The Mathematics of Asset Location

Our recommendation on asset location is to prefer holding tax-inefficient assets in tax-advantaged accounts. In our view, the expected return of an asset is close to irrelevant when determining where to locate it. This guidance applies to Roth as well as to traditional IRAs. For many, this can seem counterintuitive, given that much of what investors find in the financial media generally discusses locating the highest-expected-return asset classes in the Roth account.

This article is broken into two sections. First, we will discuss how a security’s expected return and risk characteristics can change based on where the asset is located. Second, we will walk through a Roth-versus-taxable-account asset location decision using after-tax asset allocation.

Section One: Asset Location’s Effect on Expected Return and Risk

The following table indicates the principal effectively owned by, return received by, and risk borne by individual investors in each savings vehicle. As shown, in contrast to bonds and stocks held in a Roth IRA, for bonds and stocks held in a tax-deferred account, the investor effectively owns each dollar of principal multiplied by one minus the tax rate on it but receives 100 percent of the returns and bears 100 percent of the risk.

Savings Vehicle Principal Return Risk
Roth IRA 100% 100% 100%
Tax-deferred account 1 – tax rate 100% 100%
Taxable account
 Bonds 100% 1 – tax rate 1 – tax rate
 Stocks 100% 1 – tax drag 1 – tax drag

To illustrate the risk and return sharing of bonds held in taxable accounts, we assume bonds have a 3 percent expected return and a 4 percent standard deviation (a measure of risk), as well as that the investor is in the 25 percent tax bracket. We also assume bonds earn returns of -1 percent, 3 percent and 7 percent in three years; that is, they earn the mean return and one standard deviation below and above it. The standard deviation of these returns is 4 percent. Assuming the 1 percent loss is used to offset that year’s taxable income, the investor’s after-tax returns are -0.75 percent, 2.25 percent and 5.25 percent for a standard deviation of 3 percent. In this case, the investor receives each dollar of pretax return minus the tax rate on it and bears each unit of pretax risk less the tax rate.

When stocks are held in taxable accounts (with cost bases equal to market values), the investor owns 100 percent of the principal, but their after-tax return and risk is reduced by a tax drag, specifically the taxes due on dividends and realized capital gains. The tax drag number depends upon how actively the stocks are managed, but for purposes of this example, we will assume that 15 percent of the return on stocks is lost to taxes each year. (This effectively assumes that all capital gains are realized 366 days after the stocks are purchased.)

To once more illustrate risk and return sharing properties of taxable accounts, we assume stocks have a 7 percent expected return and a 19 percent standard deviation. Stocks, we further assume, earn pretax returns of -12 percent, 7 percent and 26 percent in three years; that is, they earn the mean return and one standard deviation below and above it. The standard deviation of these returns is 19 percent. If the loss is used that year to offset long-term capital gains, the after-tax returns are -10.2 percent, 5.95 percent and 22.1 percent for a standard deviation of 16.15 percent (or 85 percent of the pretax standard deviation).

The key message from these examples is that the same underlying asset can have different expected return and risk characteristics depending upon the type of savings vehicle in which it is located.

Section Two: Asset Location and Roth IRAs

Using the framework from the first section, we can evaluate asset location decisions when it comes to Roth IRAs versus taxable accounts. This section assumes the investor will use all assets in his or her lifetime and is not designating Roth accounts for future heirs. If the investor is designating the Roth for heirs, then this account is effectively being managed for a purpose other than retirement and should have its own Investment Policy Statement.

The following are our capital market and tax assumptions:

Expected return on stocks  7.0%
Expected return on bonds  3.0%
Standard deviation on stocks 19.0%
Standard deviation on bonds  4.0%
Tax rate on stocks 15.0%
Tax rate on bonds 35.0%

Assume that our hypothetical investor has $200 split evenly between a taxable account and a Roth. Let us also express the investor’s risk tolerance in terms of acceptable volatility, and, in this case, the client is comfortable with a portfolio after-tax standard deviation about 9.7 percent.

One way to accomplish this would be to locate $100 of bonds in the taxable account and $100 of stocks in the Roth account.* The following table has the results:

Scenario 1: Incorrect Location
After-Tax Expected Return After-Tax Expected SD Start $ End $    Pre Tax End $ After Tax
Taxable account Stock 6.0% 16.2% $0.00 $0.00 $0.00
Bond 2.0% 2.6% $100.00 $103.00 $101.95
Roth IRA Stock 7.0% 19.0% $100.00 $107.00 $107.00
Bond 3.0% 4.0% $0.00 $0.00 $0.00
Total   4.5% 9.6% $200.00 $210.00 $208.95

The portfolio has an after-tax expected return of 4.5 percent and an after-tax standard deviation of 9.6 percent. At the end of the one-year period, the investor wound up with $208.95.

An alternative way to get to the 9.7 percent after-tax standard deviation would be to locate the assets in the optimal manner, with $100 of stocks in the taxable account and a 15/85 mix in the Roth account.*

Scenario 2: Correct Location
After-Tax Expected Return After-Tax Expected SD Start $ End $    Pre Tax End $ After Tax
Taxable account Stock 6.0% 16.2% $100.00 $107.00 $105.95
Bond 2.0% 2.6% $0.00 $0.00 $0.00
Roth IRA Stock 7.0% 19.0% $15.00 $16.05 $16.05
Bond 3.0% 4.0% $85.00 $87.55 $87.55
Total   4.8% 9.7% $200.00 $210.60 $209.55

The after-tax standard deviation of Scenario 2 is roughly the same as Scenario 1, even though the portfolio contains a higher allocation to stocks. The reason for this is that the government shares in the volatility of the stocks held in the taxable account. The after-tax expected return is higher in Scenario 2 than in Scenario 1, and the investor winds up with $209.55 at the end of a year.

The key insight from Robert Dammon, Chester Spatt and Harold Zhang’s 2004 Journal of Finance paper, “Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing,” is that Scenario 2 will have a higher after-tax expected return than Scenario 1, regardless of what the stock and bond returns are, as long as the following two conditions are met:

1. The tax rate on bond interest is greater than the tax rate on stock gains and dividends.

2. The interest rate on bonds is positive.

This is true even if we assume all stocks are taxed every year. In reality, some of the stock returns are tax-deferred even if the stock holding is in a taxable account. The size of the improvement in after-tax returns is exactly equal to the interest rate on bonds multiplied by the difference in tax rates.

Let’s look at one more scenario where the investor’s risk tolerance is expressed in terms of actual dollars allocated to stocks and bonds. In this scenario, we will say our investor wants a 50/50 asset allocation.

Scenario 1 still applies, but Scenario 2 has too much invested in equities. Scenario 3, then, locates $100 of stocks in the taxable account and $100 of bonds in the Roth.*

Scenario 3: Correct Location
After-Tax Expected Return After-Tax Expected SD Start $ End $    Pre Tax End $ After Tax
Taxable account Stock 6.0% 16.2% $100.00 $107.00 $105.95
Bond 2.0% 2.6% $0.00 $0.00 $0.00
Roth IRA Stock 7.0% 19.0% $0.00 $0.00 $0.00
Bond 3.0% 4.0% $100.00 $103.00 $103.00
Total   4.5% 8.3% $200.00 $210.00 $208.95

Scenario 3 provides exactly the same after-tax expected return as Scenario 1, but with less volatility. The reason for this is that the government is partaking in the volatility of the portfolio’s stocks.

It is important to recognize that the government shares in the risk and return of assets located in taxable retirement savings vehicles. Therefore, a bond or a bond fund held inside a Roth is effectively a different asset than the same bond or bond fund held in a taxable account. Using the assumptions from our last example, the return and risk for a bond held in a Roth IRA are 3 percent and 4 percent, but only 2 percent and 2.6 percent for the same bond held in a taxable account.

By employing this framework, we learn that the best assets to hold in the taxable account are those that make the best use of the preferential long-term capital gains treatment. This will typically be stocks, as long as the investor is willing to avoid short-term capital gains.

* This scenario is hypothetical and being presented for illustrative purposes only. It relies on the capital market assumptions cited in this article.

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of The BAM ALLIANCE®. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2018, The BAM ALLIANCE®

The Basics of a Spend-Down Strategy

Almost every client we talk with emphasizes one primary, overriding goal: having enough money in retirement. Most do not know how much money they need to save, or the planning process to get there. To provide the answers, we work collaboratively with clients to develop an overarching spend-down strategy designed to minimize taxes in their retirement and legacy plans.

By dividing their financial life into four timeframes, we can focus on the present but explain to clients the plan’s future benefits. Those timeframes are accumulation, blackout, spend-down and legacy. The overarching constant of these four stages is taxes. Our goal is not to help clients structure their affairs simply to pay the least amount of taxes each year. Rather, it is to create a framework that helps a family lose the least amount to taxes over a lifetime. Let’s look at these timeframes and, for each, provide examples of what strategies can be most beneficial.

Accumulation: This period begins with the first day of a career and ends when earning years cease. Some of the most common accumulation strategies are these:

  • Begin saving as early, and as much, as possible.
  • Take advantage of any employer match offered in a 401(k) plan.
  • Choose between Roth and traditional retirement accounts based on both current and future expected income tax brackets.
  • Build a globally diversified portfolio using an evidence-based approach.
  • Choose an allocation between stocks and bonds that matches your need, willingness and ability to take risk.
  • Choose the right location, that is, type of account, for holding stocks and bonds. Specifically, match ordinary-income-producing assets (bonds) with ordinary-income-tax accounts (401(k)s and IRAs). Match dividend- and capital gain-producing assets (stocks) with accounts that take advantage of preferential tax rates on those dividends and capital gains, and that allow a tax-free step-up in basis at death (joint or individual brokerage accounts).
  • Manage the financial hardship of a premature death by securing adequate and appropriate life insurance.
  • Plan for disability or premature death with powers of attorney and a will.
  • During the final earning years, when your marginal tax bracket generally is highest, fund a donor advised fund with appreciated stock worth several years of charitable contributions.

It may seem like the majority of the time and effort required to construct a comprehensive financial plan goes into formulating and executing these strategies, perhaps because they tend to get the most front-end attention or because the accumulation period is one of the longest. However, the way clients maintain and distribute the nest egg they’ve spent decades building can be just as important as the way they accumulate it, and can have a lasting impact on a family’s wealth.

Blackout: This period begins at the end of employment and ends at age 70½. It can be several years or nonexistent. Strategies useful during this time can be counterintuitive, because recommendations to pay more income taxes than necessary now can seem difficult. However, it is important to take the long-term view and avoid the common objective of always paying the least amount in taxes in the current year, focusing rather on taxes that can be saved in the future by taking advantage of potentially lower tax brackets during this timeframe.

Estimate what the marginal tax bracket after age 70½ will be if no planning is done, and consider converting a traditional IRA to a Roth IRA, thus shifting income into a lower tax bracket. Determine the optimal Social Security claiming strategy while efficiently transitioning from an employment paycheck to a paycheck from savings. Review the purpose and/or need for life insurance, and, finally, analyze supplemental Medicare policies and choose one best suited for your individual circumstances.

Spend-down: This period begins in the year you turn age 70½ and continues for the rest of your life. This is the age when the government mandates that investors begin taking required minimum distributions from their retirement accounts. The goal in this period is to use the funds you’ve accumulated to maintain your lifestyle.

Strategies during these years usually focus on after-tax, risk-adjusted returns. Review your choice of allocation between stocks and bonds to ensure it continues to match your need, willingness and ability to take risk. Start each year with an understanding of where funds will come from to support your income needs and lifestyle. Project adjusted gross income to control the impact on future Medicare premiums. In addition, consider donating to charity directly from an IRA and use the standard deduction to minimize taxable income. Sell equities with a high cost basis when necessary to fund your lifestyle, and take advantage of market downturns to harvest losses to lower taxes. Perhaps name a charity as your IRA’s beneficiary. It’s also vital to review estate-planning documents periodically and change them to adapt to your changing circumstances.

Legacy: Ultimately, this period occurs after your death, but the choices to make during your lifetime involve how much you will give to heirs, charity or the government at your death. Most of the strategies to limit the amount that goes to the government in taxes are put into place years before the end of life. Examples include equalizing the ownership of equities between spouses to take advantage of the step-up in basis on the first spouse’s death (this allows a surviving spouse to reduce equity risk, if desired, without income tax), revising beneficiary designations after the death of a spouse, selecting the best assets to give to charity, choosing the best assets to give to heirs, and preparing heirs for the transfer of wealth through lifetime gifts and/or family meetings.

Developing a spend-down plan is personal and unique to each individual, couple or family. An advisor in this arena must be comfortable and proficient in the worlds of investments, income tax, estate tax, insurance and charitable planning, to name but a few. The savings and peace of mind realized with a well-constructed and regularly reviewed plan are difficult to measure in dollars and cents. Clearly, those without a plan can suffer hardships they may not overcome. Why would anyone allow the latter to occur when proper planning, if it’s begun soon enough, can help avoid this outcome entirely?

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of The BAM ALLIANCE®. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2018, The BAM ALLIANCE®

Important To-Do’s Before Sending Your Child Off to College

The day has come. Your little baby has grown up and is now ready to leave the nest. He or she has graduated high school and the next big step is awaiting. Whether it’s college, a gap year, a year abroad or any other life adventure lies ahead, this time can be filled with much emotion for you and your child.

As departure day gets closer, you’re probably focusing on last-minute shopping lists and feeling overwhelmed with trying to get everything done in time. Of course, you have already visited Walmart, Target and IKEA for the dorm room basics, purchased the new computer (yes, that is a 529 College Savings Plan qualified expense), figured out the move-in logistics, and coordinated with the roommate about who will bring what.

Congratulations, you are well on your way. However, you might not be finished just yet. The following are six important tasks you may have overlooked.

  1. Make an appointment with your attorney to create a durable power of attorney document for financial matters and a health-care proxy.

Without them, in most states, you, as a parent, don’t have authority to make health-care decisions or manage money for your children once they turn 18. That’s true even if you are paying the tuition, have your child on your health insurance plans, or claim your child as a dependent on your tax returns. Without such documents in place, if your child is in an accident and/or becomes disabled, even if only temporarily, you might need court approval to act on your child’s behalf.

  1. Establish a monthly budget for your child.

The precise amount agreed upon in said budget is a personal discussion. However, it is especially important to set clear expectations about who will pay for what expense. Maybe you agree to pay for all school-related expenses and it’s your child’s responsibility to pay for all or some of the social expenses. Don’t spring this conversation on your child as you arrive on campus. Discuss it early enough to allow your student time to find a good summer job to earn and save money for the upcoming year.

  1. Determine whether your child will receive a credit or debit card and set rules around when to use each.

Educate your child on the difference between the two and, based upon your child, decide which is the better option. There are advantages and disadvantages with each. If your child is just starting to learn how to budget and balance a checkbook, beginning with a debit card may be best, especially for general daily expenses. Leave the credit card for larger expenses, such as travel arrangements, and emergencies.

Two important benefits of using a credit card are the ability to create a credit history and its better security. Building a credit history can work two ways – you can create a positive credit record or a negative one – so it’s imperative you educate your child on the proper way to use a credit card. Pay off the balance every month, don’t overspend, don’t assume mom and/or dad will bail you out every time, and understand how interest charges and late fees add up and are cumulative. Frank Abagnale, of “Catch Me If You Can” fame, explains that consumer protection law treats debit and credit cards very differently. Under federal law, your personal liability for fraudulent charges on a credit card might not exceed $50. But, if a fraudster uses your debit card, a direct line to your bank account, you could be liable for $500 or more, depending on how quickly you report it.

Some simple steps you, as a parent, can take:

  • Co-sign on the card.
  • Start with a low credit limit.
  • Ensure you have online access to the card.

Get ahead of the onslaught of credit card solicitations your student will receive. Advise your child simply to ignore and discard them.

In just a few years, your child will begin life fully on his or her own. Your child will need to sign an apartment lease and perhaps buy a car. While you can and will probably need to co-sign, how much better will your child feel if he or she already has established some positive credit history?

  1. Once on campus, make sure you and your child know where the closest hospital, urgent care and 24-hour pharmacy are located.

Ask your regular doctor or a trusted family member or friend familiar with the school or town if they know a good physician in case your child needs medical attention above what the college health center can provide. Make sure your child carries his or her health insurance card and you have reached an agreed-upon way to pay for any medical expenses. Does your child know when to use the credit card versus the flexible spending or health savings account (HSA) card? Remember to pack your child a simple medical kit with the essentials (bandages, anti-bacterial cream, cold and flu medicine, etc.).

  1. Have your child write down all passwords to any digital profiles, including financial and social media accounts.

Keep this in a safe place at home. Your child may not like this, but explain that you are not doing it to invade privacy, but to protect it in case of an emergency. I recommend you review this list with your child before each new school year in case any passwords have changed. On a related but separate note, have you and your spouse shared this information between yourselves? You probably should.

  1. Talk to your insurance agent and ask about covering your child’s belonging while they are living on or off campus.

The premiums associated with a dorm insurance policy or a renter’s insurance policy vary, but affordable options generally are available. Make sure the coverage amount and deductible of any policy you consider are appropriate for your and your child’s specific circumstances.

While my list of must-do items can help ensure you meet certain financial and other important needs before the first day of new student orientation, don’t let prioritizing the emotional aspect of dropping off your child at college for the first time get lost in the commotion. Indeed, this event can be a special opportunity to connect with your child.

Marshall Duke, a professor at Emory University, offers some wonderful advice on this topic. He writes: “It is a moment that comes along once in a lifetime. Each child only starts college once.… Such moments are rare. They have power. They give us as parents one-time opportunities to say things to our children that will stick with them not only because of what is said, but because of when it is said.

“Here is what I tell the parents: think of what you want to tell your children when you finally take leave of them and they go off to their dorm and the beginning of their new chapter in life and you set out for the slightly emptier house that you will now live in. What thoughts, feelings and advice do you want to stick? ‘Always make your bed!‘? ‘Don’t wear your hair that way!‘? Surely not. This is a moment to tell them the big things. Things you feel about them as children, as people. Wise things. Things that have guided you in your life. Ways that you hope they will live. Ways that you hope they will be. Big things. Life-level things.”

Duke suggests writing your child a special note, starting it with something like, “When I left you at the campus today, I could not tell you what I wanted to say, so I’ve written it all down.” Mail it, the old-fashioned way. He writes: “It will not be deleted; it will not be tossed away; it will be kept. Its message will stick. Always.”

It may take time for you and your child to adjust to this new stage of life. At the beginning, it may help to think of your child as a high school student now in college. Your child will need to learn how to become a college student – how to study, how to eat, how to handle money – and thrive amid the greater independence. So don’t be too hard on your student. This is a time to experience new things, and remember that your child will learn many of the most important lessons to prepare for life ahead outside of the classroom.

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of The BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2018, The BAM ALLIANCE®

The Keys to Effective Budgeting: Autonomy and Automation

Most people avoid budgeting because they consider it an exercise in repressive tedium. But it doesn’t have to be. By applying the science of motivation, economic evidence and the art of creativity, the apparent boredom of budgeting and saving can be remade into part a life-giving financial rhythm.

In his book, Drive, Daniel Pink teaches us that most institutions still use outdated science to motivate. Known as the “carrot-and-stick” approach, Pink demonstrates that the archaic addiction many organizations have to extrinsic motivation is far less effective than intrinsic motivation, which comes from within. The most successful resolutions are those autonomously motivated. In short, the wordcould is more effective than the overused should.

So, please hear this: Only budget if you want to, on your terms. It’s up to you.

Once you’re self-motivated enough to kick off a saving and budgeting campaign, economists Richard Thaler and Cass Sunstein can help you find the most effective way to accomplish your objectives. They recommend setting up a system of default options. Dubbed “choice architecture” in their bestselling book, Nudge, Thaler and Sunstein laud the value of helpful default mechanisms. For anything.

Consider, for example, a new computer or electronic device. Tech companies know that some of their customers want a broad range of choices in setting up their new hardware and software, but most of us just want to get up and running. Therefore, when I see a default setting labeled as appropriate “for most users,” that’s what I want.

But we can also set defaults for ourselves.

You can get a long way in effective budgeting by simply establishing default settings. But the real secret is to then automate them. This appears easy to do in the case of your 401(k) (or equivalent plan) at work. You receive a company match up to 6 percent of your salary? Bang—have 6 percent of your salary deferred to your 401(k). That will guarantee you get all the free money at your disposal.

The pre-tax salary deferral default is especially effective because you likely won’t even “feel” it come out of your paycheck. You only need to concern yourself with budgeting whatever remainder is deposited into your checking or savings account. But you can set up automatic defaults here as well. You could, for example, divert 4 percent of your salary to your Roth IRA, 3 percent to your emergency reserves and 2 percent to your new car fund.

Some financial institutions have made this task even easier, allowing savers to have multiple “sub-accounts” for their money. So, you could create separate “accounts” for an upcoming vacation, holiday gifts and even your worm-farm project, redirecting a specific amount of cash the day after your paycheck hits.

I encourage you to get bit by the automation bug, using it to pay as many bills and fund as many savings objectives as possible each month. This takes care of all the heavy lifting in budgeting. Then, you can spend what’s left guilt-free, safe in the knowledge that your major priorities have been funded.

And that’s what it’s all about—funding your priorities, not just copying someone else’s. So put your mark on your budget. Personalize it.

Years ago, when my wife and I were going through that blurred phase of life so common with very young children, we knew it was important to set aside time and money to remind ourselves that we were spouses before we were parents. But when we found the time to carve out a date night, we couldn’t do it because all of our cash flow was subsumed by diapers and doctor’s visits. So we created a “date night” category in our budget—effectively planning for spontaneity. This removed the financial constraints of getting an opportunity for a night out.

You see, budgeting can be more freeing than it is restrictive. By combining the powerful forces of autonomy and automation, budgeting can become a creative, life-giving exercise instead of the burdensome chore that most people perceive it as.

This commentary originally appeared May 8 on Forbes.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2018, The BAM ALLIANCE

Rising Interest Rates and Their Effect on Stock Prices

As the director of research for Buckingham Strategic Wealth and The BAM Alliance, one of the most-asked questions I’ve gotten lately involves the impact of rising interest rates on equity prices, with the conventional wisdom among many seeming to be that increasing rates are bad for stocks.

The specter of rising interest rates aside, it’s not as if investors don’t already have enough to worry about, with U.S. equity valuations at historically very high levels (the Shiller CAPE 10 ratio, as I write this, is above 32), the potential threat of a trade war, the risk of Italy leaving the euro, as well as other geopolitical risks, including North Korea, Iran and Syria.

With a strong economy, investors are becoming even more worried about rising interest rates and the effect they could have on equity (and bond) valuations. So what, if anything, should investors do with their equity portfolios in response to rising rate risk? As always, to answer that question, I’ll turn to academic evidence and financial theory, rather than some guru’s opinions.

Key Dichotomy

Perhaps the most important thing is not to confuse knowledge with value-added information. Let me explain.

In investing, there is a major difference between information and knowledge. Information is a fact, data or an opinion held by someone. Knowledge, on the other hand, is information that is of value.

In this instance, the information is that the Federal Reserve is expected to increase interest rates perhaps two more times in 2018. That leads many investors to conclude they should minimize equity risk, as equities compete with bonds. Thus, rising rates would no longer be supportive of today’s historically high valuations.

Of course, this ignores the lesson the market taught in 2017, as the Fed raised rates three times last year, yet the S&P 500 returned almost 22%. With that in mind, let’s turn to a review of the longer-term evidence on the link between stock prices and bond yields. Thanks to Andrew Berkin, the director of research at Bridgeway Capital Management and the co-author of two of my books, “The Incredible Shrinking Alpha” and “Your Complete Guide to Factor-Based Investing,” for his study, “What Happens to Stocks When Interest Rates Rise?”, which appears in the Summer 2018 issue of The Journal of Investing.

Rising Rates Study   

Berkin begins his analysis of the historical evidence with a review of the theory of the relationship between bond yields and stock returns. He asks: Why might stocks go down when yields rise?

Basic investment theory states that the value of an investment should equal the sum of its discounted future cash flows. Therefore, as interest rates rise, so should the discount rate, which implies that stocks should be worth less. Higher rates also slow the economy, which can dampen earnings and cash flows. Furthermore, higher yields make fixed-income investments more attractive, and equity valuations may suffer.

However, there are also reasons stock returns may be positive in the face of higher yields. Rising rates reflect a robust economy, which should enhance corporate profits and cash flows. In addition, the market already should have priced in expected changes in interest rates and cash flows. Certainly, a rise in bond yields this year would not be an unexpected event.

Berkin concluded: “There are good reasons for both sides of the direction of stocks, and which will win out is hard to say.” The reason is, as Berkin writes, that “equities are influenced by a variety of factors.”

To predict the outcome accurately, an investor would need not only to forecast the future direction of interest rates and their impact on GDP and inflation, but also to forecast accurately how it compares with what other investors already anticipate. That has proven to be an exceptionally difficult task.

Berkin presents U.S. stock returns according to the contemporaneous change in bond yields for a given year, as well as returns according to the direction of the change in yields. His 90 years of data, from 1928 through 2017, split almost evenly between negative (44 years) and positive (46 years) changes in yield.

He found that “whether yields were up or down, stocks did quite well on average. The mean return to the S&P 500 was 10.81% when yields fell and somewhat higher at 12.22% when yields rose. But in both cases there was large variation in returns, as can be seen by standard deviations of almost 20%. Furthermore, minimum and maximum returns were quite extreme whether yields were up or down.”

As a result, Berkin concluded: “There is little evidence that rising rates alone are bad for stocks. … In all cases, stock returns are on average quite strong, although with a high deviation and wide dispersion.”

Even in the quintile of years when rates rose the most, stocks provided, on average, returns of about 9%, not much below their historical average return. However, the single worst return, -43.8%, was in that quintile. On the other hand, the best return in that quintile was almost the same magnitude, at 43.7%.

Delayed Reaction?

Given that the results above are for returns in the same year as yield changes, Berkin examined whether perhaps there is a delayed reaction, where the impact of a rise in rates hits stocks later. He writes: “Such an effect would be good to know, because an investor would be able to look at a change in rates this year and make decisions about prospective returns next year.”

Here, Berkin found “some evidence that stocks do better when rates fall. When yields move lower equities returned 13.31% on average in the next year, compared to 7.55% in the year after rates rose.” When evaluating by the magnitude of yield change, stock returns are highest, at 14.17%, in the year after rates fell the most.

This is notably higher than stock returns when rate changes are in the upper two quintiles. However, he writes, “a crucial point is that stock returns are nicely positive in all cases.”

Other Perspectives

Because long-term bond yields are only one way to measure interest rates, Berkin also examined the relationship between equity returns and the level or change of short-term Treasury bills, the spread between long- and short-term yields, and real (inflation-adjusted) yields. Again, he found no significant relationships. In addition, looking at longer-term stock returns of three, five and 10 years also showed no effect.

Berkin also examined the data from international markets. Once again, he found similar results. With data from the mid-1980s for 22 developed markets, he found that whether rates rise or fall, stock returns are still quite positive on average, though, as was the case in the U.S., there is great dispersion in returns.

Interestingly, the international markets have done quite well when yields rise the most, returning on average 13.3% annually—well above the roughly 6% earned in the second and third return quintiles.

As he did with U.S. stocks, Berkin examined international equity returns in the year after a change in rates. Returns are notably weaker although still decently positive when yields rise, at 4.80% annually, compared to a 16.15% return when yields fall. When yields rose the most, equity returns are weaker yet, at just 1.42%, which offers some evidence that equity performance is relatively weaker when rates rise a lot. In contrast, returns are quite strong when yields fell the most or when yields fell into the next quintile of moderate declines.

Berkin then looked at various sectors of the market to see how they performed when yields rose. Because many investors use high-dividend-paying stocks as a substitute for safe bonds, he examined the relationship of such equities to interest rates. Defining high-dividend stocks as the top 30% of stocks that pay dividends, Berkin found that they outperform nicely when interest rates fall, but lag modestly (0.19%) when rates rise.

As Berkin writes, “when rates rose the most, high dividend stocks had a 4.20% shortfall relative to the market in that same year.” He concluded: “For investors in high dividend yielding stocks, the upshot is to be wary of an increase in interest rates. While results can vary by a lot, on average returns are weak when rates rise. But for those who can hang on to these stocks, they have tended to subsequently recover.”

Berkin also looked at small-cap stocks versus large-cap stocks and found that when long bond yields fall, smaller-cap stocks have lower returns that same year. This runs contrary to logic that dictates higher rates should hurt small stocks. Furthermore, no distinct pattern emerges in the year after bond rates change. There is also no clear trend in the same year that short-term rates change.

However, small-cap stocks do lag in the year following a sharp rise in short-term rates. Thus, while there is some evidence yield changes impact smaller-cap stocks, results are quite mixed and often do not conform to the logic that has been given.

Berkin also examined other styles of investing used in asset pricing models—specifically, value, momentum, profitability and quality stocks. He found “none of these factors showed any distinguishing pattern with interest rates. Thus it is quite difficult to make the case that a change in yield has an effect on these factors and the market segments they represent.”

Finally, Berkin looked at sector returns. He concluded: “Returns are independent of interest rates. Two possible exceptions are utilities and durables. Utilities have low returns in years when bond yields rise the most, but this tends to revert in the next year. Such behavior is similar to what is seen for high dividend payers, which utilities tend to be. Durables also have weak returns in years when short term rates rise the most, and they get even weaker the following year. This may be an effect of higher borrowing costs for a capital intensive sector or possibly just random noise given the number of different sectors and scenarios considered. … While the popular press has many stories about which sectors will do well or poorly when rates move, there is little evidence.”

Conclusion

While there has been much worry about the effects of rising interest rates, such concerns seem to be misplaced. First, to have an impact, rates not only have to rise, they have to rise more than the market already expects. Keep in mind the market is still expecting at least one, if not two, more rate hikes by the Fed this year. If there are more hikes, it’s likely they will be the result of the Fed seeing stronger-than-expected economic growth (which is good for stocks).

The bottom line is that, even if you could be certain interest rates would rise, the evidence demonstrates it would be hard to profit from that information by shifting your equity allocation ahead of time.

This commentary originally appeared June 13 on ETF.com

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