Do Implementation Costs Destroy Returns from Factor Portfolios?

Do factor premiums survive implementation costs? To answer this question, I’ll examine the returns of live mutual funds to see if they have been successful at capturing the returns of small-cap and value premiums.

As background, my book, Your Complete Guide to Factor-Based Investing, includes a checklist of criteria that should be met before you consider investing in a factor. For a factor to be considered, it must meet all of the following tests. To start, it must provide incremental explanatory power to portfolio returns and have delivered a premium (higher returns). Additionally, the factor must be:

  • Persistent – It holds across long periods of time and different economic regimes.
  • Pervasive – It holds across countries, regions, sectors and even asset classes.
  • Robust – It holds for various definitions (for example, there is a value premium, whether it is measured by price-to-book, earnings, cash flow or sales).
  • Investable – It holds up not just on paper but also after considering actual implementation issues, such as trading costs.
  • Intuitive – There are logical risk-based or behavioral-based explanations for its premium and why it should continue to exist.

This article focuses on the question of investability and implementation costs. We’ll begin by examining the size factor – a logical place to start because small-cap stocks are less liquid and thus potentially more expensive to trade. Is the size premium realizable – or does it just exist on paper? Let’s start by examining the returns of small-cap mutual funds.

We’ll begin by looking at the returns of the Bridgeway Ultra-Small Company Market Fund (BRSIX). This fund was chosen because it is passively managed (rules-based) and invests in the smallest of small-cap stocks (called “microcap” stocks), where trading costs are potentially a significant hurdle. The fund’s inception date was July 31, 1997. For the period August 1997 through June 2019, the fund returned 9.7%. (All fund returns data are from Portfolio Visualizer.) Despite its expense ratio (currently 0.86%), it outperformed the CRSP 9–10 Index (the bottom 20% of stocks ranked by market capitalization), which returned 9.6%. And it underperformed the CRSP 10 Index (the smallest 10% of stocks), which returned 9.9%, by just 0.2 percentage point. Keep in mind that indices have no costs, while any investment would incur not just a fund’s expense ratio but also trading costs.

As further evidence that returns to small-cap stocks can be captured by well-structured, passively managed funds, we can look at the returns of the DFA U.S. Micro Cap Portfolio (DFSCX), with a current expense ratio of 0.52%, and the DFA Small Cap Portfolio (DFSTX), with a current expense ratio of 0.37%. From inception in January 1982 through June 2019, DFSCX returned 10.6%, outperforming the CRSP 9–10 and CRSP 10 indices by 0.7 percentage point and 0.9 percentage point, respectively. From its inception in April 1992 through June 2019, DFSTX returned 10.3%, underperforming the CRSP 6-10 Index by 0.4% (basically its expense ratio).

Vanguard also has a small-cap index fund we can examine. NAESX, which currently has an expense ratio of 0.17% (the Admiral Shares version, VSMAX, has an expense ratio of just 0.05%), became an index fund in September 1989. The original benchmark index for the fund was the Russell 2000 Index. Due to issues with that index (which led to relatively poor performance compared to other small-cap indices), Vanguard eventually changed its benchmark, first to an MSCI index and eventually to a CRSP index. For the period September 1989 through June 2019, the fund returned 9.9%, outperforming the Russell 2000 Index (which returned 9.1%), but underperforming the CRSP 6–10 Index (which returned 10.5%). We can also examine the performance of Vanguard Small Cap ETF (VB), which has a current expense ratio of 0.05%. From February 2004 through June 2019, it returned 9.4%, outperforming the MSCI US Small Cap 1750 Index by 0.3 percentage point, and the CRSP 6-10 Index by 0.9 percentage point.

We can also examine the live returns of Dimensional’s international and emerging market small-cap funds in relation to the returns of comparable small-cap indices. From January 1999, the inception date of the MSCI EAFE Small Cap Index, through June 2019, the DFA International Small Company Portfolio (DFISX), with a current expense ratio of 0.53%, returned 8.7%, outperforming the MSCI index by 0.9 percentage point. Looking at emerging markets, we find that from its inception in April 1998 through June 2019, the DFA Emerging Markets Small Cap Portfolio (DEMSX), with a current expense ratio of 0.70%, returned 10.5%, outperforming the MSCI Emerging Markets Small Cap Index, which returned 6.4%, by a wide margin.

The body of evidence demonstrates that, in answer to our question, implementation costs do not subsume the size premium – it can be captured with long-only funds. Note that the degree to which funds can capture the factor premium (be it positive or negative) will be determined by the fund construction rules (how much exposure the fund has to the factor) as well as implementation strategy (the degree to which the fund uses patient trading strategies).

We now turn to examining the evidence on value funds. To determine if live funds are able to capture the returns of the value factor, we will compare the returns of Dimensional’s value funds with the returns of appropriate value indices.

From inception in March 1993 through June 2019, the DFA U.S. Large Cap Value Portfolio (DFLVX), with a current expense ratio of 0.27%, returned 9.9%. It outperformed the MSCI U.S. Prime Market Value Index, which returned 9.6%, and the Russell 1000 Value Index, which returned 9.7%. We can also examine the performance of the Vanguard Value Index Fund (VIVAX), with a current expense ratio of 0.17%. From June 1994 through June 2019, the fund returned 9.2%, underperforming the MSCI U.S. Prime Market Index by 0.5 percentage point, and the Russell 1000 Index by 0.4 percentage point. And finally, we can review the performance of the Vanguard Value ETF (VTV), with an expense ratio of 0.04%. From February 2004 through June 2019, the fund returned 8.3%, outperforming the MSCI Index by 0.4 percentage point and the Russell Index by 0.5 percentage point.

From inception in April 1993 through June 2019, the DFA U.S. Small Cap Value Portfolio (DFSVX), with a current expense ratio of 0.52%, returned 11.0%. It outperformed the MSCI U.S. Small Cap Value Index, which returned 10.5%, and the Russell 2000 Value Index, which returned 9.8%. Vanguard’s Small Cap Value Index Fund (VISVX), with a current expense ratio of 0.19% (the Admiral Shares version VSIAX has an expense ratio of 0.07%), returned 8.5% from inception in June 1998 through June 2019, underperforming the MSCI index by just 0.1 percentage point while outperforming the Russell index by 0.6 percentage point. Finally, we can review the performance of the Vanguard Small-Cap Value ETF (VBR). From October 2010 through June 2019, VBR returned 12.2%, outperforming the MSCI index by 1.4 percentage points and the Russell index by 2 percentage points.

From June 1994 (the start date of the MSCI EAFE Value Index) through June 2019, the DFA International Value III Portfolio (DFVIX), with a current expense ratio of 0.24%, returned 5.9%, outperforming the MSCI EAFE Value Index, which returned 5.2%.

From inception in January 1995 through June 2019, the DFA International Small Cap Value Portfolio I (DISVX), with a current expense ratio of 0.68%, returned 7.8%, outperforming the 7.4% return of the MSCI EAFE Small Cap Value Index.

From inception in May 1998 through June 2019, the DFA Emerging Markets Value Portfolio (DFEVX), with a current expense ratio of 0.54%, returned 10.0%, outperforming the MSCI Emerging Markets Value Index, which returned 7.3%.


Well-designed, factor-based funds are able to capture the returns provided by both the size and the value factors. The further good news is that increased competition, in the form of mutual funds and tax efficient ETFs, has led to lower expense ratios, allowing investors to capture more of the available return.

Full disclosure: My firm, Buckingham Strategic Wealth, recommends Bridgeway and Dimensional funds in constructing client portfolios.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

Low Risk, High Return ETF Trap

Re-posted from

June 19, 2019

A recent MarketWatch article caught my attention. It said, “This actively managed ETF has a novel approach that can cut risk and lead to higher returns.”

I’m always looking for a higher risk-adjusted return, so I thought I’d check it out.

According to the article, the actively managed TrimTabs All Cap U.S. Free-Cash-Flow ETF (TTAC) was the answer. The article interviewed the ETF manager, Janet Johnston, and went on to say: Webinar

Sponsored by: 

Join Managing Director Dave Nadig and fixed income portfolio manager Chris Harms of Loomis, Sayles & Company as they discuss how investors should be thinking about their bond portfolios in the current environment. With central banks loosening around the world, a flat yield curve, and an uncertain corporate and political environment, figuring out exactly where and how much to allocate to bonds is far from obvious.

Speaker: Dave Nadig,
Guest: Christopher Harms, Loomis, Sayles & Company
Date: Thursday, October 24, 2019 – 3:00 p.m. ET

“Johnston’s stock selection begins with the Russell 3000 Index which includes large-cap, mid-cap and small-cap companies. She narrows the list to an equal-weighted group of about 100 companies using computer models to screen for various factors. The companies are limited to those that are expected by analysts to show large increases in free cash flow (FCF) over the next several years.”

Indeed, from inception on Sept. 28, 2016 through June 7, 2019, the article was correct in its assertion that TTAC outperformed the Russell 3000. But it seems the article compared the total return of this fund to the raw Russell 3000 index, stripped of dividends. The article also didn’t mention it had underperformed over the past year.

Logic Check

It’s not my intention to single out this one ETF or even the MarketWatch article, as I’ve heard claims like this literally hundreds of times. (To be clear, TrimTabs doesn’t make the claims the reporter does.)

Yet if you compare TTAC to a broad ETF like the Vanguard Total Stock Market Index ETF (VTI), you might wonder, as I do, how an ETF with expenses 17 times that of VTI (0.59% vs 0.035%), and about 3% of the holdings (100 vs. 3,574), boosts returns and cuts risk? (I attempted to contact the author but did not hear back.)

You decide which of these two ETFs will likely cut risk and boost returns over time:



Past Failures

The promise of higher returns with less risk is alluring and downright irresistible. But past failures, such as the following, offer important lessons we should consider:

  • Master limited partnerships (MLPs) were billed as safe alternative to bonds, as they collect tolls for oil and gas that must go through the pipelines. The Alerian MLP ETF (AMLP) has returned negative 4.62% annually over the five years ended June 13, 2019.
  • Equal-weighted funds like the Invesco S&P 500 Equal Weight ETF (RSP) boosts returns, as it doesn’t overweight large growth stocks. It has underperformed the S&P 500 cap-weighted return by 2.84 percentage points annually over the same five-year period.
  • Smart beta funds such as small cap value tilted funds are a free lunch. Small cap value has underperformed large cap growth by almost 10 percentage points annually over that five-year period.

Lessons Learned

Investing is about maximizing returns while minimizing risk. Here’s my definition of investing, in eight simple words: “Minimizing expenses and emotions; maximizing diversification and discipline.”

All of these so-called higher risk-adjusted return promises failed to meet this definition. They had far lower diversification and fees many times higher than low-cost alternatives. They outperformed on a back-tested basis, and investors lacked the emotional fortitude and discipline not to chase performance.

The next time you’re promised less risk with greater returns, ask yourself if it met the eight-word investing test.

My advice? If it doesn’t, don’t follow the herd.

Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He has been a nonpaid panelist at one of NGPF’s conferences for high-school teachers, but is not part of its organization. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.

Swedroe: Factors Are For Holding

Re-posted from

May 24, 2019

In their June 1992 Journal of Finance article, “The Cross-Section of Expected Stock Returns,” professors Eugene Fama and Kenneth French revolutionized the way we think about investing. Prior to the publication of this study, the prevailing theory (known as the “capital asset pricing model,” or CAPM) was that the risk and return of a portfolio was largely determined by one factor: market beta. Fama and French added the size and value factors.

Since then, researchers have discovered what John Cochrane called a “zoo of factors.” And the mutual fund industry has developed product to meet the demand of investors who seek exposure to these factors. In some cases, they create the demand, or at least try to.

Recent Research Webinar

Sponsored by: 

Join Managing Director Dave Nadig and fixed income portfolio manager Chris Harms of Loomis, Sayles & Company as they discuss how investors should be thinking about their bond portfolios in the current environment. With central banks loosening around the world, a flat yield curve, and an uncertain corporate and political environment, figuring out exactly where and how much to allocate to bonds is far from obvious.

Speaker: Dave Nadig,
Guest: Christopher Harms, Loomis, Sayles & Company
Date: Thursday, October 24, 2019 – 3:00 p.m. ET

Eduard Van Gelderen, Joop Huij, and Georgi Kyosev contribute to the literature on factor-based investing with their January 2019 study “Factor Investing From Concept To Implementation.” The authors examined the performance of factor-based funds and compared their performance to those of actively managed funds. In addition, they examined the performance of individual investors, seeking to determine if they added value by timing their investments.

Their data sample covers the period January 1990 to December 2015 for U.S. funds (3,713 funds), and begins one year later for global funds (4,859 funds). The factors included in the study are market beta, size, value, momentum, profitability, and investment. Following is a summary of their findings:

  • Mutual funds following factor investing strategies based on equity asset pricing anomalies, such as the small cap, value and momentum effects, significantly outperform traditional actively managed mutual funds.
  • A buy-and-hold strategy for a random factor fund yields 110 basis points per annum in excess of the return earned by the average traditional actively managed mutual fund. The findings were statistically significant at the 1% confidence level.
  • Only 17% of the traditional actively managed mutual funds earn positive alphas after fees. And funds with no factor exposures systematically fail to deliver positive net alphas that cannot be attributed to luck.
  • While excess returns earned by factor funds net of fees are significantly smaller than the theoretical premiums of the asset pricing anomalies, they are still positive and statistically and economically significant.
  • The actual returns that investors earn by investing in factor mutual funds are significantly lower because investors dynamically reallocate their funds both across factors and factor managers and subtract value—by attempting to time across factors, investors lose a large portion of the return they could earn with a buy-and-hold strategy.
  • Although factor funds have attracted significant fund flows, it appears fund flows have been driven by factor funds earning high past returns and not by the funds providing factor exposures— past performance is the main driver of investor decisions and there isn’t a positive relationship between fund flows and future performance.
  • The findings are robust to a global sample of mutual funds.

Additional Takeaways

Van Gelderen, Huij, and Kyosev concluded: “Rather than timing factors and factor managers, investors would be better off by using a buy-and-hold strategy and selecting a multi-factor manager.”

They found that “if an investor would randomly select a factor fund that is exposed to two factors simultaneously and would apply a buy-and-hold strategy, this investor would earn 190 basis points per annum in excess of the return that is earned by the average traditional actively managed mutual fund.”

They also found that the figure rose as the number of factors a fund was exposed to increased (240 basis points per annum if the investor would have selected a manager that is exposed to three factors simultaneously, and 270 basis points per annum if the manager would be exposed to four or more factors simultaneously).

They noted their findings are consistent with those from prior studies (such as the 2007 study “What Are Stock Investors’ Actual Historical Returns? Evidence From Dollar-Weighted Returns” and the 2016 study “Timing Poorly: A Guide to Generating Poor Returns”), which found that the actual return earned by investors in hedge funds and small cap, value and growth mutual funds are significantly lower than the returns they could have earned with buy-and-hold strategies.

The conclusion we can draw is that individuals do invest in successful strategies, but destroy returns with their trading behavior. Even though factor funds deliver excess returns, investors have not been able to fully capture those returns due to their allocation decisions.

Van Gelderen, Huij, and Kyosev explain: “If investors believe in the value and momentum premiums but they only invest in value or momentum funds after a period of strong performance they lose a significant portion of the factor premium due to cyclicality in factor returns. A potential solution would be to buy both funds and hold on to them instead of moving assets across them.”

We have met the enemy and he is us!

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

Swedroe: Mutual Fund Flows & Factor Premiums

Re-posted from ETF.COM

June 03, 2019

Because mutual fund flows can impact securities prices, the relationship between investment flows and the performance of factors and mutual funds is of great interest. For example, do investors naively look only at raw returns when making asset allocation decisions, or do they adjust returns for risk, and exposure to various factors, using an asset pricing model?

Latest Research On Flows

Recent research has found that mutual fund investors are largely ignorant about systematic risks when allocating capital among mutual funds.

More from

 For example, Itzhak Ben-David, Jiacui Li, Andrea Rossi and Yang Song, authors of the November 2018 study “What Do Mutual Fund Investors Really Care About?”, sought to determine whether investors use prominent asset pricing models—such as the capital asset pricing model (CAPM) and the three- and four-factor versions of Fama-French models—to allocate capital, or whether Morningstar’s star ratings (which do not account for systematic exposure to explanatory factors) explain mutual fund flows better than risk-adjusted returns.

Following is a summary of their findings:

  • Ratings are the main determinant of capital allocation across mutual funds, followed by past returns.
  • Morningstar ratings predict the direction of flows up to 68% of the time versus 60% for the CAPM, and even lower (between 58% and 60%) for other common asset pricing models.
  • The spread between flows to top and bottom funds is best explained by Morningstar ratings. For example, when using Morningstar, 67% of top-ranked funds receive positive flows, while only 16% of bottom-ranked funds receive positive flows, generating a difference of 51 percentage points—significantly higher than all other measures, which generate differences in the 16 to 23 percentage points range.
  • At the aggregate level, in every single year, funds rated highest by Morningstar received more money than the funds ranked highest according to any asset pricing model.
  • There is no evidence that investors discount fund returns related to market risk exposure or to the other risk factors.
  • Recent past returns, but not volatility (once Morningstar ratings are accounted for), explain capital allocation beyond Morningstar.
  • Fund flows are weaker for high volatility funds only because Morningstar ratings penalize funds for high volatility.

The authors concluded: “In summary, we find no evidence that investors use the CAPM, or any other of the commonly-used factor models, to allocate capital to mutual funds. Rather, they naively rely on external rankings as a way to chase past winners.” They added that their results “support the proposition that mutual fund investors do not care about risk or do not understand risk.”

This naive behavior is why individual investors are referred to as “noise traders.” Despite trading on noise—rather than fundamentals—the fund flows that result from the behavior of retail fund investors can impact securities prices and returns to factors that explain performance.

Flows & Factors

Shiyang Huang, Yang Song and Hong Xiang, authors of the January 2019 study “Fragile Factor Premia,” sought to determine what, if any, impact mutual fund flows had on returns of the well-known Fama-French (FF) size and value factors.

To determine the impact, they estimated mutual fund flow-induced trading (FIT) for each stock quarter from 1980 to 2017. They used FIT, rather than all trading of mutual funds, because FIT only captures those trades driven by the demand shifts from mutual fund investors, which are largely ignorant about fundamentals.

Following is a summary of their findings:

  • Aggregate flow-driven demand shifts across the size spectrum and across the book-to-market ratio spectrum significantly affect returns of the size (SMB) and value (HML) factors, respectively.
  • The returns of six FF size and book-to-market portfolios are largely determined by the uninformed mutual fund flow-induced trades.
  • Within each of the six FF portfolios, stocks with higher FIT have higher return performance. For example, stocks with a top-quartile FIT, on average, outperform the bottom-quartile-FIT stocks in the same portfolio by about 1% per month, although they have similar firm size and book-to-market ratios.
  • Across the FF size and book-to-market portfolios, growth stocks with a positive FIT significantly outperform value stocks with a negative FIT, controlling for firm size. Controlling for book-to-market ratio, large cap stocks with a positive FIT significantly outperform the negative-FIT small cap stocks. As a test of robustness, they confirmed this reversal in premiums across 11 other CAPM anomalies.

The findings led the authors to conclude that “The well-known size (SMB) premium is due to the component of small-cap-inflow stocks minus large-cap-outflow stocks, while the value (HML) premium is due to the component of value-inflow stocks minus growth-outflow stocks. The other components of the size and value factors actually have significantly negative average premia.”

They also found that this flow-induced performance is more pronounced in the more recent sample period, consistent with the rise in the size of the mutual fund industry over time.

Flows Influence Time Variation Of Returns To Factors

Huang, Song and Xiang proceeded to determine how aggregate flow movements influence time variation of the size and value returns. Based on what we have seen, we should expect that SMB (HML) returns should be high in the periods when there are more flow-driven trades into small-cap (value) stocks relative to large-cap (growth) stocks and vice versa.

That is exactly what they found: “Aggregate flow-driven demand shifts across the small-cap and large-cap portfolios and demand shifts across the value and growth portfolios are statistically and economically significant drivers of the size and value returns, respectively.”

For example, they found that “A one-standard-deviation change of the aggregate FIT across the size spectrum is positively associated with a 1.65% change in quarterly SMB returns (6.61% on an annual basis).”

Importantly, the authors also found that “The flow-induced effects on factor returns significantly revert over longer horizons.” In other words, while inducing momentum in factor returns, the flows are just noise—while they positively affect contemporaneous factor returns, they don’t cancel out long-term premiums as factors experience strong reversals over longer horizons.

For example, they found that “A one-standard-deviation increase in the difference of flow-induced trades into value stocks and flow-induced trades into growth stocks over the prior five years, on average, predicts a 4.19% decrease in the HML returns over the next year.”

FIT Across Anomalies

In an April 2019 study, “Flow-Induced Trades and Asset Pricing Factors,” Huang, Song and Xiang expanded their work to include 50 well-known factors (anomalies to the CAPM). Their findings were consistent: “Our results indicate that these factors are heavily exposed to flow-driven ‘noise trader’ risk, which we further show is significantly priced.”

They added that the flow-driven effects on factor return dynamics can partially explain factor momentum (as well as the underperformance of large-sized mutual funds relative to small funds). Summarizing, the authors noted: “Our results indicate that these asset pricing factors are heavily exposed to non-fundamental risk that is due to mutual funds’ flow-driven demand shifts.”


Mutual fund investors are largely ignorant about systematic risks when allocating capital among actively managed equity mutual funds, causing them to trade based on noise, not fundamentals. Their naive performance-chasing behavior induces short-term momentum in factors but does not impact long-term premiums.

Note that the finding of momentum in factors is consistent with the findings of Tarun Gupta and Bryan Kelly in their December 2018 paper “Factor Momentum Everywhere.” They built and analyzed a large collection of 65 characteristic-based factors that are widely studied in the academic literature, including a variety of valuation ratios (e.g., earnings/price, book/market); factor exposures (e.g., betting against beta); size, investment and profitability metrics (e.g., market equity, sales growth, return on equity); idiosyncratic risk measures (e.g., stock volatility and skewness); and liquidity measures (e.g., Amihud illiquidity, share volume and bid-ask spread).

Following is a summary of their findings:

  • Individual factors exhibit robust time series momentum, being positive for 59 of the 65 factors, and significantly positive in 49 cases.
  • Robust momentum behavior among the common factors is responsible for a large fraction of the covariation among stocks.
  • A portfolio strategy that buys the recent top-performing factors and sells poor-performing factors achieves significant investment performance above and beyond traditional stock momentum.
  • On a stand-alone basis, factor momentum outperforms stock momentum, industry momentum, value and other commonly studied investment factors in terms of Sharpe ratio.
  • While factor momentum and stock momentum are correlated, they are also complementary—factor momentum earns an economically large and statistically significant alpha after controlling for stock momentum and expenses.
  • Demonstrating pervasiveness, factor momentum is a global phenomenon—it manifests equally strongly outside the U.S.—in a large global (ex. U.S.) sample, and Europe and Pacific region subsamples.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

Post WWII US Returns’ Changing Nature

Its good to understand what drives stock returns.  Since World War II, returns are now less about economic growth and more about shareholders. ~ Dave Archibald

Re-posted from

Investors in U.S. equities have been well-rewarded in the post WWII era. For example, over the 70 calendar years from 1949 through 2018, the S&P 500 Index returned 11.24%. And with inflation rising 3.41%, it provided a real return of 7.83%.

Should investors extrapolate that return going forward? Before doing so, you should consider how the 11.24% return was achieved. Among the questions that should be asked are:

  • How much of the return was due to economic growth (while corporate earnings’ share of the GNP is time varying, over the long term they should be expected to grow in line with the overall economy)?
  • How much, if any, of the return was due to a shift in economic rents from employees to shareholders? You can see the general upward trend in this chart provided by the Federal Reserve Bank of St. Louis. Note that we ended 2018 with corporate after-tax profits at 9.7% of GNP. From 1951 through 2004, they bounced around between about 4% and 8% (except for a brief period in the late 1970s, when they slightly exceeded 8%). In the post 2004 period, except for a brief drop during the Great Financial Crisis in 2008, the ratio has generally been above 9%, and peaked at almost 12% during 2012.
  • How much of the return was explained by falling interest rates and changes in valuations (price-to-earnings ratios)? For example, consider that we ended 1948 with the CAPE 10 for the S&P 500 being just 10.2. We ended the 70-year period with that valuation metric having risen to 28.3. In other words, the almost tripling in valuations contributed significantly to the return over the period. And while there may not be a reversion to the long-term mean (16.6) of that metric, one should certainly not expect the contribution to be repeated.

Daniel Greenwald, Martin Lettau and Sydney Ludvigson of the National Bureau of Economic Research sought to answer such questions in the April 2019 study “How the Wealth Was Won: Factors Shares as Market Fundamentals.” Their study covered the period 1952 through 2017.

Following is a summary of their findings:

  • For the 29 years ending in 1988, the real net value added of the nonfinancial corporate sector (NFCS) grew an average of 4.5% per annum. Over the next 29 years, it grew an average of just 2.5% per annum. Despite the much lower net value added, for the 29 years from the beginning of 1989 to the end of 2017, the real value of market equity for the NFCS grew an average of 8.4% per annum compared with just 2.5% per annum in the prior period. In other words, there was a widening chasm between the stock market and the broader economy. In fact, at the end of 2017, the ratio of the market value to NFCS was at a post WWII high (higher than during the dot-com boom).
  • Since 1989, equity values were boosted by persistently reallocated rents from labor compensation to shareholders. This shift explains 54% of the market price increase over the 29 years ending in 2017, and 36% of the increase over the 58-year period.
  • Since 1989 equity values have been boosted by persistently declining interest rates and a decline in risk premia, with each contributing 11% to the increase in stock values.
  • Growth in the real value of what was produced by the sector contributed just 23% to the increase in equity values since 1989 and 50% over the full sample. By contrast, from 1952 to 1988, economic growth accounted for 92% of the rise in equity values, but that 37-year period created less than half the equity wealth generated over the 29 years since 1989.
  • Taxes played a negligible role in equity market fluctuations throughout the sample. (Note their data sample ends before the impact of the lowering of corporate tax rates in 2018 helped drive corporate earnings higher).

The authors concluded: “An implication of these findings is that the high returns to holding equity over the post-war period have been in large part attributable to good luck, driven primarily by a string of favorable factors share shocks that reallocated rents to shareholders. We estimate that roughly 2.1 percentage points of the post-war average annual log return on equity in excess of a short-term interest rate is attributable to this string of favorable shocks, rather than to genuine compensation for bearing risk. These results imply that the common practice of averaging return, dividend, or payout data over the post-war sample to estimate an equity risk premium is likely to overstate the true risk premium by about 50%.”


The bottom line is that factors shares have been more relevant than economic growth in explaining stock returns in the U.S. over the past 30 years. In fact, the stock market owes much of its return over the past 30 years not to economic growth but to shareholders earning an increasing share of that growth at the expense of workers. And this can only go so far before political actions occur (and we may be approaching that point).

The implication for investors is striking. Those who rely on the historical real return to U.S. stocks of about 7% are likely to be highly disappointed, as the equity risk premium (ERP) going forward is likely (though not certain) to be significantly lower. The reason is that the ERP it isn’t likely to benefit from a further increase in economic rents allocated to shareholders versus labor capital, a further drop in interest rates, or a further increase in equity valuations.

In fact, as labor’s share of economic rents is highly cyclical (tending to fall in periods of higher unemployment and rise in periods of low unemployment), it seems likely that this factor could be a negative for stock returns going forward. As supporting evidence, consider that corporate after-tax profits as a percent of GNP peaked at almost 12% in early 2012 and declined (along with the unemployment rate) to 9.3% at the end of 2018.

It’s important to not take the above to mean U.S. stocks are overvalued or that a bear market is imminent. It is, however, a warning that future returns are likely to be well below historical returns. Thus, plans should incorporate that expectation. Forewarned is forearmed.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

Swedroe: Long Term Returns, Short Time Periods

If one thing is certain, it’s that markets can be volatile.  History has shown us that much of the markets long term gains come in short bursts but there’s no way to know when these periods will appear.  This article illustrates just how important it is to be patient, stay the course and allow your strategy to work.

Dave Archibald

Re-posted from

February 27, 2019

Investors would do well to learn from deer hunters and fishermen who know the importance of “being there” and using patient persistence, so they are there when opportunity knocks.

— Charles Ellis, on investment policy


One of my favorite sayings is, “If you think education is expensive, try ignorance.” This is certainly true about investing, which is why I believe that knowledge of investment history is an important, if not necessary, condition of achieving success. The following is offered as evidence.

Distribution Of Returns
Most investors know that the U.S. stock market has historically returned about 10%: Over the 92-year period from 1927 through 2018, the S&P 500 returned 10.1%. If we were to remove the returns of the best 92 months over that period (not the best month each year, but the highest-returning 92 months of 1,104 months), what would you guess was the return of the remaining 1,012 months? I believe most investors would be shocked to learn that the answer is virtually zero.

The remaining 1,012 months provided an average return of just 0.01%. The best 92 months (just 8.3% of the months) provided an average return of 10.4%, more than 100% of the annualized return over the full period!

In case you think the above is unique to the U.S., we can also look at the data from international markets. Over the 49-year period of 1970 through 2018, the MSCI EAFE Index (gross of dividends) returned 9.1%. The best 49 months provided an average return of 9.6%, while the other 539 months returned 0.0%. Again, we see that the return of the best 49 months was greater than the annualized return over the full period.

We see the same evidence when we look at emerging markets. From 1988 through 2018, the MSCI Emerging Markets Index (gross of dividends) returned 10.4%. The best 31 months of that 31-year period provided an average return of 12.5%, while the other 341 months returned 0.0%. Again, we find that the best 31 months (an average of just one month a year) provided more than 100% of the annualized returns.

Recent Data

The following is a more recent example of how much returns happen in short and unpredictable bursts. 2018 was a miserable year for U.S. small value stocks—and the smaller and deeper the value, the worse the performance.

As a fund with large exposures to both the size and value factors, Bridgeway’s Omni Small-Cap Value Fund (BOSVX) (which my firm, Buckingham Strategic Wealth, recommends, and I own) had even worse returns than U.S. small value indexes. Morningstar reports that the fund lost 17.2% in 2018.

Now let’s look at what happened in the month (though in this case, not a calendar month) from the period following the stock market’s bottom on Dec. 24, 2018. On that day, BOSVX closed at 13.30. One month later, on Jan. 24, 2019, the fund’s net asset value (NAV) had risen to 15.24, a gain of 14.6%. As of Feb. 24, the NAV was 16.47, a one-month gain of 8.1% and a two-month return of 23.8%. As we saw in the three earlier examples, so much of the market’s returns come in short, and obviously unpredictable, bursts.

Perhaps it was evidence like the above that convinced Charles Ellis, legendary investment consultant and author of “Winning the Loser’s Game,” that: “The best way to achieve long-term success is not in stock picking and not in market timing and not even in changing portfolio strategy. Sure, these approaches all have their current heroes and war stories, but few hero investors last for long and not all the war stories are entirely true. The great pathway to long-term success comes via sound, sustained investment policy, setting the right asset mix and holding onto it.” (Quoted in the Barrie Dunstan article, “Global Money Masters,” Australian Financial Review, November 2006.)

Such evidence likely also influenced the thinking of William Sherden, who, in his book “The Fortune Sellers,” advised: “Avoid market timers, for they promise something they cannot deliver. Cancel your subscription to market timing newsletters. Tell the investment advisers selling the latest market-timing scheme to buzz off. Ignore news media predictions, since they haven’t a clue … Stop asking yourself, and everyone you know, ‘What’s the market going to do?’ It is an irrelevant question, because it cannot be answered.”

Important Lessons

There are two important lessons in the data for investors. First, because so much of long-term returns occur over very brief periods, it’s critical that investors stay disciplined, adhering to their asset allocation plan and not paying attention to the noise of the market.

Second, when selling a fund for the purpose of harvesting losses, you should not wait the 31 days that are required to avoid the IRS’s “wash sale” rule before buying back the fund. This is a common error. Instead, when tax-loss harvesting, you should simultaneously buy the most similar fund you can find.

For example, to replace a U.S. small value fund, one could buy the iShares S&P Small-Cap 600 Value ETF (IJS) or the Vanguard Small Cap Value Index Fund (VISVX). You want the choice to be as similar as possible because, as you saw, even over a period as short as a month, you can have large gains, and you don’t want to have to take a short-term capital gain and pay the much higher tax rate.

If you have a significant gain, the preference should be to wait at least a year in order to obtain long-term capital gains. The gains could become so large that you might need to hold the fund for a very long time—which is why you want as similar a fund as you can find.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

Swedroe: Do Surprises Really Move Markets?

French economist Louis Bachelier long ago remarked: “Clearly the price considered most likely by the market is the true current price: if the market judged otherwise, it would not quote this price, but another price higher or lower.”

Prices will not change if the expected happens. It is the unexpected that causes prices to move.

In an efficient market, any new information the market receives will be random, not in the sense of being good or bad, but in the sense of whether it surpasses or falls short of the expectations that are already built into the current price.

The market quickly incorporates new information and revalues the security. The volatility of both the stock and bond markets is evidence of the frequency with which the expected fails to occur.

The following examples from my first book, “The Only Guide to a Winning Investment Strategy You’ll Ever Need,” demonstrate that it’s surprises—not whether news is good or bad—that drive changes in prices. They show how good (bad) news can lead to bad (good) results.

Good News, Bad Results

On Feb. 4, 1997, after the market had closed, Cisco Systems [check out our stock finder] reported that its second-quarter earnings had risen from $0.31 per share in the prior year period to $0.51, an increase of 65%.

No one would suggest that a rise in earnings of that magnitude is bad news. Yet the price of Cisco’s stock fell the following day from its prior close of just over $67 a share to $63, a drop of 6%.

The price drop can be explained by the fact that the market was anticipating a greater increase in earnings than the company reported. Prior to a company’s release of information, outsiders do not know whether it will report earnings higher or lower than market expectations.

Bad News, Good Results

A similar phenomenon occurs when a company’s stock price rises after a “bad” earnings report. For example, the day IBM [] released its earnings for the second quarter of 1996, the price of its stock rose 13%.

Based on the price movement, one would have thought that IBM had announced spectacular results. Their earnings were, in fact, down about 20% from the same period of the prior year.

The stock rose because the market was expecting IBM to announce far worse results.

Surprises Unforecastable

Because surprises are by definition unforecastable, whether subsequent information will affect the price of a stock in a positive or negative manner is random. The fact that the academic research, including papers such as “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” has found that fewer active managers (about 2%) are able to outperform their appropriate risk-adjusted benchmarks than would be expected by chance demonstrates that the markets are highly efficient at setting prices.

Despite the research findings, there remains a huge industry dedicated to trying to outguess the “collective wisdom” of the market and exploit surprises. The investment research team at Vanguard provided some insights into just how successful you might need to be to exploit economic surprises in its November 2018 paper, “Here Today, Gone Tomorrow: The Impact of Economic Surprises on Asset Returns.”

Anticipating Surprises

They began by noting that the belief that motivates tactical allocation strategies is that a surprise can be foreseen by prescient analysts. With that in mind, they asked the question: “How prescient do you need to be to exploit economic surprises?”

To answer that question, they built a simple model using data from the last 25 years. The economic measure used is the nonfarm payroll.

  • They start with a 60% U.S. equity (represented by the MSCI USA Index)/40% U.S. bond (represented by the Bloomberg Barclays US Aggregate Bond Index) portfolio.
  • In advance of any positive economic surprise, they increase their equity allocation to 80%.
  • In advance of any negative economic surprise, they decrease their equity allocation to 40%.

Not surprisingly, they found that if you had perfect foresight, your returns increased. However, the improvement in returns was just 0.2% per annum—and that’s before even considering trading costs, and for taxable investors, taxes. To break even with the 7.4% return of the benchmark 60/40 portfolio, the investor would have had to be right 75% of the time (again, that is before considering implementation costs).

Given today’s highly competitive markets, the odds against being able to successfully exploit mispricings after implementation costs seem daunting. Yet in a triumph of hype and hope over wisdom and experience, most investors are still engaged in that endeavor.

Vanguard’s research team concluded: “The odds of successfully trading on surprises is low.” They added: “What can seem consequential in the short run is irrelevant to the long-term investor. Short-term surprises are quickly priced into long-term expectations, and these long-term projections have almost no relationship to future returns.” (There is little relationship between economic growth and stock returns.)

I hope you will keep Vanguard’s findings in mind the next time you are tempted to tactically allocate based on your (or some guru’s or money manager’s) forecasting ability. And if you are still tempted, remember that an all-too-human trait is overconfidence in our abilities.

I offer one other suggestion: Start keeping a diary, writing down every time you are convinced the market is going to go up or down. After a few years, you will realize that your insights, unfortunately, are actually worth nothing.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

Swedroe: Long/Short Portfolios & Taxes

“Conventional wisdom” can be defined as ideas that are so accepted they go unquestioned. Unfortunately, conventional wisdom is often wrong. Two good examples are that millions of people once believed the conventional wisdom that the Earth is flat, and millions also believed that the Earth is the center of the universe. Much of today’s conventional wisdom on investing is also wrong.

Today we’ll look at the conventional wisdom that the tax burden of an investment strategy increases with its turnover—high turnover strategies exhibit a higher propensity to realize capital gains. In addition, short selling is perceived to be particularly tax inefficient, since the realized capital gains on short positions are generally taxed at the higher short-term capital gains tax rate, regardless of the holding period of the short positions.

Recent Research

Clemens Sialm and Nathan Sosner, authors of the study “Taxes, Shorting, and Active Management,” published in the first quarter 2018 issue of the Financial Analysts Journal, examined the consequences of short selling in the context of quantitative investment strategies in taxable accounts of individual investors.

They computed the tax burden of a quantitative fund manager who follows a combined value and momentum strategy. Combining value and momentum strategies is particularly beneficial because these strategies tend to exhibit negative correlation. Their model combined value and momentum with equal risk weights and targeted a tracking error of 4%. Tax awareness was implemented through a penalty term that incorporates tax costs into the portfolio’s objective function. The sample period is 1985 through 2015.

Following is a summary of their findings:

  • Short positions not only allow investors to benefit from the anticipated underperformance of securities, they create tax benefits because they enhance the opportunities to time capital gains realizations.
  • The presence of short positions gives investment strategies additional opportunities for realizing capital losses in up markets, when capital losses from long positions are scarce. Up markets are also periods when investors tend to have more abundant capital gains, making the realization of capital losses in these periods particularly valuable.
  • Long-short strategies increase the opportunity to realize short-term losses, which are particularly beneficial because the short-term capital gains tax rate is substantially higher than the long-term rate, and the realized short-term losses will first be used to offset highly taxed short-term capital gains.
  • The relaxation of short selling constraints generates tax benefits because the long positions of a portfolio tend to generate long-term capital gains, which are taxed at relatively low rates, whereas the short positions tend to generate short-term capital losses, which offset short-term capital gains taxed at relatively high rates.

Specifically, Sialm and Sosner found that “if the strategy is managed as a long-only portfolio, it generates a tax burden of 2.8% per year. On the other hand, if the strategy is managed as a relaxed-constraint portfolio that combines a 130% long exposure with a 30% short exposure, its tax burden reduces to 2.2% per year. For a long-short strategy the tax burden turns into a tax benefit of 0.5% per year.”

They also found that “the investor can further enhance the tax benefits by deferring the realization of capital gains and accelerating the realization of capital losses. As compared to the tax-agnostic approach, such tax-aware asset management reduces the annual tax burden of the long-only strategy from 2.8% to 1%, turns the annual 2.2% tax burden of the relaxed-constraint strategy into a 0.7% tax benefit, and increases the tax benefit of the long-short strategy from 0.5% to 4.6% per year.”

Tax-aware strategies also significantly reduce turnover of long-short strategies, as they reduce capital gains realizations (delaying realization until short-term gains become long term) and thus trading costs.

Additional Findings

It’s important to note that Sialm and Sosner’s results are “specific to investors who realize sufficient short- and long-term capital gains from other investment sources. The reduction in the taxes is smaller if the portfolios are structured as mutual funds according to the Investment Company Act of 1940 or if the investor does not have any other capital gains in the portfolio. In these cases, the remaining capital losses need to be carried forward to future years, which will likely reduce the benefits of capital loss realizations.”

However, they also noted that “despite these reductions in the tax benefits using limited offsets, we find a significant reduction in the tax burden in strategies that take advantage of short selling and tax awareness. For example, a tax-agnostic long-only strategy generates tax costs of 3.1% per year, whereas a tax-agnostic long-short strategy generates tax costs of only 0.7% per year despite a higher pre-tax active return. Furthermore, introducing tax awareness generates a tax benefit of 0.4% for a long-short strategy. This small benefit occurs primarily due to the fact that dividends obtained on the long positions qualify for the dividend tax rate, whereas in-lieu dividend payments on the short positions can be deducted from ordinary income emanating from cash used to finance the long-short portfolio. Thus, tax-awareness and short-selling can also enhance after-tax returns for investors who have limited opportunities to offset capital gains realizations.”

The authors also noted that their examples “assume that the portfolio does not experience any inflows or outflows of funds. Inflows provide additional opportunities to reduce the tax burden of future portfolio rebalancing since these funds are used to purchase new positions and thus increase the cost basis of a portfolio with embedded unrealized capital gains. On the other hand, outflows, if not managed in a tax-efficient manner, may trigger additional taxes as the investor needs to liquidate positions and potentially realize capital gains.”

Superior After-Tax Performance

Sialm and Sosner concluded that their results show that quantitative investment strategies that take advantage of short selling can generate superior after-tax performance by significantly reducing the tax burden, and can even generate tax benefits if executed with an eye toward tax awareness.

They also found “on average the tax benefits of tax-aware strategies come from short positions. Moreover, these tax benefits are positively correlated with market returns meaning that the short positions generate tax losses exactly at the time when other investments in the investor’s portfolio are likely to be at a gain.”

Importantly, they also found that their conclusions “are robust to the target level of active risk, to transaction and financing costs, to the level of tax aversion, and to the historical variation in tax rates.”

Summarizing, Sialm and Sosner demonstrate that the conventional wisdom on the tax-efficiency of long-short strategies is wrong, having found that, “on average, the tax benefits of tax-aware strategies come from short positions.” In addition, they found “these tax benefits are positively correlated with market returns meaning that the short positions generate tax losses exactly at the time when other investments in the investor’s portfolio are likely to be at a gain.”

According to the authors, their evidence demonstrates “that short-selling is a valuable tool for a taxable investor. While portfolio design decisions—market beta, level of risk and tax aversion, and turnover and leverage— might vary, the presence of short positions is likely to enhance after-tax returns and to interact favorably with explicit tax awareness.”

Character Of Tax Benefits Of Relaxed-Constraint Strategies

Sosner, with co-authors Stanley Krasner and Ted Pyne, followed up his original study with the October 2018 study “The Tax Benefits of Relaxing the Long-Only Constraint: Do They Come from Character or Deferral?” which covers the period January 1988 to December 2017.

The authors focus on the tax benefits of a quantitative tax-aware fund manager who follows either a combined value and momentum strategy or a passive index strategy with a quantitative tax management overlay.

They begin by noting there are two ways of achieving a tax benefit at the level of an overall investment portfolio held in a taxable account:

  • An investor can favorably affect the character of realized capital gains and income at the overall portfolio level by tilting the balance of net realized gains in a given year from short-term to long-term gains and from highly taxed ordinary income to low-taxed qualified dividends. A character benefit occurs because short-term losses offset short-term gains before offsetting any long-term gains. Thus, a strategy realizing long-term gains and qualified dividend income and short-term losses and ordinary deductions tilts the balance of net realized gains and income in a given year from short term (and ordinary) to long term (and qualified dividends) at the overall portfolio level. This benefit is permanent. However, a strategy’s character benefit only exists when other strategies in the overall investment portfolio realize their gains and income in highly taxed characters—short-term capital gains and ordinary income.
  • At the overall portfolio level, an investor can defer the realization of capital gains to future years and benefit from a reduction in the current year’s taxable gains. In this case, the benefit is temporary because, barring a tax-exempt portfolio liquidation due to donation to charity or step-up in the cost basis at death, an increase in current unrealized gains leads to higher liquidation taxes. Despite being temporary, deferral benefits add value, allowing wealth to compound at a faster rate.

Following is a summary of Sosner, Krasner and Pyne’s findings:

  • Under their tax rate assumptions, for a relaxed-constraint value-momentum strategy, tax awareness increases after-tax (net of transaction and financing cost) annual returns by close to 1%.
  • Most of the benefit comes from the realization of short-term capital losses, with a small benefit from in-lieu dividends expense on short positions.
  • The tax-aware, value-momentum, relaxed-constraint strategy tends to realize tax benefits in falling markets and tax costs in rising markets. However, its benefits in falling markets are higher and its costs in rising markets are lower compared to its long-only counterparts—tax-aware, value-momentum, long-only strategy and passively indexed, loss-harvesting strategy. This is because, due to shorting, the relaxed-constraint strategy inherits some of the properties of the very-tax-efficient long-short strategy: The tax-aware, value-momentum, long-short strategy realizes tax benefits in both rising and falling markets, with its tax benefits being even higher in rising markets, when all the beta-one strategies—relaxed-constraint, long-only and passively indexed—tend to realize significant tax costs.
  • While dividend income is a tax drag on all strategies, for the long-short strategy, dividend results are more beneficial because the short positions’ dividend expense partially offsets the interest income from money market instruments held by the long-short strategy.
  • All the tax-aware strategies—relaxed-constraint (such as 130 long/30 short), long-short, long-only and passively-indexed—convey much larger benefits to those investors who have the ability to efficiently use short-term losses and deductions realized by the strategies against short-term gains and ordinary income from other strategies in their investment portfolio.

Importantly, the new result of Sosner, Krasner and Pyne’s study is that, with the exception of the first few years, in an average year, all the tax-aware beta-one strategies—relaxed-constraint, long-only and passively-indexed—obtain their tax benefits from character, whereas the tax-aware long-short strategy obtains its tax benefits from both character and deferral.

Moreover, since the tax-aware relaxed-constraint strategy—similar to long-short—benefits from shorting, its character benefit is substantially higher than the character benefits of tax-aware, long-only and passively indexed, loss-harvesting strategies. This result is true in an average year and also in rising and falling market years.

The authors concluded: “Empirical evidence shows that for tax-aware strategies relaxing the long-only constraint results in a drastic increase in their tax benefits and in particular in the character benefit. We thus conclude that tax aware relaxed-constraint strategies are more attractive to taxable investors than their long-only counterparts.”


These findings have important implications for investors willing to consider leverage and shorting as part of their equity strategies.

For example, AQR Capital Management employs the tax-aware stock selection strategy in its Alternative Risk Premia R6 Fund (QRPRX). The short-term capital losses realized by the stock selection strategy help offset short-term capital gains from other strategies’ trading futures, forwards and options.

As a result, despite being an alternative hedge-fundlike investment, QRPRX is expected to be highly tax efficient because it: (1) distributes only a small portion of its economic return as dividends; and (2) those dividends predominantly comprise low-taxed long-term capital gains and qualified dividend income. The tax efficiency of QRPRX allows investors to hold the strategy in taxable accounts. For investors with limited capacity in tax-advantaged accounts, this is an important benefit. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends AQR funds in constructing client portfolios.)

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

When It’s Time to Stop Saving for Retirement

Re-posted from Investopedia

You’ve done all the right things – financially speaking, at least – to get ready for retirement. You started saving early to take advantage of the power of compounding, maxed out your 401(k) and individual retirement account (IRA) contributions every year, made smart investments, squirreled away money into additional savings, paid down debt and figured out how to maximize your Social Security benefits.

Now what? When do you stop saving – and start enjoying the fruits of your labor?

A Nice Problem to Have (But a Problem All the Same)

Many people who have saved consistently for retirement have trouble making the transition from saver to spender when the time comes. Careful saving – for decades, after all – can be a hard habit to break. “Most good savers are terrible spenders,” says Joe Anderson, CFP, president of Pure Financial Advisors, Inc. in San Diego.

It’s a challenge most Americans will never face: More than half (55%) are at risk of being unable to cover essential living expenses – housing, healthcare, food and the like – during retirement, according to a recent study from Fidelity Investments.

Even though it’s an enviable predicament, being too thrifty during retirement can be its own kind of problem. “I see that many people in retirement have more anxiety about running out of money than they had working very stressful jobs,” says Anderson. “They begin to live that ‘just in case something happens’ retirement.”

Ultimately, that kind of fear can be the difference between having a dream retirement and a dreary one. For starters, penny-pinching can be hard on your health, especially if it means skimping on healthy food, not staying physically and mentally active, and putting off healthcare. (For more, see 7 Signs You’re Spending Too Little in Retirement.)

Being stuck in saving mode can also cause you to miss out on valuable experiences, from visiting friends and family to learning a new skill to traveling. All these activities have been linked to healthy aging, providing physical, cognitive and social benefits. (For more, see Retirement Travel: Good and Good for You.)

One reason people have trouble with the transition is fear: in particular, the fear that they will outlive their savings or have medical expenses that leave them destitute. One thing to keep in mind that spending naturally declines during retirement in several ways. You won’t be paying Social Security and Medicare taxes anymore, for example, or contributing to a retirement plan. Plus, many of your work-related expenses – commuting, clothing and frequent lunches out, to name three – will cost less or disappear.

To calm people’s nerves, Anderson does a demo for them: “running a cash-flow projection based on a very safe withdrawal rate of 1% to  2% of their investable assets. Through the projection they can determine how much money they will have, factoring in their spending, inflation, taxes, etc. This will show them that it’s OK to spend the money.”

Another reason some retirees resist spending is that they have a particular dollar figure in mind that they want to leave their kids or some other beneficiary. That’s admirable – to a point. It doesn’t make sense to live off peanut butter and jelly during retirement just to make things easier for your heirs. (For more, see Designating a Minor as an IRA Beneficiary.)

“Retirees should always prioritize their needs over their children’s,” says Mark Hebner, founder and president of Index Fund Advisors in Irvine, Calif.  “Although it is always the desire for parents to take care of their children, it should never come at the expense of their own needs while in retirement. Many parents don’t want to become a burden on their children in retirement and ensuring their own financial success will make sure they maintain their independence.”

When to Start Spending

Since there’s no magical age that dictates when it’s time to switch from saver to spender (some people can retire at 40 while most have to wait until their 60s or even 70+), you have to consider your own financial situation and lifestyle. A general rule of thumb says it’s safe to stop saving and start spending once you are debt-free and your retirement income from Social Security, pension, retirement accounts, etc. can cover your expenses and inflation.

Of course, this approach only works if you don’t go overboard with your spending; creating a budget can help you stay on track. (For more, see The Complete Guide to Planning a Yearly Budget.)

Line in the Sand

Even if you find it hard to spend your nest egg, you’ll have to start cashing out a portion of your retirement savings each year once you turn 70-1/2  years old. That’s when the IRS requires you to take required minimum distributions, or RMDs, from your IRA, SIMPLE IRASEP IRA or retirement plan accounts (Roth IRAs don’t apply) – or risk paying tax penalties. And these aren’t trivial penalties: If you don’t take your RMD, you will owe the IRS a penalty equal to 50% of what you should have withdrawn. So, for example, if you should have taken out $5,000 and didn’t, you’ll owe $2,500 in penalties.

If you’re not a big spender, RMDs are no reason to freak out. “Although RMDs are required to be distributed, they are not required to be spent,” Charlotte A. Dougherty, CFP, of Dougherty & Associates in Cincinnati, points out. “In other words, they must come out of the retirement account and go through the ‘tax fence,’ as we say, and then can be directed to an after-tax account which then can be spent or invested as goals dictate.”

As Thomas J. Cymer, DFP, CRPC, of Opulen Financial Group in Arlington, Va., notes: If individuals “are fortunate enough to not need the funds they can reinvest them using a regular brokerage account. Or they may want to start using this forced withdrawal as an opportunity to make annual gifts to grandkids, kids or even favorite charities (which can help reduce the taxable income). For those who will be subject to estate taxes these annual gifts can help to reduce their taxable estates below the estate tax threshold.”

Since RMD rules are complicated, especially if you have more than one account, it’s a good idea to check with your tax professional to make sure your RMD calculations and distributions meet current requirements.

The Bottom Line

You may be perfectly happy living on less during retirement and leaving more to your kids. Still, allowing yourself to enjoy some of the simple pleasures – whether it’s traveling, funding a new hobby or making a habit of dining out – can make for a more fulfilling retirement.

And don’t wait too long to start: Early retirement is when you’re likely to be most active, as The 4 Phases of Retirement and How to Budget for Them makes clear.

Read more: When It’s Time to Stop Saving for Retirement | Investopedia
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6 Signs You’re Ready to Retire Early

Re-posted from 6 Signs You’re Ready to Retire Early

They’re questions nearly all young and middle-aged workers have asked themselves: Should I leave my job and retire early? What would I need? How do I know I’m ready?

If you’re considering retiring early, you’ll forego not only the headaches of working, but also the additional money earned that could have made your retirement even more comfortable. To help you decide, here are six signs you may be able to retire early instead of continuing to work.

1. Your Debts Are Paid Off

If your mortgage is paid off and you don’t have any loans, credit lines, large credit card balances or other debt, you won’t have to worry about making large payments during retirement. This leaves your savings and retirement income available to enjoy life after work, and free to use in the event of an emergency, rather than having it tied up in paying off large bills.

2. Your Savings Exceed Your Retirement Goals

You planned, set a goal for retirement savings and now your investments meet or exceed the amount you were hoping to save. This is another good sign you could take early retirement. However, keep in mind that if you do leave work several years before you planned to, your savings must be enough to cover these additional retirement years. If you didn’t set up your retirement savings plan for an early retirement, you will need to recalculate the length of your savings, including these additional years. Also, depending on your age, you may not yet be eligible for Social Security or Medicare. Your savings will need to cover your expenses until you reach the eligible age.

“Think ‘Rule 25.’ Prepare to have 25 times the value of your annual expenses,” says Max Osbon, partner at Osbon Capital Management in Boston, Mass. “Why 25? It’s the inverse of 4%. At that point, you only need to achieve a 4% return per year to cover your annual expenses in perpetuity.”

3. Your Retirement Plans Don’t Have an Early Withdrawal Penalty

No one likes to pay unnecessary penalties, and early retirees going to a fixed income are no different. If your retirement savings include a 457 plan, which doesn’t have an early withdrawal penalty, retiring early and withdrawing from the plan won’t cost you extra in penalties; but take note – you’ll still pay income tax on your withdrawals.

There’s also good news for wannabe early retirees with 401(k)s. If you continue working for your employer until the year that you turn 55 (or after), the IRS allows you to withdraw from only that employer’s 401(k) without penalty when you retire or leave, as long as you leave it at that company and don’t roll it into an IRA. However, if your 59th birthday was at least six months ago, you’re eligible to take penalty-free withdrawals from any of your 401(k) plans. These policies generally apply to other qualified retirement plans besides a 401(k), but check with the IRS to be sure yours is included.

“There is a caution, however: If an employee retires before age 55 [except as noted above], the early retirement provision is lost, and the 10% penalty will be incurred for withdrawals before age 59-1/2,” says James B. Twining, CFP, founder and CEO of Financial Plan, Inc., in Bellingham, Wash.

A third option for penalty-free retirement plan withdrawals is to set up a series of substantially equal withdrawals over at least five years, or until you turn 59-1/2, whichever is longer. Like withdrawals from a 457 plan, you’ll still have to pay the taxes on your withdrawals.

If your retirement plans include any of the above penalty-free withdrawal options, it’s another point in favor of leaving work early.

4. Your Healthcare Is Covered

Healthcare can be incredibly costly, and early retirees should have a plan in place to cover health costs during the years after retiring and before becoming eligible for Medicare at age 65. If you have coverage through your spouse’s plan, or if you can continue to get coverage through your former employer, this is another sign that early retirement could be a possibility for you. Take a look at the cost of an ambulance ride, blood test or monthly, non-generic prescription to get an idea of how quickly your health costs can skyrocket.

Another option for early retirees is to purchase private health insurance. If you have a Health Savings Account (HSA), you can use tax-free distributions to pay for your out-of-pocket qualified medical expenses no matter what age you are (though if you leave your job, you won’t be able to continue making contributions to the HSA). It is too early to say how health insurance and its costs will change and how affordable private healthcare will soon be, given President Trump’s and the Republican Congress’s goal of repealing the Affordable Care Act. Keep in mind that COBRA may extend your healthcare coverage after leaving your job, though without your former employer’s contributions to your insurance coverage, your costs with COBRA may be higher than other options. To learn more, see What You Need to Know About COBRA Health Insurance.

5. You Can Currently Live on Your Retirement Budget

Retirees living on fixed incomes including pensions and/or retirement plan withdrawals usually have lower monthly incomes than they did when they were working. If you have already practiced sticking to your retirement income budget for at least several months, then you may be one step closer to an early retirement. If you haven’t tried this yet, you may be in for a shock. Test out your reduced retirement budget to get an immediate sense of how difficult living on a fixed income can be.

“Humans do not like change, and it is hard to break old habits once we have become accustomed to them. By ‘road-testing’ your retirement budget, you are essentially teaching yourself to develop daily habits around what you can afford in retirement,” says Mark Hebner, founder and president of Index Fund Advisors, Inc., in Irvine, Calif., and author of “Index Funds: The 12-Step Recovery Program for Active Investors.”

6. You Have a New Plan or Project for Retirement

Leaving work early to spend long days with nothing to do will lead to an unhappy early retirement, and can also lead to increased spending (shopping and dining out are sometimes used to fill the time). Having a defined travel, hobby or part-time employment plan or even the outline of a daily routine can help you ease into early retirement. Perhaps you’ll replace sales meetings with a weekly golf outing or volunteering, and add daily walks or trips to the gym. Plan a long-overdue trip, or take classes to learn a new activity.

If you can easily think of realistic, non-work-related ways to enjoyably pass your days, early retirement could be for you. In the same way that you test-drive your retirement budget, try taking a week or more off work to spend your days as you would in retirement. If you become bored with long walks, daytime TV and hobbies within a week, you’ll certainly get antsy in retirement.

The Bottom Line

When it comes to deciding if you should retire early, there are several signs to watch for. Being debt-free, with a healthy retirement account that will support your extra years not working is critical. In addition, if you can withdraw from retirement accounts without penalty, get access to affordable healthcare coverage until Medicare kicks in and have a plan to enjoy your time not working while living on a retirement budget, you just may be ready to retire early. The best way to be sure you can successfully make the transition is speaking with your financial professional.

Read more: 6 Signs You’re Ready to Retire Early | Investopedia
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