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July 2, 2019

“If we’re heading to a recession, we’re already in it.” Liz Ann Sonders (Chief Investment Strategist, Charles Schwab & Co.) shares her mid-year market insights and provides strategies for removing the emotion from investing, regardless of market conditions. Plus, Joe and Big Al answer your money questions: how do you diversify a portfolio for the best returns and tax efficiency? And when does it make sense to do a traditional 401(k) instead of a Roth 401(k)?

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Show Notes

(01:14) Liz Ann Sonders: Market Recap, Recession Analysis, Interest Rates, and Inflation
(15:35) Liz Ann Sonders: Tariffs, Politics, and Investing in the Face of Recession
(25:46) How to Diversify Investments for the Best Returns or Tax Efficiency? (video)
(37:20) When Does It Make Sense to Do a Traditional 401(k) Instead of a Roth 401(k)?

Transcription

“We did see that huge denting of corporate confidence. We’ve seen two quarters in a row now of negative capital spending. Two-thirds of the time that’s happened in the past, you are actually in recession. It’s not just a warning of recession, you’re in recession. The yield curve has been inverted now for about five weeks, that’s a pretty sustainable period of time. And sadly what I’d say is, if we are heading into a recession we’re already in it.” – Liz Ann Sonders, Schwab

That’s Liz Ann Sonders, Senior Vice President and Chief Investment Strategist for Charles Schwab and Company. Today on Your Money, Your Wealth® she shares her mid-year analysis of the market. The trade war with China seems to be in a truce at the moment, following the G20 summit, but who knows what happens next. How might tariffs, interest rates, or politics affect the market, and how should investors manage their portfolios in a recession? Keep listening for strategies to take the emotion out of investing. Plus, Joe and Big Al answer your money questions: how should you diversify your portfolio for the best possible returns or tax efficiency? And when does it make sense to do a traditional 401(k) rather than a Roth 401(k)? I’m producer Andi Last, and here with our guest, Liz Ann Sonders, are Pure Financial Advisors’ Director of Research, Brian Perry, CFP® and CFA, and Big Al Clopine, CPA.

01:14 – Liz Ann Sonders: Market Recap, Recession Analysis, Interest Rates, and Inflation

Al: Liz Ann, thanks so much for joining us.

Sonders: My pleasure. Thank you for having me.

Al: Maybe I’ll start broadly. Just give us some thoughts about what happened in the second quarter then we’ll get a little bit more specific.

Sonders: Sure. So we’re, I guess, in the midst of the third leg up in the market. We had the initial top in January of 2018, and then the 10% or so correction, and then we rallied back to highs in September of 2018, then a near 20% correction. Rallied back into the high in April, then had between a 7 and 10% correction in May, depending on the index, and then we’ve since rallied back to close to all-time highs. I would say this latest rally has some different characteristics to it than the two that preceded it. With each round trip that we’ve had in the market, the leadership has gone a bit more defensive. So I think market behavior is reinforcing late cycle economic behavior. So I think you’re seeing it in market behavior as well. And that’s been our theme really for the last year and a half, that we’re in this late cycle environment. I think with the second quarter, you also brought the elevated trade tensions with the additional tariffs on the $200 billion going in, the more overt targeting of Huawei, and some of what China did in response. And I think what has been most important associated with that is it really has started to take a bite out of animal spirits and corporate confidence, and capital spending has rolled over. Analysts have not yet started to reflect it to any significant degree in earnings estimates, and of course, we start earnings season in the next couple of weeks. But I think this earnings season will be particularly important as we start to hear companies put more meat on the bones of what the trade war actually means to their companies and their industry. So I think it’s an even more important upcoming earnings season than is typically the case, and they’re always important.

Brian: So with us being in the later parts of the cycle – and I like your mid-year outlook name, “The Battle Symphony” – and you talked about the U.S. versus China and some other themes that are playing out here. What’s going to determine if this later part of the cycle extends into a continued stock rally, maybe into eventually recession of course, but what’s going to determine if that recession is six months from now or multiple years down the road?

Sonders: So I think trade is the most important factor. I think best case scenario is negotiations get them back on track and we may get some sense of that in the aftermath of the G20 meeting, but it would have to result in a true sense that the negotiations were legit and that we were on a path toward some sort of comprehensive deal – not just a “deal lite,” where maybe China promises to buy stuff from us at some indeterminate point in the future, but actually getting to the more egregious practices that initiated this trade war in the first place. I have to say, absent that, I don’t see how we avoid a recession in the near term because we did see that huge denting of corporate confidence. We’ve seen two quarters in a row now of negative capital spending. Two-thirds of the time that’s happened in the past, you are actually in recession. It’s not just a warning of recession, you’re in recession. The yield curve has been inverted now for about five weeks. That’s a pretty sustainable period of time. And sadly, what I’d say is, if we are heading into a recession, we’re already in it, I would argue, because when the bureau that dates recessions – the NBER – when they come to the conclusion that we’re in recessionary type conditions, it’s then their job to figure out when the recession started and ultimately when it ends. What they do, when they conclude that we’re in a recession, is they basically go back and say, “where was the peak?” So if we’re heading into a recession we’re probably already in it. The other side of the coin is that we get a comprehensive trade deal, you get maybe looser monetary policy by the Fed, you reignite animal spirits and you kick back in the CapEx cycle – which is what I think we need to elongate this cycle, because we’re unlikely to see the consumer continue to be the only driver. We really needed to see the next leg be driven by corporate spending, which was the purpose of that tax cut. But we offset it by tariffs, so I think trade continues to be the most important needle mover. And that makes it difficult because, you know, we’re a Tweet away on any day from the news being either better or worse. (laughs)

Al: Yeah that is a reality these days. So you brought up the dreaded word recession. So let’s talk about that a minute because I think we’ve had such a long period of bull market, albeit kind of a slow period of growth…

Sonders: Yeah, it’s the weakest economic recovery in history. But, we’re in a nice healthy ten-year bull market for sure.

Al: Correct. And so I think in people’s memories, of course, is the Great Recession, and so let’s chat about – what does this seem like versus the Great Recession? Because people hear recession now they get pretty worried.

Sonders: Right, because their muscle memory takes them to the ’07 to ’09 nineteen month recession that was absolutely brutal, both in terms of financial market performance, but also, obviously, economic performance. We don’t think the next recession looks like the prior recession. That was the result of the bursting of a massive systemic bubble that had trillions of dollars of derivatives tied to it that it infected an otherwise massively over leveraged global financial system. So it truly was a house of cards. And the popping of that bubble systematically took down the entire global financial system with it. We don’t have anything resembling that right now. I’ve said we have some microbubbles that have been inflated by all of this excess easy monetary policy. That was one of my themes at the end of 2017 heading into 2018 – that we had some of these micro-bubbles that could potentially pop. But none of them were large enough or systemic enough to bring down the system. And we did see that throughout the course of last year. We saw it happen with the short volatility trade. All the money that, at the end of 2017 into the beginning of 2018, that was in various vehicles betting that volatility would stay suppressed. Well, you got a big spike in volatility and all those vehicles that were betting it would stay suppressed got completely wiped out. So that really defined February. Then you saw the significant bear market in the FAANG stocks, you saw it in the cryptocurrencies, you saw it later in the year in emerging markets, you saw it and continue to see it in small caps. We do have probably a micro-bubble inside the corporate bond market in the lower rated space, like the triple B space. That could cause some real problems. But none of these individually represent the kind of scope and scale and severity of the bursting of the housing bubble. So that’s why we think this next recession, which by the way, it looks like we’re already in a manufacturing recession. The question is whether it morphs more broadly into the economy. In 2015 and 2016 we had an earnings recession, we had a manufacturing recession, but it ultimately did not get severe enough to become an economic recession. I think the chances that we can avoid it this time are less.

Brian: So it sounds like, absent a real deal on trade, which, who knows what the odds of that are, is the Fed the only hope then for really continuing this economic expansion? And if so, on the one hand, you have Powell and the Fed trying to assert their independence and not give in to what Trump wants, and on the other hand, you have the economic reality and trying to support the economy going forward and maybe prolong the recovery. What do you think the Fed does?

Sonders: Well I think the Fed does start cutting rates in July, but I think it begs the question: if you think that the slowdown in both the U.S. economy and the global economy – which is even more severe in the case of the latter – is because interest rates have been too high, then you could argue that if the Fed steps in and lowers interest rates, that’s sort of the elixir that cures what ails us. I frankly don’t think that the reason why we have a massive global slowdown and a compression in global trade, world trade from strongly positive to now negative and leading into a manufacturing recession in the U.S., I don’t think that any of those are because interest rates have been too high. So it’s hard to imagine that simply a 25 or 50 basis point cut by the Fed, other than how it feeds through the equity channels and “the Powell put” – like it was “the Bernanke put” – you could absolutely get a pop from easier monetary policy. But I don’t think the problem that led to us being at the point where we need the Fed to cut rates was a rate problem. It’s been a global trade and uncertainty problem.

Al: I guess if the Feds do lower the rates and as expected, and that does sort of prolong this period of expansion, recessions are, it seems that they’re inevitable. You can’t just keep doing this forever and never have a recession. So let’s talk about why that’s true. What what is it in our economy that has these periods of growth and these periods of pullback, and why that’s actually kind of the way it is and healthy?

Sonders: Well there’s sort of the normal cycle, and then there’s arguably the more recent cycle. To your point about monetary policy sort of being the only game in town and cycles may be getting distorted a little bit by virtue of all these extremes in monetary policy. So a normal cycle is one where the economy grows and maybe moves into an overheating stage. Wage growth picks up, in turn, inflation growth picks up. The Fed has to step in, raise interest rates in order to kind of cool down an overheating economy, try to cool down some of those excesses, keep inflation from getting out of hand. Eventually they raise short rates enough that the long end of the bond market starts to say, “OK, they’re sufficiently going to slow the economy,” long bond yields tend to come down, the yield curve inverts, you go into a recession, those excesses ease, and then you start the process from a healthier point. This last cycle is a lot different because the severity of the last recession was so dramatic. The fact that it was global in nature, we had all this massive coordinated central bank policy easing, not just with rates, but taking global central bank balance sheets up to $26 trillion at the peak. It is a trickier cycle to figure out. We’re in this kind of post-debt bubble supercycle for the last 10 years. That’s one of the explanations for why growth has been so suppressed, why, again, longest economic expansion in modern day history, but by far the weakest. It doesn’t look like this cycle is going to end the same way with all of this overheating and wage growth really skyrocketing and inflation becoming a problem. But what we may be facing now is more of a deflationary end of the cycle, as opposed to an inflationary end of the cycle. That may mute the severity of the recession. It’s still not fun to go through. (laughs)

Al: Are interest rates ever going to come up to where they were years ago? Sonders: You know, I don’t know. I think – I can’t help but wonder if there’s a contrarian case for inflation. I don’t think that there’s really any set of circumstances you could lay out to bring us back to – nor would anybody want to go back to – a 70s-era hyperinflation kind of environment. But the contrarian in me can’t help but, not just make the contrarian case for higher inflation simply because no one else thinks there’s going to be inflation – I’m never a contrarian just to be a contrarian – but I always want to think, “OK, what’s the story everybody’s telling versus what’s the story nobody’s telling?” And I’m generally more intrigued by the story nobody’s telling. So I think we’ve really squashed all of the ideas that inflation is possibly a risk out of the mindset of investors and pundits. So again, I just I can’t help but think, “OK, so what could trigger inflation?” I think we’re already seeing sufficient tightness in the labor market. We have started to see upward pressure on wages – not to the same degree that we have in past cycles. But maybe it’s just coming later than it had been. Tariffs are inherently, at least initially, inflationary, and I think – and here’s the rub as it relates to timing of recession – I mentioned trade deal or no trade deal, but tied to that is if there’s no trade deal, and in particular, if the next round of tariffs go into place, which is up to 25% on the remaining $325 billion of goods we import from China, 40% of those are consumer goods. So you talk about meat on the bones, if that next round goes in, this will really be felt, and even the Wal-Mart’s of the world which is obviously one of the behemoths of retailers that imports goods from China. They have said, “if the next round goes in, we will pass those higher costs on to consumers.” So you may start a bit of an inflation cycle even though probably down the road it’s more deflationary because of how it stunts economic growth. But you could have a scenario where inflation picks up a bit more than what is expected now. If it’s purely tariff related, I don’t think the Fed starts to dramatically raise interest rates because that’s not going to be the solution to that problem. So back to your question, are we ever going to get back to an environment where interest rates, from a yield that provides to investors, are back in the mid to high single digits, it’s hard to lay out that scenario, at least in the near-term – meaning sort of at least through the next cycle.

In just a minute, Liz Ann Sonders talks about Trump’s tariffs, politics, and her strategies for intelligent investing, regardless of market conditions. Read the transcript of this interview and find links to Liz Ann Sonders’ mid-year market outlook in the podcast show notes at YourMoneyYourWealth.com. Be sure you’re subscribed to the podcast for what’s coming up on YMYW: Oliver Renick from TD Ameritrade Network on the effect the media has on the markets, economist Dr. Chris Thornberg returns to YMYW with his Southern California real estate market outlook, and as always, answers to your money questions, courtesy of Joe Anderson, CFP® and Big Al Clopine, CPA. Listen, watch, read, share and subscribe at YourMoneyYourWealth.com.

15:35 – Liz Ann Sonders: Tariffs, Politics, and Investing in the Face of Recession

Brian: You know, love him or hate him, Donald Trump has a pretty robust business background so it occurs to me that he is aware of everything we just talked about and the idea that tariffs have the potential to push the economy into a recession right as he’s heading into an election year. Are there steps you think he can take to back away from this or that he will take to back away from this?

Sonders: It’s hard to say. A lot of people think that this is kind of a new tact he’s taken and that he’s getting advice from Robert Lighthizer and Peter Navarro who are notorious kind of trade hawks. But the reality is you can listen to interviews with President Trump back to the 1980s and he sounded as much a protectionist and, to use his words, “a tariff man” 30 or 40 years ago as he does now. So he truly believes that having a trade deficit is a negative thing. I don’t. He believes that tariffs is the most effective tool to enact the concessions from China and get them to change their practices around intellectual property theft. I don’t know whether ultimately it’s going to be a successful tactic. I don’t happen to be a tariffs fan because I understand the near-term economic impact it has. What we’ve been saying to our investors, just in conversations that we have with everyone from someone who thinks this is absolutely the right thing to do, is a huge Trump supporter, “thank God he’s taking on big nasty China,” all the way to, “he doesn’t know what he’s doing, this is a disaster.” What we always say is, “we’re not going to editorialize on whether ultimately this will serve the purpose of getting China to end those practices.” None of us know the answer to that. That’s just going to be a function of time. What we have to do at Schwab, what I have to do in my position, is be an objective analyst of, “OK well what is the impact right now?” What I think is disingenuous is to – it’s not disingenuous for us to say, “we think this is the right tactic and here’s what we think is ultimately going to happen as a result of us using this tactic.” Our job is to say, “OK, tactic’s in. Regardless of what happens, what is actually happening right now to the economy?” So number one is getting people to understand how tariffs actually work. China doesn’t pay the tariffs. U.S. companies pay the tariffs, and then they have a choice after they pay those tariffs. Do they eat that tariff cost, which is a tax, in their profit margins? Do they pass it on to their end customer? Or is it some combination of the two? So that has implications for – through the confidence channels, through the earnings channels, through the CapEx channels, et cetera. And that’s what we have to do is analyze it. So you know maybe down the road we all look back and say, “wow, it was the right tool to use.” But in the meantime, it’s disingenuous to suggest this doesn’t have an impact on the economy. It has had an impact, it continues to have an impact, and so far for the most part, the impact is negative.

Al: Speaking about politics, let’s get into the presidential campaign. It’s just kind of ramping up I guess as we speak, and what sort of impact do you see that having on the market, if any?

Sonders: Well we are we still have a year and a half to go before the election. Clearly, there is a shift further toward the progressive end of the spectrum on the part of the candidates that are doing well right now, with the exception of Biden, who still leads in the polls, and he is seen as more moderate. But you know with Elizabeth Warren moving up into the second spot on some polls, there seems to be that shift. But there’s a heck of a lot of time between now and November of next year to see how either positions of the various candidates morph or change, and/or what the polling looks like and what the public is starting to look for. I mean, I think that there is just by nature of our political system and gerrymandering and the way the Electoral College works, you sadly – I think, in my opinion – seem to be kind of having these pendulum swings from one extreme to another. I think if we were to – if the Democrats were to nominate a really, really progressive candidate, then I think as you get close to the election, there will be a lot of valid questions about, “OK, what does this mean for the tax cuts? What’s the likelihood that they get repealed? What does the regulatory environment look like?” And then it’s that secondary analysis of what does it look like will happen with the Senate and House. And that’s what I think will be the deciding factor as to whether this is a market-neutral thing, a market-negative, a market-positive. But I think it’s way too soon to start speculating on that.

Brian: A lot of these things going on whether it’s tariffs, the upcoming election, maybe even people’s views on the Fed, are issues that people have strong emotional ties to. And as professionals, I think our job is to remove emotion and help guide individuals.

Sonders: Exactly.

Brian: But how do individuals, what steps can they take if they’re listening to this, to remove their emotions or their thoughts around the way things should be, and focus instead on the way things actually are or the way that they’re likely to be?

Sonders: It really goes back to kind of investing 101. There is nothing terribly unique about this environment and its uncertainties. There’s always uncertainty. They tend to have different characteristics to them. Sometimes they’re more political, sometimes more geopolitical, sometimes economic. But really, stick to the basics of number one, as an investor, make sure you have a disciplined plan – that you’re not just winging it, that you have a long term plan tied to your time horizon and your risk tolerance and your need for income. And past experience is most important. A lot of investors will make the risk tolerance decision based on age and time to retirement. But you have to go way beyond that, because I know young investors who are going to freak out at the first 10% drop in their portfolio. I don’t care how young you are and how many years you have to retirement, if you’re going to freak out and panic and sell everything at the first 10% drop, you are not a risk-tolerant investor regardless of what your time horizon is. I’ve known investors well into their 80s that are very aggressive. In many cases it’s because they have a lot of money, they’re willing to take the risk. They understand the risk. So understanding who you are as an investor, looking at past decisions you’ve made, your triggers – number one important thing. Have a long term strategic asset allocation plan. And then be disciplined around that. Use volatility, importantly, to do things like rebalance. Rebalance is such a boring thing to talk about. I’m glad you’re letting me say my two cents here on rebalancing because what rebalancing does is, as you developed a plan and you have a certain allocation that makes sense to the more risky ends of the spectrum – you know, international, equities, higher risk components of the equity market, things like higher yield on the fixed income side. And if they get out of whack because certain asset classes do better than another, what rebalancing does is it does two things: number one, it forces us to do what we know we’re supposed to do, which is buy low sell high. Or add low trim high. And your portfolio is telling you when it’s time to do something. You don’t have to worry about me, Liz Ann Sonders, having the right call on the market that week or that month. You don’t have to worry about making your own kind of all-or-nothing moment in time call on the market. Your portfolio is just going to tell you, “OK, your U.S. equities have been outperforming for 7, 8 years. They’re now 10 or 15 percentage points higher in your portfolio than they were when you set up your plan at the expense of these other asset classes.” Unless your risk profile is changed, then that’s telling you trim it back and add to areas where there has been a bit more weakness. And it’s as close to a free lunch as you’re going to get in this business. You may not have the bragging rights, saying, “Hey, I got out the day before the market topped and I got back in right on March 9th of 2009.” Doing that successfully over time is virtually impossible. So we have just been reinforcing that discipline: diversification, rebalancing, kind of stick to the knitting – that’s the closest thing you’re going to get to making this easier, especially emotionally.

Al: Yeah. We could not agree more. Liz Ann, such good information. Where can people find out more information about you and your work?

Sonders: Yeah. So the nice thing, we think anyway, at Schwab is all of the research that we put out there – everything that I write, videos that I do, my colleagues on the international side, on the fixed income side – is on just Schwab.com. It’s on our public website, you don’t have to be a client, you don’t have to have a login. There’s a tab on the website called Insights. That’s where all of our research is. But the easiest and most efficient way to see all of that stuff but also get just the day to day stream of consciousness, what’s on our minds, what do I think is is interesting, charts and graphics, synopsis of economic data points that came out and opinions on what that might be saying, is the best and easiest way and most efficient way is to follow me on Twitter @LizAnnSonders. I’m on it every day throughout the day. I’ll post everything that I write, so all the formal stuff I do gets posted, but it’s also just the moment to moment kind of updates on what’s going on and my thinking.

Al: Liz Ann, Thank you so much for joining us today.

Sonders: My pleasure. Thank you so much for having me.

Al: So Liz Ann Sonders, Senior Vice President and Chief Investment Strategist for Charles Schwab and Company, great thoughts, great advice.

For more intelligent investing strategies, download the white paper, Pursuing a Better Investment Experience from the podcast show notes at YourMoneyYourWealth.com. If there is a guest you would like to hear on YMYW, if you have a money question, or if you just want to share your thoughts about the podcast, scroll down YourMoneyYourWealth.com and click Ask Joe and Al On Air to send in your question as a voice message or as an email and the fellas will answer you right here in the podcast, maybe even with a video. You’ve had a lot of questions this week, so to keep this episode to a reasonable length, Kenneth, Steve, Marcus, Judi, Oleg and James, Joe and Big Al will answer all your questions in next week’s podcast. Right now, the fellas have suggestions on diversification for best returns and tax reduction, and when to save into a traditional 401(k) instead of a Roth. Check the podcast show notes at YourMoneyYourWealth.com for the video response to this first question:

25:46 – How to Diversify Investments for the Best Return or Tax Efficiency? (video)

Joe: We got Steve, he’s our friend here in San Diego, right in our backyard. Or front yard. “Hi, Joe and Al – and Andi!” Oh, he throws Andi in- I bet she typed that in there.

Al: With an exclamation point.

Andi: Thank you, Steve, I appreciate it. Thank you for recognizing even though these guys don’t.

Joe: “Your folks -”

Andi/Al: You folks.

Joe: Oh, I thought he was talking about my parents. I was gonna be like, “Steve, Dad died. Ruthie’s awesome.” “You folks continue to be great. Every week the show has something interesting and new.” Wow. That’s very nice. Thank you, Steve. “I was wondering if you could share your thoughts on ways to diversify an investment portfolio to bring in the best returns. If you’re unable to answer from an investing perspective, maybe you can answer from a tax strategy perspective. Thank you so much. And please keep up the good work. Your answers are always helpful.” All right. Well, there are a couple different angles we can tackle this. So let’s talk about investments – and we’ll just talk broad strokes. And we can get basic and then we’ll get into the weeds just a smidge, just to give Steve some perspective because it sounds like he is a fan of the show and he’s probably listened to other podcasts and has a probably good keen on the investment world.

Al: Yes OK. We’re making that assumption.

Joe: Okay. So Steve, when you build an overall portfolio, of course, it really depends on the goals that you’re trying to accomplish. Is it for retirement? Is it for college education? Is it for wealth transfer? Whatever. So that’s the first step. But he wants the best returns. So you can have the best returns depending on what goal that you’re trying to accomplish. If I’m trying to buy a house next year, the best return that I’m going to receive is probably 50 basis points.

Al: Yeah, cash.

Joe: Maybe 1% in a one year CD.

Al: That’s where it should be.

Joe: That’s my best return that I’m shooting for because I don’t necessarily want to take on extra risk because I could lose money and then I need it for that timeframe. So I’m going to assume that this is for a longer-term goal. So if Steve is shooting for the best returns, then you have to look at, what’s your timeframe in regards to the goal? But I think more importantly it’s like what target rate of return does Steve need to generate to make sure that he can accomplish the goal? So we believe that you take the least amount of risk possible to try to get that best return. And how do you do that? The answer is somewhat simple, but it’s not necessarily easy to implement. So the first thing Steve needs to figure out is how much money he needs in stocks versus bonds. Over time, stocks will produce a higher expected return than bonds because there’s more risk in stocks. So let’s say it’s 60% stocks, 40% bonds. Fair enough, everyone with me so far?

Andi/Al: Yeah.

Joe: OK. So then you could say, in my bonds I can choose several different types or flavors of bonds. I can just go with plain vanilla or I could go through a variety of different flavors. See how I’m like doing some analogies here to keep this thing interesting? (laughs)

Al: Yeah because you almost lost me before you did the flavors. Now I’m thinking ice cream.

Joe: So Steve could go long term bonds, you’re gonna get a higher expected rate of return in long term bonds. Not necessarily right now because we have an inverted yield curve, but historically, longer-term bonds will give you a higher expected return because there’s more risk – you’re lending your money to a company or a corporation or bank or whatever for a longer period of time. A lot of things can happen. So there’s more risk, they gotta pay you a little bit more. We believe you don’t want to take that type of risk in bonds, so you might want to go short. Shorter term bonds will give you a higher level of security or safety but a lower expected rate of return. First decision: how much stocks versus bonds. Second decision now is how would you like to invest your bonds? You can go long term. You can go short term. You can go high, let’s say risk, or high credit risk. So riskier type companies, or lower risk in regards to the federal government. On your stock side, this is where it gets a little bit more interesting. You could just say I want to buy the entire U.S. or the entire global market. And you can buy an index fund and you would be completely diversified with all different sectors and countries. But it might make sense to break those up. We believe that you want to break them up into different categories. One is large companies, two is small companies, and three is value, four is growth. So over time you look at how much money do I want in larger companies, big companies that you know the names of, versus really small companies that you never heard of before. The smaller companies that you never heard of before will give you a higher expected rate of return in the stock market than large companies because there’s more risk. There’s more room to grow. Then there are value companies – lower priced – versus growth companies – higher priced. Which one we’ll give you a higher expected rate of return in the market? Well, the lower-priced stocks would. So if you do use all of this academic research and study and Nobel Prize winning stuff, for lack of a better term, you would use that and say, “How do I get the best return?” Well, you would tilt your portfolio a little bit more toward stocks. And then in your stock portfolio, you would tilt it a little bit more toward small and value. Over time – no guarantees – that, hypothetically, should give you a best return. What’d that take? Five minutes to explain modern portfolio theory?

Al: Yes. That’s pretty good. That was a good answer. Let me add a couple of things.

Joe: To tax? you do the tax part. No, I’m still on investments.

Joe: We only got three minutes to go. All right, go for it.

Al: So I would also add emerging markets would be another tilt,

Joe: International. Use that same philosophy with emerging markets and international.

Andi: So still small, large, value, and growth in the international.

Joe: Yeah yeah yeah. Use that quadrant if you will, if you can imagine it like small companies would be on the bottom, large companies would be at the top and then you’d cut it like…

Andi: But how much of that in your equities?

Joe: Well then you would look at how much risk do you want? If you’re willing to take on a lot more risk than you tilted more toward small/value. And then you tilt it more towards emerging markets small value. I mean if you want the highest expected rate of return, it’s emerging markets, small/value.

Al: Yeah I agree.

Joe: That’s high octane. That will give you the best return. But it’ll also give you the worst return in any given year.

Al: A lot of volatility.

Andi: I got a question. What about alternatives?

Joe: What about them?

Andi: What’s your recommendation?

Joe: Sure. I mean we have alts in our portfolios, it really depends on what your definition of alternatives is, and Al’s got still a couple minutes for his point.

Andi: Go for it. We can go a little bit longer in this one.

Al: OK so let’s talk taxes. Because when it comes to taxes, we like to identify three different tax pools. And we’ll call that tax-free for a Roth IRA. We’ll call it taxable, which is a non-retirement account. And then we’ll call it tax-deferred, which is a retirement type of account. And the reason we separate those is their taxed differently. The tax-free, when you take money out of that for retirement, it’s tax-free. There’s no tax at all. The taxable account is monies that you’ve already paid tax on. So the only extra taxes that you have to pay is any gains on investments, as long as you held them for at least a year and you sell them, you get a long-term capital gain rate. And those rates are 0%, 15%, and 20%, which are a lot lower than the ordinary income tax rates. Now we switch over to tax-deferred when you take money out of your IRA, your 401(k), your 403(b). That’s all taxed at ordinary income rates. That goes up to his high currently, as 37%. So what we try to do when you figure out your diversified portfolio is you put different asset classes in different pools. You put your highest expected returns in the Roth IRA. Those are the ones that you expect to grow the most over time. Like for example, as Joe, you just mentioned, the smaller companies, the value companies, maybe the emerging markets, they’re going to be more volatile but over the long term, they have a higher expected return. And you want your growth there because you pay less taxes. Then you want your safest investments, like your bonds for example, that produce interest, you want those in your tax-deferred IRA, 401(k)s and things like that because you don’t know they want your highest growth there because you’d pay higher ordinary income taxes. And then the rest goes into your non-qualified account or your non-retirement account. Now, that’s the theoretical answer. But in reality, a lot of people have almost all of their assets in retirement accounts so you’re going to have a whole bunch of things in your retirement accounts. But if you had an even balance, let’s just say theoretically, you want your highest expected return in the Roth tax-free. The lowest expected return in the tax-deferred IRA, 401(k). And what’s ever left in the middle goes into your taxable account.

Joe: Well I think that brings us to another point. Before you really look at how your portfolio should be established, you need to look at well what is the tax implication of what you’re trying to do, and where’s the money held? Because like you said, most people have all of their money in a retirement account. Well if I were Steve, now you have to be looking at, well if that’s me, maybe I should be thinking about getting money into a brokerage account that’s going to be taxed at a capital gain rate when I need the money in retirement. Maybe it makes sense for me to get money into a Roth IRA or a Roth 401(k), which is going to be 100% tax-free. So when it comes time for me to take distributions from the overall account, I can control my taxes. I can pull enough from my retirement account to keep me in the lowest tax bracket possible. Maybe that’s the 12%. But I want more income or more cash. I grab it from the Roth, or I grab it from my non-qualified account. I have more income, more cash, but I’m still paying very low in tax. So I think a lot of times we get so wrapped up on “what is this best return?” But it’s not necessarily what you earn, it’s what you keep. So if you’re jamming everything possible into the 401(k) plan, which is great, however, you might be short-sighted. You might be leaving so much money on the table just because of where income rates are, where we believe that they’re going. And if you’re getting the tax deduction today because you think tax rates are going to be lower, your tax rate is going to be lower in the future, that’s one thing. But most people that listen to the show are savers that want to do a little bit better in their overall financial situation. So I’d be extremely aware of your tax situation and I’m really glad that he asked that after – it should have been first. “Well, what’s the best tax strategy?”

Al: Yeah. They go hand-in-hand.

Joe: Yeah. One last thing too is that in the money that you have in non-retirement accounts, you want to look at that type of investment. So if I have an exchange-traded fund or index fund, that has very low turnover, so it’s not going to kick out a lot of interest and dividends and it’s going to keep it very tax efficient from an investment perspective, where we see sometimes there are actively managed funds or could be alternatives, there could be different, maybe, bonds. They might have corporate bonds that are kicking out interest. They might have a lot of different CDs but then their 401(k) plan is jam-packed full of stocks. You want to be careful too of like just the interest and dividends that all this stuff kicks out, just to keep that thing tight and tax efficient as well.

37:20 – When Does It Make Sense to Do a Traditional 401(k) Instead of a Roth 401(k)?

Joe: Stephen from Houston Texas. H-town. “When does it make sense not to do a Roth 401(k) and you should do a traditional 401(k)? If you make a lot, does Roth 401(k) investing lose its shine? Taxable income in retirement, RMD and tax consequences on Social Security earnings and current age.” So Steve, I don’t think when you invest in a 401(k) Roth it ever loses its shine. (laughs) I think it continues to shine.

Al: But he’s asking should you do a Roth 401(k) or traditional? What would you say?

Joe: I would say Roth because it’s a little bit of pain today with a lot more pleasure in the future. I’m an optimist kind of person. I’m not Ric Edelman of stating that, “they’re gonna change laws and you’re gonna get screwed and it’s all gonna be taxable” and all of this. I believe to this extent that if they change the law with Roth IRAs or Roth 401(k)s it would be grandfathered in for anyone that has money into a Roth IRA and it would not be taxable. Would you agree with that statement?

Al: I agree with part of what you said.

Joe: That it’s not going to be taxable.

Al: Yeah that’s what I agree with.

Joe: OK. Yes. So you and I have had this argument before because you’re a CPA and I am a CERTIFIED FINANCIAL PLANNER™.

Al: So you’re telling me if I’m in the 37% tax bracket to do Roth 401(k). Next year I’m retiring, I’m gonna be in the 10% bracket because I’ve got no savings. (laughs)

Joe: Well I don’t think Stephen from Houston Texas is retiring next year.

Al: I’m just saying. If you’re in a very high…

Joe: I guess it depends. But if you’re 45 years old and you’re in the 37% tax bracket, I’m saying go Roth 401(k).

Al: You would?

Joe: I would! I would. Without question.

Al: What if you have no savings whatsoever? Wouldn’t you want to build up some of the tax-deferred first?

Joe: I suppose but still – he’s not going to save the tax savings if that were the case, right?

Al: Yeah. So there I agree with you. And so let’s explain what that means.

Joe: If he’s gonna save the tax savings then yes. But people don’t do that and then you fast forward 10, 20, 30 years and they have this nice pool of money. I don’t care what it is, $100,000, $200,000, a million dollars? If that’s all tax-free? He’s not going to say, “Damn it! I missed out on these tax savings because I went after-tax versus pre-tax.”

Al: Yeah. So let me try to say what you just said in a simpler way. (laughs) And that is this: So what Joe is saying is that what we’ve seen is when people do a Roth 401(k)s, they get so concerned about their tax rate, they should do a traditional because it’s such a high tax rate to save the tax dollars. And what we find is, if there are any tax savings, they spend it instead of saving it. So they actually would have been doing better just to go into a Roth 401(k).

Joe: So the problem is, does a Roth make sense or not makes sense? If you want to go mathematics, sometimes it’s basically a wash. Depends on what tax bracket that you’re in. Because it’s like alright if I’m in one tax bracket, and if I’m gonna be in the same tax bracket in the future, well, I get a tax savings today so I don’t pay the 25% in tax today. It grows, but then I pay 25% tax coming out. If you do the math in a vacuum it kind of evens out. But life is not a vacuum. You use vacuums in life, but life is not a vacuum. (laughs)

Al: Wow, that’s a new profound statement. Joe Anderson. (laughs)

Joe: Right. Because things happen. Things change. Tax rates change. Markets change. People’s lives change, people’s needs change, and things like that. So if I just go all Roth – and that’s not my advice. That’s not what I’m saying for everyone that’s listening to the show. I think you want to be more diversified in your overall tax strategy. Steve is asking my opinion, what would I do. What I do personally with my 401(k) is I go Roth because it’s like okay, “I’m losing some money today in taxes. But guess what? I’m not going to worry about it because all of my compounding growth that I have for the next 20 years of my life until I retire is all gonna be mine tax.free.”

Al: So I’m going to answer the more traditional way to answer it, which is this: Stephen, if you’re in…

Joe: Well if you’re gonna be in a lower tax bracket in retirement you go traditional. If you’re gonna be in the same tax bracket or higher, our advice is to go Roth. Some advisors would say if I’m in the same tax bracket or lower you go traditional. We say same tax bracket and higher, you go traditional. In the future. (laughs)

Al: So there you go. I think the brain is done. (Laughs)

Joe: All right, hopefully, you enjoyed this episode of Your Money, Your Wealth®, I know I sure did. Liz Ann Sonders, want to thank you for joining us, Andi Last, thank you very much, you did a wonderful job. Way to go Al, on those very difficult questions.

Andi: Way to go on the show prep, Al, thank you.

Al: Yes, I did some research.

Joe: Yes, thank you for your show prep. All right that’s it, we’ll see you next week, the show is called Your Money, Your Wealth®.

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Stick around to the very end of the episode to hear why Joe didn’t interview Liz Ann Sonders and a complete derail about hugging vs. shaking hands. Special thanks to our guest, Liz Ann Sonders from Schwab, visit the podcast show notes at YourMoneyYourWealth.com to read the transcript of the interview and to share and subscribe to the YMYW podcast.

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