12 
12 TO SAY THAT THE PAST DECADE HAS BEEN A DIFFICULT ONE FOR investors is a gross understatement. The S&P 500 has essentially spent the past 13 years treading water. That is not to say that the market has stood still. Investors have been treated to the deflation of two major bubbles with ensuing bear markets. Many analysts describe this as a “lost decade for stocks.” We are at present living through what we described earlier as an extended drawdown for the U.S. stock market. And so the past decade should not come as a complete shock, but it is disturbing nevertheless.
Admittedly if we widen our focus, we can see that things are not nearly as bad as the story told by the S&P 500. Carl Richards notes that the lost decade is in part a myth because it focuses on this narrow slice of the investable universe.1 Every other major asset class during the past decade outperformed large cap domestic equities. An investor who was widely diversified over the past decade in bonds, small-cap domestic equities, foreign equities, emerging markets, REITs, and commodities would have weathered the past decade with solidly positive, roughly 5%, but not spectacular returns.2 The lesson of the lost decade for stocks provides us with support for a strategy that focuses on a widely diversified portfolio.
Even more significant than the financial fallout of a lost decade is the psychological fallout of living through an extended period of market volatility. Floyd Norris describes all of the market moves that add up to little progress as “excess volatility.”3 Investors are by all accounts feel beaten down. Jason Zweig writes, “People seem to feel like bystanders in their own financial lives—almost as if they were spectators at a racetrack equally incapable of stopping an impending car crash and of tearing their eyes away from it.”4
Andrew Haldane notes that financial crashes and car crashes have similar causes—an underestimation of risk. After a crash, investors subsequently have a tendency to then overestimate the risk of further financial trauma. Haldane writes: “Memories of financial disaster are now fresh, as after the Great Depression, causing an over-estimation of the probability of a repeat disaster. In these situations, psychological scarring is likely to result in risk appetite and risk-taking being lower than reality might suggest. Risk will be over-priced.”5
For some this past decade is the logical conclusion of what has been the financialization of our economy. Satyajit Das, in his book Extreme Money, notes how this increasingly financialized economy came to be and how we ended up with too many people, companies, and governments laden with too much debt.6 Maybe even worse was that a great deal of talent was siphoned off into the financial sector. Talented people were attracted to the high pay of finance and spent their time coming up with ever-more-exotic financial instruments instead of doing things that in the end actually matter for the economy. The end game for the financialized economy was the financial crisis. The subsequent support of the financial sector proved to many to be a last straw. The very industry that brought the global economy to its knees, for better or worse, got bailed out.
This past decade has turned many investors off equities as an investment for some time to come. These investors are then likely to turn to a fixed-income market that is at the moment particularly inhospitable. At least prior to the lost decade for stocks, the bond markets provided some measure of prospective returns. Unfortunately we are now in the fourth year of what can best be described as a “war on savers.” Since 2007, the Federal Reserve has kept short-term interest rates at or near 0%. As of today, that policy looks to remain in place for some time to come. So investors looking out over the horizon do not have the solace of further declines in interest rates to cushion another tough decade for equities.
The next decade will not only have to deal with traumatized investors; it will also have to deal with a very real demographic challenge. The much-hyped baby-boom generation is entering into retirement age, and with that comes the potential for a headwind for domestic equities. Research has shown that equity markets thrive when the bulk of the population is in its prime earning and savings years. That is not what is happening now. A model using U.S. demographics shows continued pressure on market P/E ratios for another decade or so.7 Demography is not destiny, and the stock market could rebound based on any number of other factors, but this potential demographic drag is worth keeping an eye on.
Nobody knows what the coming decade will bring. The past decade highlights the importance of everything other than financial market returns. Before you ever invest dollar one in the financial markets, it makes sense to understand what other factors can play an important role in generating real gains both in and out of the market.
One way the coming decade is likely to differ from the prior decades is in how Americans approach debt. The two decades leading up to the mortgage and financial crisis were filled with Americans taking on ever-increasing levels of consumer and mortgage debt. That era ended leaving the global economy on the brink of financial disaster.
Unfortunately there is no magic button to push to bring down debt levels. The only way to climb out of debt, absent foreclosure and bankruptcy, is to start living within your means. This is a difficult transition for many to make. A more conscious approach to spending seems an appropriate response when the economy and markets no longer generate ample returns. A focus on savings and debt reduction really just reflects a return to an age where credit was not so readily available.
The first step in increasing savings should be focused on reducing debt. In an age of 0% short-term interest rates, it makes little sense for families to be carrying high-interest debt, i.e., credit card debt. A sure reduction in interest expense beats the risky return in the financial markets any day. In that sense, paying down debt becomes the best available investment on the table for most investors.
We have talked about how it is essential to focus on risk when building portfolios to ensure that those portfolios survive the rough patches and allow us to reap the benefits of more favorable market environments. The same idea holds in our personal finances. We can think of living within our means, with a minimal amount of debt, as a way to withstand the shocks that life throws at us. Individuals and families that are leveraged to the hilt are vulnerable to small shocks and are unable to make the investments necessary to achieve long-term goals.
In one respect, a focus on saving diminishes the importance of investing. A dollar saved through a more conscious spending plan is a far more certain return than the uncertain return on an investment. Said another way, savings is the best investment an individual can make. In that sense, increased savings achieved through expense reduction is a sure thing. Another way of saving, without any additional hardship or risk, is through your employer’s 401(k) plan. Many retirement plans offer a matching contribution in cash or in company stock. In either case, it represents a way to bolster your savings in an easy, automatic fashion. Or viewed another way, company matching represents a way to enhance the return on your 401(k) investments.8
There are very few sure things in investing. Expense reduction seems to be one of them. Research into mutual fund returns universally shows that funds with low expense ratios, on average, outperform funds with high expense ratios. The math is pretty simple. Gross investment returns are uncertain by definition. On the other hand, expenses are pretty stable and represent a one-for-one reduction in returns. As Russel Kinnel writes: “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.”9 Costs matter. They matter in our personal lives and our investment lives. We shouldn’t need a lost decade for stocks to convince us of that simple fact.
Just because our capacity to purchase goods may have diminished doesn’t mean that our demand for new goods has waned. Luckily for consumers, there is a movement afoot that aims to enhance the opportunity to share goods and services. Lisa Gansky, author of The Mesh, writes: “The credit and spending binge has left us with a different kind of hangover. We need a way to get the goods and services we actually want and need, but at less cost, both personal and environmental. Fortunately, we’re quickly gaining more power to do so. A new model is starting to take root and grow, one in which consumers have more choices, more tools, more information, and more power to guide these choices.”10
This so-called sharing economy is being fueled by the rise of technology that allows us all to stay connected on a continuous basis. Gansky notes that it is no longer just information industries that are getting disrupted. Now all manner of physical goods are becoming fair game in this new sharing economy. Investors like Steve Case are at the forefront in funding companies that look to provide “access over ownership.”11 For consumers trying to do more with less, the sharing economy allows us to live within our means without sacrificing consumption opportunities. So while investors come to grips with the potential for a lost decade, there is the hope that a new consumption model will help us with this transition.
We have already discussed loss aversion, or how it is we feel losses more acutely than gains. However, there is one saving grace to losses. Smart tax planning makes good use of losses, somewhat easing the pain of paying taxes on April 15. Uncle Sam gives investors a number of ways to lessen their tax burdens, but for most investors taxes are at best a tertiary concern.
Part of this disinterest in taxes comes from the lack of media coverage on the investment management industry. Given our earlier discussion of the financial media, this is not altogether surprising. In terms of sex appeal and an ability to attract viewers, taxes ranks right down there at the bottom with a discussion of generally accepted accounting practices.
Much of the investment world is built on the peculiarities of tax law. For example, vehicles such as REITs and master limited partnerships exist in large part because of favorable tax treatment. Another example of this is the admittedly unique tax treatment of futures contracts. This list goes on, but suffice it to say that not much happens in corporate America or in the investment world that doesn’t include a discussion of taxes.
By definition, investors interested in generating real, after-tax returns need to focus on taxes. In a certain respect, it is easier to try and generate incremental returns from careful tax planning than trying to generate higher pretax returns on a portfolio through smarter investing. The IRS gives us all a road map, admittedly a convoluted one, on how to lower our tax bills. To the after-tax investor, a dollar saved on taxes is just as valuable as a dollar earned on investments.
A quick note: This discussion is focused on the philosophy behind generating after-tax investment returns. Tax laws change on a frequent basis, and contemplated tax law changes are a fixture in Washington. Taxes are an area where an investor should have access to competent advisors, because the decisions made surrounding taxes are irreversible. There is no substitute for expert advice when it comes to making high-stakes decisions like those involving retirement accounts and estate planning.
The one challenge that even tax experts face is the desire to try and forecast future changes in tax laws. Having perfect foresight on what tax rates will look like down the road would be quite valuable in tax planning. Tax experts are like any other expert in that their ability to forecast the future is not all that great. Investors are usually better served by focusing on the here and now and letting future taxes play out on their own time.
Given that we can’t see very far into the future, a simple principle regarding taxes makes sense. Defer taxes as long as you can. This principle is particularly important when it comes to equity investing. There is one key variable investors can control that helps minimize taxes, and that is portfolio turnover. You want to minimize it. The faster you turn over a portfolio, the greater the amount of gains that will be taxed, and they will be taxed at the higher rates prevailing for short-term capital gains. This explains one of the great attractions of index funds. Well-designed equity index funds have the benefit of having low turnover. In that sense, index funds are tax efficient by design.
The investment industry has rolled out tax-aware funds that use various strategies to try and reduce turnover and ensure that gains are long term in nature. Unlike plain vanilla index funds, these tax-aware strategies have not caught on with investors. Some analysts argue that the existence of ETFs makes tax-managed funds largely superfluous.12 Trying to minimize the tax bite from investing is far less sexy, and far less lucrative for the manager, than trying to shoot the lights out with high headline returns.
One area where equity investors have ultimate discretion is their timing in selling a stock. When you sell that stock, assuming you have a gain, can make a big difference in the tax rate you pay. Simply waiting to sell a stock after holding it more than a year currently allows for a lower capital gains rate. Likewise, selling a stock before the end of the tax year allows for those losses to offset other capital gains, or in the case of capital losses, against other income.
We have already discussed how rebalancing can help generate a better risk-return profile. Rebalancing also provides the tax-aware investor with a framework to harvest losses and defer gains. Wesley R. Gray did a simple exercise showing that a maximally tax-efficient portfolio rebalancing process could add surprisingly large incremental returns. He writes, “Stop reading this blog to try and find alphas … go out there and find a great tax attorney and CPA!”13
If you know that future tax rates are going to be higher, then it might very well make sense to defer losses to a future date. While this case is unusual, it is not out of the question. In this case heed Jason Zweig’s advice: “Before you harvest a loss, make sure you or your adviser have thought through whether it will be treated as long-term or short-term and what kind of income you can offset with it. Ask for proof that by lowering your basis today you haven’t raised your tax bill tomorrow.”14
The opportunity to limit taxes on fixed-income investments is generally more difficult. There are few ways to think about this dilemma. High-income investors have, for some time, used municipal bonds in their portfolios, especially those that avoid the alternative minimum tax, to limit their tax bite. This can make sense provided that investors are not taking on additional credit risk to do so and that the breakeven calculation between munis and comparable taxable bonds makes sense. Then there is the issue of where to hold certain asset classes.
Having tax-deferred accounts allows investors to make smarter decisions on where to house certain assets. The general principle is that investors should hold high-tax-cost assets, like corporate or Treasury bonds, in a tax-deferred account. The flip side is that investors should hold assets that can take advantage of low, long-term capital gains rates in taxable accounts. The writer Christine Benz describes this as the “art of asset location.”15 So simply by being tax aware and holding certain assets in the right place, investors can minimize the overall tax the IRS takes.
From this discussion of “asset location,” we can see the importance of taking full advantage of tax-advantaged plans like retirement accounts. It is beyond the scope of this book to discuss the intricacies and trade-offs of retirement saving schemes, including 401(k)s and the many flavors of IRAs. Suffice it say that if Uncle Sam lets you defer taxes to a future date, often retirement, you should take him up on the offer. The frequent argument given against this idea is that tax rates are going to be markedly higher in the future. Therefore, it doesn’t make sense to defer taxes to a time when rates will be higher. Nobody has a crystal ball on where tax rates will be 2 years from now, let alone 20 years from now. Unless you have perfect foresight, the principle of deferring taxes makes the most sense for investors today.
While most investors pay little attention to the topic of taxes, for a smaller subset taxes become an unhealthy obsession. Some investors, to their own detriment, try to avoid taxes at all costs. For example, some investors are reluctant to sell a stock that has greatly increased in value for the simple reason that they do not want to write the IRS a big check.
Nobody likes paying taxes, but a sensible focus on taxes can reduce their impact on investment returns. Generating returns from the financial markets is difficult enough, and so taking advantage of what the government provides is sensible decision making. Smart tax planning won’t make you rich in the absence of outsize returns, but in the world we live in, every little bit of incremental return helps.
No discussion of taxes is complete without at least touching on the topic of estate planning. Investors spend a lifetime working hard, saving, and investing. To ignore the final disposition of this lifetime of effort seems foolish. However, the majority of Americans do not take the important step of creating a will and setting up an estate plan in a timely fashion.
The recent EZLaw Wills & Estate Planning Study shows that 60% of Americans recognize the importance of having an estate plan in place. However, only 44% of Americans have such documents in place.16 There are several reasons why these numbers are all not 100%. Financial illiteracy certainly has a role to play here. So does the reluctance of individuals to face up to their own demise, which is not particularly surprising. In addition, Americans today have a number of more pressing economic issues that crowd out long-term planning.
For individuals with dependents or with estates of sufficient size that estate taxes come into play, an estate plan is essential. The best way to think about estate planning is to think about who actually benefits. Ultimately estate plans are for the living. Putting forth the effort to assemble an estate plan can seem insurmountable, but once in place, it provides a measure of comfort. The costs, both financial and emotional, of time spent in probate court far outweigh the emotional effort required to put together a sensible estate plan. We have spent a book highlighting the fact that there are no sure-thing investments. Estate planning, on the contrary, is a win-win investment.
We have already seen how costs matter in our personal and our investment lives. There is another cost that does not show up directly in our financial statements: time. If there is any resource in short supply in today’s society, it is time. Managing our investment portfolios takes time. This time spent represents an opportunity cost in that it takes time away from family, friends, leisure, or even our careers—things that for most of us represent time better spent. When investors think about their portfolio, not only do they need to think about the results they achieve and the costs incurred, but they also need to think about the time required to achieve those results.
If you hire an advisor to manage your portfolio, the time spent can be reduced on an ongoing basis. However, the time required to identify, research, and monitor an investment advisor should not be underestimated. Individuals who choose to manage their own portfolio need to be cognizant of the time involved. Active strategies require substantial time commitments. Along with these time commitments also comes the psychological stress involved in trying to keep up with the markets. Actively managing a portfolio is ultimately an ongoing series of decisions.
The twin challenges of modern society are the lack of time (which we just discussed) and the sheer volume of decisions that need to be made, decisions about investments being just one of them. These decisions can cause us stress, in large part because of the stakes involved. This constant stream of decisions can fatigue us as well. Social psychologist Roy F. Baumgartner describes this condition as “decision fatigue,” and the ensuing fallout tells us a great deal about our behaviors.17 Research shows that we have a limited store of mental energy, and when that energy is depleted, our ability to exert self-control and make rational trade-offs is greatly diminished. The implications for investing are obvious, but the solution to decision fatigue is not. According to John Tierney, Baumgartner’s research suggests “that people with the best self-control are the ones who structure their lives so as to conserve willpower … and they establish habits that eliminate the mental effort of making choices … so that it’s available for emergencies and important decisions.”18
Investing is difficult enough even without falling prey to decision fatigue. There are a couple of ways investors can reduce the amount of decisions that they need to make. The first is to automate as much of their investment process as they can. Banks and brokers these days have a number of tools that allow investors to automate some of their routine decision making. The second way to combat decision fatigue is to adopt strategies that require fewer decisions. It sounds trivial, but avoiding strategies that require frequent monitoring and transactions will reduce this mental load. Even the simplest active investment strategies require a steady stream of decisions that for most investors represent potential land mines.
Our lives are filled with plenty of stress before we ever get to the question of investing. Research shows that those individuals who best manage stress arrange their lives to minimize the amount of potentially stressful encounters.19 For the great majority of people, investments are a stress-inducing activity. Structuring our lives so that investments become a less frequent stressor can make for less stress, fewer decision-making opportunities, and simply more time to spend on the things we enjoy.
In the end, all this effort in saving and investing should work to our advantage. We have already discussed the importance of the ultimate disposition of our assets. In the meantime, the purpose of our investments is to help us better achieve our own life goals. Our investments should be working for us, not the other way around.
For some people, investing becomes an avocation in and of itself. For this crowd, investing is an intellectual challenge that has, as a side benefit, the potential for financial gain. This avocation could simply be a hobby, or for some it could become a career. However, for the vast majority of others, investing is, at best, another one of those adult responsibilities we have a difficult time staying on top of.
In that light, maybe we need to define investing a little more broadly. People who have started investing recognize that they have some goals that they are trying to meet. Obvious ones include saving for a down payment on a house, paying for college, or providing for a comfortable retirement. These are all worthy goals, but these goals should not preclude us from making what may be even more meaningful investments along the way.
For instance, for most people the most valuable asset is their human capital and the income their careers generate. The transformation of the economy over time from one of stable lifelong careers into a “freelance economy” highlights the importance of obtaining and maintaining a skill set. And so an investment in your own education and skills may be a much more valuable investment than any portfolio investment ever could be. An investment in yourself, or others, could include additional education or professional certifications, or for the more adventuresome, it might be going into business for yourself.
There is ample reason why many people over the past decade have gotten off the corporate track to strike out on their own. Being a solo operator admittedly has its challenges, but the benefits are not solely financial. Furthermore, people who work for themselves experience a level of intrinsic motivation that is very rare in traditional career paths. It is cliché to say that you spend most of your waking hours at work, but it is true. Therefore, trying to maximize the monetary and psychic benefits from one’s career is an investment well worth making.
Some of the dissatisfaction with our current work lives has to do with the fatigue many consumers now feel after the past decade. Having gorged on debt to acquire ever-more-expensive goods and services, many now recognize that the benefit of “stuff” is admittedly fleeting. How we spend our limited resources, including time and money, becomes an important determinant of how we spend our lives. Umair Haque notes: “The ‘best’ investment you can make isn’t gold. It’s the people you love, the dreams you have, and living a life that matters.”20 Haque admits that this is an idealistic approach to trying to create a new economy out of one that is so centered on acquiring “stuff.” This sentiment does provide an antidote to anyone who is hung up on the investment performance game. An additional 1% here or there is not likely to meaningfully impact your life.
Your investments are important, but they are not more important than other aspects in your life. Haque continues: “As the never-ending global economic crisis has intensified, we’ve had plenty of what economists call ‘capital flight’ to ‘safer’ financial assets, whether gold, bonds, or blue chip stocks. But perhaps the safest investments of all are the human, social, and emotional ones. They’re what give human life texture, depth, resonance, and meaning.”21 We have spent a great deal of this book talking about financial risk and returns. There are things in life that we cannot quantify. We should never let our pursuit of investment gains overshadow those things in life that can never be lost or traded.
The lost decade has been a rough time for many Americans. The poor performance of the U.S. economy, equity market, and housing market has been challenging for many. The lost decade has served as a useful exercise in stress-testing our assumptions about finance and investing. Even if you have gotten through this past decade with your portfolio largely intact, it has likely dampened your expectations about the future. Said another way, the lost decade served as a reality check on our innate sense of optimism.
Researchers have gone so far as to coin a term for the belief that the future will be better than the past—they call it the “optimism bias.”22 Research shows that optimism is a necessary ingredient in our ability to move forward after having made a decision. In fact, it is argued that this optimism bias is inherent in our brain structure, the theory being that optimism increases our odds of survival in a wide range of environments.
However, an overabundance of optimism can be dangerous. Naïve optimism can lead us to make poor decisions. We have discussed a number of biases we humans have, and we can add the optimism bias to the list. Our discussion of the lost decade is a useful antidote and planning exercise. By planning for the worst and hoping for the best, we can combat our inherent optimism while still taking concrete steps toward a better future.
Tali Sharot writes: “Once we are made aware of our optimistic illusions, we can act to protect ourselves. The good news is that awareness rarely shatters the illusion. The glass remains half full. It is possible, then, to strike a balance, to believe we will stay healthy, but get medical insurance anyway; to be certain the sun will shine, but grab an umbrella on our way out—just in case.”23 That sounds like advice all investors who are looking at a lifetime of investing can take to heart.
The past decade, filled with popped financial bubbles and economic recessions, has traumatized investors. A highly diversified approach to investing, however, avoided the “lost decade for stocks.”
Savings is the best investment. A focus on reducing expenses makes generating high but uncertain returns on your investments less critical. The so-called sharing economy is making it easier for consumers to have experiences without the cost of ownership.
In pursuit of real, after-tax returns, investors often neglect the effect of taxes. Taking full advantage of current tax laws provides a far more certain return than any investment strategy.
After a lifetime of working, saving, and investing, it makes no sense for individuals not to have an up-to-date estate plan in place.
Successful investing requires time—time that for many is better spent in other pursuits. Arranging our financial lives to minimize the number of decisions we make can result in better outcomes.
For many, the best investment may not be a financial one but rather an investment in the things in our lives that cannot be quantified.
The lost decade provided us with many lessons, not the least of which is a check on our innate optimism. Planning for the worst and hoping for the best is a sensible approach for a lifetime of investing.