Reasons to Keep Focused in Market Turbulent Markets

Picture of Mike Rodenbaugh

Mike Rodenbaugh

Founder

There’s no sugar coating it – the first three quarters of 2022 have seen almost all asset classes down and the fourth quarter hasn’t started off on a good note. The widely quoted S&P 500 index lost 4.9% in the third quarter and is down 23.9% so far this year. To make matters worse, bond prices have fallen as well (rather than provide stability) due to rising interest rates and credit risks. During times like these, the best—albeit difficult—advice is to try to “tune out” noise in the market and to focus on your longer-term investment horizon and financial planning optimization.

Last quarter we featured a look back in history at past recessions, noting that market downturns come in all shapes and sizes. This year’s drawn-out bear market may prove to be far more painful for investors than the sharp crash and fierce recovery of early 2020. It will also look different than the great financial crisis, the tech bubble’s bursting, or even the inflationary bouts of five decades ago.

There are a few patterns that tend to repeat themselves in bear markets:

  • The market is forward looking, so there is typically NOT a clear resolution to the cause of the bear market by the time the stock market begins to recover.
  • The media characterizations of the market and economic environment can still be downright scary when the market begins its recovery.
  • The subsequent recovery after market declines is typically strong, although the timing and nature of the recovery varies in each case.

Here are a few strategies that can be helpful in combatting the (counterproductive) human urge to act in the face of a market like this:

  • Based on the patterns above, realize that it’s very unlikely that you’ll be able to “time” the market bottom and that a “wait until things start to stabilize” likely means you’ll be late.
  • If you’re a saver, try to appreciate the opportunity to invest at lower prices.  Continue to save and invest to enhance the “dollar cost averaging” effect (buying more shares for the same dollar due to lower prices).
  • If you’re living off your portfolio, we’ve regularly discussed cash reserves and (if possible) had you sock away enough so that you don’t have to sell stocks in a downturn.  If that wasn’t possible, we can fund withdrawals from short-term bonds to allow time for stocks to recover.
  • Try to mentally put your stocks “in a drawer.”  We’re not planning on selling them any time soon, so try not to be overly concerned with today’s price.  You don’t check the price of your home every day or every month.  Why?  Because you’re not planning on selling it.  The same is true for stocks! 

History suggests that market downturns represent a buying opportunity for the long-term. Looking at rolling 10-year returns for the S&P 500, you can see the wisdom in a long-term investing approach that avoids market timing – it’s rare to have a poor 10-year return. By combining other asset classes with US stocks, a diversified portfolio stands the best chance of meeting your long-term goals.

At Boardwalk, we have crafted your diversified portfolio with your unique long-term goals in mind, strategically balancing various asset classes and risks. This year, the team at Boardwalk has been focused on revisiting our clients’ long-term financial goals, ensuring adequate cash flow and proper cash reserves for short-term needs, and, potentially, investing excess cash. We’ve executed on rebalancing, tax loss harvesting, and, where possible, transitioned to more tax-efficient Exchange Traded Fund (ETF) versions of our recommended funds in taxable accounts.

There may be short periods like 2022 when all asset prices seem to be falling in tandem, but tuning out the noise and looking to the future is the best course of action for your portfolio (and your blood pressure). We know maintaining peace of mind during global economic instability is easier said than done and we’re here to discuss any concerns or questions you may have.

Recession and Your Portfolio

“No man ever steps in the same river twice, for it’s not the same river and he’s not the same man.” – Heraclitus

This insight from an ancient Greek philosopher is a relevant way to consider financial markets. Many parallels can be drawn between the financial markets today and those of years past, including what things looked like heading into prior recessions. It’s very possible we’re already in – or will soon experience – a recession here in the United States. GDP contracted 1.6% in the first quarter of 2022, and the widely used definition of a recession is two consecutive quarters of negative GDP growth.

Research shows that market downturns – often contemporaneous with recessions – are, on average, accompanied by positive returns over subsequent one-, three-, and five-year periods. Through the first two quarters of 2022, the S&P 500 has fallen 20%. On average since 1926, a 20% decline in the value of the total US stock market had positive cumulative returns of 22.2% over the next one-year period, 41.1% for the subsequent three-year period, and was up 71.8% after five years. Similar returns have occurred for smaller (10%) or larger (30%) drawdowns. Here’s an interactive exhibit compiled by Dimensional Fund Advisors showing returns, inflation, and other metrics surrounding past recessions that you may find interesting to read in conjunction with our commentary below.

In the 4th quarter commentary for 2021, we pointed out some of the similarities to the US market of the dot com era. In particular, valuations were frothy. Depending on the metric, prices for publicly traded growth stocks had eclipsed their tech bubble highs of two decades prior. While the timing was never certain, that’s a recipe for a healthy pullback in the stock market. This year has featured dramatic declines for (previously expensive) shares of growth companies to the point that some are even getting picked up by value-style mutual fund managers! The bursting of the tech bubble took several years and a mild recession followed in 2001. It’s possible that today’s market also needed a healthy correction to valuations and a cooling of excesses (such as the NFT of Jack Dorsey’s First Tweet selling for $2.9M and then losing 99% of its value). Like Heraclitus would say, however, it’s not the same “river” and investors crossing today have many other currents to consider.

Inflation during the 1970’s consistently registered in the double digits. Having peaked about a year prior to the onset of the 1973-75 recession, the US stock market fell over 46% before hitting bottom. Occasionally the term stagflation gets tossed around as a risk facing the economy today. It’s a period with both flagging growth and high inflation. America experienced this in the 70’s and it is a scenario the Federal Reserve is anxious to avoid, even if that means continuing to hike interest rates higher. The good news is there are many reasons that financial markets see higher inflation coming to an end. In fact, expected average inflation for the next five years as measured by the Treasury breakeven rates has fallen from 3.5% per year in March to about 2.5% per year now. That’s a far cry from June’s 9.1% reading but goes to show that the market is not anticipating high inflation to continue for much longer.

Of course, one could draw similarities to many financial conditions we’ve experienced before to argue for how the economy and your investments may fare in the near future. We think that the markets do a good job of ‘pricing in’ the probabilities that various outcomes will occur, such as peaking inflation or a looming recession, as over $700 billion of trades occur daily (2021 global average) based on new information and best expectations of what will happen. Therefore, rather than focusing time on the hopeless task of predicting the future, we’re at work maintaining a disciplined approach and making strategic (not market timing) changes in conjunction with your long-term financial plan to help you meet your goals.

Investors’ Largest Concern and How to Manage It

And just like that, two years have passed since spring 2020! In our daily lives and in the markets, it has been both rewarding and challenging. There has been a lot – I repeat, a lot – of things outside of our control over these two years.

For most people, it’s hard not to let uncertain and often significant external events influence how we feel about everything else in our lives. Though often necessary over the last two years, I found the time I spent focused on things largely outside my control was frustrating and disheartening. Conversely, I think many people can relate to the inner peace and happiness we can get when we focus on things within our control, spending time doing things that we enjoy with people we love.

Similar in many ways, a focus on the right portfolio composition and personalized financial planning allows Boardwalk and our clients to enjoy the benefits of managing wealth and achieving goals even in the face of external pressures (such as blistering inflation).

Numerous polls show inflation is now the American public’s largest worry. It’s one of the biggest concerns for investors, too, which is why it’s been featured in our commentaries. The April consumer price index (CPI) change over the past 12 months has now spiked to 8.5%, up 1.2% since last month’s reading. The Federal Reserve has embarked on a rate hiking cycle to combat this, with the goal of orchestrating a ‘soft landing’ – where inflation subsides, but unemployment remains low and economic growth continues. There are some indications of the pace of inflation topping out, but there is a long way to go.

While we can’t control market returns over this uncertain period, there are aspects of portfolio management that are within our control as investors. Here are a few examples:

  • Most important is determining the right asset allocation based on your individual circumstances and risk tolerance. The mix of stocks and other risky assets to bonds and less risky assets is the largest driver of both risk and return, regardless of where the market moves. We believe academically driven, globally diversified investing is key to meeting your long-term goals.
  • Ongoing portfolio management such as rebalancing is also within our control. Staying exposed to out-of-favor asset classes is part of this disciplined approach, since rebalancing is in effect trimming recent winners to buy beaten down asset classes. As an example: for years, commodities dragged on performance but have been worth their weight in gold (pun intended) lately as an inflationary hedge and diversifier.
  • We can also optimize tax efficiency by strategically placing assets in certain account types according to their tax characteristics, minimizing turnover in taxable accounts, and managing portfolio withdrawals.

Within the realm of financial planning, cash flow planning and revisiting long-term goals are important ways to address current concerns of inflation and market volatility.

  • Cash flow planning: as costs rise for retired clients, increasing portfolio withdrawals (tax efficiently) is often necessary when inflows don’t match higher spending needs. For everyone, budgeting can also become more important as the same dollars need to be stretched. We help you think about proper cash reserves too, so that you can rest assured important goals can be met while minimizing cash on the sidelines being eaten away by inflation.
  • Long-term projections: revisiting your long-term plan keeps you aware of how you’re progressing towards your goals. As things change – including higher spending needs – we adjust our projections and can model scenarios that show persistently high inflation relative to a long-run inflation assumption. There’s comfort in knowing how market volatility, higher inflation, and personal changes impact your ability to meet your long-term goals and whether any current adjustments need to be made to help align your financial picture to your vision.

With market uncertainty and inflationary concerns mounting, lean on us to provide peace of mind or a course correction to help you stay disciplined and on track to meet your goals.

Whistling Happy Tunes in 2021

For much of 2021 it seemed like investors were just whistling “Walkin’ in the Sunshine” by Roger Miller and quickly forgetting the ‘worries and woes’ of the pandemic, inflation, the Fed, geopolitics and a host of other concerns. At least here in the US, 2021’s risk-on attitude didn’t let up for more than a few trading days at a time! Heading into a new year, there’s a general sense of shifting winds. So, let’s talk about 1) market highs, 2) valuation differences within the stock market, and 3) inflation. We’re here to walk with you through all that 2022 could bring and help you stay focused on the long-term trajectory of your financial plan.

Market Highs

You know it’s been a great year when the S&P 500 hits 70 new all-time highs! That’s the second most in S&P 500 history, only behind 1995’s 77 new highs. (This won’t be the last time the bull market of the 1990’s comes up.) Rising markets elicit both investor pleasure and anxiety. To quote DFA VP Weston Wellington’s year end commentary, investors “may be reluctant to make new purchases since the traditional ‘buy low, sell high’ mantra suggests committing funds to stocks at an all-time high is a surefire recipe for disappointment.” As he points out in the chart below, history would suggest otherwise:

Surprising? Rationally though, this makes sense since stock prices have increased over time and therefore new market highs must be reached on a consistent basis. Investors provide capital to companies with the expectation of positive returns over time. Whether it’s amid a recession or after an incredible rally, that long-run expectation remains the same. Our advice is to get new cash working for you in the markets as fast as you’re comfortable with, and to focus on the long-term results of diversified investing rather than short-term volatility.

Valuation Differences Within the US Stock Market

Hitting new all-time highs so frequently brings up another question: is the entire US stock market at a “lofty” stage, as some would say, or are there areas within the market with dramatically different valuations? According to most financial measurements, value-style stocks are reasonably priced verses historical averages. Depending on the valuation metric, US growth stocks have eclipsed their tech bubble highs. This is shown below in the price-to-book chart put together by Dimensional Fund Advisors.

When looking at this price-to-book chart, the spread (difference) between the lines is the key takeaway. Growth stocks always trade at higher multiples (the yellow line never crosses below the blue one). This is because investors are willing to pay more for companies with strong revenue and profit potential. Conversely, value-style stocks are usually “on sale” for a reason – they’re riskier. That extra risk has historically been compensated with higher returns. It’s difficult to predict when styles go in or out of favor and nearly impossible to predict it consistently across market cycles. Nevertheless, mean reversion is a powerful force and it’s unlikely that a growing valuation spread can continue indefinitely.

At Boardwalk, we recommend holding both growth and value stocks but incorporating a tilt away from growth stocks and towards value stocks due to their expected excess return over the market at any time, not just because of their current valuation spread.

Inflation

The December inflation data was recently published and shortly dominated financial headlines everywhere. Up 7% from one year ago, it’s the largest Consumer Price Index (CPI) bump since 1982. Alarming for all investors, we featured an in-depth spotlight on inflation during our last quarterly commentary and wanted to provide a few key updates.

First, equities are the best long run hedge against inflation even if prices reflect investors’ jitteriness in the short-term. Stocks handily beat this year’s inflation figures. Additionally, we include commodities (+27.1%) and global real estate (32.5%) in portfolios, in part due to their inflation hedging characteristics.

Second, this chart from Morningstar is helpful for describing the nature of today’s inflationary environment. This data shows month-over-month inflation in excess of the pre-pandemic trends.

The combination of supply chain issues, rising labor and production costs, and high consumer demand are all contributing to rising prices. But much of the large inflation adjustments are coming from a few select categories like “vehicles,” above. Higher automobile prices account for about half of the excess inflation we’re seeing, which gives hope of much lower inflation figures once supply chain issues are resolved in that industry (and others).Third, the bond market is expecting a return to “normal” inflation levels relatively quickly. While inflation proved to be stickier than the Fed’s initially projected “transitory” stance, market participants have priced in only moderately higher inflation over 5 and 10 years than pre-pandemic. This can be ascertained by calculating the difference between the nominal Treasury yield and the Treasury Inflation Protected Securities yield. This difference is called the “break-even rate.” The 5-year break-even rate (read: expectation for inflation) is just under 3%, compared to just under 2% in January 2020. The 10-year break-even rate is at 2.5% right now. There is no guarantee the collective expectation will prove to be right, but it’s a comforting piece of information given today’s headlines.

We’re here to help you better understand what’s going on in your portfolio and to steer you toward a long-term focus. Come what may in the markets, lean on us to help you translate your ideal goals into financial plans that make sense for you (and to you).

Can Inflation be a Good Thing?

When it comes to inflation, a small amount of it is healthy for the economy. That’s because when consumers and businesses expect prices to continue rising, they are more likely to buy something today. Strong current demand spurs growth on the supply side of the economy since businesses expand their workforces and production to meet this demand. As you can see, low and consistent inflation creates a virtuous cycle that is good for economic growth. In fact, the opposite scenario – deflation – would likely be more problematic than moderate inflation. The US Federal Reserve has set a target of 2% for core inflation with the duel aim of avoiding deflation or high inflation.

As we transition ‘back to normal’ there has been high consumer demand, massive governmental stimulus, supply chain issues, and global shortages of raw and manufactured goods. The Federal Reserve anticipates that most of these inflationary forces will abate. Caught between managing inflation and spurring growth, they’ve emphasized their goal of bringing employment back to pre-pandemic levels. If inflation proves to be less transitory than most economists expect, the Federal Reserve will likely take steps such as raising interest rates to avoid overheating the economy.

Inflation becomes dangerous when it causes too much growth and prices rise faster than wages, with everyone worse off in terms of purchasing power. To help counteract this effect for many retirees, the Social Security Administration bumped benefits for 2022 by 5.9% (compared to an annual average adjustment of 1.65% over the last decade)! For wage earners, incomes have and should continue to rise. So, for most clients there is a good amount of insulation against inflation via higher cash inflows. We also recommend appropriate cash reserves since cash is very susceptible to inflation. The inflation-adjusted ‘return’ of cash is virtually guaranteed to be negative. The risk of losing purchasing power can be mitigated through long-term, thoughtful investments and cash flow planning.

When it comes to the portfolio, we’ve designed the investment allocations with risks – like inflation – in mind.

  • Stocks typically hold up well against inflation in the long-term because companies can pass higher costs along to consumers. The bulk of most client portfolios are invested in US, developed international, and emerging market equities.
  • Bond returns may be muted or negative on a “real” (inflation-adjusted) basis in an inflationary scenario. This is especially true if interest rates rise – which is likely if the Federal Reserve deems it necessary to rein in inflation.
    • We have positioned portfolios with a healthy allocation to short-term bonds to diminish this risk. Shorter maturity bonds are less impacted by rising interest rates because they mature more frequently and can reinvest into higher interest rates.
    • We also avoid any allocation to long-term bonds right now because those would be most significantly hurt by rising interest rates. Yields at those maturities are not compelling enough for this large risk.
  • Commodities and real estate are “hard assets” that should do well in an inflationary scenario.
    • Real estate investments provide a hedge due to land scarcity and because rents tend to adjust with inflation, providing income protection.
    • Commodities have been the best performing asset class this year in part due to inflationary factors. While a laggard in the low yield and low inflation environment of the late 2010s, commodity funds have done well as an investment because prices for goods as far ranging as copper, lumber, and crude oil have all risen considerably this year.

No one knows which portfolio risk will present itself next, so we want to stress the importance of remaining diversified and disciplined in achieving long-term investing success.  If you have any questions or concerns about the positioning of your portfolio, let’s discuss it at your earliest convenience.

The Cost of Timing the Market

Markets have come down a bit from all-time highs, but the S&P 500 index is still up over 17% this year. Since March 23rd of 2020, the S&P 500 is up over 55%! For all investors, intense rallies like this beg the questions:

  • Is now a good time to put cash to work, or should I wait until the next correction?
  • Should I be trimming my winners by selling stocks and buying bonds?
  • I’m not sure the market or economy can keep this up and there are a lot of risks out there for the next year and even next decade, should I change my strategic allocation to hold fewer equities?
  • Or maybe: I know people who talk about their big gains and I don’t want to miss out – should I be changing my portfolio so that I can participate more in this exciting rally?

These are good questions to be asking. We want to talk with you about your feelings towards the market’s rally and future expectations. More importantly, we want to talk with you about how that fits into your risk tolerance, protecting your current needs, and meeting your future goals.

Many times, at the essence of these questions lies the concept of market timing – predicting when to enter and exit stocks, bonds, and cash as various investments experience rallies and corrections. The fact is, timing the market is extremely difficult.

Even missing just a few of the best days in a market rally has an enormous impact on an investor’s returns. Here are some stunning statistics put together by Dimensional Fund Advisors:

As we can see, missing the best 15 days of S&P 500 returns in the last 30 years would result in about one-third as much ending wealth!

Short periods of time “out of the market” could have huge opportunity costs, and it’s extremely difficult to accurately and consistently time entries and exits from the market. For example, someone might have seen the early declines of February 2020 and sold their stocks – correctly predicting that further losses were yet to come. But without a quick reentry, they would have been far better off to simply “ride out” the market correction and fully participate in the speedy recovery. Similarly, an investor today might leave cash on the sidelines, predicting an upcoming correction. If the market continues to rise, it often becomes harder to abandon the cash position, fearful of “buying high.” Many investors experience this ‘paralysis’ and miss out on the growth that disciplined, long-term investors receive.

On Monday, there was a great article on Morningstar that highlighted the long-term returns of market timing by professionals. Mutual funds with this focus are known as tactical asset allocation funds, and they’ve lagged their benchmarks significantly. Quite simply, it’s just hard to predict the future!

At Boardwalk, we believe in the importance of discussing our clients’ needs, goals, risk tolerance, and emotions when making investment choices and we use robust empirical findings to help clients be comfortable with their portfolio and confident in their decisions.

Investing Lessons From the Birthday Paradox

I was recently with a group of friends, and we were astonished to learn that two pairs of us had shared birthdays – out of 10 people! We were all blown away by this and assumed that the likelihood of even one pair of us having a matching birthday would be close to zero. Naturally, we turned to Google rather than our calculators, and found that a matching birthday is not nearly as rare as you would imagine. With just 10 people, there is over an 11% chance that two people will share a birthday! Perhaps even more surprisingly, the odds that two people will share a birthday are better than a coin flip within a group of 23 people and essentially guaranteed with a random group of 57! This “phenomenon” is known as the Birthday Paradox because it seems counterintuitive. But it started to be less surprising after reading about it.

Rather than thinking about the odds of getting a specific date (out of 365) to match, we need to consider the pairs of individuals present – because each person needs to be paired up against every other person in the group to see if they share a birthday. As an example, with two people there is only one pair (and very low odds of a birthday match). But with 10 people, there are 45 pairs! The number of pairs grow so quickly that with 57 individuals there are 1,596 pairs – hence the almost certain probability of a match.

Our brains have an extremely difficult time understanding this, because probabilistic and exponential calculations are not how we usually think about the world, birthdays, or money.

But perhaps they should be – even if we cannot wrap our minds around it fully! Thomas Edison’s quote, “The strongest force in the universe is compound interest,” is surprising in the same way that the Birthday Paradox catches our mind off guard. We’ve all heard the question: Would you rather have $1,000,000 today or a single penny that doubles in value each day for 30 days? And the answer…the power of compound interest is exhibited by the $5,368,709.12 you would have after a month if you opted for the penny.

Getting our minds to consider the world like this can be difficult, but it is important when it comes to investing.

To me, the lessons from the Birthday Paradox can be applied to market pricing efficiency. In liquid, transparent markets, pairs consisting of buyers and sellers trade constantly based on current information and their best future expectations. If only a few trades occurred for a stock, the odds of finding the “right price” may be low. But for markets like the S&P 500, there have been between 4-10 billion trades each day over the first three months of the year according to S&P Global Market Intelligence. Everyone is trying to assess the value of those 500 stocks, every day. And while there are certainly instances where individual stocks do not seem to trade “normally,” the market as a whole is very efficient in finding the matching price to value a company. New information and even expectations of future developments (like the odds of the next inflation reading being higher or lower than expected) are constantly assimilated into the price. This makes it very difficult to consistently outsmart the market through stock picking or market timing.

If you can’t beat ‘em, join ‘em! Despite the difficulty our brains have in understanding probabilities and exponential functions, we can still use them as we participate in the stock market. Taking Edison’s advice, saving earlier and often results in greater wealth down the road as we use compound growth to our advantage. And considering market efficiency, usually the best way to invest for the long-term is through more passive investment approaches and investing excess cash right away – because while no one knows what the future holds, our collective best guess is already “priced in.” The fruits of disciplined investing are not seen every week, month, quarter, or year, but over time will serve you well.

Do I Need a Will? What About Life Insurance?

Estate planning and personal risk management are usually not dinner table topics. And if there is going to be a conversation about personal finance among friends and family, these days a betting person would guess Dogecoin or AMC’s stock price would come up before wills or life insurance. That’s okay, they certainly are more interesting! But just because something is not interesting doesn’t mean it’s not very important. The information below is definitely less interesting than the GameStop stock drama, yet it is important to the financial wellness of your family.

Estate planning can get complex very quickly. While it is important to get a professional involved to determine what level of estate planning is appropriate, a basic “Last Will and Testament” document is typically a great start for every adult to have. So why do you, your family members, and friends need a will? A will ensures that property and assets get distributed according to your wishes. This distribution is done by a person of your choosing (the executor of your estate). Additionally, your named guardians will be responsible for your children. Without a written and legal will, a court process governed by state law determines who inherits assets and who raises children. This legal process is usually far more expensive and time consuming than setting up an estate plan. If you are married or have children, you certainly need a will. Even if someone is single and without dependents, they should strongly consider having a will if they have a positive net worth. A will eases the estate transfer process, reduces the potential for conflict among family members, and eliminates “room for error” in court interpretation.

So, what about life insurance – do we need that? Most of us also avoid talking about life insurance (or at least procrastinate on getting it)! According to Business Insider, that leaves more than two-thirds of Americans underinsured, despite a majority having some coverage. The key distinction here is whether merely having some life insurance is fine – and for those that need it, the answer is usually no. Basic coverage through an employer usually does not go very far when replacing an income, paying for childcare, or funding bigger goals like paying off the mortgage or funding a college education. As personal savings grow, children become adults, and retirement nears, life insurance can become less important or even unnecessary. Every situation is unique, but most people with dependents should get professional guidance from an independent financial advisor to ensure they have adequate coverage. The good news is that term life insurance can be very affordable, unlike whole life insurance and other complex policies. Whole life policies remain in place through a policyholder’s lifetime and pay a benefit at death, but these can be very expensive and provide coverage long after it is no longer needed. Term insurance is in place for a set period (such as 20 or 30 years) and only provides a benefit if someone passes away during that time. It is meant to act like true insurance – protecting your loved ones against an untimely death, when lost income during working years and inadequate savings could severely impact their financial wellbeing.

Here are Boardwalk, we believe in financial planning because our choices beyond the portfolio have large impacts – financial and otherwise! Actionable steps in estate planning and personal risk management have controllable outcomes (unlike the markets) and the feedback we have received from our clients demonstrates the peace of mind and financial benefits of proper planning. We encourage everyone to seek out quality, independent advice to ensure they have adequate life insurance coverage and estate planning in place.­­­

Spring Is in the Air but Your Tax Planning Shouldn’t Have to Be

For many, spring is one of the best times of the year – mostly because of melting snow and warm sunshine, and less so because of tax filing. Throughout 2020, Boardwalk actively adjusted tax recommendations for each of our clients’ specific needs in response to the CARES Act, portfolio tax-efficiency, and changes in income for many clients. We have included a brief overview of a few impactful changes for the 2020 tax season. And should you have any questions as you file your 2020 return, please don’t hesitate to reach out to Mike or John.

Along with more typical tax planning strategies, such as building your portfolio as tax-efficiently as possible or optimizing retirement savings, there were three areas impacted by the CARES Act (March) and the Emergency Coronavirus Relief Act (December) that we wanted to highlight: charitable giving, support for businesses, and economic impact payments (stimulus checks).

Charitable Giving: In response to a difficult economic environment and greater need for community support, Congress increased the deductibility of charitable giving for taxpayers that itemize their deductions as well as the vast majority of Americans who take the standard deduction. For taxpayers with enough mortgage interest, state or local taxes, or charitable giving to itemize their deductions, the CARES Act allows up to 100% of AGI to be deducted for cash charitable donations in 2020. Ordinarily, tax law limits deductions for charitable giving to 60% of AGI for cash donations and even less for non-cash gifts. If the standard deduction ($24,800 for married filing jointly under age 65) is taken, then there is a unique above-the-line deduction of $300 for charitable giving done in 2020. There is a $600 below the line charitable deduction for married tax filers in 2021 ($300 for single), but the law does not extend this deduction into future years.

For Boardwalk clients, we consider your tax situation to find the optimal strategy for charitable giving, including gifting appreciated securities, “bunching” deductions using a charitable “donor advised fund,” or donating directly from your IRA if you are required to take annual distributions.

Small Businesses: Faced with lockdowns and dramatic swings in consumer demand, the CARES Act and subsequent Emergency Coronavirus Relief Act provided small businesses with economic relief in the form of the Paycheck Protection Program (PPP). For many businesses, PPP loans are forgivable provided that the funds were used to cover payroll and other enumerated expenses. If forgiven, the loan is not taxable income and business expenses paid by PPP funds remain deductible.

As with other business-related tax law changes in years prior (like the Qualified Business Income deduction introduced in 2017), Boardwalk has advised on how to utilize these changes to help our small business owner clients.

Stimulus Checks: Economic Impact Payments last spring and at the turn of the calendar helped many Americans through a difficult year. Both the first round of stimulus checks at $1,200 per tax filer and the second round at $600 per filer were paid in full for joint (single) taxpayers with income of $150,000 ($75,000) or less on their 2019 tax returns. Higher income earners’ eligibility was phased out. For those above the phaseout points in 2019 but with qualifying income in 2020, the Recovery Rebate Credit will ensure that you receive a refundable tax credit for these missed stimulus payments. With passage of the American Rescue Plan Act expected today, families with income under $150,000 (phased out at $160,000) will receive $1,400 stimulus checks. Unlike the last two rounds where families only received money for dependent children, adult dependents (over age 17) are now eligible for checks as well. If you have already filed for 2020, your eligibility will be based on your 2020 tax return, with an opportunity to get additional amounts credited in 2021 if your income for that year is lower than 2020.

As with other tax credits, deductions, or retirement contributions, there is often an income limitation to consider and plan around if possible. More broadly, it is also important to manage income tax brackets when possible (including thresholds that increase capital gains rates or IRMAA charges). If flexibility exists in your recognition of income and deductions, we analyze tax projections to optimize your tax position.

Please reach out to Boardwalk with any questions you may have on these specific 2020 tax items or the usual tax planning items such as IRA contributions, Roth conversions, HSA contributions, or savings to 529 plans. We are keeping close tabs on how strategies for 2021 will impact our clients, especially in the event that any significant tax law changes are enacted.

How Much Does Your Attention Impact Your Finances?

Many of the most recent breakthroughs in financial research have been discovered by psychologists rather than economists or investment researchers.  The branch of study they’ve pioneered is known as “behavioral finance.”  This was evidenced in 2002, when the Nobel Prize in Economics was given to psychologist Daniel Kahneman.  The insights gained from research in behavioral finance reveal how our brains process decision making and how this can heavily impact our finances – in both helpful and harmful ways.  Of the many behavioral biases that we can have, many are rooted in how we apply our attention.

As humans, we tend to avoid “headline” risks (like those on the front page of the newspaper or widely discussed in public).  While this seems appropriate, this tendency often causes us to take on larger but lesser known risks.  A good example of this occurred in the aftermath of September 11, 2001.  Due to the “headline risk” of flying, more people opted to drive instead of fly even though air travel is much safer than driving – especially over long distances.  Professor Gerd Gigerenzer, the director of the Harding Center for Risk Literacy in Berlin, estimates that an extra 1,595 Americans died in car accidents in the year after the attacks due to this tendency.  Because of our poor understanding of danger, the maxim “out of the frying pan into the fire” often applies to our behavior.  This holds true in our financial decisions.  If the stock market crashes, it is understandable that many people don’t want their portfolios to suffer the same fate.  Avoiding this risk by holding excess bonds or cash in advance may accomplish that, but at a near certain risk of their portfolio failing to generate sufficient inflation-adjusted returns.  Even more, deciding amid a downturn to offload risk by selling stocks in favor of bonds or cash poses an even more significant risk to the portfolio’s recovery.  It matters where we focus our attention – are we just “seeing” headline risks or are we focused on our exposure to real risks and actively working on what we can control?

Just how it’s easy to focus on “headline” risks, we also tend to commit our attention to seeking complex solutions rather than embracing simple, powerful ones.  As a derivative of this behavioral bias, we often try to “outsmart” the system.  A study, “The Left Hemisphere’s Role in Hypothesis Formation,” published by The Journal of Neuroscience in 2000, examined how humans and animals “guess” when certain probabilities are in place.  In one experiment, 80% of the time a light would appear on the right.  The remainder of the time it was on the left, but the sequence was random.  Prior to each trial, the subject would predict which side the light would be on.  Rats, discovering that the light on the right would appear most times, continually selected that side.  On the other hand, humans tried to use frequency matching to guess when the left light would appear – with minimal success!   Human subjects chose a less optimal strategy than rats because of our desire to find patterns and outsmart the system.  Like in this study, we tend to overlook the simple solutions to investing intelligently.  Instead, we attempt to beat the rest of the market with exotic or complex solutions.

The simple but powerful index fund doesn’t have all the bells and whistles that actively managed mutual funds tout, but they have outperformed most active managers over the past decade.  According to S&P Dow Jones’s 2017 SPIVA (“S&P Indexes Vs. Active”) scorecard, 63.43% of actively managed funds invested in U.S. stocks underperformed their benchmark in 2017 – over a three-year period the number of underperforming funds jumps to 83.40% and at 10 years reaches 86.65%.  In some categories, like funds invested in U.S. “small-cap” stocks, less than 5% of actively managed funds outperform their benchmark over a period of 10 years.  Despite not offering all the expertise of fund managers and their bold predictions, a simple strategy for diversification – the index fund – almost always wins out.  Our human desire for complexities is seen even more in the appeal of hedge funds and the way pensions and endowment funds typically invest.  As a testimony to simple, powerful investing solutions, my alma mater, Carthage College, was featured in numerous articles for having better returns than Harvard’s $37 billion endowment fund over the 10-year period leading up to June 30, 2017.  When asked why reliance on indexing isn’t more common among the nation’s endowments, Carthage’s endowment manager replied, “Maybe it’s too simple.” 

At Boardwalk Financial Strategies, one of our goals is to help you focus your attention on the important things and not let behavioral biases negatively impact your wealth.  Where we focus attention often gets the better of us: humans focus on avoiding “headline risks” (even if we take on larger but lesser known risks) and overlook simple, powerful solutions because of our desire for complex solutions.  It can be hard at times to not let our impulses dictate how we invest money or handle financial decisions.  But we believe focusing our attention on the things we can control – like financial planning – and utilizing an academic, data-driven (though simple) investment philosophy are ways we can help you build wealth, remove financial stress, and find the time and peace to enjoy what matters most to you in life.