The big question: Risk vs Return, Part 1

Everyone loves higher returns. At least I assume so. All else given, I'd much prefer my money grows at 1000% compared to 100% annually. OK, I'm dreaming.

But still, everyone loves higher returns. So where do they come from? Investments. Let's start from the highest return.

1. You start a company! Yes, if you start a company, your expected return will be huge. Let's see, Bill Gates, Larry Ellison, Mark Zuckerberg, Larry Page, etc... Just take these people as an example, they probably have 30 billion dollars each, so there's your 120 billion dollars. If they started with a combined total of 100k, then it's more than 1 million times in return! Even taking people who fail when starting up their own company, the average return is probably still well over 100 times. That's 10000% return in probably 20 years, a mouth-watering yearly average of 26%. Considering increasing the return by even 5 percentage points over the average of 8% is considered a major feat, this rate of return is simply astonishing. Now clearly, we don't see people flocking to start their own companies, why? Mostly because it's risky! Of all entrepreneurs, maybe 5% will succeed with millions in 20 years, 90% will fail with no return, and 5% probably will keep their investments. (I'm making numbers up here, but I'd say it's an educated guess) We must understand that for an average person, the pain of losing 1 million dollars is much greater than the joy of making 1 million dollars if they had 1 million to start with. Of course, other factors such as higher time / energy devotion required for one's own business may also play a part. 
2. Equities. If we ignore the characteristics of derivatives such as leveraged funds, futures, options and the like, for the period of 1926 to 2011, the broad stock market, each individual stock weighted by their market value, had an annual return of 9.9%. A really high number. To put this into context, in 30 years, your portfolio is expected to grow by 16 time. I.e. what was 10k will become 170k. And the down side is that stocks are very volatile, meaning that their prices vary a lot from year to year. The worst year for 100% stocks was 1931, a year where the broad stock market dropped 43%. Take a moment and just imagine if all your savings, probably 100k, is now only 57k, in just a year! Ouch. What's more, in 25 years out of those 86, almost 30% of the entire duration, you'll end up with some kind of loss. Imagine the psychological effect it might have on you, a lot of people are not willing to bear this psychological pain, or they do not have enough time to wait for the market to "come back to normal". 
3. Bonds. Bonds have risks too. You can get defaults and interest variations. But bond risks are significantly lower: for the same historical period of 1926 to 2011, the absolutely worst year for bonds were -8.1% in 1969. In other words, in almost 100 years, investors would have never lost more than a tenth of their investment had they gone for diversified bonds only. A price had to be paid to the low risk though, in this case a much lower return of 5.6% annually, not even two thirds of what equities can provide you with.
4. Cash or cash equivalent (CDs). Now these have almost zero risk. All bank deposits in the U.S. are insured by FDIC for up to 250k. So essentially they are completely "safe".  I wasn't able to gather historical data back to 1926, but we currently have an average deposit interest rate of below 1%. 

The general trend is clear, higher risk, higher return. This may not hold true for short periods of time though, and "short" can actually be fairly long. For example, since the early 1980s, where interest rate was at sky-high 20%+, bond yield has kept dropping steadily, which created the biggest bond bull market. Therefore, for the most recent 30 years, bonds actually offered higher returns than stocks. But since interest rate can not  decrease forever (there is this magic number called zero), the potential gains from bonds will be limited. And personally I think over another 10 or 20 years, bond returns will come back to the normal 5% ish range. 

Personally I think this post has been rather chaotic, as I tried to take on too many things in a single post. I guess on the next post I'll start with just stock, and hopefully discuss risk involved in some depth when it comes to stocks. 

Stock vs Bonds, tax comparison, Summary

This is the summary table.

	Stock, Bond ST capital gain	Stock, Bond LT capital gain	Stock qualificed Dividend	Stock non-qualified Dividend	Tax-exempt bond interest	Taxable bond interest
Tax rate	28%	15%	15%	28%	0%	28%

Now let's get familiar with the concept of asset location. Many of you might have heard of the term asset allocation, which we will discuss in the future posts, but asset location is a quite different beast that is still important for a successful investor.

If every other investment decision remains the same, a good asset location will maximize after tax investment return. Note, we always talk about after-tax return, not the actual amount of taxation. It does not matter how much Uncle Sam charges you, as long as we end up with more money in the pocket, that asset location is a successful one.

Personally, I employ this strategy for when it comes to asset location:


Maximize tax-free and tax-deferred (401k and IRA, maybe 529 as well) accounts with investments with the following priority

1. Taxable bonds. These bonds are guaranteed to generate realized interest gains every year that are taxed at a hefty 28%.
2. Actively managed stock funds. Actively managed funds tend to have high turn-over, which means that they may incur a lot of realized capital gains at 28%. 
3. Foreign stocks. Foreign stocks are taxed heavily on their dividends at 28%.

The location of other types of investment does not matter too much if you are a buy-and-hold investor. If you often trade, then it makes sense to treat them the same way as actively managed stock funds with high turn-over.

So the idea is pretty simple, put the tax-efficient investments in your normal accounts and put those less tax-efficient into tax-advantaged accounts. 

At the end of this rather short post, I want to stress again, always aim for maximizing AFTER-TAX RETURN instead of minimizing tax. A lot of people have fallen to the trap of omg-I-don't-want-to-pay-tax.

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Stock vs Bonds, tax comparison, Part 3

In this post, I'll discuss the tax implications of bonds.

Bonds are actually pretty inefficient when it comes to taxation, but hey, it makes sense, because stock dividends are actually double-taxed, once at the corporate level, and once at individual income level, whereas interest payments on bonds are tax-free on the corporate side.

Following the grand theme of 2s, let me introduce you to the two types of bonds: taxable and tax-exempt.

Taxable bonds are fairly easy to understand, their interest payments are taxed at the regular income tax rate, which means 28% federal and whatever state tax. Interestingly, treasury bills are taxable!

Tax-exempt bonds are slightly more complex. Most bonds marketed as tax-exempt actually only means that you are exempt on federal taxation for interest gain. If you state happens to tax your income, then you'll have to pay the state tax. Our beloved California will then get a 9.3% cut of your interest gains. I guess this is the price you have to pay for nice weather and the existence of silicon valley, huh? There is another kind of tax-exempt bond funds, those state specific. Usually, you can only buy state-specific bond funds only if you are a resident of that state. For example, the Vanguard California Long-term Tax-exempt Fund are only available to California residents, but the interest gains from this fund is then also exempt from CA taxation.

Two common misconceptions!

1. "I bought a tax-exempt fund! Now all my gains are tax free!"
   Not true! As I mentioned, tax-exemption only applies to the interest earnings. If you sell a tax-exempt bond fund, you still have to pay tax on any capital gain. 
2. "Tax-exempt bonds are always better because I pay no tax!"
   Not true! The ultimate goal of investment is to maximize after-tax return, not minimize tax. If you have two funds with exactly the same characteristics, except A is taxable with 5% yield and B is tax-exempt with 3% yield, then obviously you should take the 5% one. 5% * (1-0.28) = 3.6%.

You may have a question with regard to the 1st misconception, namely, how exactly do you get a capital gain from bonds? Are they not just instrument that generate income? Well, just like stocks' return consist of appreciation and dividend, bonds' return also consist of both. The price of a bond varies with its demand, the higher the demand, the higher the price. If you look at it from another angle, then it can be interpreted as a variation in yield. Let's take a look at an example.

You bought 10k worth of bond at 10% yield (yeah, super bond, or maybe super risky bond), it has a maturity of 10 years. The moment you bought it, suddenly the yield dropped to 0%. (Very unlikely to happen, but we do see zero or even negative bond yields, we've even seen them recently in the case of 3 month US treasury bills and German bunds) Now how much is your 10k bond? Since most of the bonds are fixed rate, your 10% yield will continue to provide 10% annual income for 10 years before the principal is paid back to you. So your 10k bonds in 10 years time will be worth 10k + 10k * 10% * 10 years = 20k. 

Now for people that bought the 0% yield bond right after you, in 10 years time, their bond will be exactly 10k. Therefore, your 10k bond with 10% yield now is exactly the same as 20k bond with 0%. So you can sell your bond for 20k and cash in an extra 10k! This is basically how capital gain occurs. Similarly, when the yield rises, the value of bond you hold will drop. 

Of course, bonds' yield don't change by 10 percentage points every day, most of the time, their price hardly changes. This is especially true for short-term bonds, as even if the yields fluctuate, the impact on the entire value of the bond is small. Take the made-up 10k 10% example again, if the maturity is only 1 year, you'll gain 10% instead of 100%. 

In the next post, I'll summarize what I touched upon, and introduce the concept of what's known as "asset-location". 

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Stock vs Bonds, tax comparison, Part 2

In this post, I'll write about tax implications of losses in investment.

As I mentioned previously, the IRS is actually pretty fair when it comes to capital gains / losses. What I mean is that it taxes you when you make money, and it refunds you when you lose money.

In case you still haven't noticed a theme with IRS and their enormous tax code, let me give you a hint, "two" lurks around everywhere. Yes, losses come in two types, too. And no, this is not going to be the end of "two"-types streak.

First type is "short-term" capital loss. These are losses due to selling shares before holding them for one year. The second type is "long-term" capital loss, originating from selling shares that have been held by you for more than a year. And when I refer to capital loss, I always mean realized losses, you need to have sold the shares for the losses to be realized. 

As you probably noticed, they are the exact mirror of ST and LT capital gains. When it comes to tax credits, the rules are closely tied to the ST and LT characteristics as well.

ST capital losses incurred in a year can be used to offset ST capital gains, if there is any excess, you can then use it to offset LT capital gains. In case you're a super loser (in the investment sense), and you lost so much in ST investment, you can then use the rest to offset your your net LT capital gains (defined by LT capital gain - LT capital loss). Now in the hyper loser case, you can then use what's left of your current year's ST loss to offset ordinary income, up to 3k. If you qualify for ULTRA loser, i.e. you exceed 3k a year, you get to carry the losses over to the next tax year. Combined with the new losses, you repeat the steps again.

LT capital losses work much the same way as ST capital losses. The only difference is that they are used to offset LT capital gains first, then net ST capital gain, then ordinary income.

Now people have noticed a potential loophole here. Imagine you bought Stock A for 10k, before the end of the tax year, it has fallen to 5k. (I know, tough luck). You could potentially sell the stock and incur a 5k realized ST capital loss. What you could then do, is to buy it back using 5k. Sure, you lost probably 7 dollars of trading fee, but assuming a combined federal and state tax rate of 30%, you saved 5k * 0.3 = 1.5k of tax money. Of course you'll end up paying more tax later when the stock's price goes up, but you essentially have 1.5k for free until you sell the stock at a gain. And if you have those 1.5k invested, you probably end up with more than 1.5k by the time you have to pay the tax on your gains by selling Stock A. Feels like free money, huh?

Well it doesn't work, sorry to burst your bubble. What I just described there is called a "wash sale", and it is a practice forbidden by IRS. Wash sale is defined as selling and buying investments that are "substantially the same" within 30 days. The window is actually more like 60 days, because if you buy something in July 1st, you couldn't sell between June 1st and July 30th. Well, I'm being sloppy here, yes you can "sell" or "buy", but you just can't take tax credits for your losses. Of course, the IRS being "fair", it also means that you don't incur capital gains in the same window.

Some people unintentionally introduce wash sales to their portfolio when the stock market is very volatile and one tries to chase performance and stop loss. This is fine, just pay attention to the tax filing, do not blindly include your ST capital losses if your financial institution does not take wash sale related regulations into account. Because the IRS may find you later with hefty fines and other undesirable punishments.

Stock vs Bonds, tax comparison, Part 1

Stocks and Bonds are the most common investment options, each has its own tax characteristics.

In this post, I'll primarily discuss the tax liabilities of stocks.

People make money from stocks through two methods, price increase (appreciation) and dividend. Both are fairly intuitive. You buy low, you sell high, then you have appreciation, in IRS's books, it's called capital gain. Companies pay their shareholders part of the earnings, and that's dividend.

Price appreciation, or capital gain, is taxed differently depending on how long you hold the stocks for. If shares of a stock is sold within 1 year of the purchase date, whatever you gain is categorized as short-term capital gain, which means the tax rate is exactly the same as your marginal ordinary income tax rate. In my case, that's 28% federal tax + 9.3% state tax. Ouch, more than a third of what I make is going to the government! Even though I don't hate the government, I don't like it too much either, not so much that I'm willing to part with 37.3% of my investment earnings. On the other hand, if shares of a stock is held for more than 1 year and then sold, it is taxed according to the rules of long-term capital gain, at a much more favorable rate of 15% federal + 9.3% state (I know, sucks to be in California, many other states differentiate between long-term and short-term capital gains though).

Conclusion here is that Uncle Sam loves buy and hold investors more! (I'm sure it loves everyone none-the-less, LOL)

Some caveats here:

1. That 15% LT capital gain tax can change, and in fact, it's scheduled to increase to 20% starting January 2013. Moar tax plz...
2. Many of us invest through mutual funds, myself included. The taxation for mutual funds are slightly more complex than individual stocks. In the eyes of IRS, what you are buying is not "THE FUND", you are buying individual stocks in some proportion. That proportion is dictated by the fund manager, and can change over the course of a year, sometimes drastically. Every time when this proportion changes differently than the prices of each individual stock, your fund manager is essentially selling / buying stocks on your behalf. And that is a taxable event, which follows the tax rules I described above. When you sell the fund, of course, that's another taxable event, because in essence you are selling every individual stocks that you own through that mutual fund. Therefore, when you select funds, it probably makes sense to pay attention to what's known as "turn-over rate", a number that measures how much the manager has traded in a year. 0% means the manager never exchanged any shares, and 100% means none of the shares that the fund had at the beginning of a year has remained at the end of that year (read: probably a lot of tax). Index funds usually have close to 0% turn-over, and actively-managed funds tend to be a lot higher. But don't just shy away from actively-managed funds, because if they offer much better returns such that earning - tax is higher than the index fund, it makes perfect sense to buy actively-managed funds. How you determine how much a fund will return in a year, is a completely different matter though.

Now dividends also have two categories since IRS loves complexity. Those "qualified" dividends are basically all the dividends that you get from U.S. companies. They are taxed identically to LT capital gain. Those "non-qualified" dividends, are mostly foreign company dividends, some banking accounts' "dividends" (interests really) , and pretty much anything that is not included in the lonely qualified category. They are treated the same way as ST capital gain (read: a lot of tax). 

If you choose to employ a dividend-oriented investment strategy, i.e. buying shares of stable companies that pay high dividends, such as Microsoft, it then makes sense to stick to U.S.-based companies, because otherwise you'll get hit pretty heavily with non-qualified dividend tax. 

Assuming you are in the 28% tax bracket, here is a summary table for you:

Type	Long-term Capital Gain	Short-term Capital Gain	Qualified Dividend	Non-qualified Dividends
Applicable to	Share price appreciation when held for more than 1 year	Share price appreciate when held for less than a year	Dividends paid by U.S. companies	Any other kind of dividend
Tax rate	15%	28%	15%	28%

We discussed the "gain" situation in this post, as we know, stocks go down too, and they can go down by a lot, which means the "loss" situation is equally important. Luckily, the IRS is pretty fair when it comes to losses during an investment. I'll write out what I know in the next post. 

Thoughts on IRAs and 401k's for high income individuals, Part 3

Having written two posts about the relative pros and cons of IRA, Roth IRA, 401k and Roth 401k, in this post, I will try to give a somewhat comprehensive summary.

	IRA	Non-deductible IRA	Roth IRA	401k	Roth 401k
Contribution limit	5k	5k	5k	17k	17k
Income phase out start	56k	N/A	110k	N/A	N/A
Income cap	66k	N/A	120k	N/A	N/A
Withdrawal Tax after 59.5	Entirity	Earning only	Free	Entirity	Free
Early withdrawal penalty (In addition to normal tax)	10%	10% on earning	Free after 5 years	10%	10% pro-rata

Personally, I'd maximize the Roth options of both as they are more flexible when it comes to early withdrawal, and they effectively increase the amount of money that you have which is tax-free! A simple calculation for maximizing IRAs that assumes 8% annual return, 30 years time frame, 28% federal tax and 2% state tax shows the following result:

	IRA	Roth IRA
Contribution (after tax)	105000 (After tax equivalent)	150000
Ending balance	566416 + (150000-105000) = 611416	566416
Tax due	566416 * 0.3 = 169924.8	0
Total after tax	441491.2	566416

The traditional IRA's total asset after 30 years plus the sum of tax savings every year is only about 78% of the Roth IRA's total asset.
The situation is similar for 401k and Roth 401k.

Thoughts on IRAs and 401k's for high income individuals, Part 2

In the last blog post, I discussed some of the features and limitations of both IRA and Roth IRA plans, and came to the conclusion that for young high-incoming individuals, jumping through the hoops in order to achieve a "backdoor Roth" is probably the best option. Now let's see what are our options for 401k plans.

The main advantage of 401k over IRA is the contribution limit. For 2012, an individual is allowed to contribute up to 17k per year. That is quite a bit of money! It may not sound like too much, but the tax-deferred status of 401k really makes a difference. Let's imagine a hypothetical situation where you max out your 401k on some steady investment that returns 5%. Note, 5% is a very conservative number, most other sources assume that you get 8%. Over 30 years, assuming annual compouding, your total in your 401k account would be 1129460 dollars, of which only 510k is your principal! Of course, the 1.1M in 30 years may not buy you as much, but even if you take into consideration of inflation, assuming it will be at 2% per year(Fed has been trying to achieve that number), we'll still end up with  808k.

Now keep in mind this number is achieved using a very modest earning estimate. If we use the standard 50/50 asset allocation, according to Vanguard, for the period of 1926 to 2011, the annual return is 8.2%! Even though past performance is no guarantee for the future, we have reasonable confidence that the performance of the markets will not stray too far from this number given a long enough time frame. So that 17k per year, i.e. 510k principal, in 30 years time will end up as 1.9M after inflation!

Without the tax benefit from 401k, you basically reduce your earning by whatever percentage your highest tax bracket is. Assuming a 28% federal tax (which is potentially going to rise), and 2% state tax (probably an underestimate), our glorious 1.9M will be reduced to 1.25M, a 35% reduction in final value, and a 47% reduction in profit! So the tax deferral really makes a difference. Bear in mind though, this tax calculation method is a very simplified approximation, as it does not take into account the difference in tax treatment between long-term and short-term capital gains or the portfolio turn-over rate.

Employers are also able to "match" employee contribution, essentially doubling your 401k's, *if* they so choose to. In that case, by all means maximize your 401k, because the "matching" part is almost like a salary raise!

The bad thing for 401k though, is that you have a limited choice of investment options. Basically companies choose a custodian for you. Usually, companies choose decent financial institutions, but they can still be limiting. For example, the company I work for chooses Fidelity as our 401k custodian. Even though by no means is Fidelity a bad choice, we only have a limited sub-set of fidelity funds to invest in, and can not invest in some potentially more lucrative investment, e.g. P2P lending. This is not the end of the world though, since you can always rollover your 401k plans to IRA, which then gives you unlimited freedom :)

401k's, just like IRAs, come in two flavors. Roth and non-Roth. The non-Roth one are almost identical to IRA apart from the advantage and disadvantage I mentioned above. But the Roth one is slightly worse than the Roth IRA when it comes to distribution. Roth IRAs allow you to withdraw your principal after 5 years tax-free, but Roth 401k applies a "pro-rata" rule. E.g. Imagine you have 10k in Roth IRAs and Roth 401k's respectively, the newest contribution in both were made more than 5 years ago, and 5k from each type of accounts are earnings ( I know, super earning rate) . Now you want to withdraw 5k from each type. On the Roth IRA side, you pay no tax, but on the Roth 401k side, you have to pay tax on 2.5k of the distributions if you are younger than 59.5. Not too good huh? Of course, you can always wait for a job change and do a rollover from Roth 401k to Roth IRA, which then entitles you to tax-free principal withdrawals even before 59.5.

In fact, I'd argue that anyone with Roth 401k's should rollover all their assets into a Roth IRA whenever possible, for greater flexibility in both investment and withdrawal.

I'll be make some little tools for estimating growth, maybe I can do better than most of the tools on the internet :)

Thoughts on IRAs and 401k's for high income individuals, Part 1

As we know, tax in the U.S. can be pretty hefty for anyone with over 100k annual income. And many limitations also come into play as soon as you are slightly over the magic 100k number.

I did some reading on how IRAs and 401k's function, and came up with some personal opinions that I'd like to share with anyone who cares reading my little blog. :) Since I'm in my early 20s, I will mostly focus on info that's relevant to my own age group.


So the first question for many people would be, which one is the best? The answer is clearly ---- both. 
The reason is that you want to maximize the amount of money you have that has the ability to grow tax-deferred or even tax-free. There are limitations to each though, and some apply specifically to high-income individuals. Now let's discuss the relative pros and cons for each.

IRAs have a much smaller annual contribution cap, 5000 USD for people under 50. You put pre-tax money in, the money grows tax-deferred, and later when you withdraw, you pay tax on both the principal and the earning. But the traditional IRA in its original flavor is actually not available to us, since there is an income cap as well. For 2012, the income cap is 68000, which means that if you earn more than 68k a year, you can make zero tax-deductible IRA contributions. 

Now you're probably like, "waaaat". I know, I was the same when I read that line, but as the saying goes, "when god closes a window for you, he often opens an entire door", or something like that. OK, in this case, it's more like a series of hoops. So notice I said "zero tax-deductible IRA contributions", yes, it implies there is another form of IRA contribution, i.e. non-tax-deductible contributions. But wait a minute, if you have any idea of how the retirement accounts work in the US, you'd probably ask: "doesn't that mean Roth? "

The answer is unfortunately "no". It is not Roth, it basically has all the disadvantages and none of the advantages of Roth. A non-deductible IRA contribution is after-tax money, which means the principal will not be taxed again, but since the account is still an IRA, you'll end up paying tax on the earnings. Then why don't we just contribute to Roth?

The problem is, you can't do that either. There is a cap for Roth IRA contribution, too! For 2012, it is 120k. Admittedly, the complete cutoff is much higher, but you'll still get a phase-out issue starting at 110k. I.e. if you make 115k, you can only contribute 2.5k a year instead of 5k. This goes against our doctrine of maximizing tax-free growth! Now we are stuck with no normal traditional IRA and no Roth IRA. Is there another option other than sticking with the sub-par non-deductible IRA stuff?

Prior to 2010, the answer would have been "no". But since 2010, the IRS has decided to remove the cap on what's called a "Roth conversion". Essentially, you withdraw IRAs, pay tax now, and put them back into Roth IRAs within 60 days. It's the IRS's way of getting paid earlier. (much like killing a goose that lays golden eggs, ok, maybe not to that extent) This enables us to convert our non-deductible IRAs into Roth, essentially completely bypass the limitations on both flavors of IRAs. This method is also known as "backdoor Roth".

What you do is stack up 5k, contribute to an IRA, and immediately do a conversion. Since you already paid tax on the 5k, the conversion is free (unless you somehow made a bunch of money during the conversion processing time, in which case, good for you). Now we get to reap the benefit Roth IRA!

One added benefit of Roth IRA which I particularly value is the ability to withdraw the principal after 5 years. Since I'm still in my early 20s, I have ambitious in my life that will need money, such as starting a company or something. If I put a lot of money in retirement accounts, when I really do need money to kick-start my business, I'll probably find myself unable to retrieve them without paying a 10% penalty tax to the IRS. Not good! But if I don't use the retirement accounts, I'm essentially leaving money on the table! Much of the investment gains will be paid to the IRS due to the high income tax bracket. Not good either! Roth IRA solves this problem for me though. With Roth IRA, I can save 5k, let it grow, and withdraw that 5k after 5 years while leaving the earning to do further growth. 

In my opinion, Roth IRA is the best option for anyone that would like to save up for their retirement but don't want to lock themselves completely into the whole retirement saving thing. It is a shame the limit is only 5k, but I still think the benefit is completely worth jumping through these hoops to get the job done. 

On my next blog post, I'll discuss features and limitations of 401k plans.