We’ve all heard the saying “ask and you shall receive,” but what if you’re asking the wrong questions? This week, John unveils the most important questions to set you up for long-term financial success. (24:25) Plus, learn how to avoid getting burned on investment income taxes (12:25) and hear the single most crucial money skill you should have to secure your financial future. (44:43)
Episode Notes
Presented by Creative Planning, each week Host and Managing Director John Hagensen cuts through the headlines and loud takes to challenge the advice you may have been given and reaffirm what you know to be true. Plus, don’t miss his weekly interviews with Creative Planning specialists as they cover investing, taxes, estate planning and many other areas that impact your financial life!
John Hagensen: Welcome to the Rethink Your Money podcast, presented by Creative Planning. I’m John Hagensen, and ahead on today’s show, why pessimism is so seductive, the right and wrong questions to be asking about your personal finances, as well as one of the most common mistakes I consistently see in retirement. Now, join me as I help you rethink your money.
You’re familiar with the term misery loves company, and it’s true. Negativity is contagious, unfortunately. And if we’re not careful, it can pull us in and it can consume a lot of our thoughts and really the framework with which we’re viewing the world and in particular, our financial situation. This week, I had one of those days. You know what I’m talking about? Where you just feel angry, frustrated. It’s like, man, why are the kids being so loud? I don’t know. Because you’ve got seven kids, with the youngest being one. That’s what they do. They’re children. Everything was annoying me. Oh, man. Now, I forgot my shoes? I got to go back upstairs? Terrible day.
My wife, Brittany, at one point looked at me and she’s like, “What is going on with you? Why are you in such a bad mood?” “I don’t know. I just feel nasty, angry.” And her being the awesome wife that she is, said, “Why don’t you go take a jog or something? You need to get out of the house.” “Yep, you’re right.” I felt better, and that usually is a great solution. If you’re feeling gross, don’t scroll on social media another hour. Get out in the fresh air. It’s summertime. Take three big inhales through your nose. Hold it, exhale. Think of a few things you have to be grateful for. Whatever it takes. That works for me most of the time. But this negativity bias just rears its ugly head, and has forever, and probably will continue forever, when it comes to personal finances.
Investors, we have this love-hate relationship with bad news. We hate unpleasant news about the economy and the financial markets, but we love to read about it. We love to click on it and sometimes, we can’t look away. There are a few key reasons to this. The first is that our brains are wired to treat threats as more urgent than opportunities. The whole rustle in the weeds. Maybe it’s a saber tooth tiger. Focus on the threat. Yeah, that’s what’s kept human beings out of extinction. That’s just inherently in us.
Also, negative events have a much more lasting impact on our memories than positive ones. If you try to think of a couple of the most traumatic, terrible things that have happened to you, I know I shouldn’t be conjuring up these memories, but you remember them well. What everything looked like around you, the smell, the temperature, it’s vividly seared into your mind. Also, bad news grabs front page headlines because they’re often sudden noteworthy events. Most good news is gradual. It’s not noteworthy.
I remember one of my colleagues, a wealth manager here at Creative Planning, Dr. Dan Pallesen, who’s been on the show several times as a guest. His wife is in PR. Well, there was this global Pay It Forward Day. Basically, it was this ripple effect of kindness. Really amazing thing. She was reaching out to the media, this was a couple of years back, and they were like, “That is so cool, but we’re not actually going to put it on the news because the ratings will be terrible. And no one’s interested.” They, instead, probably talked about a local liquor store getting robbed, or a car accident, or something awful, but actually going to get eyeballs.
Lastly, and maybe the most important, pessimism tends to push investors toward taking action. For all I cared about was having as many people that listen to this program become clients at Creative Planning, and that was the sole objective. I would do what most life insurance salespeople have done for the last 60 years. Talk about how awful things are, the upcoming recession, the bear market, the crash, how it’s going to ruin your financial life. Metaphorically throw you into a hole and then say, “Hey, fortunately for you though, I’ve got the rope here. I can save you.”
The reason is that we take action when we are scared. When we are feeling a threat that could have a major impact on us, we get moving. Whereby contrast, if we intuitively know that something will be better for us, but there is really no urgency or threat to us in the moment, those are all the great aspects of life that we procrastinate on because we’re not really all that concerned about it. But while what you’re seeing on social media, the news, radio, podcasts, are disproportionately negative relative to reality, let this be an encouragement to you; the stock market, our country, the economy, it is resilient, and it’s survived all sorts of challenges.
If you’ve been feeling down, maybe pessimistic about accomplishing your financial goals, why not give your wealth a second look? Speak with one of our 300 certified financial planners just like myself. Here at Creative Planning, we will review your existing financial plan and offer suggestions for how it might be improved. We’ve been helping families for 40 years as independent fiduciaries. Visit creativeplanning.com/radio now to speak with a local financial advisor.
How has the economy really stayed so resilient? After 14 months of historic rate hikes by the Fed, we had inflation at over 9%. Let’s face it, it was pretty easy to be negative. Well, as I just alluded to, you should expect the economy to be resilient. Why? Because it’s shown that looking at well over a century of stock market data. At one point, a little over a year ago, there were some economists forecasting a 100% chance of a recession. Not sure how you can say 100%, but that was what they were claiming, and that negativity leads headlines. You get on your iPhone, you look at the stock app and in red you see so-and-so economists forecasting 100% chance of a recession. You throw your hands in the air, you go, “Oh, this is going to be terrible.” Yet, the government’s expected to report that the economy just grew by about 1.8%.
Here in the second quarter, last month, employers added 209,000 jobs, and average wages grew 4.4% annually, which was higher than inflation. Wages are outpacing inflation. That’s a great thing. That’s buried in the headlines. And you’re going to have to search for that one though because it’s positive. Financial conditions have been very favorable. The S&P 500 went up 16% in the first half of the year. The NASDAQ was up over 30%, marking one of its best first halves to a year. I’ve had a lot of clients ask me why? How have we avoided, at least up to this point, an inevitable recession? The answer specific to this situation is employment.
Most expected that these rate hikes would massively impact corporate earnings and as a result, many companies would lay off employees, many small businesses would go under. But we haven’t seen that. Right now, unemployment is at about 3.5%, which basically means that most people who want a job can find one. If you’re not that happy in your current job, you’re switching jobs to a competitor or a different industry that’s paying you more money. These are the lowest levels in the last 50 years. This is newsworthy.
Compare both inflation and unemployment to other periods of history. Yes, inflation was at 9.1% when it peaked. Now, it’s down to 3% when looking at the trailing 12 months. While that’s still above the 2% long-term target that the Fed has, it’s actually slightly below the long-term average of about three-and-a-quarter percent for inflation. Think of it this way. Inflation was high and it probably persisted too long for those who were saying it was going to be transient to declare a victory lap. But this is in the 1970s where we saw inflation average seven-and-a-quarter percent for an entire decade.
Yes, unemployment increased during the pandemic, but it wasn’t sitting there at 25% like it was during the Great Depression in 1933. As long as unemployment remains low, a deep significant recession is unlikely. And it’s logical if you think about it. Consumer spending is still the economy’s main engine. And despite higher borrowing costs and prices, you generally don’t see a significant drop-off in spending if everyone’s employed. If you’ve been asking yourself over these last few years since the global pandemic shut everything down early in 2020, what should I be doing with my money? Am I still going to be able to retire? Should my investment strategies change? In the midst of all of this uncertainty, I want to encourage you, a lot of the headlines are overdramatizing this uncertain economy and market. You know why? Because the only certainty if you are going to be a long-term investor is that there is going to be uncertainty at all times.
If it’s not inflation or a looming recession, it’s a war in Ukraine. It’s a terrorist attack. It’s a financial crisis. It’s a pandemic. It’s a slowing economy. It’s doing so well that oh no, now is this a bubble? It’s political unrest. If you are waiting for someone to shoot flares in the air and tell you the coast is clear, you’re waiting to feel real comfortable before you invest, you will sit on the sidelines forever. You have got to get comfortable with uncertainty. You need to get comfortable playing the odds as an investor, giving yourself the highest likelihood of success given the information that exists. And here is that information.
Bonds have slightly outpaced inflation over the last 100 years. Especially, if you’re shorter duration and in higher credit quality bonds, meaning you’re lending for short periods of time to financially-stable corporations, or the federal government or municipalities, you’ve suffered very few big losses. How about stocks? When you look at stocks, unlike bonds where you’re lending money, you’re an owner. You should expect the best opportunity to grow your wealth over time through ownership, whether it be your business, real estate. Maybe it’s owning companies through the stock market. Speaking of the stock market, that strategy over the last 100 years has earned a little more than 6% per year above inflation.
You don’t get that for free. The cost of that return premium is higher short-term uncertainty. But for most, accomplishing all of your financial goals is going to require you to outpace inflation and grow your wealth. But here’s what that means. The average correction is 14% and happens nearly once per year. Historically, expect a bear market, which is a drop of more than 20%, they average about 30% down, about every five years. That’s the challenge with stocks. Up to this point, it’s always gone up into the right over long periods of time, has never suffered a down market over a 20-year period.
But there are all sorts of speed bumps along the way, which is why you implement bonds for more stability. While you expect their returns to be much lower, they allow you to bridge bad times in the stock market. So you never have to worry when you hear on the news that there might be a recession, or corporate earnings are down, or unemployment’s rising. If you are a buyer of stocks because you’re not yet retired, you should smile and say, “I’m going to be accumulating ownership while everything’s on sale.” If you’re near or in retirement, taking withdrawals from your portfolio, you should be able to shrug it off knowing that you don’t need to sell any of those stocks which are long-term investments for seven to 10 years, or more, per your plan.
By the way, make tax trades along the way and rebalance to buy more shares while they’re on sale. The one thing you can continue to count on while the market marches higher is that you will see countless headlines every single day, telling you why a correction or a bear market or a crash is just around the corner. If you feel a lack of clarity around your financial plan, around your investment strategy, your tax strategy, your estate planning strategies, we’re a law firm with over 70 attorneys, A tax practice with over 100 CPAs, and a wealth management firm with 300 certified financial planners just like myself. We manage or advise on a combined $210 billion for families in all 50 states in over 75 countries around the world, because we believe your money works harder when it works together. To request a complimentary visit with a local financial advisor, visit creativeplanning.com/radio. Want to give your wealth a second look.
Well, remember during the pandemic when seemingly every stock you bought went straight up? We were all cooped up inside with stimulus money. Well, during that time, over eight million people opened new brokerage accounts during the year of 2020. Many new investors, who were enticed by those big stock market gains, unfortunately, are now facing unexpected tax bills. If you’re ready to have your mind completely blown, there was one shocking case that involved a Robinhood trader who made a $45,000 net trading profit. Did pretty well. Made 45 grand in a year, but is now facing, get this, an $800,000 tax bill due to disregarding what’s called the wash sale rule.
The wash sale rule disallows you to claim losses when selling and purchasing the same security within 30 days. You sell something at a loss, you can’t rebuy that for a month if you’d like to book those losses. While this is an extreme example in a very unique time, during the pandemic, it illustrates the point that how our investments are taxed can be confusing. That’s why I’ve asked my special guest, Creative Planning Senior Tax Director, Certified Public Accountant Ben Hake, to join me today here on Rethink Your Money. Thanks so much for coming back on the show, Ben.
Ben Hake: Thank you for having me, John. It’s been a little while.
John: It has. Yeah, it’s great to talk with you. Great to see you again. Today, I want to discuss with you the types of investment income, how those are taxed from the simple to the complex. Maybe you can give us a few examples of each to start.
Ben: With Creative Planning, we’ve got clients who are invested. And we’ll start simple. The most obvious thing is interest income. You got a bank account, maybe you got a US savings bond somebody gave you before you graduated high school. And that interest, as you receive it, is taxable to you. The bank gives you $10 of interest, you’ve got income of $10 on that. The next one is going to be dividends. Again, this is you’ve bought shares of a company. Let’s think AT&T, Coca-Cola, something like that. You’re a fractional owner in there, so every quarter they say, “Hey, you earned your six cents for this share,” and they pay it out every single quarter. That’s pretty common for what we’ll see in the brokerage accounts.
But you could also decide, I” want to sell my shares of Coca-Cola and buy something different.” At that point, maybe you bought it for $10 and now it’s worth 60. That spread would be a realized capital gain when you sell it. And then the final item, and maybe we’ll get into this a little deeper at the end, would be partnership. Maybe you’ve got a piece of real estate that you and some other individuals have purchased, or maybe you’ve started a business with, again, you and somebody else, and now you’re going to start paying taxes on the profits of that because it’s separate from what the entity’s going to pay.
John: If you see this on the tax side, and I see this as a wealth manager on the financial planning side, sometimes this surprises clients. On the interest and dividend side, a bank pays interest, but they leave it in the account. Or they’re reinvesting a dividend, and so they get taxed on it at the end of the year. “Wait, I didn’t take this money. I didn’t spend it. I didn’t do anything with this. Why am I being taxed on it?”
The other one on the capital gains side, but sometimes there’s a merger or a company sells and capital gains get distributed. Or it’s inside of a mutual fund and the manager decides to sell something, but they didn’t sell anything with the overall mutual fund. And now, they’re surprised that they got hit with capital gains. I’m assuming you see that from time to time, too, when you’re doing people’s taxes and they’re going, “Why do I owe so much, Ben?”
Ben: 100%. I always joke, you start your life, most people get a paycheck. And you’re like, “I got the money in my bank account, I spent it on stuff.” That all makes intuitive sense. But especially with dividends, and if you get a pretty decent-sized brokerage account, you made 10, 20, $30,000, you never see it. It gets received, you buy more shares and it just carries on its mery way. Well, that’s $30,000 that didn’t have one cent paid to the IRS of the states you live in.
All of a sudden, we get to the end of the year and you owe $6,000. You’re like, “Well, that’s not in my bank account.” You’re like, “Well, it’s in the brokerage account. You received it. You own more things than you did at the beginning of the year.” But there’s a little bit of a surprise because again, it’s just different than the income you’ve earned up until that point in your life.
John: This speaks to the coordinated approach so that there aren’t surprises. Because often, it’s not so much what they owe or that anything was done incorrectly, it’s that they weren’t expecting it.
Ben: Exactly. I think expectations, especially from our side, we’re always trying to get with our clients near the end of the year, just to put it all together. It’s a little bit like a physical. Sometimes the right answer is you’re doing great and there’s nothing to change, but it’s nice to know you’re healthy. Or in this case, it’s nice to know what you’re going to owe come April. And then not to be worried, not to wake up mid-March and be like, “What is going on,” and not have any idea.
John: Well and speak a little bit to the types of tax forms that they’ll receive, like interest dividends, capital gains, partnerships, and that K-1, obviously, you spoke of.
Ben: All these forms generally have 1099 in the name. From your bank, or again, maybe with what US treasuries are doing, we’re getting a lot more people who are getting US savings bonds and things of that nature, but you get a 1099-INT, which is reporting your interest income. For that, one other consideration is that the IRS taxes that at your ordinary rate. If you normally make $100,000, that next dollar gets taxed at whatever your ordinary rate is.
The next thing that we see pretty commonly is going to be a 1099-DIV or a 1099 consolidated. This is from your brokerage. TD, Schwab, Fidelity, they all just summarize everything and say, “Here’s your 10-page form. It’s got everything you need.” Shows the dividends you had if there were realized gains, losses, maybe you earned a little interest there. That all happens there. For the dividends, most clients are interested in having qualified dividends because they pay a little bit lower tax rate.
You make 100 grand, maybe you owe the IRS 22% on that income. But if you earn dividends, instead of paying 22, you only pay 15. Or maybe even lower than that, depending on your makeup. There’s definitely some tax advantages there. And then the final item, and this is especially the first year you get it, would be a K-1. This is your share of the partnership interest or activity that reported, and that can end up causing your return to get a lot more complex, a lot more quickly.
John: The timing of when you receive these forms at tax time vary, and especially when speaking of the K-1. Before you get involved in a partnership, just know you’ll be filing extensions for a long time. We have clients going, “Where’s my K-1?”
Ben: Yeah.
John: “Well, it’s February. You’re not going to get a K-1 for a while.”
Ben: Yeah. Those K-1s, they’ve got until September. We’ve got some clients, they’re in October filing every year. There’s definitely, again, a little bit of a psychological impact where you’re used to filing in March. To be able to have that and be pushed out, sometimes that feeling isn’t worth the investment in that partnership.
John: I’m speaking with Creative Planning Senior Tax Director Ben Hake. How about the taxation of investment income?
Ben: That’s always something we’re looking at, and a really common one, especially recently, is in bonds. Clients are like, “Should we get municipal bonds where you don’t pay income tax on those to the IRS, or should we get corporate bonds or bond ETF funds where we’ll pay tax on that?” A lot of that’s relevant to where you’re located. If you’re a really high-income earner in California, you may be paying 50 cents on the dollar from those corporate bonds versus if you get a muni bond, maybe you’re paying 10%. Or if it’s a California bond, zero. A lot of the times, when you’re looking at just bonds, there could be a huge difference there.
John: One of the things that just drives me crazy, I’m going to go into my soapbox here for a moment, is our clients that say, “Well, I want a municipal bond. I like having tax-free interest.” You’re in a 12% tax bracket. The taxable equivalent yield on a similar bond after you pay 12% taxes is way higher, right?
Ben: Yep.
John: You really want to understand where your tax bracket is, to your point. And is it also within the state that you live, so you’re also getting state tax-exempt as well? Make sure you’re in a high bracket, generally speaking, for a municipal to make sense. Even though it does feel good to be receiving interest that doesn’t show up on your tax return, you may be better off paying tax if you’re in a lower bracket.
Ben: Which is hard for a lot of clients to hear from their CPA, that paying taxes is okay. Not what I’m advocating for.
John: Yeah. “You CPAs, I know. It’s always, how can we pay the least amount right now?” If there’s a trickle-down effect that makes it so the person’s lifetime tax bill, and by the way, I’m not blaming CPAs, I think this is just in general, it feels good to show up and say, “Oh, I don’t owe a lot in taxes this year.” But you may be compounding a problem that’s unintended, where you end up paying more over your lifetime than you would have if you had been willing to eat a little bit more in the short term.
Ben: Exactly.
John: By the way, that’s not you, Ben. That’s CPAs. Big, giant-lettered, capital CPAs.
Ben: Capital. All capital.
John: Not you.
Ben: Even though I think CPA is always capital.
John: Yeah. Yeah. Yeah, exactly. Yeah, we’ll go with it. We’ll go with it. How about preferred rate?
Ben: Preferred rate, and that’s qualified dividends, so again, that Coca-Cola dividend, that example that I had. And those rates, so the ordinary income rates can go all the way up to 37% versus the top rate on those preferred rates is only 20. That could be pretty significant if you’re applying that to $100,000. There’s a pretty big swing there.
John: Sure.
Ben: The reason it comes up most of the time is those long-term capital gains. You sell shares of Coca-Cola or AT&T that you received a long time ago, being able to have that reduced rate can be really beneficial. That’s also a reason why a lot of times we’re wanting to hold shares. Maybe if you’ve owned it for just shy of a year, that value in waiting even just another couple of days to get long-term can make a huge swing in the amount of tax due.
John: We’re here in the summer when people like to forget about their taxes, even though this is when it probably would be good to pick up the phone and call you and say, “How can we strategize?” What tax considerations do you think people could be thinking about, considering, here in the summer?
Ben: One really big one is especially for our early retirees. Maybe you’ve retired, but you haven’t started drawing Social Security or your RMDs haven’t started. There could be a window there where you can have pretty significant sums, almost $100,000 dollars for a married couple. If the bulk of that is at preferred-rate income, either long-term capital gains or qualified dividends, instead of the IRS saying, “Hey, that’s 15 or 20%,” that rate can actually be zero.
There could be a scenario in early retirement years, maybe there’s some value in keeping your income or living off that brokerage account versus drawing from the IRA. Because you’re able to pay 0% for a number of years. Now, to your point earlier, we’re looking at lifetime taxes, not on year-by-year. That’s something that should be part of a holistic approach, to see if that makes sense over the long term.
John: That’s a really good point because for some people, that might be the right approach. And for their neighbor, the approach might be to accelerate income early in retirement before they kick on Social Security and large Roth conversions and these other types of things. That’s why it’s so difficult to just say, “This is the right approach if you’re 62,” because no two people are alike.
Ben: Exactly. It depends on the mix of your assets. And then it isn’t necessarily investment-related, but another thing we’re looking at is for people that are charitably inclined is those donations of appreciated security. Instead of realizing that long-term capital gain and giving your church or local charitable organization cash, you can donate that directly to them. You avoid the gain. The charity doesn’t pay any tax on that. That’s, again-
John: Missed all the time. Missed all the time, right?
Ben: Exactly.
John: Because cash just feels like the logical thing to give.
Ben: Exactly.
John: But it may be the least tax efficient.
Ben: Exactly.
John: Well, Ben, do you have any other final tips here as we wrap up?
Ben: A lot of these income sources don’t have any taxes withheld, either the IRS or maybe your resident state. Another item to talk with your CPA about this summer may be, “Let’s look at all the things we have coming in. And do we need to make some estimated payments?” With the interest rate environment going up, the IRS and states are charging a higher interest rate for waiting to make those estimates, which, for a lot of clients, was a little bit of a surprise this last year after so many years of low rates. Another great item to look at. Save yourself a little bit of money and again, that peace of mind that you’re caught up in the IRS’s good graces.
John: Before you’d underpay or make no estimates, some clients felt like it was almost a better bet. “Oh, the interest rate the IRS is charging me is so low. If I can make some money in the meantime, I may still end up ahead.” Now, it’s a little tougher to overcome that. What are they charging? 5%, 6%, 7% right now?
Ben: Something like that. Yeah. Two years ago, it was two-and-a-half. That doesn’t seem like a huge spread, but when you’re assuming you can beat that consistently, a little less likely.
John: Well, and in some cases, it’s a large sum of money that’s required for the estimates, which is why people didn’t want to pay it in advance and they wanted to keep it in their pocket. Now, that’s pretty punitive, so I’ve heard from a lot of clients that that’s certainly different and caught them off guard a little bit. Those are great tips, Ben. Thank you so much for joining me again here on Rethink Your Money.
Ben: Thank you.
John: That was Creative Planning Senior Tax Director and Certified Public Accountant Ben Hake. If you have questions surrounding the taxation of your investments, maybe your financial advisor hasn’t reviewed your tax return in the last year, what might you be missing? Visit creativeplanning.com/radio now to speak with one of our local advisors. Why not give your wealth a second look?
Well, I have one child in particular, love them to death, not going to name them, who asks a lot of questions. You have a kid or grandkid like this? Maybe? It’s great because I know that curiosity is going to get them somewhere in life. They’re thinking. They’re getting smarter. They’re learning. But wow, sometimes as a parent, it is exhausting. “What about this?” You answer it. “Why?” You answer it. “I don’t understand. Why that? What about this?” At some point, you just go, “Ah, well, let’s talk about it later.” Great questions.
But in general, asking questions is great, and asking questions when it comes to your money should help you make progress. But with one caveat. You got to ask the right questions. We ask a lot of the wrong questions and so regardless of the quality of the answer, it just may not be that helpful. A common wrong question is, which investment will grow my wealth the quickest? There are so many examples of this. During the pandemic, you had Zoom and Peloton and Teladoc and GameStop, during the meme stock craze, having meteoric rises. And crypto was similar in that way.
A lot of wealth created very quickly, but that volatility, remember, works both up and down. And so get rich quick and get poor quick are two sides of the same coin. At a more broad level, think about ARK Investments, one of the highest-performing, most publicized funds in the world. If you look at the performance since inception, still up about 11% per year. Very respectable. Basically, tied with the S&P 500. But here’s what’s crazy. The average ARK investor, so not the fund itself, but real people that have gotten into the fund, have a dollar-weighted return of negative 21%.
If you look year to date, it’s up 60%. Yet, it’s still in a 67% drawdown. In February of 2021, it was outperforming the S&P 500 by 600%. As I just mentioned now, it’s about tied with the S&P since inception. But so often, when we’re looking to get rich fast, we get in at the wrong times; after much of the run-up has already occurred and we’re sort of there. And if we’re not careful, we end up being the proverbial last one standing without a chair.
Another bad question to ask, where do you think the markets are headed from here? Think about this. How many economists have been predicting a recession for the last 24 months? How about the Fed, who has difficulty forecasting the implications of their own monetary policy with 400 PhD economists? Exhibit A for why this is a bad question is early 2020, at the start of the pandemic. Imagine asking the question, where do you think the market’s going from here? Any rational person would’ve said, “Way down. Let’s go to cash. Let’s short the market.”
Well, temporarily, you would’ve been right. The bear market was the fastest we’ve ever seen in history. It was a 30% drawdown, basically, before you could blink an eye. But it only lasted two months and snapped back and rebounded 70%, coming right out of it on the back half of the year. You can’t figure out which way the market’s going, and any advisor or money manager you’re asking, they don’t know either. The reason is because the markets aren’t just unknown, they’re unknowable. It doesn’t matter how smart you are, they are unpredictable.
The most brilliant person on planet Earth did not know in the summer of 2019 that a pandemic would occur in 2020. Here’s the crazy part. Even if you had a crystal ball and someone did happen to know and tip you off in advance, you wouldn’t have expected the stock market to end that year up nearly 20%. We don’t know the future and even if we did, the way billions of people on the planet will react and in turn, move the stock market, is impossible to forecast. Of course, there are 1,000 other terrible questions that we’ve all asked at one point in time, but let’s move to the positive side.
What are the right questions I want you asking? First is, how do I invest to get the best long-term, sustainable returns? I like to use the word durable. The key to you finding financial success over the rest of your life is achieving the best returns that you can obtain over a lifetime. It’s the opposite of, how do I grow my wealth the quickest? It’s, how do I grow my wealth the most consistently and methodically, allowing it to compound over the longest period of time? Which leads me to another great question, which is, how do I ensure my portfolio is protected against big losses?
You put everything in annuities and insurance and cash? No. Of course, you do not do that. I know it’s tempting. Sometimes those salespeople are really good. But no, you broadly diversify, so you have no big bets in any single spot. You solve your short-term needs with low-volatility investments, like bonds. You have a defined approach for driving income, if you need income from the portfolio. You have an adequate emergency fund. You keep yourself out of debt. That’s how you avoid big losses. Here’s your third most important question to ask, and I really want you to do this. This isn’t rhetorical. I want you thinking through right now.
Do I have a written, documented, detailed financial plan? This doesn’t mean you need a financial planner. This doesn’t mean you need to work with us here at Creative Planning. But you need a defined financial plan, one that accounts for your taxes and your estate planning and your retirement projections, so that you have a game plan with which to work off of as you move through life. The majority of Americans, even those with good-sized portfolios, do not have what I would consider a real, legitimate financial plan.
If there’s only one question that you need to answer, it’s that one. Because so many of the other great questions that you’ll be asking when it comes to your personal finances are answered through that plan. If you don’t have that, like our clients do here at Creative Planning, and you want one, we can show you how. Lean on our experience. We’ve been helping over 60,000 families and have been in business since 1983. Schedule a complimentary meeting at creativeplanning.com/radio.
Well, a piece of common wisdom that I’d like us to rethink is that as you get older, it makes sense to put other family members on your accounts. I see this all the time, and it’s a big mistake. Elderly couples will name kids on their accounts. Retirees will add their children as owners to their residence. “Well, that way, if something happens to me, they’ve already got ownership. It’s so much easier.” Another example would be when you add a child to your bank accounts, very common one as well.
The problem is, your joint account holder can write checks or make withdrawals without any limitation. Your child, in that case, will inherit the account upon your death, which, I don’t know, might be different than you intended. Any account that you hold jointly passes outside of probate and the proceeds go directly to the other joint account holder. Which means, if you have other children, you may be disinheriting them from that account unintentionally. But here are some of the other big challenges. Creditors of either owner can use the account to satisfy debts.
Child has money problems, that account can be drained or taken by a creditor for unpaid debts. Another problem is that an ex son or daughter-in-law may get access to some of those account assets. If your child is involved in a divorce, that bank account may be listed as a marital asset for splitting. While adding a joint owner to your account’s fairly easy, removing them can be a nightmare. You’ll have to get them to agree and sign to remove themselves as a joint account holder.
A joint bank account potentially could also prevent someone from obtaining Medicaid or Mass Health benefits because the money would be factored into their eligibility. This can extend to your grandchildren if your adult child is the joint owner. I know it’s confusing. And they have a child who would be your grandchild in that case going off to college. Well, now, they may not qualify for financial aid because their parents have a lot more assets as owners of those accounts. Lastly, from a tax standpoint, it may not be as favorable.
If you have a non-qualified investment account and you bought Apple stock in 1983 and it went from $100,000 to $50 million, well, first of all, you’d be really happy. But you’d also have a lot of unrealized capital gains. You’d want the cost basis of those capital gains stepped up at the time of your death. Meaning, your children would inherit them with a cost basis of whatever the value was at your date of death. By making them an owner, depending upon how it’s registered, tenants in common, joint tenants with rights of survivorship, you could be negatively impacting the after-tax outcome for your family members.
What should you do? Name them as beneficiaries, align it with your estate plan. Have your trust potentially as a beneficiary and that trust will designate where things are going. You can do a POD or a TOD, payable on death, transfer on death. But do not jointly own assets with family members as a succession play, as it can lead to all sorts of problems. I also want to rethink the notion that disability insurance is not for everyone.
Disability insurance is a nonnegotiable. It’s much higher likely if you are under 65 years old that you will file a disability insurance claim over a family member filing a life insurance claim. You’re in a car accident. You break both arms. You can’t type. You can’t work. What are you going to turn to? Disability is built into many companies’ payrolls. Sometimes it’s adequate, sometimes it’s not nearly enough. But review your company benefits to ensure that you have coverage that would protect you and your family in the event that you could not work.
A couple of key components to review in your coverage, which we can do for you here at Creative Planning if you’re not sure where to turn, is whether or not the policy will pay if you can only not perform your specific job, or any job. For example, if you’re a surgeon and you know longer can perform surgery, certain policies would pay. Other policies might say, “Well, you can still do billing at the hospital, or be a greeter at the hospital. You just can’t perform surgeries anymore.” That is a very important distinction within disability policies.
Another one is, how long will it pay for? Is it all the way until death or 65? Or is it just three years or five years? But the statistics show us that far more people have life insurance than disability, yet are far more likely to need disability insurance than life insurance. One of the things a good financial planner will provide for you in the planning process is a review of all risk management. Because if you invest properly and you reduce taxes, and you have a great estate plan, and then you’re underinsured in the event that something unexpected happens, it can blow up the entire plan. It can negate every other great aspect that you had planned for. No one wants to be over-insured. No one likes buying insurance. I get it.
But I encourage you, make sure you don’t have any large gaps that put your plan at risk. If you’d like to review your plan to ensure you’re not missing something, I recommend seeing an independent fiduciary that’s not looking to sell you something. If you’re not sure where to turn, or you’d like to visit with us here at Creative Planning, do what thousands of others have already done, by scheduling your meeting at creativeplanning.com/radio. Why not give your wealth a second look?
It’s time for listener questions and for that, I’ll throw it over to one of my producers, Lauren. Hey, Lauren. What do we have today?
Lauren: Our first question today is from Jane in Casa Grande, Arizona. She writes, “I’ve started researching trust options and have come across the terms revocable trust and irrevocable trust. Can you please explain the difference between these two types of trusts? Is there one you recommend more than the other?”
John: Great question, Jane. I had this discussion with two clients just this past week. Let’s start with the basics of a revocable trust. From a control perspective, you, the grantor, retain full control over the trust assets during your lifetime. This means you can make changes, you can modify the trust terms. You can even revoke, as in the name, the trust altogether if you wish. Think of a revocable trust like this. You don’t personally own the assets anymore, the trust does, but that trust is 100% within your control. From a flexibility standpoint, you can add or remove assets from the trust. You can change beneficiaries or appoint new trustees whenever you see fit. From a tax standpoint, since you remain in control, the trust income is usually taxed as part of your personal income tax return.
What would be the advantages in that case to a revocable trust since it sounds a lot like just owning the assets jointly, or individually, without the need of a trust? Well, it helps avoid probate. It keeps your information private. It can avoid unnecessary delays and hassle for your family members if something were to happen to you. And beyond death, a trust can be extremely helpful to designate your wishes in the event you don’t die but are incapacitated.
Now, I think often, when people hear the word trust, they think of an irrevocable trust. From a control perspective, in an irrevocable trust, it’s completely different. You, as the grantor, relinquish all control over the assets. You transfer them into the trust and they are no longer yours. Once established, the terms of that trust generally cannot be changed, they cannot be revoked without the consent of all beneficiaries. A positive to an irrevocable trust is that it provides asset protection.
When you place assets into an irrevocable trust, they’re typically shielded from creditors and estate taxes, since they’re no longer considered part of your estate any longer. From a tax standpoint, an irrevocable trust is treated as a separate legal entity. It files its own tax return, has its own tax ID number, and depending upon the trust structure, may even have its own tax rates and deductions. There are the differences, Jane. You had asked which one I recommend more often? And I’d say maybe only one out of every 20 clients who do estate planning with one of our 70 attorneys here at Creative Planning need an irrevocable trust.
Generally, those who need an irrevocable trust have very high-net worths and are looking to use some of the estate tax exemption, which right now, due to the Trump tax reform, is over 12 million per person. It can be a way to avoid that 40% estate tax or death tax, as you’ll hear it referred to, or you use an irrevocable trust for very specific circumstances that frankly don’t apply to a high percentage of the population. The next time you hear me or a friend say, “Maybe you should look into a trust,” they’re probably not referencing an irrevocable trust. But Jane, if you have more questions about that, we have offices in Scottsdale, Phoenix, and Gilbert, and we’ll be happy to sit down and discuss this further with you in terms of how it pertains to your situation. You can request that visit by going to creativeplanning.com/radio. All right, Lauren, who’s next?
Lauren: Our next question is from Wayne and he writes, “I recently heard you answer a listener’s question on an emergency fund and it got me thinking about my own. How much would you say we should have in an emergency fund? Also, how do I strike the right balance between having enough money in my emergency fund to be protected, but also keep as much of my money in the market as possible to maximize returns?”
John: It’s a great question because I think so often we think of this emergency fund as, I don’t know, a dead asset, just a waste. Because it’s not invested in the market with the rest of your securities, but it serves an incredibly important purpose within a comprehensive financial plan. Three to six months of expenses is the canned financial planning 101 answer for an emergency fund. Tilt it more toward three months if you have two income streams, or closer to six months if you are living on one income stream. You may also tilt that slightly based upon your specific situation and knowledge of how stable those incomes are and how varied your expenses are.
Wayne, I wouldn’t look at the emergency fund in a vacuum because it will feel like you are simply losing to inflation. And you may dwell on that opportunity cost for not having the money invested in a location that is growing more. Remember, the primary purpose of that emergency fund is to allow your stocks time to grow, so that you’re never forced to sell them when you don’t want to. When you’re in a pinch personally, maybe the broad economy’s not doing very well. Maybe the stock market is down in value, which would be one of the worst times to liquidate long-term investments. What really is the return premium or value of your emergency fund if it allows you the ability to not interrupt compounding unnecessarily, as Charlie Munger so eloquently put it? But keep in mind, your emergency fund does not need to sit in cash at your bank, earning zero, while the bank lends it out and makes a bunch of money, while paying you nothing.
Money markets, short-term bonds, government treasuries, they’re paying 3%, 4%, 5%, 6%. And in many cases, you have access to link them to your bank account and move them back into that checking or savings account within a couple of days. Wayne, if your emergency fund needs to be 50 or $75,000 and you don’t like the idea of that losing to inflation, well, you’ve got better short-term options than we’ve seen at any point in the last 20 years. And your entire emergency fund does not need to be sitting in cash at the bank. Thank you for that question. A reminder, if you have a question, submit those to radio@creativeplanning.com and I’m happy to answer them on the air, or I’ll reach out directly to you for my answer. All right, Lauren, what’s the last question?
Lauren: Finally, James, in Milwaukee, Wisconsin writes, “Given the market conditions, is a diversified portfolio still my best option, or would it be better to focus on sectors with less risk?” Thanks, John.
John: I think it’s important to make a distinction between the word risk and volatility. We use those often synonymously in investing, but they’re very different. Volatility is the variance of your returns. It means that your investments will go up and down in value, sometimes violently. But of course, a diversified portfolio, while it’s been volatile, it’s moved up into the right at about 10% per year the last 100 years. By contrast, risk is Enron, America Online in 2001, or Washington Mutual during the Great Financial Crisis. Risk is losing your money, not having a temporary downturn in the value of your account.
The reason that I point that out is because even a sector or a durable dividend-paying stock that’s paid its dividend 40 straight years, sure it may have less volatility than a diversified portfolio if it happens to be a sector with a very low standard deviation. But that doesn’t mean you’ve lowered your risk. In most cases, even a more stable single sector or investment will be riskier than a diversified portfolio. See, the reason you diversify, making no big bets in any one spot, you own large stocks, you own small stocks, growth, value, emerging markets, developed international companies across all sorts of sectors, diversifying bond durations, credit quality, who you’re lending to, is because you’re trying to minimize risk.
In most cases, depending upon how you are building that asset allocation, it may also lower your volatility, certainly if you’re adding bonds. I am not a proponent of concentrating in a single sector or in a handful of securities. Because while it may potentially lower short-term movement, it will almost certainly increase your risk of a persistent and sustained and potentially permanent loss of principle. Thank you for those questions. James, if you’d like to speak with us, we have an office there in Milwaukee. We can review your financial plan, as well as your investment allocation, to ensure that it’s consistent with your time horizons, as well as your risk tolerance. You can visit creativeplanning.com/radio now to speak with a local advisor.
Well, as we wrap up today’s show, I want to end with what I believe might be your most important financial skill. I know that’s a big statement. There are a lot of things required to be a great investor, but your ability to never fear missing out, it might be the most important. Put another way, you being immune to others’ financial success is certainly more important than an ability to find the right investments or try to time the market. Now, it mostly comes down to you avoiding FOMO. Which is really just recklessness masked as ambition so often, isn’t it? I’m guilty of this. I compare myself to others. I have the fear of missing out.
Dwight Eisenhower used to quote Napoleon, saying, “A military genius is the man who can do the average thing when everyone else around him is losing their mind.” You don’t need to be brilliant to get ahead, you just need to be average when everyone else is going crazy. This goes back to the question that I posed at the beginning of the show. How do I ensure I never have big losses? Part of that is avoiding FOMO. If there’s no comparison to other humans, you’re going to be a whole lot happier with your current situation, and more content, which will provide assistance in you not falling victim to greed; taking bigger risks than are appropriate for your situation.
Charlie Munger said, “Somebody will always be getting richer than you, and that’s not a tragedy.” If you remove FOMO from the equation, you know what’s left? You only care about your own goals. You tend to think long term and you avoid getting sucked into bubbles. My favorite financial writer, Morgan Housel, had an entire chapter in his book, The Psychology of Money, on the idea of a wealth spectrum. It pertains directly to this idea of FOMO. I’m going to use the example he has in the book, where there’s a rookie baseball player.
Imagine this. You finally make the big leagues. You’re playing for the Angels. You walk into the locker room and who’s right next to you? Mike Trout, arguably the best player of this generation. Now, you’re making a million dollars a year as a rookie. By all measurements, you are crushing it. You’re wealthy. You’re in your 20s, making seven figures a year. But you look to your left and you go, “Wow, he’s making 50 million a year.” His contract’s for close to half a billion dollars over the next decade. “Man, 50 times as much as me? I don’t feel very wealthy.”
But then, what if Mike Trout compared himself to the average hedge fund manager making over $100 million a year? Man, they’re doubling him up. And they don’t have to travel all around the country playing 162 baseball games in a year. Mike Trout may be thinking to himself, “Man, I’m not doing that well.” But then, what if that average hedge fund manager compared themselves to the top 5% of all hedge fund managers? Some of them made well over $500 million in a year. Now, that regular hedge fund manager doesn’t feel like they’re doing quite so well. And then lastly, what if the top hedge fund managers compared themselves to Warren Buffett, who, during the pandemic, saw his net worth increase by $20 billion?
You see, the point in this, in what we can learn as normal people by these comparisons is that no amount of money will inherently stop you from that comparison trap. No amount of money will make you immune to FOMO because there’ll always be someone you can find who has more. The key to financial success and your long-term contentment with your money is to focus on the game that you are playing, the goals that you have, the objectives that bring you joy, the financial achievements that will enhance your relationships with friends and family and provide financial security, and allow you to live the life that you desire.
Fortunately, that has nothing to do with others. Because after all, we are the wealthiest society in the history of planet Earth. Let’s make our money matter.
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Disclaimer: The preceding program is furnished by Creative Planning, an SEC-registered investment advisory firm that manages or advises on a combined $210 billion in assets as of December 31st, 2022. John Hagensen works for Creative Planning, and all opinions expressed by John or his guests are solely their own and do not represent the opinion of Creative Planning or this station.
This commentary is provided for general information purposes only, should not be construed as investment, tax or legal advice, and does not constitute an attorney-client relationship. Past performance of any market results is no assurance of future performance.
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John Hagensen: Welcome to the Rethink Your Money podcast, presented by Creative Planning. I’m John Hagensen. And ahead on today’s show, why pessimism is so seductive, the right and wrong questions to be asking about your personal finances, as well as one of the most common mistakes I consistently see in retirement. Now, join me as I help you rethink your money.
You’re familiar with the term misery loves company, and it’s true. Negativity is contagious, unfortunately. And if we’re not careful, it can pull us in and it can consume a lot of our thoughts and really the framework with which we’re viewing the world and in particular, our financial situation. This week, I had one of those days. You know what I’m talking about? Where you just feel angry, frustrated. It’s like, man, why are the kids being so loud? I don’t know. Because you’ve got seven kids, with the youngest being one. That’s what they do. They’re children. Everything was annoying me. Oh, man. Now, I forgot my shoes? I got to go back upstairs? Terrible day.
My wife, Brittany, at one point looked at me and she’s like, “What is going on with you? Why are you in such a bad mood?” “I don’t know. I just feel nasty, angry.” And her being the awesome wife that she is, said, “Why don’t you go take a jog or something? You need to get out of the house.” “Yep, you’re right.” I felt better, and that usually is a great solution. If you’re feeling gross, don’t scroll on social media another hour. Get out in the fresh air. It’s summertime. Take three big inhales through your nose. Hold it, exhale. Think of a few things you have to be grateful for. Whatever it takes. That works for me most of the time. But this negativity bias just rears its ugly head, and has forever, and probably will continue forever, when it comes to personal finances.
Investors, we have this love-hate relationship with bad news. We hate unpleasant news about the economy and the financial markets, but we love to read about it. We love to click on it and sometimes, we can’t look away. There are a few key reasons to this. The first is that our brains are wired to treat threats as more urgent than opportunities. The whole rustle in the weeds. Maybe it’s a saber tooth tiger. Focus on the threat. Yeah, that’s what’s kept human beings out of extinction. That’s just inherently in us.
Also, negative events have a much more lasting impact on our memories than positive ones. If you try to think of a couple of the most traumatic, terrible things that have happened to you, I know I shouldn’t be conjuring up these memories, but you remember them well. What everything looked like around you, the smell, the temperature, it’s vividly seared into your mind. Also, bad news grabs front page headlines because they’re often sudden noteworthy events. Most good news is gradual. It’s not noteworthy.
I remember one of my colleagues, a wealth manager here at Creative Planning, Dr. Dan Pallesen, who’s been on the show several times as a guest. His wife is in PR. Well, there was this global Pay It Forward Day. Basically, it was this ripple effect of kindness. Really amazing thing. She was reaching out to the media, this was a couple of years back, and they were like, “That is so cool, but we’re not actually going to put it on the news because the ratings will be terrible. And no one’s interested.” They, instead, probably talked about a local liquor store getting robbed, or a car accident, or something awful, but actually going to get eyeballs.
Lastly, and maybe the most important, pessimism tends to push investors toward taking action. For all I cared about was having as many people that listen to this program become clients at Creative Planning, and that was the sole objective. I would do what most life insurance salespeople have done for the last 60 years. Talk about how awful things are, the upcoming recession, the bear market, the crash, how it’s going to ruin your financial life. Metaphorically throw you into a hole and then say, “Hey, fortunately for you though, I’ve got the rope here. I can save you.”
The reason is that we take action when we are scared. When we are feeling a threat that could have a major impact on us, we get moving. Whereby contrast, if we intuitively know that something will be better for us, but there is really no urgency or threat to us in the moment, those are all the great aspects of life that we procrastinate on because we’re not really all that concerned about it. But while what you’re seeing on social media, the news, radio, podcasts, are disproportionately negative relative to reality, let this be an encouragement to you; the stock market, our country, the economy, it is resilient, and it’s survived all sorts of challenges.
If you’ve been feeling down, maybe pessimistic about accomplishing your financial goals, why not give your wealth a second look? Speak with one of our 300 certified financial planners just like myself. Here at Creative Planning, we will review your existing financial plan and offer suggestions for how it might be improved. We’ve been helping families for 40 years as independent fiduciaries. Visit creativeplanning.com/radio now to speak with a local financial advisor.
How has the economy really stayed so resilient? After 14 months of historic rate hikes by the Fed, we had inflation at over 9%. Let’s face it, it was pretty easy to be negative. Well, as I just alluded to, you should expect the economy to be resilient. Why? Because it’s shown that looking at well over a century of stock market data. At one point, a little over a year ago, there were some economists forecasting a 100% chance of a recession. Not sure how you can say 100%, but that was what they were claiming, and that negativity leads headlines. You get on your iPhone, you look at the stock app and in red you see so-and-so economists forecasting 100% chance of a recession. You throw your hands in the air, you go, “Oh, this is going to be terrible.” Yet, the government’s expected to report that the economy just grew by about 1.8%.
Here in the second quarter, last month, employers added 209,000 jobs, and average wages grew 4.4% annually, which was higher than inflation. Wages are outpacing inflation. That’s a great thing. That’s buried in the headlines. And you’re going to have to search for that one though because it’s positive. Financial conditions have been very favorable. The S&P 500 went up 16% in the first half of the year. The NASDAQ was up over 30%, marking one of its best first halves to a year. I’ve had a lot of clients ask me why? How have we avoided, at least up to this point, an inevitable recession? The answer specific to this situation is employment.
Most expected that these rate hikes would massively impact corporate earnings and as a result, many companies would lay off employees, many small businesses would go under. But we haven’t seen that. Right now, unemployment is at about 3.5%, which basically means that most people who want a job can find one. If you’re not that happy in your current job, you’re switching jobs to a competitor or a different industry that’s paying you more money. These are the lowest levels in the last 50 years. This is newsworthy.
Compare both inflation and unemployment to other periods of history. Yes, inflation was at 9.1% when it peaked. Now, it’s down to 3% when looking at the trailing 12 months. While that’s still above the 2% long-term target that the Fed has, it’s actually slightly below the long-term average of about three-and-a-quarter percent for inflation. Think of it this way. Inflation was high and it probably persisted too long for those who were saying it was going to be transient to declare a victory lap. But this is in the 1970s where we saw inflation average seven-and-a-quarter percent for an entire decade.
Yes, unemployment increased during the pandemic, but it wasn’t sitting there at 25% like it was during the Great Depression in 1933. As long as unemployment remains low, a deep significant recession is unlikely. And it’s logical if you think about it. Consumer spending is still the economy’s main engine. And despite higher borrowing costs and prices, you generally don’t see a significant drop-off in spending if everyone’s employed. If you’ve been asking yourself over these last few years since the global pandemic shut everything down early in 2020, what should I be doing with my money? Am I still going to be able to retire? Should my investment strategies change? In the midst of all of this uncertainty, I want to encourage you, a lot of the headlines are overdramatizing this uncertain economy and market. You know why? Because the only certainty if you are going to be a long-term investor is that there is going to be uncertainty at all times.
If it’s not inflation or a looming recession, it’s a war in Ukraine. It’s a terrorist attack. It’s a financial crisis. It’s a pandemic. It’s a slowing economy. It’s doing so well that oh no, now is this a bubble? It’s political unrest. If you are waiting for someone to shoot flares in the air and tell you the coast is clear, you’re waiting to feel real comfortable before you invest, you will sit on the sidelines forever. You have got to get comfortable with uncertainty. You need to get comfortable playing the odds as an investor, giving yourself the highest likelihood of success given the information that exists. And here is that information.
Bonds have slightly outpaced inflation over the last 100 years. Especially, if you’re shorter duration and in higher credit quality bonds, meaning you’re lending for short periods of time to financially-stable corporations, or the federal government or municipalities, you’ve suffered very few big losses. How about stocks? When you look at stocks, unlike bonds where you’re lending money, you’re an owner. You should expect the best opportunity to grow your wealth over time through ownership, whether it be your business, real estate. Maybe it’s owning companies through the stock market. Speaking of the stock market, that strategy over the last 100 years has earned a little more than 6% per year above inflation.
You don’t get that for free. The cost of that return premium is higher short-term uncertainty. But for most, accomplishing all of your financial goals is going to require you to outpace inflation and grow your wealth. But here’s what that means. The average correction is 14% and happens nearly once per year. Historically, expect a bear market, which is a drop of more than 20%, they average about 30% down, about every five years. That’s the challenge with stocks. Up to this point, it’s always gone up into the right over long periods of time, has never suffered a down market over a 20-year period.
But there are all sorts of speed bumps along the way, which is why you implement bonds for more stability. While you expect their returns to be much lower, they allow you to bridge bad times in the stock market. So you never have to worry when you hear on the news that there might be a recession, or corporate earnings are down, or unemployment’s rising. If you are a buyer of stocks because you’re not yet retired, you should smile and say, “I’m going to be accumulating ownership while everything’s on sale.” If you’re near or in retirement, taking withdrawals from your portfolio, you should be able to shrug it off knowing that you don’t need to sell any of those stocks which are long-term investments for seven to 10 years, or more, per your plan.
By the way, make tax trades along the way and rebalance to buy more shares while they’re on sale. The one thing you can continue to count on while the market marches higher is that you will see countless headlines every single day, telling you why a correction or a bear market or a crash is just around the corner. If you feel a lack of clarity around your financial plan, around your investment strategy, your tax strategy, your estate planning strategies, we’re a law firm with over 70 attorneys, A tax practice with over 100 CPAs, and a wealth management firm with 300 certified financial planners just like myself. We manage or advise on a combined $210 billion for families in all 50 states in over 75 countries around the world, because we believe your money works harder when it works together. To request a complimentary visit with a local financial advisor, visit creativeplanning.com/radio. Want to give your wealth a second look.
Well, remember during the pandemic when seemingly every stock you bought went straight up? We were all cooped up inside with stimulus money. Well, during that time, over eight million people opened new brokerage accounts during the year of 2020. Many new investors, who were enticed by those big stock market gains, unfortunately, are now facing unexpected tax bills. If you’re ready to have your mind completely blown, there was one shocking case that involved a Robinhood trader who made a $45,000 net trading profit. Did pretty well. Made 45 grand in a year, but is now facing, get this, an $800,000 tax bill due to disregarding what’s called the wash sale rule.
The wash sale rule disallows you to claim losses when selling and purchasing the same security within 30 days. You sell something at a loss, you can’t rebuy that for a month if you’d like to book those losses. While this is an extreme example in a very unique time, during the pandemic, it illustrates the point that how our investments are taxed can be confusing. That’s why I’ve asked my special guest, Creative Planning Senior Tax Director, Certified Public Accountant Ben Hake, to join me today here on Rethink Your Money. Thanks so much for coming back on the show, Ben.
Ben Hake: Thank you for having me, John. It’s been a little while.
John: It has. Yeah, it’s great to talk with you. Great to see you again. Today, I want to discuss with you the types of investment income, how those are taxed from the simple to the complex. Maybe you can give us a few examples of each to start.
Ben: With Creative Planning, we’ve got clients who are invested. And we’ll start simple. The most obvious thing is interest income. You got a bank account, maybe you got a US savings bond somebody gave you before you graduated high school. And that interest, as you receive it, is taxable to you. The bank gives you $10 of interest, you’ve got income of $10 on that. The next one is going to be dividends. Again, this is you’ve bought shares of a company. Let’s think AT&T, Coca-Cola, something like that. You’re a fractional owner in there, so every quarter they say, “Hey, you earned your six cents for this share,” and they pay it out every single quarter. That’s pretty common for what we’ll see in the brokerage accounts.
But you could also decide, I” want to sell my shares of Coca-Cola and buy something different.” At that point, maybe you bought it for $10 and now it’s worth 60. That spread would be a realized capital gain when you sell it. And then the final item, and maybe we’ll get into this a little deeper at the end, would be partnership. Maybe you’ve got a piece of real estate that you and some other individuals have purchased, or maybe you’ve started a business with, again, you and somebody else, and now you’re going to start paying taxes on the profits of that because it’s separate from what the entity’s going to pay.
John: If you see this on the tax side, and I see this as a wealth manager on the financial planning side, sometimes this surprises clients. On the interest and dividend side, a bank pays interest, but they leave it in the account. Or they’re reinvesting a dividend, and so they get taxed on it at the end of the year. “Wait, I didn’t take this money. I didn’t spend it. I didn’t do anything with this. Why am I being taxed on it?”
The other one on the capital gains side, but sometimes there’s a merger or a company sells and capital gains get distributed. Or it’s inside of a mutual fund and the manager decides to sell something, but they didn’t sell anything with the overall mutual fund. And now, they’re surprised that they got hit with capital gains. I’m assuming you see that from time to time, too, when you’re doing people’s taxes and they’re going, “Why do I owe so much, Ben?”
Ben: 100%. I always joke, you start your life, most people get a paycheck. And you’re like, “I got the money in my bank account, I spent it on stuff.” That all makes intuitive sense. But especially with dividends, and if you get a pretty decent-sized brokerage account, you made 10, 20, $30,000, you never see it. It gets received, you buy more shares and it just carries on its mery way. Well, that’s $30,000 that didn’t have one cent paid to the IRS of the states you live in.
All of a sudden, we get to the end of the year and you owe $6,000. You’re like, “Well, that’s not in my bank account.” You’re like, “Well, it’s in the brokerage account. You received it. You own more things than you did at the beginning of the year.” But there’s a little bit of a surprise because again, it’s just different than the income you’ve earned up until that point in your life.
John: This speaks to the coordinated approach so that there aren’t surprises. Because often, it’s not so much what they owe or that anything was done incorrectly, it’s that they weren’t expecting it.
Ben: Exactly. I think expectations, especially from our side, we’re always trying to get with our clients near the end of the year, just to put it all together. It’s a little bit like a physical. Sometimes the right answer is you’re doing great and there’s nothing to change, but it’s nice to know you’re healthy. Or in this case, it’s nice to know what you’re going to owe come April. And then not to be worried, not to wake up mid-March and be like, “What is going on,” and not have any idea.
John: Well and speak a little bit to the types of tax forms that they’ll receive, like interest dividends, capital gains, partnerships, and that K-1, obviously, you spoke of.
Ben: All these forms generally have 1099 in the name. From your bank, or again, maybe with what US treasuries are doing, we’re getting a lot more people who are getting US savings bonds and things of that nature, but you get a 1099-INT, which is reporting your interest income. For that, one other consideration is that the IRS taxes that at your ordinary rate. If you normally make $100,000, that next dollar gets taxed at whatever your ordinary rate is.
The next thing that we see pretty commonly is going to be a 1099-DIV or a 1099 consolidated. This is from your brokerage. TD, Schwab, Fidelity, they all just summarize everything and say, “Here’s your 10-page form. It’s got everything you need.” Shows the dividends you had if there were realized gains, losses, maybe you earned a little interest there. That all happens there. For the dividends, most clients are interested in having qualified dividends because they pay a little bit lower tax rate.
You make 100 grand, maybe you owe the IRS 22% on that income. But if you earn dividends, instead of paying 22, you only pay 15. Or maybe even lower than that, depending on your makeup. There’s definitely some tax advantages there. And then the final item, and this is especially the first year you get it, would be a K-1. This is your share of the partnership interest or activity that reported, and that can end up causing your return to get a lot more complex, a lot more quickly.
John: The timing of when you receive these forms at tax time vary, and especially when speaking of the K-1. Before you get involved in a partnership, just know you’ll be filing extensions for a long time. We have clients going, “Where’s my K-1?”
Ben: Yeah.
John: “Well, it’s February. You’re not going to get a K-1 for a while.”
Ben: Yeah. Those K-1s, they’ve got until September. We’ve got some clients, they’re in October filing every year. There’s definitely, again, a little bit of a psychological impact where you’re used to filing in March. To be able to have that and be pushed out, sometimes that feeling isn’t worth the investment in that partnership.
John: I’m speaking with Creative Planning Senior Tax Director Ben Hake. How about the taxation of investment income?
Ben: That’s always something we’re looking at, and a really common one, especially recently, is in bonds. Clients are like, “Should we get municipal bonds where you don’t pay income tax on those to the IRS, or should we get corporate bonds or bond ETF funds where we’ll pay tax on that?” A lot of that’s relevant to where you’re located. If you’re a really high-income earner in California, you may be paying 50 cents on the dollar from those corporate bonds versus if you get a muni bond, maybe you’re paying 10%. Or if it’s a California bond, zero. A lot of the times, when you’re looking at just bonds, there could be a huge difference there.
John: One of the things that just drives me crazy, I’m going to go into my soapbox here for a moment, is our clients that say, “Well, I want a municipal bond. I like having tax-free interest.” You’re in a 12% tax bracket. The taxable equivalent yield on a similar bond after you pay 12% taxes is way higher, right?
Ben: Yep.
John: You really want to understand where your tax bracket is, to your point. And is it also within the state that you live, so you’re also getting state tax-exempt as well? Make sure you’re in a high bracket, generally speaking, for a municipal to make sense. Even though it does feel good to be receiving interest that doesn’t show up on your tax return, you may be better off paying tax if you’re in a lower bracket.
Ben: Which is hard for a lot of clients to hear from their CPA, that paying taxes is okay. Not what I’m advocating for.
John: Yeah. “You CPAs, I know. It’s always, how can we pay the least amount right now?” If there’s a trickle-down effect that makes it so the person’s lifetime tax bill, and by the way, I’m not blaming CPAs, I think this is just in general, it feels good to show up and say, “Oh, I don’t owe a lot in taxes this year.” But you may be compounding a problem that’s unintended, where you end up paying more over your lifetime than you would have if you had been willing to eat a little bit more in the short term.
Ben: Exactly.
John: By the way, that’s not you, Ben. That’s CPAs. Big, giant-lettered, capital CPAs.
Ben: Capital. All capital.
John: Not you.
Ben: Even though I think CPA is always capital.
John: Yeah. Yeah. Yeah, exactly. Yeah, we’ll go with it. We’ll go with it. How about preferred rate?
Ben: Preferred rate, and that’s qualified dividends, so again, that Coca-Cola dividend, that example that I had. And those rates, so the ordinary income rates can go all the way up to 37% versus the top rate on those preferred rates is only 20. That could be pretty significant if you’re applying that to $100,000. There’s a pretty big swing there.
John: Sure.
Ben: The reason it comes up most of the time is those long-term capital gains. You sell shares of Coca-Cola or AT&T that you received a long time ago, being able to have that reduced rate can be really beneficial. That’s also a reason why a lot of times we’re wanting to hold shares. Maybe if you’ve owned it for just shy of a year, that value in waiting even just another couple of days to get long-term can make a huge swing in the amount of tax due.
John: We’re here in the summer when people like to forget about their taxes, even though this is when it probably would be good to pick up the phone and call you and say, “How can we strategize?” What tax considerations do you think people could be thinking about, considering, here in the summer?
Ben: One really big one is especially for our early retirees. Maybe you’ve retired, but you haven’t started drawing Social Security or your RMDs haven’t started. There could be a window there where you can have pretty significant sums, almost $100,000 dollars for a married couple. If the bulk of that is at preferred-rate income, either long-term capital gains or qualified dividends, instead of the IRS saying, “Hey, that’s 15 or 20%,” that rate can actually be zero.
There could be a scenario in early retirement years, maybe there’s some value in keeping your income or living off that brokerage account versus drawing from the IRA. Because you’re able to pay 0% for a number of years. Now, to your point earlier, we’re looking at lifetime taxes, not on year-by-year. That’s something that should be part of a holistic approach, to see if that makes sense over the long term.
John: That’s a really good point because for some people, that might be the right approach. And for their neighbor, the approach might be to accelerate income early in retirement before they kick on Social Security and large Roth conversions and these other types of things. That’s why it’s so difficult to just say, “This is the right approach if you’re 62,” because no two people are alike.
Ben: Exactly. It depends on the mix of your assets. And then it isn’t necessarily investment-related, but another thing we’re looking at is for people that are charitably inclined is those donations of appreciated security. Instead of realizing that long-term capital gain and giving your church or local charitable organization cash, you can donate that directly to them. You avoid the gain. The charity doesn’t pay any tax on that. That’s, again-
John: Missed all the time. Missed all the time, right?
Ben: Exactly.
John: Because cash just feels like the logical thing to give.
Ben: Exactly.
John: But it may be the least tax efficient.
Ben: Exactly.
John: Well, Ben, do you have any other final tips here as we wrap up?
Ben: A lot of these income sources don’t have any taxes withheld, either the IRS or maybe your resident state. Another item to talk with your CPA about this summer may be, “Let’s look at all the things we have coming in. And do we need to make some estimated payments?” With the interest rate environment going up, the IRS and states are charging a higher interest rate for waiting to make those estimates, which, for a lot of clients, was a little bit of a surprise this last year after so many years of low rates. Another great item to look at. Save yourself a little bit of money and again, that peace of mind that you’re caught up in the IRS’s good graces.
John: Before you’d underpay or make no estimates, some clients felt like it was almost a better bet. “Oh, the interest rate the IRS is charging me is so low. If I can make some money in the meantime, I may still end up ahead.” Now, it’s a little tougher to overcome that. What are they charging? 5%, 6%, 7% right now?
Ben: Something like that. Yeah. Two years ago, it was two-and-a-half. That doesn’t seem like a huge spread, but when you’re assuming you can beat that consistently, a little less likely.
John: Well, and in some cases, it’s a large sum of money that’s required for the estimates, which is why people didn’t want to pay it in advance and they wanted to keep it in their pocket. Now, that’s pretty punitive, so I’ve heard from a lot of clients that that’s certainly different and caught them off guard a little bit. Those are great tips, Ben. Thank you so much for joining me again here on Rethink Your Money.
Ben: Thank you.
John: That was Creative Planning Senior Tax Director and Certified Public Accountant Ben Hake. If you have questions surrounding the taxation of your investments, maybe your financial advisor hasn’t reviewed your tax return in the last year, what might you be missing? Visit creativeplanning.com/radio now to speak with one of our local advisors. Why not give your wealth a second look?
Well, I have one child in particular, love them to death, not going to name them, who asks a lot of questions. You have a kid or grandkid like this? Maybe? It’s great because I know that curiosity is going to get them somewhere in life. They’re thinking. They’re getting smarter. They’re learning. But wow, sometimes as a parent, it is exhausting. “What about this?” You answer it. “Why?” You answer it. “I don’t understand. Why that? What about this?” At some point, you just go, “Ah, well, let’s talk about it later.” Great questions.
But in general, asking questions is great, and asking questions when it comes to your money should help you make progress. But with one caveat. You got to ask the right questions. We ask a lot of the wrong questions and so regardless of the quality of the answer, it just may not be that helpful. A common wrong question is, which investment will grow my wealth the quickest? There are so many examples of this. During the pandemic, you had Zoom and Peloton and Teladoc and GameStop, during the meme stock craze, having meteoric rises. And crypto was similar in that way.
A lot of wealth created very quickly, but that volatility, remember, works both up and down. And so get rich quick and get poor quick are two sides of the same coin. At a more broad level, think about ARK Investments, one of the highest-performing, most publicized funds in the world. If you look at the performance since inception, still up about 11% per year. Very respectable. Basically, tied with the S&P 500. But here’s what’s crazy. The average ARK investor, so not the fund itself, but real people that have gotten into the fund, have a dollar-weighted return of negative 21%.
If you look year to date, it’s up 60%. Yet, it’s still in a 67% drawdown. In February of 2021, it was outperforming the S&P 500 by 600%. As I just mentioned now, it’s about tied with the S&P since inception. But so often, when we’re looking to get rich fast, we get in at the wrong times; after much of the run-up has already occurred and we’re sort of there. And if we’re not careful, we end up being the proverbial last one standing without a chair.
Another bad question to ask, where do you think the markets are headed from here? Think about this. How many economists have been predicting a recession for the last 24 months? How about the Fed, who has difficulty forecasting the implications of their own monetary policy with 400 PhD economists? Exhibit A for why this is a bad question is early 2020, at the start of the pandemic. Imagine asking the question, where do you think the market’s going from here? Any rational person would’ve said, “Way down. Let’s go to cash. Let’s short the market.”
Well, temporarily, you would’ve been right. The bear market was the fastest we’ve ever seen in history. It was a 30% drawdown, basically, before you could blink an eye. But it only lasted two months and snapped back and rebounded 70%, coming right out of it on the back half of the year. You can’t figure out which way the market’s going, and any advisor or money manager you’re asking, they don’t know either. The reason is because the markets aren’t just unknown, they’re unknowable. It doesn’t matter how smart you are, they are unpredictable.
The most brilliant person on planet Earth did not know in the summer of 2019 that a pandemic would occur in 2020. Here’s the crazy part. Even if you had a crystal ball and someone did happen to know and tip you off in advance, you wouldn’t have expected the stock market to end that year up nearly 20%. We don’t know the future and even if we did, the way billions of people on the planet will react and in turn, move the stock market, is impossible to forecast. Of course, there are 1,000 other terrible questions that we’ve all asked at one point in time, but let’s move to the positive side.
What are the right questions I want you asking? First is, how do I invest to get the best long-term, sustainable returns? I like to use the word durable. The key to you finding financial success over the rest of your life is achieving the best returns that you can obtain over a lifetime. It’s the opposite of, how do I grow my wealth the quickest? It’s, how do I grow my wealth the most consistently and methodically, allowing it to compound over the longest period of time? Which leads me to another great question, which is, how do I ensure my portfolio is protected against big losses?
You put everything in annuities and insurance and cash? No. Of course, you do not do that. I know it’s tempting. Sometimes those salespeople are really good. But no, you broadly diversify, so you have no big bets in any single spot. You solve your short-term needs with low-volatility investments, like bonds. You have a defined approach for driving income, if you need income from the portfolio. You have an adequate emergency fund. You keep yourself out of debt. That’s how you avoid big losses. Here’s your third most important question to ask, and I really want you to do this. This isn’t rhetorical. I want you thinking through right now.
Do I have a written, documented, detailed financial plan? This doesn’t mean you need a financial planner. This doesn’t mean you need to work with us here at Creative Planning. But you need a defined financial plan, one that accounts for your taxes and your estate planning and your retirement projections, so that you have a game plan with which to work off of as you move through life. The majority of Americans, even those with good-sized portfolios, do not have what I would consider a real, legitimate financial plan.
If there’s only one question that you need to answer, it’s that one. Because so many of the other great questions that you’ll be asking when it comes to your personal finances are answered through that plan. If you don’t have that, like our clients do here at Creative Planning, and you want one, we can show you how. Lean on our experience. We’ve been helping over 60,000 families and have been in business since 1983. Schedule a complimentary meeting at creativeplanning.com/radio.
Well, a piece of common wisdom that I’d like us to rethink is that as you get older, it makes sense to put other family members on your accounts. I see this all the time, and it’s a big mistake. Elderly couples will name kids on their accounts. Retirees will add their children as owners to their residence. “Well, that way, if something happens to me, they’ve already got ownership. It’s so much easier.” Another example would be when you add a child to your bank accounts, very common one as well.
The problem is, your joint account holder can write checks or make withdrawals without any limitation. Your child, in that case, will inherit the account upon your death, which, I don’t know, might be different than you intended. Any account that you hold jointly passes outside of probate and the proceeds go directly to the other joint account holder. Which means, if you have other children, you may be disinheriting them from that account unintentionally. But here are some of the other big challenges. Creditors of either owner can use the account to satisfy debts.
Child has money problems, that account can be drained or taken by a creditor for unpaid debts. Another problem is that an ex son or daughter-in-law may get access to some of those account assets. If your child is involved in a divorce, that bank account may be listed as a marital asset for splitting. While adding a joint owner to your account’s fairly easy, removing them can be a nightmare. You’ll have to get them to agree and sign to remove themselves as a joint account holder.
A joint bank account potentially could also prevent someone from obtaining Medicaid or Mass Health benefits because the money would be factored into their eligibility. This can extend to your grandchildren if your adult child is the joint owner. I know it’s confusing. And they have a child who would be your grandchild in that case going off to college. Well, now, they may not qualify for financial aid because their parents have a lot more assets as owners of those accounts. Lastly, from a tax standpoint, it may not be as favorable.
If you have a non-qualified investment account and you bought Apple stock in 1983 and it went from $100,000 to $50 million, well, first of all, you’d be really happy. But you’d also have a lot of unrealized capital gains. You’d want the cost basis of those capital gains stepped up at the time of your death. Meaning, your children would inherit them with a cost basis of whatever the value was at your date of death. By making them an owner, depending upon how it’s registered, tenants in common, joint tenants with rights of survivorship, you could be negatively impacting the after-tax outcome for your family members.
What should you do? Name them as beneficiaries, align it with your estate plan. Have your trust potentially as a beneficiary and that trust will designate where things are going. You can do a POD or a TOD, payable on death, transfer on death. But do not jointly own assets with family members as a succession play, as it can lead to all sorts of problems. I also want to rethink the notion that disability insurance is not for everyone.
Disability insurance is a nonnegotiable. It’s much higher likely if you are under 65 years old that you will file a disability insurance claim over a family member filing a life insurance claim. You’re in a car accident. You break both arms. You can’t type. You can’t work. What are you going to turn to? Disability is built into many companies’ payrolls. Sometimes it’s adequate, sometimes it’s not nearly enough. But review your company benefits to ensure that you have coverage that would protect you and your family in the event that you could not work.
A couple of key components to review in your coverage, which we can do for you here at Creative Planning if you’re not sure where to turn, is whether or not the policy will pay if you can only not perform your specific job, or any job. For example, if you’re a surgeon and you know longer can perform surgery, certain policies would pay. Other policies might say, “Well, you can still do billing at the hospital, or be a greeter at the hospital. You just can’t perform surgeries anymore.” That is a very important distinction within disability policies.
Another one is, how long will it pay for? Is it all the way until death or 65? Or is it just three years or five years? But the statistics show us that far more people have life insurance than disability, yet are far more likely to need disability insurance than life insurance. One of the things a good financial planner will provide for you in the planning process is a review of all risk management. Because if you invest properly and you reduce taxes, and you have a great estate plan, and then you’re underinsured in the event that something unexpected happens, it can blow up the entire plan. It can negate every other great aspect that you had planned for. No one wants to be over-insured. No one likes buying insurance. I get it.
But I encourage you, make sure you don’t have any large gaps that put your plan at risk. If you’d like to review your plan to ensure you’re not missing something, I recommend seeing an independent fiduciary that’s not looking to sell you something. If you’re not sure where to turn, or you’d like to visit with us here at Creative Planning, do what thousands of others have already done, by scheduling your meeting at creativeplanning.com/radio. Why not give your wealth a second look?
It’s time for listener questions and for that, I’ll throw it over to one of my producers, Lauren. Hey, Lauren. What do we have today?
Lauren: Our first question today is from Jane in Casa Grande, Arizona. She writes, “I’ve started researching trust options and have come across the terms revocable trust and irrevocable trust. Can you please explain the difference between these two types of trusts? Is there one you recommend more than the other?”
John: Great question, Jane. I had this discussion with two clients just this past week. Let’s start with the basics of a revocable trust. From a control perspective, you, the grantor, retain full control over the trust assets during your lifetime. This means you can make changes, you can modify the trust terms. You can even revoke, as in the name, the trust altogether if you wish. Think of a revocable trust like this. You don’t personally own the assets anymore, the trust does, but that trust is 100% within your control. From a flexibility standpoint, you can add or remove assets from the trust. You can change beneficiaries or appoint new trustees whenever you see fit. From a tax standpoint, since you remain in control, the trust income is usually taxed as part of your personal income tax return.
What would be the advantages in that case to a revocable trust since it sounds a lot like just owning the assets jointly, or individually, without the need of a trust? Well, it helps avoid probate. It keeps your information private. It can avoid unnecessary delays and hassle for your family members if something were to happen to you. And beyond death, a trust can be extremely helpful to designate your wishes in the event you don’t die but are incapacitated.
Now, I think often, when people hear the word trust, they think of an irrevocable trust. From a control perspective, in an irrevocable trust, it’s completely different. You, as the grantor, relinquish all control over the assets. You transfer them into the trust and they are no longer yours. Once established, the terms of that trust generally cannot be changed, they cannot be revoked without the consent of all beneficiaries. A positive to an irrevocable trust is that it provides asset protection.
When you place assets into an irrevocable trust, they’re typically shielded from creditors and estate taxes, since they’re no longer considered part of your estate any longer. From a tax standpoint, an irrevocable trust is treated as a separate legal entity. It files its own tax return, has its own tax ID number, and depending upon the trust structure, may even have its own tax rates and deductions. There are the differences, Jane. You had asked which one I recommend more often? And I’d say maybe only one out of every 20 clients who do estate planning with one of our 70 attorneys here at Creative Planning need an irrevocable trust.
Generally, those who need an irrevocable trust have very high-net worths and are looking to use some of the estate tax exemption, which right now, due to the Trump tax reform, is over 12 million per person. It can be a way to avoid that 40% estate tax or death tax, as you’ll hear it referred to, or you use an irrevocable trust for very specific circumstances that frankly don’t apply to a high percentage of the population. The next time you hear me or a friend say, “Maybe you should look into a trust,” they’re probably not referencing an irrevocable trust. But Jane, if you have more questions about that, we have offices in Scottsdale, Phoenix, and Gilbert, and we’ll be happy to sit down and discuss this further with you in terms of how it pertains to your situation. You can request that visit by going to creativeplanning.com/radio. All right, Lauren, who’s next?
Lauren: Our next question is from Wayne and he writes, “I recently heard you answer a listener’s question on an emergency fund and it got me thinking about my own. How much would you say we should have in an emergency fund? Also, how do I strike the right balance between having enough money in my emergency fund to be protected, but also keep as much of my money in the market as possible to maximize returns?”
John: It’s a great question because I think so often we think of this emergency fund as, I don’t know, a dead asset, just a waste. Because it’s not invested in the market with the rest of your securities, but it serves an incredibly important purpose within a comprehensive financial plan. Three to six months of expenses is the canned financial planning 101 answer for an emergency fund. Tilt it more toward three months if you have two income streams, or closer to six months if you are living on one income stream. You may also tilt that slightly based upon your specific situation and knowledge of how stable those incomes are and how varied your expenses are.
Wayne, I wouldn’t look at the emergency fund in a vacuum because it will feel like you are simply losing to inflation. And you may dwell on that opportunity cost for not having the money invested in a location that is growing more. Remember, the primary purpose of that emergency fund is to allow your stocks time to grow, so that you’re never forced to sell them when you don’t want to. When you’re in a pinch personally, maybe the broad economy’s not doing very well. Maybe the stock market is down in value, which would be one of the worst times to liquidate long-term investments. What really is the return premium or value of your emergency fund if it allows you the ability to not interrupt compounding unnecessarily, as Charlie Munger so eloquently put it? But keep in mind, your emergency fund does not need to sit in cash at your bank, earning zero, while the bank lends it out and makes a bunch of money, while paying you nothing.
Money markets, short-term bonds, government treasuries, they’re paying 3%, 4%, 5%, 6%. And in many cases, you have access to link them to your bank account and move them back into that checking or savings account within a couple of days. Wayne, if your emergency fund needs to be 50 or $75,000 and you don’t like the idea of that losing to inflation, well, you’ve got better short-term options than we’ve seen at any point in the last 20 years. And your entire emergency fund does not need to be sitting in cash at the bank. Thank you for that question. A reminder, if you have a question, submit those to radio@creativeplanning.com and I’m happy to answer them on the air, or I’ll reach out directly to you for my answer. All right, Lauren, what’s the last question?
Lauren: Finally, James, in Milwaukee, Wisconsin writes, “Given the market conditions, is a diversified portfolio still my best option, or would it be better to focus on sectors with less risk?” Thanks, John.
John: I think it’s important to make a distinction between the word risk and volatility. We use those often synonymously in investing, but they’re very different. Volatility is the variance of your returns. It means that your investments will go up and down in value, sometimes violently. But of course, a diversified portfolio, while it’s been volatile, it’s moved up into the right at about 10% per year the last 100 years. By contrast, risk is Enron, America Online in 2001, or Washington Mutual during the Great Financial Crisis. Risk is losing your money, not having a temporary downturn in the value of your account.
The reason that I point that out is because even a sector or a durable dividend-paying stock that’s paid its dividend 40 straight years, sure it may have less volatility than a diversified portfolio if it happens to be a sector with a very low standard deviation. But that doesn’t mean you’ve lowered your risk. In most cases, even a more stable single sector or investment will be riskier than a diversified portfolio. See, the reason you diversify, making no big bets in any one spot, you own large stocks, you own small stocks, growth, value, emerging markets, developed international companies across all sorts of sectors, diversifying bond durations, credit quality, who you’re lending to, is because you’re trying to minimize risk.
In most cases, depending upon how you are building that asset allocation, it may also lower your volatility, certainly if you’re adding bonds. I am not a proponent of concentrating in a single sector or in a handful of securities. Because while it may potentially lower short-term movement, it will almost certainly increase your risk of a persistent and sustained and potentially permanent loss of principle. Thank you for those questions. James, if you’d like to speak with us, we have an office there in Milwaukee. We can review your financial plan, as well as your investment allocation, to ensure that it’s consistent with your time horizons, as well as your risk tolerance. You can visit creativeplanning.com/radio now to speak with a local advisor.
Well, as we wrap up today’s show, I want to end with what I believe might be your most important financial skill. I know that’s a big statement. There are a lot of things required to be a great investor, but your ability to never fear missing out, it might be the most important. Put another way, you being immune to others’ financial success is certainly more important than an ability to find the right investments or try to time the market. Now, it mostly comes down to you avoiding FOMO. Which is really just recklessness masked as ambition so often, isn’t it? I’m guilty of this. I compare myself to others. I have the fear of missing out.
Dwight Eisenhower used to quote Napoleon, saying, “A military genius is the man who can do the average thing when everyone else around him is losing their mind.” You don’t need to be brilliant to get ahead, you just need to be average when everyone else is going crazy. This goes back to the question that I posed at the beginning of the show. How do I ensure I never have big losses? Part of that is avoiding FOMO. If there’s no comparison to other humans, you’re going to be a whole lot happier with your current situation, and more content, which will provide assistance in you not falling victim to greed; taking bigger risks than are appropriate for your situation.
Charlie Munger said, “Somebody will always be getting richer than you, and that’s not a tragedy.” If you remove FOMO from the equation, you know what’s left? You only care about your own goals. You tend to think long term and you avoid getting sucked into bubbles. My favorite financial writer, Morgan Housel, had an entire chapter in his book, The Psychology of Money, on the idea of a wealth spectrum. It pertains directly to this idea of FOMO. I’m going to use the example he has in the book, where there’s a rookie baseball player.
Imagine this. You finally make the big leagues. You’re playing for the Angels. You walk into the locker room and who’s right next to you? Mike Trout, arguably the best player of this generation. Now, you’re making a million dollars a year as a rookie. By all measurements, you are crushing it. You’re wealthy. You’re in your 20s, making seven figures a year. But you look to your left and you go, “Wow, he’s making 50 million a year.” His contract’s for close to half a billion dollars over the next decade. “Man, 50 times as much as me? I don’t feel very wealthy.”
But then, what if Mike Trout compared himself to the average hedge fund manager making over $100 million a year? Man, they’re doubling him up. And they don’t have to travel all around the country playing 162 baseball games in a year. Mike Trout may be thinking to himself, “Man, I’m not doing that well.” But then, what if that average hedge fund manager compared themselves to the top 5% of all hedge fund managers? Some of them made well over $500 million in a year. Now, that regular hedge fund manager doesn’t feel like they’re doing quite so well. And then lastly, what if the top hedge fund managers compared themselves to Warren Buffett, who, during the pandemic, saw his net worth increase by $20 billion?
You see, the point in this, in what we can learn as normal people by these comparisons is that no amount of money will inherently stop you from that comparison trap. No amount of money will make you immune to FOMO because there’ll always be someone you can find who has more. The key to financial success and your long-term contentment with your money is to focus on the game that you are playing, the goals that you have, the objectives that bring you joy, the financial achievements that will enhance your relationships with friends and family and provide financial security, and allow you to live the life that you desire.
Fortunately, that has nothing to do with others. Because after all, we are the wealthiest society in the history of planet Earth. Let’s make our money matter.
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Disclaimer: The preceding program is furnished by Creative Planning, an SEC-registered investment advisory firm that manages or advises on a combined $210 billion in assets as of December 31st, 2022. John Hagensen works for Creative Planning, and all opinions expressed by John or his guests are solely their own and do not represent the opinion of Creative Planning or this station.
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