The investment process can be a very complex topic, but I will cover it here in abbreviated form. The main steps are as follows:

1. Determine your Goals and the Available Resources. The first step is to determine what you want to accomplish. For example, many people have retirement as one of their goals (which we prefer to call “achieving financial independence”). Think about what this means to you. Visualize it. How you will spend your time each day? Now identify the earliest time you would like to retire. If that isn’t possible, how long is the maximum you would work? What standard of living would you like to enjoy in retirement? If that standard isn’t possible, how much could you live on? How much are you saving now toward retirement? How much can you save? How much would you like to save? How much volatility in your investments would you prefer? How much can you tolerate? There are tradeoffs in all these factors. Saving more can “purchase” an earlier retirement date. Retiring later can enable a more comfortable retirement lifestyle. Taking on more investment volatility (and thus earning a potentially higher return) may allow you to save less. Clarifying and identifying all of your goals and the resources available to meet them is an important first step to achieving those goals.

2. Develop your Capital Markets Assumptions and Optimized Portfolios. This section is necessarily technical and will no doubt not make much sense to you if you are not an investment professional. However, while most people (and, appallingly, even many advisors) don’t understand these concepts, they remain vitally important to the process. The second step is to develop a list of the categories of investments you will consider investing in. For each of these asset classes, you will need to develop an estimate of the future arithmetic mean return (as opposed to the geometric mean), the future standard deviation, and the future correlation with every other asset class. This data is then put into an “optimizer” (a type of software program) to develop (combined with experience and judgment) a set of model portfolios (or asset allocations) that are expected to be optimal for different levels of risk and return.  (This step, now called Modern Portfolio Theory or MPT, earned Harry Markowitz the 1990 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel aka the Nobel Prize in Economics.  The original, 1952 paper can be found here among other places.)

3. Perform a Monte Carlo Simulation. A Monte Carlo Simulation is a quantitative technique for developing projections under conditions of uncertainty – like not knowing what the market will do in the future. This process combines the portfolios developed in the previous step with the goals and resources identified in the first step and determines the feasibility of the combinations. In other words, there may be no portfolios that give a high probability of meeting goals such as retiring tomorrow on a very high income. We recommend continuing to adjust the plan (step one, not step two) until there is an acceptable probability of success in meeting your goals with a given portfolio.

4. Implement the Plan. It isn’t until this step that the actual investments are selected. The criteria here should be how efficiently and effectively the optimal portfolio determined byt the last step can be implemented by the actual investment choices – in some cases the lack of acceptable choices by influence the asset classes included in the second step.

5. Monitor the Plan. After the plan has been implemented, it must be monitored for changes in the goals and resources (step one) or for changes in capital markets assumptions or available investments (step two).

That’s it.  Simple, but not easy.

A post about the federal budget sounds excruciatingly boring, but I hope this will be helpful in putting the putting the federal budget in perspective, because perspective, when numbers get into the billions or trillions, is difficult. We simply can’t comprehend such large figures so below I will show federal taxes, spending, and debt broken down per family to make them more comprehensible. All the figures for income and spending given are for fiscal 2015. The debt figure is as of the end of 2015 and the household count is from the Census Bureau.

The percentage listed is the percentage of total federal spending, and figures are rounded to the nearest hundred dollars for simplicity. Differences between the itemized figures and the totals are due to rounding.

Federal Income:

• Personal Income Taxes: 42% or about $12,400 per family. Obviously most of us pay this, but approximately half of U.S. taxpayers owe no income taxes due to various exemptions, deductions, and credits. This means the other half (on average) are paying double.
• Social Security, Medicare, etc. Taxes: 29% or about $8,600 per family. Most retirement taxes are ostensibly paid half by the worker and half by the company, but this is a fiction. The company isn’t concerned with what workers take home; their concern is how much it costs to employ them. Thus the “company’s” share of the taxes would otherwise be available to pay to the workers. Further, there is no “lock box” or separate accounts or investments waiting for workers when they retire. All of these taxes are spent either on current retirees or other government programs.
• Corporate Income Taxes: 9% or about $2,800 per family. While economists disagree on the exact breakdown, there is no question we all pay this in some combination of three ways, 1) as a worker through lower wages, 2) as a consumer through higher prices, or 3) as an investor through lower returns. There isn’t any place else for the funds to come from. Also, as with the next item, there are large inefficiencies as companies lobby furiously and structure themselves suboptimally (in economic terms) to try to reduce their taxes.
• Excise, Customs, Estate, Gift, and Miscellaneous Taxes: 8% or about $2,400 per family. The estate and gift taxes are particularly inefficient because they cause large (relative to the revenue) non-productive expenditures (from people trying to avoid them) and/or inefficiencies (from economic dislocations).
• Borrowing: 12% or about $3,500 per family. We pay interest on this as do our children and their children until it is paid off (or we default). Financing almost an eighth of our spending is obviously not optimal.
• Grand Total: about $26,100 of tax income and another $3,500 borrowed per family at the federal level alone.

Federal Spending:

• Income Security & Health: 27% or $8,000 per family. This category includes Medicaid, food stamps, unemployment compensation, assisted housing and social services, and other welfare programs.
• Social Security: 24% or about $7,100 per family. Our current seniors had their social security taxes spent to fund the previous generation’s retirement, so this is funded out of current taxes.
• National Defense: 16% or about $4,700 per family.
• Medicare: 15% or about $4,400 per family.
• Interest on the accumulated debt: 6% or about $1,800 per family. Fortunately, the federal government is considered an extremely good credit risk and current interest rates are extremely low. This will probably not be true for an extended period of time.
• Other: 11% or about $3,200 per family.
• Grand total: about $29,600 spent on behalf of your family.

Federal Debt:

• Net Public Debt: about $13.6 trillion or about $110,000 per family.
• Gross Public Debt: about $18.9 trillion or $152,000 per family. This includes the net public debt, but adds another $5.1 trillion that the government owes to itself. For example, current Social Security “surpluses” are invested in Treasuries, which in reality means it is lent to the rest of the government to spend now.

I hope this view of some very large numbers in a more meaningful context has been helpful.

Sources:

• http://www.treasurydirect.gov/NP/debt/current (as of 12/31/2015)
• http://www.whitehouse.gov/administration/eop/cea/economic-report-of-the-President/2016 (Table B-19)
• http://www.census.gov/hhes/families/files/cps2015/tabH1-all.xls

It is difficult to compare gift vs. estate vs. generation skipping tax rates and how they are computed, especially considering the “inclusive” vs. “exclusive” treatment of various pieces. So I did a calculation that “normalizes” them to equivalent terms.

Assuming a taxpayer has already used up all of their exemptions and exclusions, and ignoring the three-year look-back on transfer taxes paid, if the taxpayer gifts/leaves funds to their (U.S. citizen) spouse or charity, there is no tax impact. However, if they chose to have the spouse or charity get less (by leaving or gifting it to someone else), a portion will go to tax and a portion to those recipients. This seems like a better way of thinking about the efficiency of those transfers because they are in the same terms.

In other words, at a “cost” of $X total, what percentage will the government get and what percentage will the children or grandchildren get? You might assume that the current rates, 40% for the generation skipping tax and 40% for gift/estate tax, will equal 80% if both apply; but it is a lot more complicated than that.

The short version below is ranked in order of efficiency:

Of course, many options are available for planning around those rates, but I do think the comparison is interesting, and I haven’t seen it laid out this way anywhere else. Also, if the asset is an IRA or something similar that is considered IRD (Income in Respect of a Decedent) you will have income taxes to contend with as well (and an offsetting deduction for the federal estate taxes attributable to the IRD asset).

Short selling is selling a security (typically a stock) one doesn’t own in hopes of buying it back later at a lower price. It is just the reverse of the normal practice of buying first then selling (which is called being “long” the security). Because short sellers are predicting a price decline, and will profit if they are correct, they are much maligned. In times of market turmoil they are invariably blamed and frequently there are calls to ban or restrict short selling. This is unfortunate because short sellers serve a very important function.

First, it might be helpful to further describe exactly what short selling is. If a trader gets paid on the opening transaction he or she is short. If the trader pays on the opening transaction, he or she is long. There is a stigma with short selling, but it is done all the time. If a contractor wins a bid to build an office building, the contractor is then “short” bricks, drywall, labor, etc. He or she has sold all of those for a fixed price without actually owning them at the time he or she sells them.

Incorporating all known information into prices (including negative opinions) aids price discovery (this is the technical term for finding what the “real” price is). We shouldn’t want prices high, we should want them right, and short sellers help reduce bubbles and volatility. In the long run prices will always approach their correct level; temporary imbalances because all opinions can’t be expressed don’t raise the long-term return on the investment.

It is understandable that when prices go down folks want someone to blame, and people with negative opinions who are selling are a convenient target, the theory being that the short sellers can drive the price down and then buy to cover their positions without those buys driving the price back up and removing the profits. Not only is that probably not possible to do, but notice that people don’t get worked up about the reverse – buying to drive the prices “too high” and then selling at a profit, even though it is exactly the same thing. Knowingly disseminating false rumors (positive or negative) to move a stock is securities fraud regardless of whether the investor is long or short. Short sellers have a very tough time in the first place because stocks have an upward trend. This is one of the reasons we are biased against it as a strategy – there is a headwind. Further discouraging short sellers is the frequent existence of uptick rules, the difficulty of locating shares to borrow, etc.

In my view structural difficulties should be eliminated if at all possible. For example, I don’t see why you should have to locate shares to borrow to sell short. You should be able to create “synthetic” stock. If someone wants to be short and someone else desires to be long, there is no reason not to have a derivative transaction where they settle up later based on the value of the underlying without forcing them to actually locate it and borrow it as is required now. This does lead to two slight issues for the long side since the stock wouldn’t actually be owned: dividends would not receive the qualified treatment for taxes, and there would be no voting rights. I envision these “synthetic” shares trading alongside the regular ones with small discounts because of those two detriments. Assuming adequate collateral requirements to protect the long side of the transaction, I imagine the spread would be very small.

In short, you should be thankful for short sellers.  They take significant risk and incur sometimes substantial costs (in the course of seeking a profit for themselves, of course) that help make prices more accurate reflections of the underlying values of securities.

We frequently find circumstances in which a financial advisor’s lack of knowledge of some specific tax-related techniques may have cost the client money. Upon asking a number of financial advisors and CPAs about these situations, the unawareness on these points in particular appears to be widespread:

• Net Unrealized Appreciation or NUA. Assume that you have a 401(k) with employer stock that was purchased far below the current value. Upon separation from service and prior to doing an IRA rollover, you may take the stock out directly (in-kind distribution). You will pay ordinary income taxes on the amount of the original purchase price, not the current market value. When the stock is then sold, the remaining gain is at capital gains rates, not ordinary income rates. Three circumstances will make this technique more advantageous: 1) the original purchase price is very small relative to the current fair market value of the stock; 2) you will need the money shortly anyway, so the continued tax-deferral is less of an issue; 3) the spread between the ordinary income rate and capital gain rate is high. All of these factors do not have to be true, but to the extent they are, the advantage of using the NUA tax treatment is greater.

• Losing tax basis in a permanent insurance policy. If you are surrendering a permanent insurance product for less than the premiums paid, you should probably do a 1035 exchange into a low-cost annuity instead. In spite of my well-known dislike of variable annuities in most situations, in this case, you will get tax free earnings until the “losses” from the insurance are earned back. Moreover, you can even add additional funds to the annuity to accelerate the time to achieve break-even from a tax perspective. This means the poor tax treatment (all ordinary income) of the annuity never comes into play.

• The earlier withdrawal date from a 401(k). Funds may be withdrawn from a 401(k) upon separation of service without a 10% penalty at age 55 not 59½ as with an IRA. This is without a 72(t) (substantially equal periodic payment) schedule. In other words, if you are retiring at age 56, the funds that may be needed prior to 59½ probably should not be rolled over to an IRA without some further thought and analysis.