. The basket analogy in this context refers to what the investment world calls diversification.
Diversification in its simplest form means having a mixture of different things, or in this analogy, spreading your eggs into multiple baskets. The “eggs” are your financial assets, and the “baskets” are asset classes (typically stocks, bonds, cash, real estate, and commodities). The idea behind diversifying (i.e. buying two or more asset classes) is to increase the odds of picking the best performers and eliminate the chance of owning only the worst performer.
But wait! Doesn’t that mean I will increase my chances of picking poor or mediocre performers? This is the heart of the diversification question.
Asset classes tend to perform differently to each other over short periods of time (over long periods of time they appreciate). Precious metals might do well when the economy is hurting and stocks are doing poorly. Real estate might crash while cash holds its value (I know, I know…that’ll never happen!).
By holding different types of investments (asset classes), you accept ownership in both high performers and some that are just mediocre. By investing in only one asset class, you are taking a risk that your thesis is incorrect (your chosen basket is a poor performer). If you’re right, you might achieve tremendous returns (a la Warren Buffett). However, if you’re wrong, you might “lose your shirt”.
The ultimate goal of diversification is to minimize risk. Said another way, the goal is to give you the highest odds of achieving a satisfactory return.
So what makes sense for you?
If you need high returns and can afford to lose in the short-run (perhaps you have high-income potential, time horizon, and risk tolerance), maybe you should follow the Buffett method and go shopping for the right basket. If that’s not you (perhaps you’ve already saved a tidy sum and would like to live off it one day), I advise you to find a few baskets and spread the eggs around.
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