Building the Perfect Portfolio

I wrote previously about The Perfect Portfolio. Spoiler Alert: I contend in the article that there is no such thing as the perfect portfolio.   This is because we can’t foresee the future for investment returns, and we all have different investment needs. Even so, I believe that an investor can build a portfolio that is nearly perfect for them.

How would someone go about achieving such a challenging objective? To answer that question, I like to use a little game or thought experiment that builds a portfolio one step at a time. To begin, assume that you could only have one investment for the rest of your life, what would it be?

Before I go on, I must lay out a few rules since all games must have rules.   First, the investment you choose must be a discrete security or asset class not a mixture like a balanced fund or a fund-of-funds. That would be cheating. You can have any investment you want but you must keep it for the rest of your life. What would you choose?

First, I would choose a mutual fund or exchange traded fund (ETF) rather than an individual security for the diversification advantage. Individual companies carry more risk than diversified funds without a commensurately higher return.   It doesn’t make sense to take on more risk without getting something for it. Of course, an individual stock might do much better than a diversified portfolio, but my purpose is to invest not to gamble. Secondly, I would want an index fund rather than a managed fund. Whereas managed funds might perform about the same before expenses, they almost always underperform after expenses are considered. Lastly, I would want a US based investment because ours is the largest and most dynamic economy in the world.

To fit these criteria, I would select a total US market index fund or ETF. Such a fund would provide both income and growth potential. Income would be generated from dividends and growth would come from the share price appreciation of the underlying securities.   It would be as broad-based and balanced as possible because it would cover the entire US market of publicly traded stocks – essentially representing the economy. I can’t imagine a single better investment to own than a total US market index fund.

Assuming that you agree with my logic, let’s continue the game. What if I was to offer you the opportunity to select a second investment for your portfolio. Keep in mind that adding another investment means that you must take dollars away from the total market index fund. You should only add something if there is a net incremental benefit. There are many types of investments from which to choose, so what would you add, if any, to get an expected marginal benefit?

I would add bonds to the portfolio even though it would mean less in stocks and slower growth. Bonds are a completely different asset class because they behave differently than stocks in many ways. Whereas stocks represent equity ownership, owning bonds is lending your money. Lending typically affords a safe and predictable return but cannot match the return from equities. By adding bonds to a stock portfolio, I’m sacrificing some long-term return in exchange for less volatility or risk.   This is not a trade-off to take lightly because over long periods of time stocks produce exponentially better results through the magic of compounding. In fact, I want as little as possible in bonds so I can sleep well at night and ride out the inevitable stock market roller coaster. Most investors should have both stocks and bonds in their portfolio because there is a low correlation between the two asset classes which provides a strong diversification benefit.

Specifically, I want high quality bonds since the whole purpose of adding them is to lower the risk. And, I’m going to prefer US bonds over those of other countries. In addition, I want broad exposure to the asset class. Therefore, the clear choice for my second fund is a US bond index fund which by its nature will be dominated by US Treasury bonds.

If we are still in sync with this building blocks approach, together we have developed a two-fund portfolio. We could stop here and have an excellent portfolio – far better than most investors. I’m confident that even Warren Buffet and the late Jack Bogle – two of the greatest investors of all time – would have endorsed such a two-fund portfolio. Each might have suggested a slight variation, but they are both on record saying that a low-cost portfolio of US stocks and bonds is all anyone needs.  

While I agree that just two index funds would get you pretty close to perfect, I still think an investor can generate some marginal benefit by adding at least one other fund.   I think you could get 80% to 90% of the way to where you want to be, but why not try to get even closer? What if you could add one more fund to the portfolio, what would it be?

I would add a broad-based international stock index fund.   There are more stocks outside the US than there are here, and many are high quality companies.   Economic theory suggests that non-US stocks in the aggregate should perform about the same as US stocks over the long-term even though international stocks have underperformed in recent years.   Statistical data shows a significant reduction in volatility from adding internationals stocks to an existing portfolio of domestic stocks. If you can produce a smoother ride without sacrificing return, why not?  

Simplicity might be a valid reason stay with just two funds – and I’m sure it was Buffet’s and Bogle’s thinking - but I think the marginal benefit would be worth the added complexity as international index funds are readily available at a low cost. Therefore, if I’m allowed to add a third fund to my portfolio of US stocks and US bonds, I’m going to add an international stock index fund.

At this point in the game, you have created what has become known in the investment world as the “Three-Fund Portfolio”.   This basic three-fund index portfolio which covers the most important asset categories is probably going to meet all of your needs and get you about 95% of the way toward the perfect portfolio.  Any additions are likely to have a very small incremental impact.

Even so, in the spirit of the game, let’s say you could add another fund or more to the portfolio. Keep in mind, though, that you should not add another investment unless you are confident it will produce a marginal benefit greater than the loss from taking away from the other funds. That is, is there another asset class that would increase the expected return, reduce the expected risk, or have some combination of the two? There could be in certain situations, but again, the impact is likely to be small.   Let’s take a look at some candidates.

I often recommend that clients add an inflation protected US bond fund to the portfolio, but mainly for people at or near retirement. This is because older investors typically have a significant amount in bonds, and bonds expose long-term investors to two primary threats. One is called credit risk which is the chance that the borrower will not make good on its promise to repay the loan as planned. US inflation protected bonds are backed by the full faith and credit of the US government which eliminates credit risk. The other danger is that inflation will erode the value of future payments, but this is negated with Treasury Inflation Protected Securities known as TIPS.   With normal expected inflation, TIPS and regular treasury bonds should perform about the same, but TIPS would do better in high inflationary periods thereby providing a hedge against unexpectedly high inflation.   I’m never completely sure that adding a TIPS fund will ultimately lead to better results, but in building a portfolio, I think adding a TIPS fund to the 3-fund portfolio makes a lot of sense for some investors.

I’ll sometimes suggest a fifth fund for certain clients, which is an international bond index fund. Again, this would be for someone with a large amount in bonds as a way to further diversify the portfolio. International bonds represent a very large part of the global securities markets, so they are a natural asset class to consider. Even so, the diversification effect is not nearly as great as with international stocks because bonds by their nature are very stable.

There are other asset classes that could also be added to provide either higher returns or greater diversification, such as real estate, commodities or cryptocurrencies.   These could benefit certain investors but would not be a net positive for most. For example, some people like to own gold as in investment – and it does have some advantages - but gold can be volatile and the long-term expected return is low. This is not a good combination and therefore not appropriate for most investors.

In addition to adding asset classes, some investors try to improve a portfolio by engaging in active trading activities.   For example, hedge funds employ a myriad of strategies to generate a desired return. As such, they are not really a separate asset class but are just manipulating other securities using various strategies. If they seek or actually earn higher returns, you can be sure that they have higher risk. An investor should certainly seek a higher return if they are truly willing to take higher risk, but hedge funds are not the answer because of their excessive costs.   You should expect a higher return than the overall market if you emphasize certain areas such as small companies or technology stocks. By adding such stocks, you are in effect reducing the amount in lower risk stocks. This is a valid strategy for someone willing to make that trade-off. But you could achieve similar results using a three-fund portfolio and reducing the bond allocation and increasing the stocks.

Note that we have not discussed how much of the portfolio would go into each of the funds. This is called asset allocation and is very important in order to match the desired investment objectives and risk profile. This discussion will have to wait for a future article. My purpose here is to demonstrate that most investors would be best served with a three-fund portfolio of low-cost funds. Some might gain small incremental advantages by adding one, two or even three more funds. Beyond that, it is hard to say with confidence that any additions would improve the portfolio.

Of course, this exercise assumes that you are starting with a clean sheet of paper whereas we know it’s not always this easy. People often have legacy assets to contend with and many types of accounts, which can make the job more daunting.   But if you play the game of starting from scratch and only adding one investment at a time you will quickly see an outstanding portfolio start to form – and little room for improvement by adding funds.   We know that it will not be perfect - but it will be nearly perfect for you.

The Perfect Portfolio

In the early months of the COVID-19 Pandemic, I engaged in many of the same diversions as many of you such as binge watching Netflix shows and surfing YouTube.   One of my favorite discoveries was a series of interviews by the MIT Laboratory for Financial Engineering called In “Pursuit of the Perfect Portfolio.” The program’s interviewers were Andrew W. Lo and Stephan R. Foerster, who have also co-written a book by the same title.

These in-depth interviews were with some of the pioneers of finance who developed the academic work of modern portfolio theory in the 1950’s, 60’s and 70’s, which underpin the entire field of finance today. The series included Harry Markowitcz, Eugene Fama, William Sharpe, Robert Merton and Myron Scholes. These are the names I remember from my text books in graduate school and also in trade papers known for their seminal work in the emerging field of financial economics. In watching the series, I liked being able to put faces to the names and hear the stories of how they developed the models of how investments and portfolios behave. They discussed the origins of the Efficient Market Hypothesis and the Capital Asset Pricing Model and other concepts that make up Modern Portfolio Theory.

Some like Paul Samuelson and Fisher Black were no longer living to give firsthand accounts, but clearly it was a small community centered mostly on a few graduate business schools like the Chicago School of Business, MIT and Princeton. They all seemed to have known each other and could tell the stories of the early days of financial theory.

You might recognize the names of some of the other people interviewed: Jack Bogle, Jeremy Siegel, Charles Ellis and Robert Schiller. They were either colleagues or students during that time period and have gone on to publish many bestselling books that have brought important knowledge to the masses. Many of the interviewees have won the Nobel Prize for their work.   This was an enormous amount of brain power assembled for one series of videos.

Each interview ended with a question asking the featured person to describe The Perfect Portfolio. Each time I knew the answer before the question was asked. Nobody could offer The Perfect Portfolio because of course no such thing exists. The future is uncertain, so there is no way to know with foresight the outcome of future events.   I would contend that we can’t even know The Perfect Portfolio in hindsight because any assessment made at a single point in time could be rendered premature by subsequent events. Besides, what is good for one person is not necessarily appropriate for another.

If they can’t tell you what constitutes The Perfect Portfolio, I certainly can’t either. Based on the interviews of the great scholars, I can tell you that if there was such a thing as a perfect portfolio, what characteristics it would have.  

The Perfect Portfolio should not try to beat the market. Markets are not perfectly efficient, but they are efficient enough that it is highly unlikely that anyone can outperform the market after adjusting for risk and transaction costs. I don’t think any of these great minds would say otherwise.   They created models to describe the way security prices behave. They are by definition estimates, not actual results. There is always unexplained variation – especially when you are dealing with human behavior. In hindsight, the models are not always accurate. The world is too complex with far too many variables to quantify in a few formulas. That said, the efficient market hypothesis does say that security prices encapsulate all known information. Without a crystal ball, there is no reason to think that assets are mispriced.

For example, a common stock is always priced based on all known information.   Therefore, it represents the consensus view of its intrinsic value – encompassing the opinions of potentially millions of investors, many of whom are full time professional analysts.   There is no reason to think a stock is anything other than fairly valued at any point in time. The price will not change unless new information becomes available. New information is the future, which we cannot know.   The price already includes all of the positive things known about a company as well as all the risks. There is no objective reason to think that you can profit by finding undervalued stocks.    

Attempting to beat the market entails effort, costs and potentially taxes. It doesn’t make sense to expend these resources if the markets are efficient. So, The Perfect Portfolio will not even attempt to beat the market - it will simply own the market. The best way to own the market is with index funds and passive exchange traded funds (ETFs). In doing so, you get the market return with minimal drag from the friction of expenses and taxes. You also save the anxiety of trying to guess the future – or worse yet – hiring someone to guess the future for you.

A corollary is that The Perfect Portfolio keeps expenses as low as possible. If no person can be expected to beat the market, it doesn’t make sense to spend money trying to do so. Again, index funds and ETFs provide access to the markets with minimal cost, thereby giving you almost all of the return that is available from the market.   The Perfect Portfolio avoids giving a cut of the action unnecessarily to a middle man.

The Perfect Portfolio must be diversified. Diversification cannot eliminate market risk – which is the tendency for most stocks to go up and down together. However, diversification can eliminate single company risk. It would not make sense for the market to reward a single security risk, when it can be so easily eliminated through diversification. Sure, a person can get lucky and buy the right stock at the right time and look like a genius. In doing so at the time of purchase, they were taking on more risk than the asset was likely to return in benefits.   In retrospect, a single bet might have worked out well, but it does not represent a good strategy.

Once again, the better strategy is to use index funds to diversify away all single security risk and garner the market return with an acceptable level of market risk.  I would argue that diversification is an exception to the axiom in economics that there is no such thing as a “free lunch.” If you can get the same expected return with lower risk by using diversification, you are getting a free benefit.

The Perfect Portfolio should also be well balanced. This concept is similar to diversified, but not quite the same. Both relate to the concept of risk. Different asset classes carry different types of risk. For example, high beta stocks like technology and small cap stocks are considered to have greater volatility than defensive stocks like large consumer goods stocks or utilities.   International stocks are pretty similar to US stocks in the aggregate, but their returns will vary quite a bit in any given time period. Ideally, an investor will build a portfolio by starting with well-balanced and diversified broad-based market exposure, and then adjust the weight of the asset classes based on their own fondness for the characteristics of each group.   Judgements must be made by each investor in selecting types of assets to include in the portfolio and the amount of each. The Perfect Portfolio will embody good judgements by the individual based on their own personal circumstances and preferences.

Ultimately, The Perfect Portfolio must match the needs and risk preference of the investor. A portfolio that is right for a 25-year old investor just starting an investment program is probably not going to be suitable for a 65-year old near retirement.   This is obvious, but even two different 65-year olds can have greatly different investment objectives and risk profiles.   Some people want to draw more income, some prefer more growth. The ability to handle the inherent volatility is also quite personal. Some folks have more appetite for risk than others. To even approach being The Perfect Portfolio, each portfolio should be uniquely suited to the individual investor.

If you ask me to describe The Perfect Portfolio, my answer will be similar to those expressed by the pioneers of financial economics.   I can’t tell you The Perfect Portfolio, but I can tell you the things that it would include. It should be low-cost, diversified, and well-balanced and match the individual’s personal situation.   You aren’t likely to ever achieve The Perfect Portfolio, but if you learn these lessons you will certainly be much closer.

Finding a Fortune

Lately with more free time under the stay-at-home mandate, we have been able to engage in neglected tasks. While cleaning her home office, my wife Jan discovered an old Fortune Magazine from March 1996 buried amongst the clutter. I knew immediately that it would provide a treasure trove of interesting nuggets for an article. It’s fun to look back with nostalgia, but there are also lessons to be learned from the past.

The year of 1996 was a pivotal time in my life.   It was the year that I became a Certified Financial Planner and transitioned from the corporate world into my career in personal financial planning.   I had enjoyed my prior career, but the opportunity to help hundreds of individuals and families secure a better financial future has been far more satisfying.  

Also in 1996, my wife and I were about to have our first child as well. At the time, I could not have imagined that becoming a father would have such a profound effect on my life.   The last twenty-four years has been quite a journey for me – and I’m sure for you as well.    

The changes in society and lifestyles are easy to forget without this type of a reminder.   Windows 95 had just been released with great fanfare, but only 68% of US households had a computer. Just 23% of US households had dial-up services provided through names like America Online, CompuServe and Prodigy. Web-based services like Google and Facebook had not yet emerged (even Myspace was years away)!

It would be a few more years before I even purchased my first cell phone, although as an early adopter Jan had a plug-in car phone for a few years at that point.   The tech bubble was just starting to inflate, so the tech bust was still a few years away. The events of 9/11 were not yet part of our consciousness and there were two more stock market meltdowns ahead including our present Covid-19 pandemic.

Alan Greenspan, the former chairman of the Federal Reserve, was the cover story of this March 1996 Fortune magazine. The profile piece was resoundingly positive about his performance with four years still remaining in his term. From the start of his first term in 1987 to the present, there have been just four chairpersons of the Federal Reserve. That’s impressive stability for such a critical position in our financial system. It helps that the chairperson, while appointed by the president, is largely autonomous and non-partisan.

Ben Bernanke later succeeded Greenspan as the Fed Chair and was at the helm during the 2008 Financial Crisis. Especially in 2008 and more recently with the monetary actions during the pandemic, people frequently take potshots at the Fed and its chairperson and lambast its policies and practices. I’ve noticed over the years that criticism of the Federal Reserve Board and its chairperson is practically a cottage industry. I think it is fair to debate the long term implications of the Fed’s actions. When it buys trillions of dollars of assets, bails out certain companies and industries and injects a massive infusion of liquidity, there must be some scrutiny as oversight. That said, it’s difficult to prove or disprove the counter-factual. What would have happened in 2008 had there not been bailouts? What will be the implications of the massive stimulus this COVID 19 time?

Since I tend to look at things more simply, I may not be smart enough to make such a determination. It seems to me it worked out pretty well last time and quite frankly, I don’t see an alternative this time. Two of the primary roles of the Fed are to maintain order in the banking system and to promote full employment.   Instead of wading into the weeds, sometimes it’s better to just look at results.   Overall, I’ve been impressed with the quick and decisive moves that the Fed has made in times of crisis.

Inflation was a separate topic in the same Fortune issue. In an article “Fun and Games with Inflation”, the author notes that the movie E.T. – the Extraterrestrial was not really the top-grossing movie of all time as many believed, Gone with the Wind was instead, when adjusted for inflation.   The article rightly points out that inflation has adverse effects beyond just the obvious loss of purchasing power over time, citing tax bracket creep and a hidden tax on capital gains when taxes are based on inflated numbers rather than real (inflation adjusted) numbers. Fortunately, the ordinary tax brackets are indexed for inflation, but there are still plenty of provisions in the tax code that have not been updated, thereby benefiting the tax collector at the expense of the tax payer.  

The other primary role of the Federal Reserve is to control inflation.  While trending down between 1982 and 1996, we know in hindsight that inflation would remain low for the next 24 years.   In this regard, the Federal Reserve has been a huge success.

Even so, the threat of inflation is always with us. According to this 1996 article, the average cost of an automobile was $20,000. A quick web search today shows that the average today is about $34,000.   These numbers are not exactly apples-to-apples, but they suggest an average inflation rate of just over 2% per year, which is about what the government has reported for general inflation over that same time period.   This highlights that even with historically tame inflation, purchasing power erodes over time. Since 1996, the same dollars would buy about 40% fewer goods and services today. For example, if someone retired in 1996 with a $2,000 per month pension, it would be like retiring today with $1,200 per month.   This can be problematic on a fixed income, but potentially devastating to a retiree if inflation runs out of control like in the 1970’s when prices climbed 7% per year.   At that rate, the same $2,000 per month pension would shrink to the equivalent of $400 per month in buying power. To guard against this threat, I’m been a long-time advocate of growth investing so that people have a rising income during retirement.

Taxes are an evergreen topic for financial publications and were featured prominently in this 1996 Fortune magazine.   Tips for cutting taxes is always a favorite subject because people hate to pay taxes.   There were several articles offering tax advice to the reader, including “Four Sure Fire Tax Relievers”; “Be a Tax Savvy Investor”; and “How to Leave the Tax Man Nothing.” The Roth IRA had not even been born yet, but the article suggests funding a SEP if you have self-employment income, which still is a good idea.   Reminders to take a deduction if you live in a disaster zone or to give clothing to charity were worthwhile if not terribly impactful. For sure, I want to take advantage of any reasonable tax break that I can, but from my experience most of the ideas presented in financial publications don’t matter all that much. Sometimes they are too impractical for my taste. For example, today’s equivalent tax advice might be to “bunch” charitable deductions in alternate years to get around the new higher standard deduction.   While a legitimate way to potentially save a few dollars, such a strategy might not be worth the trouble.

Noteworthy to me was that the capital gains tax rate in 1996 was 28% compared to just 15% today and people with modest income receive a special zero tax rate. From 28% to zero, that’s quite a difference. Similarly, the estate tax exemption was only $600,000 back then, compared to $11.2 million today. Very few people pay estate taxes anymore. These changes make me think that a better way to enjoy lower taxes is through legislation, rather than tax cutting tips from the media.

From this issue from the past, I enjoyed reading about the Fidelity Magellan Fund again.   Like other prominent names of the past, such as General Electric, it has since been superseded by competitors that have executed better.   It was featured in a story that questioned whether it was time to bail out of the fund as the performance had faltered under Jeff Vinik for the previous 2 ½ years following the tenure of the legendary Peter Lynch.   Vinik’s performance was actually mixed. He started out great, but then faltered after making big tactical bets that didn’t pay off, such as moving stocks into cash and bonds during a rising market. He left soon after that and there have since been several managers of the fund. The person at the helm hasn’t made much difference, as the fund has trailed its category average and the benchmark S&P 500 index substantially for the last 3-year, 5-year, 10-year and 15-year periods.  

What’s notable to me is that the Magellan Fund was the flagship fund of Fidelity and the company has had the resources to draw from the best and brightest minds to find a manager. Yet it has returned an astounding almost 3% less per year than the index over the last 15 years. This fund, which was once lauded as a 5-star fund by Morningstar, sunk as low as 1-star status before rebounding to its present 3-star ranking. I’m not trying to pick on the Magellan Fund, as it’s not much different than many celebrated active funds of the past brought down to earth by the weight of management fees and judgment errors .   That said, this type of example should be a wake-up call for anyone who still believes in the virtues of active management.  If Fidelity has this much difficulty, what chance do other active strategies have?

In a separate article, featuring Warren Buffett, I noted that the stock price of his Berkshire Hathaway A shares (BRK-A) was $32,800 per share at the time. It recently traded at about $253,500 per share for an average gain over the last twenty-four years of almost 9%. Mr. Buffett is widely considered one of the best investors of all time, yet his performance over that time is only a little better than the S&P 500 index.  What it does highlight is that buying and holding good companies can produce great results over time. Although an active investor, Buffett’s style might have more in common with an S&P 500 index fund than with active fund managers like Mr. Vinik. His disciplined, low cost and tax efficient investing methodology never goes out of style and is a great way to build long-term wealth.

It can often be fun to look back in time, especially when there are fond memories. There are also many lessons to be learned from the past.   I’m glad that Jan found this old Fortune magazine. It was a nice reminder of some interesting times. Normally, I throw old magazines out after I’m finished reading them, but I might just hold on to this one.

Three Core Beliefs

Since the Covid-19 outbreak, many people have contacted me concerned about the decline in value of their investment accounts.   I sense that there has been more anxiety this time than during the previous bear markets, when stocks plunged even more. This is probably because the coronavirus has caused economic uncertainty in addition to a public health crisis, unlike anything we have seen before. This time it is different.    

We are in the midst of a recession that will be deeper than what we have seen since the 1930’s. Please note that I didn’t say worse than other recessions – I said deeper. I’m hopeful that it will not last long – at least the worst of it, but there is no question that a mandated shut down of the economy is unprecedented and will have some lingering effects.   Even though this time is different – that doesn’t mean that we should respond differently.

To be a successful investor, I think you need to hold some fundamental beliefs and then adhere to them to the best of your ability.   When it comes to investing, I have three core beliefs that inform my personal decisions and the advice I give to clients.

My first core belief is that I believe that our system of capitalism and free enterprise offers the opportunity for boundless prosperity.  

Especially in recent decades, globalization and technology developments have spurred productivity gains, and advanced our standard of living and lifted billions of people out of poverty worldwide.   If you look at a chart of the global economy over the last 150 years, you see relentless growth.   Some recessions aren’t even visible on the graph, and even the Great Depression is just a blip on the chart. Humankind has a tremendous capacity for ingenuity to solve problems and improve our way of life.   When hard work and creativity are rewarded, it provides the incentives for individuals to act in ways that benefit all of us.

Americans are especially adaptive and resilient. The amazing things that we’ve seen the last few weeks from our friends and neighbors is a great example of the innate creativity and spirit of people everywhere. The heroic efforts and unselfishness of the healthcare workers as well as the willingness of ordinary citizens and private companies to assist in any way possible during the pandemic demonstrate our ability to overcome any obstacles. This same spirit and work ethic has allowed us to recover from wars, terrorism, natural disasters, financial crises and other pandemics. 

The stock market simply mirrors the global economy. There is an almost perfect correlation between global GDP growth and stock prices over long periods of time.   While the private sector doesn’t comprise the entire GDP, it certainly is the driver for growth. Stock market levels are really just the consensus estimate of the present value of all future corporate profits into perpetuity – and a proxy for future GDP growth. If you believe that the global economy will be higher in ten, fifteen and twenty years, you have to also believe that the stock market will be much higher.   The inevitable conclusion is that if you have long term goals, you want at least some portion of your portfolio in the stock market. 

My second core belief is that the future is unknowable and investment decisions are made under extreme uncertainty.  

You should be skeptical of anyone who claims to have the ability to predict future events with any precision or certainty.  This includes bloggers, market timers, active money managers, speculators, and media commentators.   Nobody really knows any more than the rest of us about the future. We are all working from the same information, which is already reflected in security prices. For every buyer, there is a seller. With most trading done by institutions these days, generally there is a very smart person (or a computer) on both sides of every trade.   Ultimately, prices converge to a rational and fair value that will not change much until new information becomes available.   By definition, that’s the future - which is unknowable.  

Please don’t misunderstand me, I do not think the financial markets are perfectly efficient. People are not always sensible, so the market is not always rational. That said, the markets are very efficient at processing information, which makes them rational enough.   The stock market often turns out to be wrong in hindsight, but in the moment it is the best estimate we have and generally works fairly well. It is almost impossible for anyone to gain a clear advantage.

Some realizations flow logically from this core belief.  The obvious thing is why pay fees for any advice that is based on an ability to foresee the future or to “beat the market”?   Any type of human interaction that involves tactical maneuvers to gain market advantage is a complete waste of money.   There are tools like index funds to allow you to own the entire market cheaply and easily, so predictions are not necessary. It doesn’t make sense to spend money to beat the market when we know it can’t be done consistently.  

If experts can’t predict future events, nor outperform the market, you might also think twice about trying to do it yourself. As they say, hindsight is 20/20, but I don’t know anyone who truly predicted the 2000 and 2008 bear markets, or this year’s precipitous drop in stocks for that matter. It’s hard to resist the urge to react, especially in the face of falling investment values. However, by the time you realize it is happening, the damage has already been done and it’s too late.  

When you accept that the future is unknowable, it leads to another conclusion. If you don’t know what is going to happen, you should prepare for a multitude of possibilities.   This is where another core belief comes in.

For my third core belief, I believe that an individual must have a plan to address the myriad of investment decisions that must be made.

Like going on a trip without a defined route, you might get lucky and end up at your desired destination. Arriving at your desired destination in an expeditious manner is much more likely if you have a map.    Without something to guide you, many things can go wrong along the way. You need to protect yourself from getting sidetracked by an unforeseen event and also guard against self-inflicted wounds.   The best way is to start with a knowledge of the reasons that you are investing in the first place and make sure that your actions are consistent with those goals.

Diversification is an essential component of any portfolio. While diversification is necessary, it is not sufficient.   Proper balance is also essential to make sure that you employ the right types of investments and in proper proportions.   This is called asset allocation.   Each asset class has a unique risk and return profile, which means it has advantages and disadvantages under diverse economic conditions.   For example, regular US treasury bonds should perform well during deflationary times but get hurt when there is excessive inflation.   Treasury inflation protected bonds (TIPS) hedge against unexpected inflation, but they will underperform at other times.   Since you don’t know what lies ahead for inflation – and nobody really does - wouldn’t you want to own both?

Decisions must be made about what to include in a portfolio, and what to exclude. I don’t know how you would do this without a plan and setting your priorities.   There are tradeoffs to consider. Standard pie charts are not the answer. They are typically based on the investor’s age. Asset allocation should include an individual’s entire financial situation.  For instance, someone with a strong desire to leave an inheritance might invest as aggressively as a much younger person because in effect they are investing on behalf of a younger person.   In contrast, if your primary goal is to maintain your standard of living during your lifetime, you will probably allocate more conservatively.

Individuals also vary in the way they respond to volatility, so temperament and willingness to assume volatility should be considered.   An allocation isn’t appropriate if it won’t allow you to stick with the plan, or worse cause you to panic and sell out at the first sign of trouble.

During a turbulent and fearful time like the present, if someone asks me if they should make adjustments to their portfolio, I would first caution against making any sudden changes when the market is unusually volatile on a daily basis.   Sometimes it’s better to do nothing and let things settle a bit. Since it has been a few weeks since stocks hit the low point in late March, prices have recovered somewhat and there is a little more stability. I think it would be appropriate to make changes at this time if necessary to have a portfolio that fits your situation better.  

Further, a portfolio should be structured to allow you to weather all types of market conditions.   The Covid-19 pandemic presents a unique challenge, but it is not the last time we will have major turmoil in the economy and stock market. The catalyst for the next disruption is unknown, but history tells us it will happen again. History also suggests that when your goals are many years away, you should continue to invest in the stock market in order to enjoy the long-term benefits.  

Consistent with my core beliefs, I would make sure that the portfolio is not based on speculation about future events or rely on unsupported assumptions.  You can probably tell that I’m optimistic about the future, which I don’t view as speculation.   Over a reasonable time period, growth in the stock market is sure to follow the inevitable progress of the global economy.   I’m confident that innovations in artificial intelligence, automation, digital technology and biotechnology will lead to enormous gains in productivity in the years to come.

At the same time, I’m a realist.   I would not assume the worst is over or that we will see a quick return to the stock market high in February.   That could happen, but it’s not likely when the economy is struggling to return to normalcy.   While I think that we will manage through this public health crisis, the shock to the economic system will take time to fully recover.   I think we are talking years, rather than months. Stocks tend to recover faster than the economy as a whole, but even so these disruptions could linger for a while.

For the near term outlook, I think there might be more downside risk than upward potential.   Fortunately, investing by its nature is a long term proposition and we don’t have to rely on short-term forecasts.   That’s a good thing because mine are no better than anybody else’s.   For long term investors, I’m much more confident in my forecast.   Having core beliefs – and staying the course in times of trouble - can help you to weather any storm and take you safely to your destination.

Margin Call

Often the greatest impact from events occurs at the margin. My theory is that small incremental changes can cause disproportionate outcomes.   For example, just a few thousand people in a handful of states decided the 2016 Presidential election for a nation of 330 million people.

In economics there is equilibrium when supply equals demand. That said, when either supply or demand shifts – even just a little – there can be a huge change in prices.   When there is a reduction in OPEC oil or a disruption to refinery production after a hurricane in the Gulf, gas prices can escalate rapidly. We can cynically wonder why gas prices never seem to fall back as quickly as they rise, but there is no denying that gas prices are very sensitive to supply and demand forces.

Security prices operate under similar supply and demand dynamics, as markets of buyers and sellers bid against each other based on common information, which drives prices to converge to a consensus price.   With all information accounted for and baked into prices for stocks and bonds, the consensus or market value is not going to change much unless there is new information. Just a little new information can cause a major variation in price. For example, news about the Coronavirus impacted many stocks – some more than others – because of the implications for the broader economy. Of course for events like this, the psychological impression is often greater than the true economic threat.

Buying investments with borrowed money, such as real estate or stocks on margin, the leverage can magnify the potential swings in price.   For instance, if a stock bought on margin heads south even by a fairly small amount, the investor could suffer a margin call and potentially be wiped out.

Marginal analysis can be very helpful for tax planning.   Taxes are paid in layers or “brackets” whereby the tax rate increases based on a person’s income bracket.   The highest marginal tax rate does not mean that all income is taxed at the highest rate, rather, just the income in that particular bracket.   Income is taxed at different rates as income increases from one bracket to the next, which is known as “progressive taxation.”  While it might be interesting to know your average tax, it’s your top bracket – or marginal tax rate - that is more relevant for decision making.   What will be the incremental tax for an additional amount of income? The answer determines your marginal tax rate and this information can be used for a variety of decisions, such as should you save with pre-tax dollars like with a 401(k), or use an after-tax account like a Roth IRA?  

Many people don’t realize that the ordinary tax bracket also determines your tax rate for certain investment income. When you sell an asset for a gain or receive qualified dividends, there is a separate rate structure. If you are in the 22% or higher normal bracket, your tax rate for dividends and capital gains is 15%. That said, if the regular bracket is below 22%, your rate for dividends and capital gains is zero. That’s quite a difference! So keeping your income below the breakpoint between ordinary income brackets might permit you to sell appreciated assets and pay no tax whatsoever.  

Let’s say you are nearing retirement and have a stock with a large unrealized gain that you would like to sell.   While you are working, you might have to sell in the 22% ordinary bracket and therefore pay 15% tax on the gain.   Delaying the sale until the year after retirement when your tax bracket drops, could allow you to avoid all taxes from the sale (depending upon the amount sold). Of course you would have to weigh the tax savings against the risk of continuing to own the stock. Good marginal analysis could use the progressive nature of our tax system to your advantage.  

Let me give a final example of incremental analysis that few people ever think about.   When weighing a decision of how to manage your portfolio, what will be the true marginal impact of the decision? I find that most people who have accumulated significant assets will always have enough money for their personal needs whether or not they invest wisely. They will ultimately leave an estate to their heirs as a matter of course – whether it’s their intention or not.   The specific rate of return will not change that outcome – only the amount left behind will change based on how well they invested. In other words, as long as they have a good plan their lifestyle will not be affected one bit by the investment results. Because they’re not spending all the earnings anyway, their income will be sufficient under either a good plan or a great plan.   The incremental impact of their investment decision will not be felt by them during their lifetime - but it will be felt by their heirs.  

I’m not saying that you should invest for your heirs. Certainly, you should focus on your own needs first and foremost. But if personal needs are covered, shouldn’t we at least consider that an estate will probably be left and that management decisions could have a greater bearing on the amount left for beneficiaries?  

For example, a $1 million portfolio invested for 30 years at 6% might grow to almost $5.75 million, whereas if invested at 4% it would reach about $3.25 million. There aren’t too many recipients that wouldn’t be happy with such a windfall, but the difference is still $2.5 million or 43.5% less wealth!  

You might be surprised by how many investors surrender 2% of their portfolio return because they pay unnecessary investment advisory fees. Many people pay an advisor 1% of their assets under management (AUM) and another 1% in mutual fund operating expenses for a total of 2%. There are other fee structures used by advisors, but I find that active money management costs about 2% per year. In such a case, a 6% return could easily shrink to 4%, and underperform a comparable portfolio of index funds with negligible expenses by about 2% per year.

Before embarking on an investment program, you might want to use marginal analysis and ask yourself “What will be the true incremental impact of your decision?”      If there are people you care about, family or otherwise, you should be as efficient as possible with your investments. Poor investment could cost many thousands of dollars, and potentially millions. At the margin, you’re probably not the only party with a stake in your investment results. The marginal cost of a bad decision could be to give your hard-earned money to strangers instead of leaving it to your children, church, or favorite charities.

Simple Not Easy

I don’t think people always believe me when I tell them that investing is simple. It really is.  It’s just not easy.

The process of buying and maintaining investments doesn’t take much effort or knowledge.   There are great investment products available like index funds and ETFs.   Discount brokers like Vanguard, Fidelity, and Schwab do most of the implementation work for free.   Transaction costs have also been driven down to zero with Schwab’s recent announcement of no-fee trades, which has been echoed by its competitors.  Anyone can put together a portfolio of just a few funds and get results as good as or better than a professional. Just look at the performance history of managed mutual funds and money managers compared to passive index funds in any category over any timeframe.   Simple, low-cost investing consistently beats complex, active investing.

In fact, there are funds-of-funds that offer a diversified and well-balanced portfolio of index funds within just one fund managed for you at no additional charge.   This approach can essentially put your portfolio on auto-pilot.   One good choice can pretty much guarantee long-term investment success.  With this kind of simplicity readily obtainable, why do so many people find investing so difficult? 

I think one reason is that human beings are just not wired to deal with the emotional and psychological aspects of investing. We are prone to all kinds of mind traps that prevent us from dealing with things in a sensible manner.  Behavioral finance experts cite confirmation bias, mental accounting, cognitive dissonance, anchoring and overconfidence as just a few of the many documented behaviors that interfere with rational decision-making.  I can’t help but think this derives from our lizard brains, which see danger lurking everywhere.  How else can you explain the propensity for investors to buy high and sell low when all of the evidence suggests that the opposite would be so much better?  The fight or flight response within our DNA might have served us well when our neighbors were saber tooth tigers, but poses a serious impediment for investors today. 

The mainstream and financial media compound the problem by sensationalizing even the most routine events.   TV anchors breathlessly exclaim “The stock market was in free fall today …” and then later you learn that the Dow Jones stock average dropped only 1.5% for the day.  Really?  A 1.5% decline is a free fall?  Clearly, the media doesn’t view its job as educating the public. Garnering eyeballs and clicks takes precedence over delivering helpful information.

Don’t just look to the financial service industry to provide independent information and advice either. The industry is rife with conflicts of interest.    Sales of products like equity index annuities are the obvious example, but the problem is much more widespread.   Fiduciary advisors also thrive and prosper on misinformation and complexity.   They want you to think that investing is much too complicated for you to undertake on your own.   The message is that you are not smart enough to handle things on your own and should hire them to navigate the confounding maze of investing.  

Traditional education is not helping. K-12 education has never been big on teaching basic life skills.  Kids don’t take home economics or shop classes much anymore, and even fewer learn personal finance in school.   It seems even when investing is taught to kids it usually involves some sort of stock picking contest that teaches the wrong things about investing.  Is it any wonder that many people don’t know the difference between a stock and a bond?    Without basic knowledge, you can’t expect to know the finer points of diversification or asset allocation.

Even if you are able to navigate around these challenges, you must still deal with some practical investing obstacles. There is an overwhelming amount of information to wade through.     There are hundreds of investment companies, but only a few worth considering and thousands of products with only a few worth using.   An online search is unlikely to elicit anything remotely helpful. Most of what you see, hear and read about investing is “noise,” which should be discounted or ignored as either irrelevant or flat out wrong.

Adding to the confusion, people have different types of accounts to coordinate. Employees can have a 401(k), 403(b) or 457 plan with their employer, and some have more than one.  Then there are traditional IRAs, Roth IRAs, annuities and regular brokerage accounts.   Marriage sometimes doubles the number of accounts in a household.  How many people really understand what they own?  Many times, I’ve been well into a conversation with a client, before I realize that the account they have been calling their 401(k) is really an IRA – or vice versa! 

Differences in potential tax consequences muddle things even more. Consider that a traditional IRA is typically comprised of pre-tax dollars and the gains are tax deferred, but eventually taxable as ordinary income. Whereas a Roth IRA is after-tax dollars and the account grows totally tax free.   Non-qualified annuities and non-deductible IRAs are sort of a mixture, containing after-tax dollars but the gains are fully taxable when withdrawn.   While with a regular account the gains might qualify for lower capital gain tax rates.   How do you allocate the portfolio between accounts and later rebalance when each has a different tax treatment?  

You might think that someone with just one account would have an easier time, and they should. But even when the portfolio implementation would otherwise be simple, there are other decisions required.  The most important is how much of the portfolio should be in equity investments for growth, and how much to allocate to more stable income-based investments? That said, it doesn’t end there.   How much of your stock exposure should be in international stocks? How much in small cap stocks versus large companies?   What types of bonds and how much of each?   Most portfolios would have a mixture, which should include treasury bonds, inflation protected bonds and corporate bonds, but there might also be a place for international bonds, high-yield bonds, or municipal bonds.

It’s not like there is universal agreement about how a portfolio should be allocated. There can be major disagreement between advisors regarding the allocation between stocks and bonds.   Experts also disagree on the asset classes to include in a portfolio and/or how much weight to give each.  For example, high yield bonds provide a nice yield and are a good way to diversify the bond side of a portfolio, but some advisors say to take your risk on the equity side of the portfolio and stay clear of riskier bonds.    There is generally no right or wrong when it comes to asset allocation decisions.

Investing can be very simple. In fact, almost anyone can manage their own investments effectively if they want to. The question is do you want to, because investing is not easy and carries risk.  It is difficult enough that you might want to hire an advisor - not to delegate responsibility - but to assist with the process and provide an independent perspective.  A true fiduciary advisor can help establish an investment plan, assist with the asset allocation, rebalance as needed, and provide education and support.   At the very least, a good advisor can help make investing simple. Unfortunately, I don’t know anyone who can make it easy.

Buckets of Money

Buckets of rain

Buckets of tears

Got all them buckets comin' out of my ears

These lyrics from Bob Dylan’s classic Blood on the Tracks album come to mind when I hear people talk about the bucket system for portfolio management.  Although not a new concept, I’ve been seeing more articles lately about this technique whereby an investor keeps two to five-year’s worth of income in a liquid cash account (bucket) for spending. One or more other buckets would be used to hold stocks and bonds to earn a higher return albeit with some additional volatility. The idea is that an investor, especially one drawing income on a regular basis, will be more willing to place a portion of their portfolio in riskier investments knowing that they have a bucket of safe money to provide their spending needs for at least a few years even if the stock market drops as it did recently by about 20%.

For example, if you had a $1 million nest egg and wanted $40,000 per year to supplement your social security income. You might put $80,000 (two years) into a stable money market account and $320,000 (eight years) into a bond fund. The combined amount of the two conservative buckets would be $400,000 or 40% of the portfolio. This would leave $600,000 for stock market investment or 60% of the portfolio. You would take income from the first bucket for two years until it was nearly exhausted.   At that time, you would draw from one of the other buckets to replenish the spending bucket and start the process over again.   Another variation of this approach might be to keep five years of income in a stable account and the rest in a mixture of stocks and bonds.

This methodology makes perfect sense in theory. There is nothing inherently wrong with a bucket system.   However, there are practical obstacles to consider.   A bucket system produces a lower return on the amount that goes into the spending bucket. You wouldn’t want to keep too much in a regular bank account paying no interest. Further, when the spending bucket needs to be replenished, you would have to determine how to draw from the other buckets.   The other buckets would also change in value with the performance of the funds within them so some administration effort is required anyway.   Things get messier when you realize that there are many types of financial accounts. A married couple might have a joint taxable account, two Roth IRAs, two Traditional IRAs and other retirement accounts like 401(k)’s and variable annuities. A supposedly “simple” bucket system can eventually become not to so simple.

There can also still be some anxiety for investors prone to worrying about their money. For instance, let’s say in the earlier example that $20,000 per year is needed for income. The spending bucket would be just $40,000 and there would be $160,000 in bonds, for a total of $200,000 or just 20% in conservative investments.  Would you be comfortable with the remaining 80% in the stock market?   Your income needs would be met for at least the next 10 years, but how will you react if the much larger bucket of longer-term funds drop dramatically? I imagine that most people would find this scenario a bit unnerving, putting a great importance on getting the right overall initial investment mix.

A client recently asked my opinion of the bucket system.   I asked, “Which one?” because there are many.   I went on to say that it’s fine conceptually and I would support anyone’s attempt to use such an approach. Even so, there are limitations.   Although not terribly difficult to manage, I think the same result or better can be achieved in an easier manner. In fact, I advise clients to maintain two major buckets, but I don’t call it a bucket system.   The portfolio would be divided into two primary asset classes:   stocks for growth and bonds for income.  The funds would be chosen to generate the best total return for the given level of acceptable volatility overall. The growth side would be stock funds and the income portion would be comprised of bond funds. In both cases, I would use index funds to implement the plan to incur the lowest-cost possible in the most diversified manner.  

The split between the two primary assets classes would be based on particular needs and the individual investor’s desired risk profile. In this scenario, an income investor would draw from the bond funds as needed for spending.   Rebalancing every year or two to the target mix of stocks and bonds would automatically take care of replenishing the spending “bucket” and keeping the overall risk level of the portfolio in check.   The total return generated should be as good or better than the typical bucket system that I’ve seen promoted by many advisors.

This method sets an appropriate initial risk level and keeps it in check. Stocks should never have to be sold when they are down and there would be no idle cash.   I believe this promotes the best total rate of return possible for a desired level of risk.   The best part is that this option truly is simple!

Admittedly, even my simple approach can get more complicated when there are multiple accounts and taxes to consider, especially when there are IRAs with Required Minimum Distributions (RMDs).   That said, you may have these challenges anyway, so you might as well make the rest of your plan as easy as possible.  While my methodology could be characterized as a “bucket system” as well, I don’t call it that. In fact, I don’t really have any name for it.   It’s just a simple and effective, low-cost way for anyone to manage their portfolio.  

Having a catchy name offers more marketing panache for advisors wanting to showcase their expertise and gives financial writers and commentators something to write and/or talk about. Essentially, any bucket system is really just about managing behavior and addressing the psychological side of investing.   If having buckets of money helps an investor stick with a disciplined program, I’m all for it. So, the next time I hear a reference to a bucket system, I’ll lean back in my chair and play back Dylan’s words in my head:  

Buckets of rain

Buckets of tears

Got all them buckets comin' out of my ears

Loss Leader

Fidelity Investments has sent a jolt through the investment world with its release of four new mutual funds with zero expense ratios.   That’s right – they’re free!   The Fidelity Zero Total Market Index Fund (FZROX) has no operating expense ratio and no minimum investment requirement either.  This means that anyone with any amount of money can invest for free.    Three other zero-fee index funds are also available covering the U.S. and international stock markets.  

These new zero-fee funds from Fidelity take the pricing wars to a new level.  I’m actually more excited that Fidelity has also simultaneously cut expenses across its entire line-up of index funds, which were already extremely low-cost.   This is just the most recent volley in the index fund wars.  Vanguard started it by pioneering index funds and relentlessly driving down prices as the only significant player in the low-cost, passive marketplace for many years.   This forced other companies to follow suit.  Fidelity leapfrogged them a few years back by launching a number of index funds of their own with even lower expenses.   More recently, Charles Schwab made a lot of noise with a loud promotion of its own index funds, which undercut both Vanguard and Fidelity.  The proliferation of exchange traded funds (ETFs) has also helped to drive down prices.  

Savvy consumers have been able to take advantage of this price war between the big three discount brokerage firms.    In fact, I’m confident that these companies actually may not make any money on my clients and quite probably lose money servicing them.   In addition to incurring the costs to handle the mutual fund investments, they also provide various custodial duties including recordkeeping and tax reporting, for a paltry amount of money.   That said, please don’t feel bad for these companies.   Fidelity is a private company owned by the Johnson family of billionaires, and Charles Schwab shareholders have done quite nicely over the years, including Mr. Schwab himself.   Vanguard’s profits are given back to the investors through lower fees by virtue of its status as a mutual company rather than a traditional profit seeking enterprise.   If they are willing to offer index funds at a loss, I’m all for it.  They will make plenty of money on other products and services.

In fact, I recall the term “loss leader” from my graduate school days to describe how many companies sometimes offer products at a loss in order to bring in customers in order to sell them other products.   The idea is to promote tomato soup priced a few cents below cost and place the cans on the shelf next the pricier Classic Chunky Tomato Bisque!   This marketing battle with index funds is similar although much tastier in my view.   As long as you stick with the low-cost funds, and steer clear of the expensive offerings, it’s a great deal for consumers.   These products cut out the middleman and leave the investor with nearly the entire return provided by the investment.  Their loss is definitely our gain!

The free part is a bit of a marketing gimmick in my view, although I’m not complaining.  Fidelity had already been offering index funds nearly for free.  The previous expense ratio for the Fidelity Total Market Index Fund – Premium Class (FSTVX) was 0.06 of 1%.  This means that on an investment of $100,000, an investor previously paying $60 per year will now pay nothing for the equivalent Fidelity Zero Total Market Index Fund.  With the latest across the board cuts, the more established Fidelity Total Market Index Fund – Premium Class (FSTVX) is 0.015 of 1%, or just $15 per year for a $100,000 investment.    When you are slicing this thin, there’s really not much room for improvement.

Rather than using an established benchmark like the Dow Jones U.S. Total Stock Market Index in order save the license fee payable to the index owner, the new free version will use its own in-house index to replicate the return of the stock market.  Of course, it is also important to note that it will not have a track record.  Since they are passive investments that are not trying to beat the market, this should not be concern in that purchasing index funds from reputable companies doesn’t require the same level of due diligence as other funds.   They are transparent and essentially interchangeable, so low-cost usually wins.  Even so, the manner in which the index fund is constructed and maintained should be considered.  For the small difference in cost, any of the index funds offered by Fidelity, Vanguard and Schwab – and some ETFs – are excellent investments.  

At the same time, how can you not love the value proposition of free investing?  Consider for example a young person who wants to get started with investing – maybe in a Roth IRA.  With no minimum amount required, a young investor can effectively own thousands of publicly traded companies and enjoy all of the gains they produce over time and not incur any costs or taxes whatsoever!   I can’t think of a better way to grow wealth. 

This entire “Loss Leader” saga reminds me of the song lyric chanted by bystanders during the Limbo dance craze, “How low can you go?” and makes we wonder how low will they go?  Can fund expenses go any lower than zero?   I don’t know, but I can’t help but wonder if companies will soon start paying me to invest with them?

The Stupidest Thing You Can Do With Your Money

I recently encountered one of the best podcasts that I’ve ever heard on the subject of investing.   In a re-broadcast from Freakanomics Radio, Stephen J. Dubner takes a look at a phenomena that I’ve wondered about for a long time.    In The Stupidest Thing You Can Do With Your Money he essentially asks the question, “why are so many people willing to pay for subpar performance?”

The assertion of the episode is that active management remains the preferred choice for most investors despite chronic under-performance.  There are about 60 years of research and data to support the idea that after subtracting fees - active management is very unlikely to generate value to the investor.   This well-produced show tells a fascinating story through interviews with Jack Bogle (the founder of Vanguard), Kenneth French (renowned finance professor), and Eugene Fama (Nobel Prize winner).  

Some other industry insiders are also represented to give opposing views, but there really isn’t much debate among professionals and academics.  The facts are hard to argue against.  In fact, it’s difficult to find anyone in the investment community that even tries to refute the premise that the great majority of active investors under-perform when compared to low-cost passive strategies.   Even Warren Buffet, arguably the single greatest investor of all time, advocates for index funds.  I’ve addressed this topic many times over the years, most recently in A Sucker’s Bet, which highlights how a passive index fund has clobbered the best hedge fund managers in a head-to-head competition over the last ten years.   Why then, do people continue to turn over their hard earned money to investment managers? 

Awareness of index funds is certainly increasing.  Money has been pouring into Vanguard funds in recent years at an astonishing pace, making it the largest investment company in the world.   The podcast describes this as a revolution, which I suppose it is, but it’s a “quiet” revolution.   Target date retirement funds are often the default choice for 401(k) participants and some are comprised of index funds.    To their credit, some large employers, like Ford and GM, have arranged access to very low-cost investments within employee retirement plans for those knowledgeable enough to sift through an array of choices.   Institutional money has to a great extent taken advantage of the abundance of research and data available, and some smart retail investors have also found their way to index funds, but there is not yet general understanding of the superiority of index strategies over active management.    To gain broader acceptance, I think more education is needed.

The Freakinomics podcast attempts to explain the logic behind low-cost investing.  Investing is a zero sum game before costs – because for every trade there is a buyer and a seller.  Investing is a negative sum game after costs, because both the winners and losers pay the fees.   The efficient market hypothesis, which is generally advocated by Bogle, Fama, and French, and which is one of the underpinnings of index funds, doesn’t mean that markets are perfectly efficient.  It just means that markets reflect all known information.   So, it is difficult for anyone to gain an advantage.  When all is said and done, very few investors can overcome the drag of expenses to take advantage of any inefficiencies to earn a higher return than a low-cost, buy and hold strategy.   Fama has found that only 2% or 3% of all investors had enough skill to overcome their costs.   These are bad odds for an investor looking to professionals for help.

Of the few investors who might seem to beat the market, it’s mostly by chance.    How do you identify the few extraordinary managers in advance?   Using past performance to select the best mutual funds or money managers is a futile exercise because the top performers are unlikely to remain in the top tier going forward.     As explained by Bogle, the end result is that investors put up 100% of the capital, take 100% of the risk, and get a fraction of the return!

Bogle goes on to ask, why did it take so long for index funds to become popular?  I wonder, why are they not more popular?  Clearly, the Wall Street marketing machine is one major reason.  The active money management industry has considerable resources to fight this revolution and they are highly motivated, because index funds are truly their “worst nightmare”.  

Sadly, there is much more to overcome than just industry opposition.   Human beings can be very irrational creatures.  There are numerous mind traps that make investors their own worst enemy.   One must delve deeply into the emerging discipline of behavioral finance to understand why smart people do stupid things with their money.   I hope to explore this mystery in future articles.   For now, I will do my part to advance the revolution by inviting you to listen to this excellent podcast The Stupidest Thing You Can Do With Your Money.  

The Holy Grail

To many people, retirement is the Holy Grail of financial planning.  Clients almost always list retirement as their top financial planning objective.    This makes retirement planning central to what I do for a living, yet I don’t spend much time thinking about actual retirement.  I’ve been focused more on the process of helping people grow and protect their wealth in order to have more choices in the future.  Prior to writing this article, I didn’t give retirement much attention except as my role as a facilitator for others in their pursuit.    My assumption has been that people know what they want and my job is to help them get it.   While largely true, not everyone truly knows what they want or have even given retirement any deep thought.

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A Sucker's Bet

It’s not supposed to be over until it’s over - but since most of the results are already in – I guess it’s over.   Hedge fund manager, Ted Seides of Protégé Partners, has conceded defeat before the “official” end of his public wager with billionaire investor Warren Buffett.   

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Animal Spirits

The term Animal Spirits seems to have replaced The New Normal as the description of choice for economic commentators.     The new normal describes an indefinite state of slow economic growth, while animal spirits represents a more positive outlook that is underpinning the surge in stock prices since the November election.    While intriguing language, neither term helps much with understanding or navigating the financial markets.    Let me give you my perspective and a potential solution to the inherent uncertainty of the current financial climate.

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Understanding Tax Jargon

Tax time is sure to bring out certain things, such as confusion, anxiety, and shoe boxes of records and receipts to name a few.  It also invariably invokes financial articles, providing advise such as “last minute tax saving tips” that are either irrelevant to the average reader or not really helpful.    Susannah Snider, of US News & World Report, took a refreshing twist in her piece, Making Sense of 10 Confusing Tax Phrases, where she asked financial professionals to list tax jargon that they would like to see disappear.  

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True Believer

Are you a true believer? If you are not, it’s okay. Most people who invest in index funds do not fully understand them. You can still be a successful investor, but it would be even better if you were a true believer.

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New "Fiduciary Rule" for Retirement Accounts

Last week, the Department of Labor (DOL) issued a rule change that imposes higher standards on brokers and other commission-based investment advisors in an attempt to reduce conflicts of interest.   The DOL, which overseas retirement accounts such as 401(k) plans and IRAs, issued the new regulations after six years of debate.  These regulations impose fiduciary responsibility on anyone giving advice regarding retirement accounts and are supported by the CFP Board, the National Association of Personal Financial Advisors (NAPFA) and the Financial Planning Association (FPA).  The fiduciary standard says that advisors must put the interests of the client ahead of their own. 

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Two Social Security "Loophole" Options Closed

With the recent Bipartisan Budget Act of 2015, Congress has closed the door on two social security claiming strategies that it considered “loopholes.”    The File-and-Suspend strategy allowed a person to delay his or her own benefit in order to get a higher amount later while still allowing a spouse to claim spousal benefits based on the worker’s earnings record.  The Restricted Application technique allowed a person to collect a spousal benefit, while delaying their own benefit to get a higher amount later.    These procedures had been used either separately or together.   Following a brief transition phase, the File-and-Suspend and Restricted Application strategies will no longer be available.  

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The Build-A-Bear Experience

When my younger son Kevin was just a little guy (he’s sixteen and six-feet tall now), he absolutely loved stuffed animals.  More specifically, he loved stuffed dogs.  He had dozens of them, which we called his “buddies.”  On special occasions such as birthdays, the family would visit the Build-A-Bear Workshop store at the local mall to shop for a new buddy.   The Build-A-Bear store allows children to follow an assembly line and create their own personalized stuffed animals.  Kids select an animal, fill it with stuffing, and choose outfits, accessories, scents, and sounds.    At the end of the production line to complete the Build-A-Bear experience, the child gives the new friend a name and even creates a birth certificate!

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Much Ado About Nothing

The investment world has been all a twitter lately, both literally and figuratively. Since Bill Gross announced he was leaving Pacific Investment Management Fund Co. (PIMCO), the company he co-founded more than forty years ago, and moving to Janus Capital, investors have been uncertain what to do.   The investors and advisors have been wringing their hands and anguishing about whether or not to stay with the PIMCO Total Return Fund managed by Mr. Gross, or move money to other bond funds.

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Piano Guy

Have you seen the PBS program where Scott “The Piano Guy” Houston teaches adults who have always dreamed of playing the piano to learn to play using a simple, easy method?  Whenever the Learn Piano in Flash program airs (usually during pledge week), I stop what I’m doing and watch.

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Lucky Man

As June rolls around each year, the time comes again for the annual graduation speeches.  Though most will be quickly forgotten (and probably should be), some do provide valuable inspiration and insight.   Thanks to YouTube, I stumbled upon a speech that struck me as particularly meaningful. In a baccalaureate address given by author Michael Lewis (Liar’s Poker, Blind Side, Moneyball) to the Princeton graduating class of 2012, Lewis made a succinct statement about the role of luck in life’s successes.

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Beware of Fido

Our family dog, Brittney, is very affectionate and has a sweet disposition most of the time.  However, when provoked she can get aggressive.  As with all dogs, you have to be careful around her when she might be protective of her food, yard or one of the family members.  As a comparison, I hope my clients will exercise similar caution when dealing with Fidelity Investments.

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The Right Stuff

When it comes to investing in commodities, I don’t recommend them to my clients for one simple reason: I don’t understand them well enough.

The first rule of investing is to never invest in something you don’t understand. Don’t get me wrong, I know what commodities are and I’ve done enough research to form an opinion. I just don’t understand enough to know specifically what to expect from commodities in the future or to have any confidence that the asset class will provide an adequate return on investment.

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The Best of Times/The Worst of Times

It was the best of times; it was the worst of times. This is what author Charles Dickens said of eighteenth century London and Paris around the time of the French Revolution. These same words could also be used to describe the current environment for investors in America.

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The Tyranny of Compounding Costs

Bringing awareness to excessive and unnecessary costs and fees has often been a subject of my writings, as it affects many portfolios and so few investors are aware of the “true costs” they are incurring.  On April 23, 2013 PBS Frontline aired a hard-hitting expose´ called The Retirement Gamble.  I don’t know if it will be broadcast again, but you can click here to see a replay from the PBS website.

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401(k) Awareness

E*Trade, known for its talking baby TV commercials, aired a different TV commercial recently stating that a typical family could pay $155,000 in hidden fees in their 401(k) over their lifetime.  The ad prompted viewers to Google “401k 155k” to learn more, so I did.  I found an article discussing the basis for the claim.

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March Madness

The NCAA basketball tournament (otherwise known as March Madness) tipped-off last week beginning three weeks of basketball frenzy that some have compared to a national holiday.  It’s certainly one of the best sporting events of the year, but it’s more than that.  Some studies have shown that when March Madness arrives, there is a huge productivity loss across America as many workers get caught up in the excitement.

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Making Smart Social Security Decisions

Lately, one of the hottest topics in financial planning concerns maximizing one’s social security benefits.   In fact, it’s hard to find an industry publication without an article on the subject.  Even the mainstream financial magazines, such as Money Magazine and Kiplinger’s Personal Finance, have made social security claiming strategies one of their favorite subjects.

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Benchmarking Performance

“How are your investments doing?” If you don’t know the answer to that question, don’t feel so bad. Most investors don’t know the answer either.

That said, it’s a logical question and one that should have an easy answer. After all, there is an abundance of financial companies touting numerous products and services as well as scores of investment advisors representing individual investors. The technology also exists to provide results with great speed and accuracy. Therefore, what makes it so difficult to know how well your investments are performing?

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The Top 1%

How would you like to be in the top 1%? You might be surprised how easy it can be to attain this elite 1% status.

No, I’m not talking about people with the highest income or net worth – those individuals who currently are the target of the Occupy Wall Street movement. If you’re not already there, I can’t get you into that group. However, I can tell you how to become one of the top 1% of the most effective investors.

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Free Lunch

The common phrase “there's no such thing as a free lunch” was made famous by the Nobel-Prize winning economist Dr. Milton Friedman. In economic terms, it means that everything must be paid for by someone in some way.

Have you ever been invited to a lunch or dinner at a nice restaurant by a local investment advisor? If you think the meal is really free, think again. There will be a cost, which could range anywhere from relatively small to extremely expensive.

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Gold Rush

Over the last few years, the price of gold has soared. Spurred by advertisements on television, people have been predictably rushing to buy. It has also been a topic of interest for many of my clients. While I had planned to write this article for some time, I have procrastinated until now, because it seemed like such a daunting task.

For one thing, it’s hard to define. Is gold an investment? Is it money? It’s even more difficult to place a value on gold. Will prices continue to escalate? Is it too late to buy? Are we in the midst of a price bubble?

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Downdraft and Downgrade

It was quite a week. We had just breathed a collective sign of relief after the debt ceiling compromise was reached, when the Dow Jones Industrial Average tumbled 512 points in one day based on fears surrounding the global economy. This was followed by the announcement late on Friday that Standard and Poor’s had downgraded the U.S. credit rating. While these are both unsettling events to say the least, neither should have been a surprise.

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High Anxiety

In today’s volatile market, I find it interesting that lately clients are showing higher anxiety about their bond holdings than about the stock market. They hear that interest rates “have to rise” and bond values “will get hammered” as a result. The logical inference from these ominous warnings is to avoid bonds, but there are some problems with such thinking.

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Speaking Plainly

Although it will go largely unnoticed by most consumers, there has been a major change within the investment industry.

All registered investment advisors must now provide a “Plain English” disclosure document to all clients and prospects outlining their business practices as well as any potential conflicts of interest. Some disclosure was required previously, but in a much less readable and less comprehensive way. Despite the mandate for advisors to write in “plain English,” the government regulators have titled the new document Form ADV Part 2 Brochure. Although the name lacks panache, it is a positive step for consumers and serves a useful purpose.

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Take It to the Limit

Like the 1970’s Eagles song “Take It to the Limit,” our political leaders are about to take it to the limit one more time.

The national debt sits just a hairsbreadth from the statutory ceiling of $14.3 trillion. Unless Congress votes to raise the debt limit again, as it has done a number of times, the government could default on its obligations within the next couple of months. If that happens, the full faith and credit of the United States of America will never mean the same again.

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Phone a Friend

Do you remember the prime-time hit game show hosted by Regis Philbin called Who Wants to be a Millionaire? If game contestants got in trouble answering a question, they had several lifelines to use. One lifeline was to “phone a friend” for the answer.

Every so often, I learn that a client has deviated in a significant way from the game plan that we had formulated together. They forgot their “phone a friend” option. For example, a client might hire a high-priced investment management service, even though there are much better options available. Since I have an open line policy that encourages clients to call before making any major financial decision, I do not fully understand a client’s reasoning for under-utilizing one of their financial information lifelines.

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How to "GRASP" the Investment Process

When new clients come to me for help in their implementation of an investment plan, I go through five major steps. Whether you intend to design and manage your own portfolio - or hire me as your personal consultant, it would help you to know the key steps for building a successful investment plan. The acronym G•R•A•S•P is a good way to remember the process:

  • G - Goal identification
  • R - Risk assessment
  • A - Asset allocation
  • S - Select investments
  • P - Performance monitoring

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How to Invest Like a Pro

In September 2010, I was quoted in the on-line edition of Financial Advisor Magazine in an article titled Pension-Style Investing Limits Individuals. Despite the title, I believe just the opposite is true. I think many individuals would do well to emulate pension plans.

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A Simpler Life

Especially around the time of the New Year’s holiday, thoughts come to mind of finding ways to simplify our lives. For this very reason, my new-client questionnaire has a section on lifestyle goals with a list of thought-starters. The purpose is to initiate discussion and to help clients prioritize what is most important to them. One of the most commonly expressed desires is to simplify one’s financial life.

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Shopping for Funds

Last Saturday, I was forty-five minutes early for an appointment, so I decided to wait in my car and listen to the radio. I listened to The Mutual Fund Show. This program is hosted by Adam Bold, the founder of The Mutual Fund Store. Although I’ve listened to the show before, I was especially struck by the amount of self-serving and disingenuous comments made in such a short period of time.

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The New Normal

According to Bill Gross, co-chief investment officer of the PIMCO money management firm, the U.S. economy is going to be sluggish for the next few years and investment returns muted. Therefore, investors should get used to it. Mr. Gross is one of the most highly respected investment managers on the planet. He is credited with coining the term “The New Normal” to describe an economic environment quite different than we have experienced during our lifetimes. The new normal will be characterized by a slower growth in economic activity, more government intervention and lingering high unemployment.

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Fix Our Mix

I recently participated in a “money makeover” project for Money Magazine. In the August 2010 issue’s Fix Our Mix feature, I advised a couple from Southfield, Mich. in their early 40’s on how to integrate their separate financial lives to better communicate in order to achieve their common goals. Since the subjects, Michelle and Scott, also needed to be more aggressive savers and less aggressive investors, I prescribed a 15% savings rate target for retirement and a significant reallocation of the investments.

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The Power of 'Best of' Lists

In the June 2010 issue of Hour Magazine, I was named one of the top wealth managers in the Detroit area. You might think that I would feel honored by the recognition, but I find it a little troubling that these types of lists carry so much weight with consumers. It’s natural to want to work with the “best of” any profession. Even so, I believe if you are serious about hiring someone to help with your financial life, you should do more than select from a simple list.

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As the Stomach Turns

Like an episode of the well-watched daytime soap operas, the stock market has been full of drama lately. On May 6th between 2:00 and 3:00 p.m. EST, the Dow Jones stock market average plunged nearly 1,000 points. If you didn’t watch the evening news that day, you might not have even known about it. You won’t see it reflected on your month-end financial statements, because by now the loss has already been largely recovered.

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Advice for the New Grad

Shortly after writing Taking Aim at Target Funds, I was contacted by Jane Hodges, who was writing a story for the Wall Street Journal. Jane was looking for funds that a new investor should consider for a fledgling portfolio. Naturally, I suggested target-date index funds. How can you beat an investment that is low-cost, extremely diversified, and easy to purchase and maintain?

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Before accepting recommendations from anyone concerning your financial future, there is one thing you should always remember - everyone has an agenda.

Their agenda could support your objectives, or it could also be hazardous to your financial health. To protect yourself, you need to keep your eyes wide open.

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Taking Aim at Target Funds

In today’s market, it seems that target-date funds and other lifecycle funds have a bull’s eye on them. Many financial commentators have taken aim at these investments claiming that they have failed investors. I think it’s the critics who have missed the mark.

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Motley Fool Endorses Garrett Planning Network

I’m writing to let you know about an exciting new development in my business. The Motley Fool has exclusively endorsed and is promoting the services of financial advisors affiliated with the Garrett Planning Network, the international organization of fee-only financial advisors with which I am proud to be associated.

The Motley Fool has long admired Garrett’s approach to fee-only financial advice. And we are fans of The Fool’s approach to everything they do to educate, empower and amuse the public and their members about investing. Garrett, The Motley Fool and I share a commitment to make trustworthy financial advice accessible to everyone.

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Helpful Tip: Moving Funds to a Roth IRA

Recently, I wrote about the opportunities and potential pitfalls of employing a Roth IRA conversion strategy. In a previous article for those who otherwise would not qualify due to income limitations, I also presented a back-door way to get money into a Roth IRA. Although these techniques require careful thought and analysis, I can also present a much simpler way to take advantage of Roth IRAs that is often overlooked.

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Roth Conversion Confusion

If you’ve read the financial press lately, you’ve seen many articles trumpeting the benefits of converting traditional IRAs to Roth IRAs. The Roth conversion is the latest ‘hot idea’ in financial planning, because of a new provision in the tax laws to take effect January 1, 2010. This revision repeals the income limit and permits the tax bill to be spread over the two years following the conversion year. This change is undoubtedly a great opportunity for some people, but does it make sense for you?

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Garrett Planning Network

This past September, my three-year term as a member of the Garrett Planning Network Member Advisory Board ended. It was a privilege to serve on the inaugural panel of advisors, whose role is to provide a sounding board for Sheryl Garrett as she steers the organization toward her vision to make competent, objective advice accessible to all people. I’m please to have played a small role in helping shape the direction of the organization.

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Buffet's "All In" Bet

I must confess that I do something, which I tell my clients not to do. I watch CNBC.

I can’t help myself. I like watching CNBC, even though I don’t care about the daily machinations of the stock market or what’s happening with individual stocks. You can go crazy from the cacophony of financial information and endless commentary from talking heads throughout each business day. I watch more to follow the major events and trends that shape the financial markets. Every so often, something noteworthy happens.

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The media loves milestones. Last month, there was a proliferation of “One Year Later” articles to mark the anniversary of the Wall Street meltdown. I almost wrote one myself.

Last week, CNBC ran a special called “Dow 10,000” to commemorate the stock average breaking the milestone. It was a feel-good story, but not nearly as exciting as their first “Dow 10,000” special 10-1/2 years ago when the stock market hit the landmark level the first time. They didn’t have a special when the market plunged below 10,000 on its decent to 6500, nor did I hear how the mark had been crisscrossed many times during this decade.

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One Week is Not Enough

I hope you are enjoying Financial Planning Week! If not, perhaps you haven’t heard the news.

The week of October 5-11, 2009 is officially Financial Planning Week. Each year around this time the Financial Planning Association (FPA) designates a week to help individuals discover the value of financial planning and make smart decisions to achieve life goals and dreams. I’m not really sure how official this is, but some states have issued proclamations to support the designation. I haven’t always given the FPA my full backing for this effort, so this year I’m determined to do my part.

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The Economic Stimulus Hits Home

I just realized that I qualify for a special 2009 sales-tax deduction for purchasing a new car. In fact, my household will get two deductions because my wife also purchased a new vehicle this year. It’s about time that some of the stimulus dollars stimulated my pocketbook.

I’d heard about this, of course, but I figured it would not apply to me. These types of tax give-a-ways never seem to come my way, usually due to income restrictions. But sure enough, I checked the IRS website www.IRS.gov/recovery and it says the following:

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A Blogger's First Blog

I never thought that I’d be a blogger - but here I am – blogging my first blog.

It seemed a little pretentious to think I’d have enough to say to warrant a blog. Of course, that hasn’t stopped many others from putting pen to paper - or should I say - keyboard to html? Political commentators, sports writers and financial columnists who have a hard time writing one good article now treat us to daily doses of their wisdom.

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