Financial markets are scary… and we humans make decisions largely based on our current emotions. Mixing those two things together, and you get a toxic concoction.
Investing should be based upon us acting on our own rational and intellectual thoughts, but it hardly ever is… So rather than staring at markets and making emotional decisions, what can we actually do to better the outcomes of our financial situations?
More specifically, I discuss:
- How to “check yourself” when markets are volatile and declining
- What investments you probably shouldn’t have
- Using bad markets to get rid of tax inefficient investments
- Recency bias
- Buy out the government’s share of your retirement account at a lower cost
- How to take less risk going forward in order to pursue your retirement income goals
- Buy low, sell high
Resources From This Episode:
Retired-ish Newsletter Sign-Up
Podcast: How to Harvest Capital Gains & Losses
Blog: How Capital Gains Tax Works
When Markets Are Bad
Welcome to Retired-ish. A podcast produced for those exploring retirement and those currently in retirement. I'm your host, Cameron Valadez, and today I have a feeling I'm going to tug on your emotions a little bit. And no, not in a weird way. I mean, when it comes to investing because investing is emotional, believe it or not.
Investing should be based upon us acting on our own rational and intellectual thoughts, but it hardly ever is. We, as humans, end up acting upon and making decisions based on our feelings at any given time. You know, I feel like the market won't come back in my lifetime, or I feel like this particular stock I have will outperform all the others for the next 10 years because it's doing so well right now, even when the rest of the market seems to be suffering. When in fact you don't actually know whether or not it will do that, but it's hard to be truly honest with yourself.
These emotions are completely okay and normal to have. It's how we're wired, and quite frankly, it's how we survived as a species for so long. We just need to be cognizant of how they can impact our decision-making. I've seen this play out time and time again with real everyday people like you and me, real money. And you likely have to. Everyone knows someone that says they lost all their money in their 401(k) during 2008 or the Great Recession. And the truth is that some investors may have caused that to happen themselves because of a lack of planning or acting on an overwhelming set of emotions about their money.
Yes, there were a lot of what I would call “sexy investments” that actually poofed outta thin air, basically kind of like some cryptocurrencies recently. But for most investors in 401(k)s and the like, it was due to, again, overwhelming emotions during uncertain times. But I get it, it's hard. Investing is hard. If it were easy, we'd all be Warren Buffet. Now, there are many reasons for these types of thoughts and behaviors as well. There's actually a whole field of study called behavioral finance that dives into those different reasons. Emotional investing is why some mom-and-pop investors consistently buy high and sell low, which is, of course, the opposite of what they should do to build capital and increase their wealth. And you're not alone. Extremely high net-worth investors do this from time to time as well.
Now, for those of you who know me or receive our newsletter on a monthly basis, you know that I'm a huge proponent of behavioral finance because I personally believe it is one of the top determinants of your investing success. Whether it be for retirement or to provide a lasting legacy for your family. And yes, it's your behavior, not what's the most recent and best performing and cheapest US stock fund you can buy.
So, the reason I want to talk about this right now is, of course, because emotions are running rampant in this current market environment, and for good reason. Let's face it, when it comes to investing, 2022 has been tough. People are nervous and uncertain. And I want to let you know that this is completely okay to feel this way and to vent your concerns and your fears. This market has tested nearly everyone's capacity for risk-taking and investing. Risks that once seemed reasonable in recent years because returns had been rather great for the last, I don't know, 10, 11 years. That's quite a long time to keep in our memory bank and realize that markets don't always act like that. Not only are stocks down good in 2022, but bonds are too. And this is actually the worst year for bonds ever. Sounds scary, doesn't it?
What are we supposed to do when the very asset class we own in our liquid portfolios that is supposed to be there to diversify us away from stocks does the exact same thing as the stock market? It acts in the same way, goes the same direction. What if you just retired or decided in 2021 that you were going to work one more year and made all of your near-term retirement plans? Do you need to now work longer? Can your investments still carry you through a 25 to 30-year retirement? What if you just started your long-term investing journey right before the markets went haywire? Are you now going to abandon your original strategy because it looks like it doesn't actually work?
The answers to these problems largely depends on your original plans and the purpose for your investments. I can’t emphasize this enough. Without plans or a specific purpose for your savings and your different accounts, you are much more likely to react based upon current emotions or recent emotions. You will always make a decision based on current emotions when you have nowhere else to turn. No plan to adhere to.
This is where investing can get incredibly dangerous. Even though it's okay to feel nervous or pessimistic, it's not going to be the best method for making investment decisions that will impact the rest of your life. Do not allow short-term emotions to dictate your long-term outcomes. One small and very quick decision can derail your livelihood for good. Times have changed. It's much harder for us now. It's too easy to press a button on our phone or the computer after a steep market downturn than it is to hold yourself accountable to your long-term plan that you may have made a year ago or two years ago. Because simply pressing a button, it makes the pain go away immediately. And not reacting or doing the opposite of what our emotions tell us that feels like a gamble. And again, as humans, we like easy. We don't like pain. If we have the control to turn it off, we will. We know that these feelings and thoughts are irrational, but we act on them anyways.
And I typically explain it like this. Imagine trying to talk your preteen out of a stupid decision or irrational decision, and you throw a bucket of facts and figures at them. It doesn't work. Of course, it doesn't. That never works. They are way too caught up in the moment, and they will always be biased towards their own current and recent thoughts. So what do you do? Well, sometimes we just need to let some time pass, as basic as that sounds. Let those recent thoughts fade a bit.
Let's gather our thoughts, let enough time to pass so we can really think through the potential outcomes of the different decisions we could possibly be making. How might those alternatives impact us in the long run?
This leads me to the most related or common and related phenomenon in behavioral finance, in my opinion, which is called Recency Bias. Now, Recency Bias in investing is basically the assumption or decision that the markets or a particular investment will continue doing what it has just done recently, and therefore you feel that you need to react accordingly. Now, this could have a good or a bad context, such as holding onto a stock that is done phenomenal for three years straight or gained value when nearly everything else hasn't in a particular year, so you decide to hold onto it for that reason alone. Or it could be that the overall market is falling, and you think that it will continue to fall indefinitely, or at least for the rest of your lifetime, just because it has been falling recently. In both of these scenarios, you may eventually get burned if not right after you make whatever decision it is that you're gonna make.
And that's usually how it happens. More often than not, I see this behavioral error play out when investors chase returns. You're probably guilty of this at least once. Most people are. You see that everything is crashing, right? And maybe energy stocks or gold seem to be doing incredibly well, so you start shifting more and more money there. Then something happens, and those assets crater right after you jumped in.
Think of it like the cryptocurrency craze that's been recently going on. This happened to a lot of cryptocurrency investors as well. Assessing recent returns or even looking at a mutual fund's recent return track record that's no investment plan. That, again, is just Recency Bias. You succumb to the emotional whipsaws of fear and greed that compel you to do the exact wrong thing at nearly the exact wrong time. If you're going to do anything, it should be implementing something that will actually benefit your situation. Unlike reading the financial news on a daily basis or constantly checking the latest story on your stock app.
So enough of that. I want to give you some ideas of things you can do when markets are “bad” instead of abandoning the plan or strategy that made sense for you when you started your journey or if you're just sitting on your hands. Now the first actionable thing you can do is to assess what you own and look for opportunities to strengthen your portfolio. Most of the time, when new clients come to our firm, we find some expensive funds or “sexy investments” that really aren't necessary for their needs, let alone anyone else's in my opinion.
You know, the ones that you had to sign eight different pieces of paper just to buy or the one that doesn't trade in the public markets. And because of that, it's special and can offer you these returns that are unlike anything else or the really complicated insurance product that's used as a retirement income vehicle and can spit out tax-free income as well. You know, those kinds of things. Unfortunately, a lot of this junk gets pitched to people by some financial gurus and advisors out there with some false promises.
Now I want to caveat that I'm an advisor myself, of course, but trust me when I say that we are all different. Your advisor or some other advisor may very well have had your best interests in mind when recommending some of those sexy or complicated investments, but actually, sometimes it really just comes down to their own lack of understanding how that investment really works when you get down to the fine details or when excrement hits the fan in the financial markets.
Now, because we've had some pretty good markets for several years, almost any investment you may have owned, likely gained value. A lot of value. Most DIY investors or new DIY investors thought they were pros overnight back in 2020 and 2021, and that investing was simple because the markets were just going gangbusters, and they're likely not feeling that way anymore. If you identify that you have some of those investments I mentioned and you know you should probably get rid of them, you may be hesitant to get rid of them if you have a lot of taxable gains built up in them. Which most people do if they've been invested over the past several years. And, if you were to sell these investments in a non-retirement account at a gain, you'll pay taxes on those capital gains.
You may even own something as simple as stock mutual funds in your non-retirement accounts. In these cases, whether or not you realized any gains during the year yourself, you will likely still have to pay taxes that will be due from what are called capital gains distributions, even if your account balance is down by year-end.
These distributions inherent to mutual funds tend to be very large in very volatile years and can often lead to large and surprising tax bills come tax time. However, in a market environment such as the current one in 2022, this may be your chance for change. You can assess what you own and what you probably shouldn't own and potentially use this as an opportunity to sell them with a lower gain or maybe even a loss.
Now, if you're in that situation, I'm sorry about your loss first and foremost, but let's try to make the best of it. Now that loss, again, only if it's in a non-retirement account, can be used to offset your income and other potential capital gains. If you have losses in excess of your gains, you can carry those losses forward into future years and continue to get an economic benefit from them. This is referred to as tax gain and loss harvesting, which I discussed at length in a previous episode and even more in-depth in a blog post, which I will share both in this episode’s show notes. So, check those out to get some more context of what I'm talking about and how to do it.
Now, this is just one example of something you can do in sour markets that can actually add value to your situation. Another thing you can do if your portfolio isn't doing so well due to a market downturn and you're in or nearing retirement, then it may be a good time to consider a Roth conversion strategy. Roth conversions, generally speaking, are when you convert pre-tax retirement money in, say, a traditional IRA 401(k) and the like over to a Roth account. The main benefit being that the money can grow tax-free in the Roth if you meet a couple of simple rules. You will, however, pay the taxes on any money that you convert in the year you convert it. One thing you want to understand is that the government essentially subsidizes losses for you in these pre-tax retirement accounts. The reason is because a pre-tax retirement account is basically a partnership between you and the federal government and or state government.
Let me explain. If, for example, you had a million-dollar 401(k) at the beginning of the year, and you expect to be in the 30% marginal tax bracket in retirement, or right when you retire, you actually have $700,000 in that account. The other 30% is for the IRS. If the account value fell by, say, $100,000 and now you have a balance of $900,000, you now actually own $630,000 of the account. See, you only lost $70,000. The $700,000 minus the $630,000. The government subsidized the remaining $30,000 of that loss. The $100,000 total loss. So again, you lose $70,000. The government's losing $30,000 because they have their hand in the cookie jar too.
Now, if you wanted to convert some amount to a Roth, it would theoretically be a better time to do it then versus when the account was worth more. The conversion is like buying the government's piece of the pie, albeit at a lower cost to you.
Now the next thing you should know is that since just recently, in 2022, newly issued bonds actually pay a reasonable rate of interest to bondholders. This is otherwise referred to as yield. Now bonds can be issued by our own government. These are called treasuries, and they're also offered by companies. Those would be called corporate bonds as well as foreign governments in foreign companies. There are even bonds issued by local municipalities that are called municipal bonds, and those often pay tax-free interest payments.
When you own a bond, you're essentially loaning money to the issuer for a stated period of time. So, for example, that could be three months, one year, two years, ten, thirty, et cetera. You get paid the interest, or what is called a coupon payment, while you wait to get your principal back, which is the amount that you loaned at the end of the period.
Now I want to focus on treasuries that are issued by the US government because those are backed by the full faith and credit of our government. Basically, meaning that they are guaranteeing you'll be paid your interest payments and get your principal back as long as you hold your bond for its entire term. Because of this, these bonds eliminate a lot of risks that other bonds and investible securities have. This is why they're often seen as a good diversifier from, say, the stock market. They still do have some risk, such as reinvestment or interest rate risk, but they are still considered a “safer investment,” especially when compared to stocks or even corporate bonds.
The reason I wanna focus mainly on these types of bonds are because of the massive opportunity they present today that has not been present for over nearly a decade, and it's dramatically different than just one year ago in 2021. And that is that the interest rates on newly issued treasuries are substantially higher. To give you some context, The lowest yield or rate that a 10-year treasury provided in 2021 was 0.91%. Still better than the bank, but still pretty low. Today, just one year later, the 10-year US treasury yield is 3.95 to 4%. That's a huge difference! And the reason for this is the interest rate increases recently due to the inflationary pressures that we've had here in the US and actually around the world. And not only that, but what is seen as an even less risky security, the 2-year US Treasury, that is currently yielding 4.29%, even more. And this is up from an astounding 0.10% at its lowest point in 2021. So, these are huge jumps in the interest that these treasury bonds can pay you.
There's also another type of treasury bond that actually adjusts with inflation called a Treasury Inflation Protected Security or TIP for short. These are like treasuries. Well, they are a form of treasury, but they adjust up or down for changes in inflation. These securities only recently started paying attractive real yields compared to the negative rates for the last few years.
Now a real yield is the yield you get after factoring in the effects of inflation on the yield you would otherwise receive. I don't wanna get into the nitty gritty on why or how these look better today than they were just recently, but just know that if you think inflation will remain elevated or increase even further in the near future, TIPS might be a good option to adjust for that risk. So, what's the opportunity? Why is it a good thing that bonds are paying more? Well, with many retirees trying to create a sustainable income stream with their investments, it has become easier in a sense to meet this goal. As I said before, bonds, such as US government treasuries, carry significantly less risk than many other investments. And if you can get treasuries that are currently paying upwards of 4% or more, this allows you to earn a decent rate of return without having to take on more and more risk.
In summary, retirees are currently able to reduce risk in their portfolios while still maintaining an investment allocation that can help them work towards their long-term income goals. Not only that, but in rather normal markets, the value of treasuries can act completely different or go in the opposite direction of, say, the stock market. We call this negative correlation or being non-correlated, and that's good for diversification. Not only are they paying you interest no matter how the markets move, but they can also appreciate in value when the stock market is having trouble, which can help buoy your account balance.
Now, it doesn't always work this way, and 2022 is a great example. But typically, when events other than being in an increasing interest rate environment hit the markets, treasuries serve as a good diversifier, and we have history to prove that to us.
Now, this last one I wanna discuss can seem rather obvious, but I can tell you that most people actually don't act on it. And that is, if you are still investing like you're still working or maybe still investing in retirement, you're able to buy stocks and bonds currently at cheaper prices compared to when the market was at its highest point in history. Of course, we don't know what the future holds. My crystal ball is broken just like yours, but I'm almost certain that most all stocks and bonds are cheaper today than they were just last year in 2021. And as we should all know, when investing, buying low and selling high is better than buying when investments are at their most expensive point and then selling them when they go lower. But as I said, most people don't act on this principle when asset prices and markets are going down, they reflect on the recent past and assume that those investments are now riskier than they were before, which is often the opposite.
Sure, the markets could drop even lower after you buy in or invest, and you could have maybe invested at even lower prices if you would've waited, but the key is that no one knows if that will be the case. We don't have the benefit of hindsight in that case. One thing you can do to check yourself on this is to look at a chart that shows the history of the stock market and look for any one of the big drawdowns that have happened in history. So, it will look like a V shape on the chart. There's many of them. Now pick any one day on the line that is going down. So the left part of the V shape, and don't pick the very bottom. Just pick any of the days or times on the left side when the market is dropping.
Now imagine that's the day you bought into the markets. Now compare it to today on the chart. Today's value is almost always higher, even if you didn't time it right exactly at the bottom when you invested. The point is that you don't need to catch the bottom. When you're looking back at the market's history, you'll be able to realize that it's likely that no matter what day you bought during the downturn that you chose, today it looks like a huge opportunity. Remember that every current market downturn feels like a crisis, and every past crisis ends up looking like a missed opportunity.
And that's it for today's show. I hope this conversation has been helpful for you. I know that thinking through these things and taking the time to do that will help you make better decisions. It's not about making the right decision at the right time all the time. We're humans, that's never gonna happen. But if we can be less wrong or wrong less often, we will likely be more successful. So, that's my goal, and hopefully, this helps you out on your journey. If you have a minute and found this information actionable and insightful, please give us five stars and leave us a review of the podcast, as it helps us reach more people just like you that need this information.
You can also share the podcast directly with others you think might benefit using your podcast app. If you would like to learn more about the rules and strategies discussed in the show and want to find more information to help you retire on your terms, you can find the links to the resources we have provided in the show notes on your podcast app, or you can visit us at retiredishpodcast.com/six.
You can also sign up for the monthly Retired-ish newsletter there as well, where each month we discuss money and emotions, investing, tax, estate planning, Medicare and Social Security, and even a brief discussion about the current markets in layman's terms. We always put something actionable in our newsletters that you can implement right away, such as how-to guides and other simplified strategies. Again, this can all be found at retiredishpodcast.com/six. Thank you for tuning in and following along. See you next time on Retired-ish.
Securities and advisory services are offered through LPL Financial, a registered investment advisor, member FINRA, SIPC. The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision. Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA.
In addition, if you are required to take a required minimum distribution, RMD, in the year you convert, you must do so before converting to a Roth IRA. Investing involves risk, including the potential loss of principle. No investment strategy can guarantee a profit or protect against loss. Past performance is not a guarantee of future results.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, and bonds are subject to
availability and change in price. Government bonds and treasury bills are
guaranteed by the US government as to the timely payment of principal and interest, and if held to maturity, offer a fixed rate of return and fixed principal value.
Treasury inflation-protected securities or TIPS are subject to market risk, and significant interest rate risk as their longer duration makes a more sensitive to price declines associated with higher interest rates. Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity.
Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free, but other state and local taxes may apply. If sold prior to maturity, capital gain tax could apply.
Neither LPL Financial nor its registered representatives offer tax or legal advice. Always consult a qualified tax advisor for information as to how taxes may affect your