Never forget these two axioms:
Money frees us, but its pursuit enslaves us.
It’s not how much you have at the end; it’s how much you could have made.
JUDGING PERFORMANCE
Unfortunately (at least for some), there is a lot of math and statistics entailed in investing. Lots of metrics, numbers, stats, and the like are thrown around on the news, by financial advisors, in the papers and websites, etc, etc,
It’s rare that I speak in absolutes (which often drives my family and friends, but extremely rarely patients and their families), but in this one case, I will speak in definitive absolutes.
THE SINGLE MOST IMPORTANT NUMBER IN ALL OF INVESTING IS UNDERSTANDING HOW WELL YOUR INVESTMENT IS DOING—IE, ITS PERFORMANCE.
Nothing will impact what you do as much as this one number. It will guide you in what to do, when to do it, and whether to change course or not.
A few basic rules of the road when judging performance:
- Always calculate your returns net of fees (I warned you that you’d hear this phrase again) and your total amount after taxes are paid out of that amount
- Always use your benchmarks for comparisons rather than just looking at your percent return in a vacuum and think “Hey, I’m pretty awesome at this investing thing. Move over, Warren Buffett!” when in reality you’re worse off than the average investor. You need to know your guideposts for understanding where you stand each quarter or year especially if paying fees for what should be a higher return. (You’re paying for something, so shouldn’t you be getting what you pay for? Shouldn’t you know if you’re truly getting a higher return and not just being reassured or reassuring yourself with what you want to be true rather than what is true?)
- You need to look at your monthly, quarterly, or, at a minimum, annual statements. No matter how “remote control” or “passive portfolio” you’re in (or, much worse, think you’re in), you need to see what is going on there. Falling asleep at the wheel of your portfolio for a decade is just a terrible idea. You literally cannot afford to do that. Literally, And, I mean that. It’s literally not like all the people who use “literally” as a crutch word and actually mean figuratively.
{RLE #8: An extremely hard working and dedicated doctor I know only opens his statements and sees what they were in value last month and now this month with nothing else even remotely looked at. It was only after I spoke with him that he even realized that he may actually be losing money many months, but it looked like he was making money since the loss for that particular month may be less than he was contributing to his investment account. You have $100,000 in your investment account and are putting in $5,000 a month. Then, the next month, when you have $103,000, you’ve not actually gained $3,000. I don’t want alarm you. But I do have bad news for you. You’ve lost $2,0000. I couldn’t believe a guy as smart as him didn’t understand that basic truth of investing and how to even read your statements. In his entire professional career, he wouldn’t even think of being this careless or superficial in understanding a test, imaging, lab, or pathology report when it came to his patients. Yet, here he was, without even a basic grasp of his entire investment account…twenty years after he began investing for his retirement. If he was like this, how many others are there? And they don’t even know it? That is the really alarming part of this whole RLE.}
BENCHMARKS
OK, let’s get started.
First thing is to know what you should be comparing your investment to.
Stocks=S&P 500. It’s that simple…for once.
Mutual Funds and ETF’s are more complicated. They each have their own benchmark which is shown on each statement. If you search online for the performance of the fund in question, you will also see the accompanying benchmark fund to compare against. There is something known as the Lipper awards where a financial analytical company (Thomson Reuters Lipper) scours tens of thousands of funds over dozens of countries to grade each one (1 to 5 with the higher the number being better), They even award the best funds in each sector or category (eg, utilities, foreign, financials, etc.) at the end of each year based on expense and returns among other things, The Lipper grade for funds’ performance over 3, 5, and 10 years is assigned by the following metrics: Total Return, Consistent Return, Capital Preservation, Tax Efficiency (For US Funds Only), and Expense . You can use these Lipper grades to give you an idea how your fund compares to its peers.
But recall, the comparison is apples to oranges until you subtract your fees (ie, the fund’s expense ratio—remember that?) out of your fund’s performance numbers. Just simply take the percent return your fund did over the year and subtract out the expense ratio from it.
Bonds are either the simplest investment to track for performance or the most complex.
Dr. Unwise: Huh?
Dr. Scared: This is it! This is it!! This is how they screw you!!!
PWT: No. Exactly no. It’s precisely how no one screws anyone else.
A bond has a coupon (remember?) which tells you how much you’ll get in interest payments each year until it “matures” (ie, it expires and your original value or par value is returned to). There is no true benchmark to compare against for bonds, but you can compare one bond’s performance to that of another (YTM or yield to maturity, remember?). The thing to keep in mind is that inflation (3.22% on average, right?) is eating away at your returns, especially on bond returns since they are generally speaking such low returns.
[My opinion here only: Regardless of how conservative of an investor you are, low yield (ie, low interest) bonds are not a good way to invest until you near retirement and just want to maintain what you’ve already earned. You won’t build wealth with low yield bonds and could actually lose money in a relative sense even as you gain in numerical value if your yield is less than what inflation is during the entire term of your bond. Not a great investment. Not swell. Not. At. All.]
Let’s go through some examples.
STOCKS
You have $10,000 of stock in Company X and check on it every so often when you hear about it on the news. It does well over the year and like a dutiful investor armed with the learned knowledge from PWT, you check on how it did versus the S&P 500.
2017 returns for Company X= 15.8% (Great job, major player!)
2017 returns for S&P 500=21.83% (Uh..oh…well, not so great job, little player…)
If you have used a financial advisor to purchase this stock for you, then that fee will need to be paid out as well. Let’s say that your financial advisor is nice and very affordable and charges you 0.5% (AKA 50 basis points in their jargon) which means that you are being charged 0.5% of the total assets with your advisor (regardless if it’s stocks, funds, or bonds).
SR: Hey, guy, I warned you about all these statistics…
PWT: Yeah, yeah, I know.
For that $10,000 you have with your advisor, you’ll be paying your advisor $50 every year as long as you hold that money or investment with him or her. (Or, in other words, for every $10,000 you have with your advisor, you’ll pay $50 yearly. So $500 each year for $100,000. $5,000 for $1 million. And so on and so forth.) As your investment increases, so does the payout to your advisor. Therefore, your interests are aligned since the advisor makes more money as you do.
In this example then, your 2017 return for holding Company X was 15.3% (15.8-0.5), not 15,8%.
Let’s do the same example with a new twist.
$10,000 in Company X with a 4% dividend (paid out quarterly into a cash account) with a 2017 return=15.8%
2017 returns for S&P 500=21.83%
Your total investment return (pre-tax) is then at 19.8% without any advisor or 19.3% with an advisor.
However, if the dividends are automatically reinvested into Company X each quarter, then the return will be different and possibly significantly so. The total return in this case will be determined by the following:
- how much stock was purchased by each dividend payout (ie, what the stock price was at the time of each purchase) which will in turn determine how much the next dividend payout will be with each dividend reinvestment leading to a higher one the next payout
- what the stock itself is doing in terms of its price
- what the dividend yield is doing (stable, up, or down) as the year progresses
- the taxes on your dividends
- the taxes on your sale of the stock if it happens (ie, capital gains taxes if you are selling higher than you bought for)
The easiest way to calculate total return in stock you held all year and didn’t sell is to just look at your 2016 year end statement and then see the value of the same stock in your 2017 year end statement, then do the easy math with a calculator. After that, you need to subtract out the taxes you owe for the dividends (whether the dividends are generating cash or being reinvested into the stock generating the dividend in the first place AKA a DRIP [Dividend Re-Investment Plan] or any other investment) no matter what. (As of 2013, the dividend tax has been 15% (or 20% for you all rich fat cats that light your fancy cigars with $100 bills and are in the top income tax bracket of 39.6%) with a 3.8% surcharge for married couples with incomes over $250,000 or single taxpayers with an income of $200,000 which was enacted in 2010 to help pay for the Affordable Care Act. [Thanks a lot, Obama!])
If you were in the top income tax bracket of 39.6% from 2010-2017, your entire dividend tax was 23.8% (20% dividend tax + 3.8% NIIT [Net Investment Income Tax AKA the Obamacare surtax among many other things]. It was fairly easy to calculate an approximate figure of your post-tax dividend gains—just divide your dividend gains by four and hold three parts for you and give one part over to the federal government or multiply the dividend gains by 0.75 if you prefer (since 23.8% is approximately 25%).
Therefore, in the above tax bracket, it will be calculated as the following.
$10,000 in Company X with a 4% dividend (paid out quarterly into a cash account) with a 2017 return=15.8%
2017 returns for S&P 500=21.83%
Pre-tax dividend gains + Company X return= 19.8% return
Post-tax dividend gains + Company X return~18.8% return (or, precisely, 18.848%).
You can see the attraction to dividend paying stocks or funds now. They can really juice the returns.
Now, the new tax reform passed in December 2017(officially titled as The Tax Cuts and Jobs Act of 2017 [TCJA]) changed all of this. (One thing that didn’t change is the following: Dividends are considered “qualified” once you own the stock or fund producing the dividend for over sixty days (ninety days for preferred stock). Selling before that would make your dividends taxed as ordinary income which would mean that they are taxed far higher than what the taxes would be for qualified dividends given the income levels for the average physician.
Dividends are now taxed at the following rates:
- 0% below $77,200 of taxable income for married joint filers or below $38,600 if single (or, the rarer category, married filing separately)
- 15% between $77,200-$479,000 for married joint filers or $425,800 if single (or, in the rarer category of being married filing separately, $38,600-$239,500)
- 20% if above any of the upper thresholds listed above in the 15% bracket
- The 3.8% NIIT is still applied to all dividends based on your modified adjusted gross income (more on taxes in a later post) of $250,000 for married joint filers or $200,000 for single (or all other) filers.
If you’re selling stocks and/or funds for a gain, you will be taxed at a capital gains tax rate. Short term capital gains are defined as anything held less than a year. Anything held over a year and then sold for a profit is considered a long term capital gain. Short term capital gains are taxed at whatever level your income level determines as short term capital gains are taxed as ordinary income. Long term capital gains are taxed far below what the taxes would be for short term capital gains given the income levels for the average physician.
Long term capital gains would be taxed as the following:
- 0% below $77,200 of taxable income for married joint filers or below $38,600 if single (or, the rarer category, married filing separately)
- 15% between $77,200-$479,000 for married joint filers or $425,800 if single (or, in the rarer category of being married filing separately, $38,600-$239,500)
- 20% if above any of the upper thresholds listed above in the 15% bracket
- No NIIT!!
SR: Hey, wait a second…those long term capital gains tax rates…aren’t they…?
PWT: Yep. Both the qualified dividend and long term capital gains tax rates are identical.
Mutual Funds
Thankfully, mutual funds are treated exactly the same as stocks in terms of taxing the dividends and capital gains. So re-read the above (or reference the above passage) when dealing with mutual funds and their tax implications.
SR: About time something broke our way…
There is one exception however when it comes to ETFs.
SR: God Damn it! Well, that didn’t last very long…
Dr. Scared: This it! This is it!! This is how they screw you!!!
PWT: It’s actually a good thing.
The dividends of ETF’s are taxed precisely the same way as those of mutual funds. The one difference is that ETFs create less taxable events leading to what should be less taxes for you on average over an extended period of time (years, not months).
Just don’t forget to subtract out the expense ratio from your earnings from any fund, then your taxes out of that figure. It’s an extra expense (and step) you don’t have to deal with when it come to stocks.
Bonds
Bonds can be a little tricky when it come to taxes depending on the type you get.
Dr. Scared: This is it! This is it!! This is how they screw you!!!
Dr. Unwise:…so annoying….
Let’s go over the generalities first.
Only the earnings from the bonds (either the payout or the difference between the original purchase price and what you sell it for are what is taxed, not the original principal investment) are taxed. By whom for each bond is explained below.
The earnings from corporate bonds are taxed by all levels of government (federal, state, and local) as ordinary income. Keep that in mind as you calculate your earnings from a corporate bond.
The earnings from municipal bonds are free from local taxes. State issued bonds are free from state taxes. Most state bonds have their earnings taxed at the federal level as ordinary income whereas municipal bonds are usually exempt from federal taxes.
However, there is a potentially juicy bonus here. There are municipal bonds that are known as “triple tax free” where all three levels of government have decided that a certain construction project is so important that no local, state, or federal taxes will be levied against the earnings from these particular municipal bonds. Often, these “triple tax free” bonds have a lower yield rate since they already have such a great tax advantage to them. Therefore, a little math will be needed to figure out if these bonds are the best earning for you vs other bonds that are taxed by one, two, or even all three levels of government, but have a significantly higher yield to compensate for these taxes. That’s also where you handy dandy friendly neighborhood financial advisor comes in. They do all those math, so you don’t have to. Honestly, they should. You’re paying them after all. This is exactly how they earn it.
Lastly, the earnings from federal AKA US Treasury bills/notes/bonds (remember the difference?) are not taxed at the federal level, but are at the local and state level.
I always judge performance only after all fees and taxes owed are paid out. After all, that’s what you will live off of eventually, not the debt to your mutual fund, financial advisor, or taxes still owed. I look at how much total I put into any investment and then take out all the fees and taxes owed and then see what I have left thus telling me exactly what I made each year or over the years. Anything else is a complete overestimation of how much you have/have made which will blind you to how well you or your financial advisor is really doing and how tax efficient your investing is which would in turn help you decide if you should stay the course and keep adding to said investment or change it for better returns by making either at least this investment or even your entire portfolio more tax efficient (at a minimum) OR just changing your investments totally in a different direction/asset class,etc.
One last point before we depart…
When figuring out how well your investment has done over multiple years (say, 3, 5, 10, 15, or even 20 years), you need to understand how to calculate how well your investment did on average yearly over that time, not just as one lump sum at the end of the time period you decided to study/look at your investment.
If you put $10,000 into an investment—anything as it doesn’t matter what for the sake of this example, but to make it simple, let say it’s an index mutual fund—and five years later, it has grown to $15,000 (Hells yeah!), then you’ve had a fifty percent gain over the past five years. The temptation is to say that you have earned an average of 10%/year over the past five years to give you a total return of 50% over the past half decade. Then, you march out the (in this example) fund’s expense ratio (let’s say…hmm, I don’t know, 0.14%, for no particular reason) and you get a very healthy 9.86% per year average over the past five years.
Right?
Right??
Wrong.
Dr. Scared: Oh God, just kill me now!
When you calculate your average growth rate over five years properly, the actual compound average growth rate (CAGR) is 8.45%/year over the past five years, not 10%/year which is just the arithmetic mean (total return/years needed to gain this return). After your theoretical expense ratio is subtracted out, then your CAGR is actually 8.31% over the past five years, not 9.86%. If it had been 9.86%, then your $10,000 would be $16,000 five years later, not $15,000—a sizable difference when dealing with tens or especially hundreds of thousands of dollars, no?
The reason for the difference here is simply that you have to account for the yearly gains since the money is gained throughout each year and not just all at once at the end of the five years in this example.
Ten percent of $10,000 the first year would be $1,000 making $11,000. Then, 10% of $11,000 would be $1,100 making the total $12,100 thus already showing you how off the calculation is by year two alone. (Even these calculated assumptions can be quite off depending on when the gains are made [ie, how early or late in the year] versus when the interest is applied [beginning of the year, end of the year, or throughout the year evenly or irregularly throughout the year as more money is put into a stock or fund which is usually the case when investing money at regular time intervals without paying attention to the cost of the equity which is known as dollar cost averaging as sometimes you will buy at a lower price and other times at a higher price, but overall will get it at a hopefully great company at a good price on average.])
Well, I think we have done enough (and then some) for one post.
I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.
Please spread the word to your family, friends, and colleagues. It would be greatly appreciated.
Until next time…