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Does Overweighting Domestic Stocks Count as Active Management?

A reader writes in, asking:

“I’ve read in the past that you utilize Vanguard’s LifeStrategy funds.  You and I share the same passion toward favoring passive strategies rather than active. My question is then, do you consider the funds’ home bias reflective of an active strategy that deviates its asset allocation away from traditional weightings (based on actual market cap) inconsistent with Vanguard’s overall approach to indexing?”

I don’t have any strong opinion on whether the domestic tilt of the LifeStrategy portfolio (i.e., the fact that the LifeStrategy funds overweight domestic stocks and underweight international stocks relative to their market capitalization) constitutes active management.* If, however, it does count as active management, then there are several other characteristics of the LifeStrategy (and Target Retirement) funds that we must also consider active management. Specifically:

  • The overall stock/bond breakdown does not reflect the respective sizes of those markets,
  • Non-investment-grade bonds, bonds with maturities of less than 1 year, muni bonds, and TIPS are generally excluded from the portfolio (because none of those bonds are included in the Vanguard Total Bond Market Index Fund), and
  • The portfolio is rebalanced rather than simply allowing the allocation to each piece to shift naturally in accordance with market capitalizations.

If we’re treating one of those decisions with skepticism — because it could be considered active management — then we must be skeptical of each of the others as well.

Personally, I don’t worry too much about whether something is or isn’t active management. The primary problem with the most popular forms of active management (e.g., paying a fund manager to pick stocks or time the market) is that they increase costs without increasing returns by a sufficient amount to overcome those additional costs.

But the LifeStrategy (and Target Retirement) funds’ policy of overweighting domestic stocks doesn’t actually increase costs. In fact, it reduces costs slightly because the domestic index funds have somewhat lower expense ratios than the international ones. In other words, the skepticism with which I generally regard active management strategies (because they, in general, don’t improve returns enough to overcome the additional costs) doesn’t really apply in this case (even if it could be considered active management).

*With regard to whether the fund is somewhat out of character for Vanguard in particular, I can only say that Vanguard is pretty consistent in their message that they aren’t an indexing-only company and they have no philosophical opposition to active management.

Investing Blog Roundup: Using PE 10 for Retirement Planning

One of the more common methods of market timing (a.k.a dynamic asset allocation) is to shift your allocation toward or away from stocks based on PE 10 (a.k.a. Shiller PE).

But as author/advisor Michael Kitces explains this week, PE 10 isn’t actually that useful for market timing. It does, however, have other valuable applications for retirement planning.

Investing Articles

Other Money-Related Articles

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Why Would Somebody Buy a Deferred Lifetime Annuity?

After our recent discussion about the new “qualifying longevity annuity contract” rules, several readers wrote in to ask why anybody would buy a deferred fixed lifetime annuity — a product which has a significant likelihood of paying nothing whatsoever (i.e., in the case that the annuitant dies before the income kicks in).

Relative to an immediate lifetime annuity, the advantage is simply that you have more liquid assets available after the purchase of the annuity. This is preferable for a few reasons:

  • If you die soon after purchasing the annuity, your heirs get a lot more money, given that a smaller portion of your overall net worth went toward the annuity purchase;
  • You have more liquidity, which is good for handling unexpected expenses; and
  • You have more of an upside, given that more of the portfolio will remain to be invested in asset classes with higher expected returns (namely, stocks).

How About an Example?

Juanita just retired at age 70. She wants $45,000 of total income per year. She has $20,000 of annual Social Security income, meaning that she needs an additional $25,000 per year to come from her portfolio. She could purchase an immediate lifetime annuity paying $25,000 per year for $337,051 (based on a quote from Income Solutions).

Alternatively, she could purchase a deferred lifetime annuity, for which the payments start at age 85. If she purchased such an annuity right now at age 70, it would cost $68,479, thereby leaving her with an additional $268,572 in liquid assets relative to purchasing an immediate annuity. (Of note, however, is that the goal for this money is to satisfy $25,000 of annual spending from age 70 to age 85.)

But There’s a Catch

Our example above has one big problem: We’ve ignored inflation. In reality, Juanita probably wants to spend $45,000 adjusted for inflation every year for the rest of her life.

And that brings up my major qualm with deferred lifetime annuities: They leave you with quite a bit of inflation risk. You can purchase deferred lifetime annuities with an inflation adjustment, but, with the only such annuities I’ve seen, the adjustment doesn’t kick in until the income kicks in. For example, if you purchase an inflation-adjusted deferred annuity at 65 that will begin paying you $1,000 per month at 85, you really do get just $1,000 per month at 85. It’s only inflation after age 85 for which you would be protected. If there’s a ton of inflation between age 65 and 85, tough luck.

In contrast, with an immediate lifetime annuity, the inflation adjustments begin immediately — thereby making immediate annuities significantly more useful as a tool for creating a safe “floor” of income (i.e., for ensuring that your standard of living does not drop below a certain level).

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Investing Blog Roundup: Individual Stock Perks

This week I came across an interesting Bogleheads discussion about perks offered by certain companies to their shareholders.

For example, I learned that if you own shares of Berkshire Hathaway — even just a single Class B share, which currently runs just $125 — you can get an 8% discount on GEICO car insurance (unless you already have some other “affiliate” discount). For me, that’s a savings of about $65 per year — a pretty good effective dividend for a $125 investment!

I don’t usually think it’s a good idea to buy individual stocks, but I’ll be making an exception in this case.

Investing Articles

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How Do Capital Loss Carryovers Work?

A reader writes in, asking:

“I just read your article on capital gains and losses. I understand that up to $3,000 of a net capital loss can be used to offset ordinary income in a year, and the rest is carried over to use in future years, but I am unsure of whether the carryover is short-term or long-term. For example, if I have the following for one year:

$ 4,000 in STCL
$ 6,000 in LTCL
$10,000 in losses
-$ 3,000 writeoff against ordinary income
$ 7,000 capital loss carryover

Is the $7,000 carryover considered a short-term or long-term capital loss? Or is it divided on a pro-rata basis, such that there would be a carryover of $2,800 STCL and $4,200 LTCL?”

For questions of this nature, it’s often helpful to look at the tax forms themselves, to see how the numbers flow from one line to the next (and from one form to the next). In this case, doing an example run through Schedule D, using the “Capital Loss Carryover Worksheet” from Schedule D’s instructions can give you a good idea of how this all works.

The short answer is that the $3,000 that is deducted from ordinary income comes first from STCLs to the extent possible, then from LTCLs. Then the remaining losses retain their character when carried over for the next year.

So, if the numbers in your example were a taxpayer’s numbers for 2013, when that taxpayer filled out his Schedule D for 2014, he would have a $1,000 STCL carryover ($4,000 STCL, minus the $3,000 that had been used in 2013 to offset ordinary income) and a $6,000 LTCL carryover.

Alternatively, if the taxpayer’s 2013 numbers were as follows:

$ 2,000 in STCL
$ 6,000 in LTCL
$8,000 in losses
-$ 3,000 writeoff
$ 5,000 capital loss carryover

The entire $2,000 of STCL would be used up for the deduction, and the capital loss carryover for 2014 would be considered entirely long-term capital loss.

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Investing Blog Roundup: Retiring Baby Boomers

This week, author/advisor Larry Swedroe provided an excellent answer to a question I see from time to time: Should we fear a stock crash as a result of baby boomers retiring and selling off their shares?

Swedroe writes:

“We’ll begin by pointing out that only unexpected events have an impact on stock prices. And if anything can be forecasted, it’s demographic data. You can be certain that investors in general are well aware of this trend, and thus have incorporated that knowledge and the expected effect of retirees’ equity sales into current prices.”

Investing Articles

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