By Jeremy Runnels

How does this sound? You give me $1 today, and I will give you 99 cents a year from now. Crazy, right? You may be surprised to learn that many people in a large part of the world are currently saying “yes” to that offer.

People are paying banks to hold their money.

The money is losing money, or in other terms, earning negative interest. And it’s not just short-term bonds that are being offered at negative interest rates. Germany recently issued zero-coupon bonds for 824 million Euros that will only repay 795 million Euros when the bonds mature in 30 years - a willing loss.1 As of this writing, about $11 trillion of negative-yielding debt exists worldwide (this is down however from $17 trillion in mid-2019.)2

Negative interest rates seem counterintuitive to everything we learned about saving and earning interest. You might be asking, why would a bank charge me to hold my money? How could financing be cheaper than paying with cash?

Central banks around the world, including the United States Federal Reserve, support their respective economies through monetary policy. One vital tool in monetary policy involves adjusting interest rates. Lower interest rates mean that the costs to borrow money are reduced, incentivizing investment and subsequently providing economic stimulus. In the years after the Great Recession, most countries have not experienced the economic rebound that we have witnessed in the US. As a result, some central banks around the world have dared to take the drastic measure of reducing interest rates below 0%. In 2012, facing economic collapse, Denmark became the first country to submerge into negative interest rates. Japan and the European Central Bank later followed suit.3

But why would someone park their money somewhere earning negative interest? Here are two reasons. First, some people believe that yields will become more negative, increasing the value of their bond. Second, geopolitical risks may prompt some people to pay for the perceived safety of government-issued debt.

Negative interest rates have been used around the world as a desperate attempt to stimulate local economies. Despite this intention, sub-zero rates are not exactly having the effect that central banks were hoping for. However, in the absence of a robust economy, normalizing rates could further dampen their respective economies. Since negative interest rates are a new phenomenon, we are unable to observe all the consequences yet. Economics is not an exact science; only time will tell how this all shakes out.

1. Davies, Paul J., and Patricia Kowsmann. “Germany for First Time Sells 30-Year Bonds Offering Negative Yields.” The Wall Street Journal. Dow Jones & Company, August 21, 2019.
2. Bloomberg.
3. Blanke, Jennifer, Signe Krogstrup, Social Development, African Development Bank Group, Research Department, and Imf. “Negative Interest Rates: Absolutely Everything You Need to Know.” World Economic Forum.

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.

  • The more money you make, the more tax (as a percentage of income) you will pay.
  • Each bracket represents a bucket that needs to be filled up before you can move on to the next. The highest tax bracket you reach is called your marginal tax rate.
  • Moving into a higher tax bracket does not rob you of the benefits of the lower brackets. It simply applies a higher tax rate to each additional dollar of income you earn over the previous threshold. Making more money and paying a higher marginal tax rate still puts you in a better economic position.

In the U.S., the Federal income tax system is pay-as-you-go. As you earn income, you pay taxes on that income.

  • Most workers receiving W-2 income withhold federal income taxes from their paychecks based on the information they provided on their W-4 (that confusing form you filled out on your first day with HR). Depending on the number of dependents you claim, Uncle Sam will either take more or take less money from your paycheck.
  • If you receive income through a 1099, taxes aren’t automatically withheld. Instead, you are probably (or should be) putting money aside for Federal income taxes. 1099 employees or those without earned income pay their estimated tax owed on a quarterly basis.

When you file your Federal tax return before April 15th, you settle with the government for the previous year.

  • The government starts with your gross income and then subtracts deductions to reach your taxable income.
  • Next, your taxable income flows through the tax brackets mentioned above to arrive at your total tax owed.
  • Lastly, the government compares your total tax owed to what you withheld from your paycheck and/or paid through quarterly estimated payments.
    • Refund = you paid more tax than you owe.
    • Tax bill = you owe more tax than you paid.
  • You may also file an extension which allows you to extend your filing date up to 6 months (October 15th). However, your tax liability is still due on April 15th, and penalties can be applied if you don’t meet that deadline with payment.

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

This is the 3rd part of a series. If you have not read the others: “Diversification or Di-WORSE-ification" and “Ancient Greek Investment Advice”, I recommend you do so before starting this one.

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.

Shannon's Demon

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.